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Stefan Niemann

Course Organization

I Contact time:

I Lecture: Thursday, 14:00-16:00

I Class: Friday, 13:00-14:00

I Email: sniem@essex.ac.uk

Assessment

I Coursework:

I compulsory midterm test on Thursday 17th December,

17:00-19:00

I optional term paper, submission by Friday 22nd January, 12:00

I Exam:

I 2 hours, during the summer term

I EITHER 50% coursework mark, 50% exam mark

I OR 100% exam mark

Reading

I Textbook:

I Romer, D. (2006): Advanced Macroeconomics, 3rd Edition,

McGraw-Hill.

I Supplementary readings:

I Barro, R.J. and X. Sala-i-Martin (2004): Economic Growth,

2nd Edition, MIT Press.

I Blanchard, O. and S. Fischer (1989): Lectures on

Macroeconomics, MIT Press.

I Obstfeld, M. and K. Rogoff (1996): Foundations of

International Macroeconomics, MIT Press.

I Wickens, M. (2008): Macroeconomic Theory: A Dynamic

General Equilibrium Approach, Princeton University Press.

I Journal articles as indicated.

Agenda

3. Investment

4. Unemployment

5. Economic Growth

Growth and Business Cycles

United States: Real GDP per Working-Age Person

12.499

800

11.499

400

index (1900=100)

10.499

200

100

9.499

50

8.499

1900 1910 1920 1930 1940 1950 1960 1970 1980 1990 2000

year

Stefan Niemann EC 904 Macroeconomics - Lecture 1

Business Cycle Statistics

Table 14.2a: Macroeconomic volatility in the United

Kingdom and the United States

Note: Based on quarterly data from 1947Q1 to 2003Q4. 24 end-point

observations excluded.

Sources: Bureau of Economic Analysis, Bureau of Labor Statistics, Federal Reserve Bank of St. Louis.

Business Cycle Statistics

Table 14.3a: Macroeconomic correlations, leads and

lags in the United Kingdom and the United States

Note: Based on quarterly data from 1947Q1 to 2003Q4. 24 end-point observations excluded. Sources: See Table 14.2 .

Economic Fluctuations

I alternative models of economic fluctuations:

I RBC approach: emphasis on aggregate supply, together with

propagation mechanisms via intertemporal substitution and

capital accumulation

I Keynesian tradition: emphasis on aggregate demand,

together with the assumption of stickiness in nominal prices

and/or wages

I further reading: Mankiw (1989, JEP)

I investigate aggregate demand

I consider alternative assumptions about the form of nominal

rigidities

I provide microfoundations

Background: Models of Incomplete Nominal Adjustment

I Romer, chapter 5

1. Aggregate Demand

3. Output-Inflation Tradeoffs

Aggregate Demand

The IS Curve

I then, output and interest rate determined by two equations:

I demand for goods

I money market

E = E (Y , r , G , T ), (1)

often: E = C (Y − T ) + I (r ) + G

Aggregate Demand

The IS Curve

I from NIPA: expenditures = output, i.e., E =Y

I hence:

Y = E (Y , r , G , T ) (2)

Planned

Expenditure

E=Y

45°

Output

Aggregate Demand

The IS Curve

I since Er < 0, an increase in the interest rate r shifts the

planned expenditure schedule E (·) down in (Y , E ) space

I get downward-sloping IS curve in (Y , r ) space

Interest

Rate

IS

Output

Figure I-1. The Macroeconomics - Lecture 1

Curve

Aggregate Demand

The IS Curve

I algebraically:

Y = E (Y , r , G , T )

dY dY

|IS = Ey |IS + Er

dr dr

dY Er

|IS = , (3)

dr 1 − EY

where 0 < EY < 1 and Er < 0

needed to restore the equality of E and Y is larger than the

fall in E at a given Y

Aggregate Demand

The Money Market

M

= L (r + π e , Y ) , (4)

P

where Lr +πe < 0, LY > 0

I two more or less equivalent approaches:

1. exogenous money supply: LM curve

I with completely fixed prices have P = const. and π e = 0, so

LM curve upward-sloping in (Y , r ) space

I interest rate rule r = r (Y , π), with rY > 0, rπ > 0, so MP

curve upward-sloping in (Y , r ) space

Aggregate Demand

Equilibrium in (Y , r ) Space

Interest

Rate

MP

IS

Output

Stefan Niemann EC 904 Macroeconomics - Lecture 1

Aggregate Demand and Aggregate Supply

of aggregate demand (AD) and aggregate supply (AS)

with πY ≥ 0 (SRAS)

I AD curve is derived from IS and MP (or LM) curves:

I consider rise in inflation

I E (·) unaffected; IS unchanged

I but interest rate rule r = r (Y , π) affected, so CB sets higher

interest rate for any given level of output; MP shifts up

IS-MP Model

Effects of an Increase in Inflation

Interest

Rate

MP1

MP0

IS

Output

Stefan Niemann EC 904 Macroeconomics - Lecture 1

Aggregate Demand and

Diagram: Aggregate

The Supply

ADAS Equilibrium with Un-

employment

πt, Inﬂation

Transit

LRAS

SRAS

• The

calle

tran

rium

π0

• Pro

get

AD

• Pers

y0 y yt, Output

to g

Unemployment, ŷ < 0

• Reca

Suppose there is some shock (unspeciﬁed) in cycle

I Romer (2006,

periodp.229) shows

t = 0 that how

shifts theto

ASdetermine

‘left’. We the

are slope of AD

algebraically

out of equilibrium. What happens in periods

t > 0?, i.e. how do we get back to equilibrium.

