overview of macroeconomic analysis · 2019. 1. 3. · course details contact: 1 lectures: 2...

Overview Of Macroeconomic Analysis

Dudley Cooke

Trinity College Dublin

Dudley Cooke (Trinity College Dublin) Overview Of Macroeconomic Analysis 1 / 39

Course Details

Contact:

1 Lectures: 2 lectures a week [tuesdays, 1800 in Rm. 2039 andwednesdays, 0900 in Rm. 2041B]

2 Classes: 1 class every two weeks, with problem set to solve (I will alsobe the TA this semester)

Office Hours: Fridays, 1600-1800; Email: [email protected]

Assessment:

1 Mid-Term - 10%

2 Summer Exam - 90%


Reading

Main text: Sørensen, Peter Birch, and Hans Jørgen Whitta-Jacobsen2005. Introducing Advanced Macroeconomics: Growth andBusiness Cycles, McGraw-Hill.

Alternative texts: Romer’s book ‘Advanced Macroeconomics’ coversthe same topics at a higher level (not required reading); likewiseMankiw’s book ‘Macroeconomics’ is at a lower level.1

Lecture notes: on my webpage.

1E.g., the consumption topic is covered in Romer ch. 7 and Mankiw ch. 16.Dudley Cooke (Trinity College Dublin) Overview Of Macroeconomic Analysis 3 / 39

EC3010 Topic 1: Historical Overview and Stylized Facts

Reading

SWJ Ch. 14 and Stock and Watson (2003), FRB Kansas Citysymposium, Jackson Hole, Wyoming (on Kansas City Fed webpage).

Plan

Course Overview

Historical Perspective

Measuring Business Cycles/stylized facts


Approach

What we want to do:

Build a model of the macro economy based on solid (microeconomic)foundations.Build a model of the macroeconomy that fits the facts (time-seriesdata).Consider transmission of different ‘macro’ shocks and policy issues.

What we don’t want to do: Make ad-hoc assumptions or ignore thedata.

Broadly, in this course, we’ll consider:

Time series properties of the data.Consumption and investment.Monetary policy rules.Monopolistic competition and nominal rigidities.Expectations and design of monetary policy.


EC3010 Topic 1A

Historical Perspective.

Loosely based on Blanchard’s (2000) QJE paper.


Development Of Modern Macroeconomics

We can identify three broad periods for macroeconomics.

1 Pre-1940: Right ideas, no framework.

2 1940-1980: Development of the IS-LM framework and models of thebusiness cycle.

3 Post-1980: Role of market imperfections (i.e., micro behind macro).

Economists took various positions/schools of thought: Classicals,Keynesians, Monetarists, New Classicals, Real Business Cycle andNew Keynesian approaches.

Very recently: much more quantitative approach to macroeconomics(following from the RBC tradition). Post-crisis, now heavilycriticized.


Pre-1940 Period

Macroeconomists engaged in two largely unconnected strands ofthought:

1 Monetary theory: MV = PY type reasoning - looks reasonable in thelong-run.

2 Business cycle statistics covering real and monetary factors: largelydescriptive, and not integral to theory.

The missing links:

1 The natural rate of interest (i.e. the rate of return on capital).

2 The money rate of interest (i.e. the rate of return on bonds).

John Maynard Keynes provided the connections/integrated theory(followed by Hicks’ exposition).


Pre-1940: The Great Depression

In 1929, the US stock market crashed. 25% drop in prices, 25%unemployment in the US. The same thing happened in otherindustrialized countries.

The US and other countries used macroeconomic policies to attemptto stimulate economic activity - not enough/didn’t work - welldocumented.

Prior to that, the economy had seemed to go along by itself prettysmoothly. Panics were rare and short-term.

When macro policy ‘succeeded’ in the Great Depression, governmentscontinued to apply it in less extreme circumstances.

In the UK, Keynes advocated the use of demand-side policies, i.e.‘demand management’ of the economy by the government tocompensate for swings in consumer demand.


Pre-1940: Keynes And The General Theory

That is, we should think of macro as a subject born out of the greatdepression.

The links that Keynes’ General Theory provided basically connectedthree markets:

1 Goods market: Changes in savings and investment lead to changesin Y . The vehicle: consumption function, ‘IS curve’, and real interestrate.

2 Financial market: Households have access to bonds and money:described through the ‘LM curve’ and the nominal interest rate.

