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EC 904: Macroeconomics

Introduction & Background

Stefan Niemann

October 15, 2009

Stefan Niemann EC 904 Macroeconomics - Lecture 1


Course Organization

I Contact time:
I Lecture: Thursday, 14:00-16:00
I Class: Friday, 13:00-14:00

I Course supervisor: Stefan Niemann

I Email: sniem@essex.ac.uk

I Office hours: Friday, 14:00-16:00.

Stefan Niemann EC 904 Macroeconomics - Lecture 1


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 Final mark: whichever is the greater


I EITHER 50% coursework mark, 50% exam mark
I OR 100% exam mark

I Details in Postgraduate Economics Handbook.

Stefan Niemann EC 904 Macroeconomics - Lecture 1


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.

I Lecture notes and additional material posted on the CMR.

Stefan Niemann EC 904 Macroeconomics - Lecture 1


Agenda

1. Models of Incomplete Nominal Adjustment

2. Consumption and Asset Pricing

3. Investment

4. Unemployment

5. Economic Growth

6. Inflation and Money

Stefan Niemann EC 904 Macroeconomics - Lecture 1


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

Source: Kehoe and Prescott (2007).


Stefan Niemann EC 904 Macroeconomics - Lecture 1
Business Cycle Statistics
Table 14.2a: Macroeconomic volatility in the United
Kingdom and the United States

1 Standard deviation relative to standard deviation of GDP.


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.

©The McGraw-Hill Companies, 2005 Slide 1/17

Stefan Niemann EC 904 Macroeconomics - Lecture 1


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 .

©The McGraw-Hill Companies, 2005 Slide 1/23

Stefan Niemann EC 904 Macroeconomics - Lecture 1


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 we will start from the latter:


I investigate aggregate demand
I consider alternative assumptions about the form of nominal
rigidities
I provide microfoundations

Stefan Niemann EC 904 Macroeconomics - Lecture 1


Background: Models of Incomplete Nominal Adjustment

I Romer, chapter 5

1. Aggregate Demand

2. Alternative Assumptions about Wage and Price Rigidity

3. Output-Inflation Tradeoffs

Stefan Niemann EC 904 Macroeconomics - Lecture 1


Aggregate Demand
The IS Curve

I start with extreme assumption: completely fixed prices


I then, output and interest rate determined by two equations:
I demand for goods
I money market

I IS curve: planned = actual expenditures

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

where 0 < EY < 1, Er < 0, EG > 0, ET < 0

often: E = C (Y − T ) + I (r ) + G

I these are ad-hoc assumptions!

Stefan Niemann EC 904 Macroeconomics - Lecture 1


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

C(Y-T) + I(r0) + G + CF(r0)

C(Y-T) + I(r1) + G + CF(r1)

45°

Output

Stefan Niemann EC 904 Macroeconomics - Lecture 1


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

Stefan Niemann EC IS904


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

I multiplier effect: since E depends on Y , the fall in Y


needed to restore the equality of E and Y is larger than the
fall in E at a given Y

Stefan Niemann EC 904 Macroeconomics - Lecture 1


Aggregate Demand
The Money Market

I equilibrium in 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

2. endogenous money supply (Taylor rule): MP curve


I interest rate rule r = r (Y , π), with rY > 0, rπ > 0, so MP
curve upward-sloping in (Y , r ) space

Stefan Niemann EC 904 Macroeconomics - Lecture 1


Aggregate Demand
Equilibrium in (Y , r ) Space

Interest
Rate

MP

IS

Output
Stefan Niemann EC 904 Macroeconomics - Lecture 1
Aggregate Demand and Aggregate Supply

I now, drop assumption of completely fixed prices

I then, equilibrium is determined in (Y , π) space as intersection


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

I AS curve will be analyzed later, for now assume: π = π(Y )


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

I AD curve downward-sloping in (Y , π) space

Stefan Niemann EC 904 Macroeconomics - Lecture 1


IS-MP Model
Effects of an Increase in Inflation

Interest
Rate

MP1

MP0

IS

Output

Figure I-6. The Effects of a Shift to Tighter Monetary Policy


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

Figure I-5. The Effects of an Increase in Government Purchases


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 starting point: LRAS curve is vertical


I long-run neutrality of money

I but nominal rigidities matter in the short-run; hence, SRAS is


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

I frictions simply assumed here; will seek to endogenize them


later

Stefan Niemann EC 904 Macroeconomics - Lecture 1


Case 1: Keynes’s Model

I production: Y = F (L), F 0 (L) > 0, F 00 (L) < 0

I nominal wage predetermined: W = W̄

I competitive labor market: F 0 (L) = W


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

I model is conceptually unsatisfactory and fails empirically

Stefan Niemann EC 904 Macroeconomics - Lecture 1


Case 2: Sticky Prices, Flexible Wages, Competitive Labor
Market
I production as before, but reverse assumptions on stickiness of
wages and prices

I prices and hence inflation predetermined: π = π̄


 s0 W 
I flexible wages, labor supply: L = Ls WP , L P >0

I from individual firm’s perspective, real unit labor costs are


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)

I AS horizontal, rationing for Y D > Y max

I real wage procyclical, markup countercyclical, but no


(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

I setup as for case 2, but introduce real-wage function:


W
= w (L), w 0 (L) ≥ 0
P
I shortcut for labor market frictions: wage bargaining by trade
union, efficiency wages, ...

I again, changes in aggregate demand have real effects

I employment determined by intersection of effective labor


demand and real-wage function

I since real-wage function 6= labor supply, may get involuntary


unemployment
Stefan Niemann EC 904 Macroeconomics - Lecture 1
Case 4: Sticky Wages, Flexible Prices, Imperfect
Competition

I objective: generalize basic Keynesian model

I setup as for case 1, but introduce 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

Stefan Niemann EC 904 Macroeconomics - Lecture 1


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):

Wt = APt−1 , A>0 (5a)


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

Stefan Niemann EC 904 Macroeconomics - Lecture 1


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

Stefan Niemann EC 904 Macroeconomics - Lecture 1


The Natural Rate

I Phillips Curve came under attack in late 1960s/early 1970s


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

I empirically: breakdown of the Phillips Curve

Stefan Niemann EC 904 Macroeconomics - Lecture 1


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

Stefan Niemann EC 904 Macroeconomics - Lecture 1


The Expectations-Augmented Phillips-Curve

I long-run analysis based on fully flexible prices and wages

I LRAS is vertical at Ȳ , i.e. changes in aggregate demand do


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:

πt = πt∗ + λ ln Yt − ln Ȳt + εSt , λ > 0



(7)

Stefan Niemann EC 904 Macroeconomics - Lecture 1


The Expectations-Augmented Phillips-Curve

πt = πt∗ + λ ln Yt − ln Ȳt + εSt ,



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

πt = πte + λ ln Yt − ln Ȳt + εSt ,



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

Stefan Niemann EC 904 Macroeconomics - Lecture 1


Outlook

I Lucas imperfect-information model

I Imperfect competition, price-setting and real rigidity

I Dynamic New Keynesian models

Stefan Niemann EC 904 Macroeconomics - Lecture 1