Stefan Niemann EC 904 Macroeconomics - Lecture 1

IS-MP Model

Effects of an Increase in Government Purchases

Interest

Rate

MP

IS1

IS0

Output

I dG > 0 shifts AD curveon to

Output and the Interest Rate

the right

I the impact on output and inflation depend on AS; this is

where the adjustment of nominal prices matters

Stefan Niemann EC 904 Macroeconomics - Lecture 1

Alternative Assumptions about Wage and Price Rigidity

I long-run neutrality of money

upward-sloping

I explore implications of nominal wage and price rigidity as well

as characteristics of labor and goods markets:

1. Keynes’s model

2. sticky prices, flexible wages, competitive labor market

3. sticky prices, flexible wages, real labor market imperfections

4. sticky wages, flexible prices, imperfect competition

later

Case 1: Keynes’s Model

P

I implications:

I employment determined by labor demand only, there can be

involuntary unemployment

I AS upward-sloping

I countercyclical real wage in response to aggregate demand

shocks

Case 2: Sticky Prices, Flexible Wages, Competitive Labor

Market

I production as before, but reverse assumptions on stickiness of

wages and prices

s0 W

I flexible wages, labor supply: L = Ls WP , L P >0

constant (= WP ); hence, firms meet demand as long as

marginal cost does not exceed the price; denote the level of

output where P = F W 0 (L) by Y

max (determined via AD)

(involuntary) unemployment

Stefan Niemann EC 904 Macroeconomics - Lecture 1

Case 3: Sticky Prices, Flexible Wages, Real Labor Market

Imperfections

I objective: link from aggregate demand to unemployment

W

= w (L), w 0 (L) ≥ 0

P

I shortcut for labor market frictions: wage bargaining by trade

union, efficiency wages, ...

demand and real-wage function

unemployment

Stefan Niemann EC 904 Macroeconomics - Lecture 1

Case 4: Sticky Wages, Flexible Prices, Imperfect

Competition

W

P = µ(L)

F 0 (L)

I µ(L) is markup of prices over marginal costs

W F 0 (L)

I assumtions on µ(L) determine cyclicality of P = µ(L)

W

I if µ(L) is sufficiently countercyclical, P becomes procyclical

I if labor supply is more than level of employment determined by

AD and AS, get unemployment

Output-Inflation Tradeoffs

I previous models are based on nominal rigidities

I if nominal wages and/or prices are predetermined, the models

imply a permanent tradeoff between output and inflation

I consider model 1 (fixed wages, flexible prices, comp. markets):

0 00

Yt = F (Lt ), F (Lt ) > 0, F (Lt ) < 0 (5b)

Wt

F 0 (Lt ) = (5c)

Pt

I combine:

APt−1 A

F 0 (Lt ) = = (6)

Pt 1 + πt

I equation (6) implies a stable upward-sloping relationship

between employment (output) and inflation (Phillips Curve)

Stefan Niemann EC 904 Macroeconomics - Lecture 1

TheFigure 18.1a:

Phillips CurveThe Phillips Curve in the United Kingdom,

1861–1913

Source: Figure 1 of A.W. Phillips, ‘The Relation between Unemployment and the Rate of Change of Money Wage

Rates in the United Kingdom, 1861–1957’, Economica, New Series, 25 (100), Blackwell Publishing, (Nov., 1958),

pp. 283–299. Figure: The Phillips Curve in the UK, 1861-1913. Slide 1/1

©The McGraw-Hill Companies, 2005

The Phillips

Figure 18.2a: Curve

The Phillips curve in the United States of the 1960s

Source: R.B. Mitchell, International Historical Statistics, Macmillian, 1998; and Bureau of Labor Statistics.

Figure: The Phillips Curve in the US, 1960s.

©The McGraw-Hill Companies, 2005 Slide 1/3

The Natural Rate

I conceptionally: natural rate hypothesis

I in the long-run, behavior of real variables is determined by real,

not nominal forces

I if policymakers systematially try to exploit the supposed

tradeoff, then this will be understood by the public

I there exists a ”natural” rate of unemployment, i.e., LRAS is

vertical

Figure 18.2b: The breakdown of the simple Phillips curve

The Phillips Curve? in the United States

Source: R.B. Mitchell, International Historical Statistics, Macmillian, 1998; and Bureau of Labor Statistics.

Figure: The Phillips Curve in the US, 1961-1980. Slide 1/4

©The McGraw-Hill Companies, 2005

The Expectations-Augmented Phillips-Curve

not affect output in the long-run

I but what about AS in the short-run?

I New Keynesian models differ from (5a)-(5c) in that they (i) do

not assume prices and wages to be completely fixed, (ii) allow

for supply shocks, and (iii) adjustment processes are not

backward-looking as in (5a)

I expectations-augmented Phillips-Curve:

(7)

The Expectations-Augmented Phillips-Curve

I version 1: λ > 0,

where core inflation: πt∗ = πt−1

I permanent tradeoff between output and changes (rather than

level) of inflation - accelerationist Phillips Curve

I however: natural rate critique still applies

I version 2: λ > 0,

where expected inflation: πte = ...

I formation of expectations crucial

I under rational expectations: policy ineffectiveness

I version 3:

πt = φπte + (1 − φ)πt−1 + λ ln Yt − ln Ȳt + εSt ,

0≤φ≤1

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