3 Labor market: There is some form of disequilibrium. For example,wages are sticky and labour is demand determined. Markets do notclear, so unemployment may result.


1940-1980 Period

Economists addressed four big issues:

The further development of the ISLM model: That is, thefollowing variety:

Y = C (Y − T ) + I (r) + G

M

P= L (Y , i)

Conceptual issues:

Classical DichotomyWalras’ LawLoanable Funds vs. Liquidity Preference


1940-1980 Period

Dynamics

Central to the further development of the consumption function -saving decision is intertemporal. Explicitly model time.

Paved the way to help model the business cycle (as opposed todescribe it).

Expectations formation reconsidered

Rational Expectations were introduced. Agents in the economy nowassumed to think about the future and use all information to makeforecasts.

This helped clarify the differences between anticipated andunanticipated policies, and highlight the role of credibility.


1940-1980: Time And Quantitative Models

More generally, macroeconomists used static ad-hoc/descriptivemodels less and used dynamic optimizing models with ‘shocks’ andrational agents more.

There was also a shift away from qualitative to quantitative analysis.

Models could now explain by how much the interest rate fell - notjust whether the interest rate fell - when the money supply rose.

The same principle applies to other economic relationships we hadalready discovered.


1940-1980: Disputes And Unresolved Questions

There was a basic problem with the standard Keynesian models.They postulated that the nominal wage was rigid. But there was noreason to assume this. No justification other than casual observation.

The careful analysis of savings and investment was thereforecompromised by the ad-hoc approach to the labor market.

When Robert Lucas popularized the theory of Rational Expectations,there was a split:

New Classical macroeconomists thought they could model theeconomy reasonably well without market imperfections and rigidities.Keynesian macroeconomists thought market imperfections andrigidities were essential.


1940-1980: The Consequences Of The 1970s

The 1970’s saw a series of exceptional events which again changedideas about the macro economy.

The most obvious example are the oil shocks and subsequentstagflation (high inflation and high unemployment) in many countries.These persisted into the early 1980s.

Again, it is clear that some of the big changes in macroeconomicscame about precisely because our old models couldn’t explain the newfacts (essentially catch-up).

We couldn’t explain the Great Depression and we couldn’t explain thereaction of the economy to shocks that occurred in the early to mid1970’s.Seems likely that the current crisis will lead to similar attempts at newtheories to explain big events.


US Unemployment Rate

Source: Ireland, 1999 JME

�King and Watson (1994) "nd that a similar picture emerges when the data are passed through

a "lter that is optimally designed to isolate long-run trends.

Fig. 1. Quarterly in#ation rate and 10-year centered moving average, United States.

1. Introduction

The behavior of the in#ation rate in the United States, as measured by

quarter-to-quarter percentage changes in the GDP implicit price de#ator, is

shown in Fig. 1. The graph serves to identify two major episodes in post-war US

monetary history: the "rst, a period of rising in#ation that extends from the early

1960s through the early 1980s, and the second, a period of falling in#ation that

begins in the early 1980s and continues to the present day. These two long-run

trends appear more clearly in the 10-year centered moving average that is also

displayed in Fig. 1.� Why did US policymakers allow in#ation to drift higher

throughout the 1960s, 1970s and early 1980s? And, conversely, what factors

have contributed to their ability to bring in#ation down more recently?

Barro and Gordon's (1983) celebrated model of time-consistent monetary

policy o!ers answers to these questions. In Barro and Gordon's model, a

policymaker desires to reduce unemployment and, lacking the ability to commit

in advance to a monetary policy rule, is tempted to do so in each period by

creating surprise in#ation in an e!ort to exploit an expectational Phillips curve.

Private agents in the model have rational expectations, however; they recognize

that the government faces this temptation to in#ate and adjust their decisions

accordingly. In equilibrium, therefore, unemployment is no lower than it would

otherwise be, and yet the rate of in#ation is ine$ciently high. Moreover, given

the convex costs assigned to unemployment in the model, the policymaker'stemptation to in#ate } and hence the magnitude of the in#ationary bias itself

280 P.N. Ireland / Journal of Monetary Economics 44 (1999) 279}291


Post-1980 Period

Economists addressed two major questions. The course will covereach of these:

1 Why does money affect output, and what role do nominal rigiditiesplay in the relationship?

2 What are the major shocks that affect output, and what are thepropagation mechanisms?

The key to both of these was thought to be developing models basedon micro-economic foundations. Micro-founded models became invogue.

Now (and also at the time) criticized as overly reliant on sophisticatedmaths.


Post-1980: Micro-Foundations

For example, what are the effects of monetary policy?

Say that prices are rigid (P0 = P). The money supply rises(M0 > M). This stimulates aggregate demand via investment andthe interest rate (r0).

But why are prices rigid?

Firms are not perfectly competitive. They have some marketpower to set the price of their goods. In order to maximize theirprofits, they set price over marginal cost, i.e. P > MC .2 Higher MCmeans prices are set at a higher level.

Also, different firms set prices at different times. Many prices areset in discrete intervals, like years. Think about contracts that specifyfixed money amounts. Therefore, the overall price level evolves slowlyover time (i.e., it is sluggish/has inertia).

2Recall that it is optimal for a firm in a PC market to allow P = MC . Imperfectlycompetitive firms don’t have to take the market price, though.


Post-1980: Market Imperfections

We need market imperfections. Fortunately for us, few real worldmarkets are perfectly competitive.

If there is monopolistic competition, i.e. imperfect competition, totaloutput will rise when there is a money supply shock.

Why? Output is below the perfectly competitive level and it isdetermined by demand. Monopolists will always be willing to supplymore goods after a shock, as long as the condition P > MC holds.

Why? In that case, they will always be making profits.

We can also apply this reasoning to the price of labour, i.e. thenominal wage rate. That makes Keynes’ original ideas moreappealing.


Post-1980: The Significance Of Micro-Foundations

Micro-founded models do not only allow us to justify Keynesian-typeassumptions, but also:

1 Agents make sensible utility/profit maximizing decisions.

2 We respect their budget constraints.

3 We can measure the welfare implications of macro policies.

4 Our models are ‘internally consistent’.


End Of The 2000s: Financial Crisis

During the very late 1990s and 2000s, the economy seemed to ‘calmdown’. Business cycles in OECD countries were less severe. Manywondered if this was because shocks were smaller, economies functionmore efficiently, or policy was better? This was referred to as theGreat Moderation.

The financial crisis that began in 2007 ended the Great Moderationand began a new period, but we haven’t been in this new situationlong enough to describe its characteristics. Hindsight is useful.

Macroeconomists will try to design models that explain how the crisisstarted and, later, why it became worse than all the other crises since1929.


EC3010 Topic 1B

Business Cycles and Stylized Facts


Interesting Economic Variables

We are interested in GDP, unemployment, investment, consumption,inflation, etc. That is, all the familiar macro variables.

In particular we need to know:

1 how they move together (correlation)

2 and how they change across time (auto-correlation).

Remember that throughout this course, we think of the economy asbeing closed: Y = C + I + G


Business Cycle Analysis

If we are interested in the business cycle, then we need to use timeseries.

Consider United State GDP between 1950 and 2000. This series doestwo things:

1 evolves in an upward direction (i.e. there is a trend).

2 fluctuates around this trend.

The difference between the trend and the fluctuation is the cyclicalcomponent of GDP.

Questions:

1 What caused GDP to move from its trend?

2 How long will it take before GDP reverts to its trend?


Terminology

When GDP at its highest point above trend, in a given period, it is atits peak.

When GDP is at its lowest point below trend, in a given period, it isat its trough.

The length of time between the peak and trough is the businesscycle.

1 Peak to trough phase: contraction (recession)

2 Trough to peak phase: expansion (boom)

For there to be a recession, GDP needs to be consistently below trendfor a given period of time. The US National Bureau of EconomicResearch uses ‘at least two quarters’ as its test.


Measuring Volatility

We can use the standard deviation to measure the amplitude of thefluctuation (i.e. the volatility). That is, for some variable y ,

σy =

√√√√ 1

T

T

∑t=1

(yt − y)2

Great moderation saw a big fall in σy , for example.


Correlation: GDP And Other Variables

If corr (x , y) > 0, then x and y move in the same direction. If y isGDP, then we say x is procyclical. (y moves with the business cycle.)

If corr (x , y) < 0, then x and and y move in opposite directions, andx is countercyclical. (y moves against the business cycle.)

If corr (x , y) ' 0, then x and y are independent, and x is acyclical.

Finally, corr (x , y) ∈ (−1, 1). The larger the absolute value, themore synchronized the variable movements are.


Time Series: GDP As An AR(1) Process

Suppose we want to build a model of the economy based around GDP.

First guess: Use today’s GDP to predict tomorrow’s GDP. We willprobably be wrong, so suppose there is some random error. GDP thenevolves in the following way:

yt = ρyt−1 + Dt (1)

for t = 0, 1, 2, .. where ρ < 1.

The shock term is Dt ∼ N(0, σ2

); that is, it is a normally

distributed random variable. We may over- or under-estimate actualGDP.

We refer to Equation (1) as an autoregressive process of order one.“Order one” comes from there being one lagged term.


Time Series: GDP As An AR(1) Process

This is our first real macro model (doesn’t look like previous macromodels?). Why?

For some given level of GDP, y−1, we can figure out y0, y1, y2, etc.3

We know this model isn’t the best, but if we draw equation (1), weget something that looks like what we see in the data.

That makes figuring out the values of Dt and ρ very important.

3So, yt = ρyt−1 + Dt for t = 1, 2, ... Then, y1 = ρy0 + D1 and y2 = ρy1 + D2, sothat, .y0 = 1/ρ (1/ρ (y1 −D1) + D0). Then keep doing this.


Volatility

Consider the shock: Dt .

From our model, we can see the pattern of the business cycle. Thatis, the ups (Dt > 0) and downs (Dt < 0).

Add a trend to capture growth, say.


AR(1) with trend

0 100 200 300 400 500 600 700 800 900 1000-5

0

5

10

15

20

25

30AR(1) with time trend

Output


Persistence

We can model other features of the economy as well.

Imagine there was a one-off shock in period t = 0. We want to knowhow long it takes for GDP to get back to trend.

As it turns out, the parameter ρ determines time to return to trend.

We can also use the idea of a half-life, as in ‘regular (real?) science’.


Impulse Responses

0 5 10 15 20 25 30 35 40 45 50 55

-2

0

2

4

6

8

10RBC Model: Impulse Responses to Technology Shock

OutputConsumptionInvestmentHours


Causes Of Volatility And Persistence

There is a follow-up problem. Say we believe that our model is agood one. We need to know:

1 Where do the Dt terms come from? Example: A contraction in themoney supply (i.e. contractionary monetary policy) could makeDt < 0.

2 Where does ρ come from? Example: ρ can be high if there are lots oftrade unions. For example, the UK in the late 1970s had powerfultrade unions.

We need some theory to back up our guesses about Dt and ρ. Wealso need to be careful that our model/they captures the right shocks.


Some Stylized Facts

1 Investment is more volatile than GDP. (Why? News.)

2 Employment/unemployment is less volatile than GDP. (Why?Adjustment in labour market)

3 Private consumption and investment are strongly positively correlatedwith GDP.

4 Employment is procyclical, and real wages are weakly correlated withGDP.

5 GDP is persistent (e.g. we have a high ρ, a high autocorrelation/unitroot).

6 Employment is even more persistent than GDP (hysteresis. especiallyin Europe during 1980s).


Summary Of Stylized Facts

x corr (x , y) σx/σy

Consumption > 0 < 1Investment > 0 > 1

Employment > 0 < 1Hrs. per Worker > 0 < 1

Total hrs. > 0 . 1Price Level < 0 < 1

Money Supply > 0 . 1Real Wage > 0 < 1

Av. Labour Prod’y > 0 < 1Real Int. Rate > 0 < 1

Note: corr (x , y) > 0 implies the variable x is procyclical. σx/σy > 1implies the variable x is more volatile than GDP.


Autocorrelations

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Macro Time Series

0 20 40 60 80 100 120 140 160 180 200-50

-40

-30

-20

-10

0

10

20

30

40Volatile Investment and Consumption Smoothing

outputinvestmentconsumption


AD-AS Model

We want an AD-AS model that can explain part of the story.

Note how markets and their interactions affect the lines on ourgraphical models:

Goods Market (consumption and investment) ⇒ IS.

Money Market (money and bonds) ⇒ LM.

IS and LM (with well-specified monetary policy) ⇒ AD.

Labour market (price and wage setting curves) ⇒ AS.


overview of macroeconomic analysis · 2019. 1. 3. · course details contact: 1 lectures: 2...

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