Introduction: Modern Macroeconomics

- Sources: E. Prescott (2004) The Transformation of Macroeconomic Policy

and Research (Nobel Lecture).R. Lucas (1980) ‘Methods and Problems in Business Cycle Theory” Journal

of Money, Credit and BankingM. DeVroey (2016) A History of Macroeconomics.O. Blanchard and L. Summers (2017) Rethinking Stabilization Policy C. Azariadis (2018) ‘Riddles and Models’ Journal of Economic LiteratureG. Akerlof (2019) ‘What were they thinking then?’ Journal of Economic

Perspectives

- Questions: Why a second macroeconomics course? Why 2 types of macro?

What is ‘Modern’ DSGE-style Macroeconomics?

A Quick History and Overview of Macroeconomics

- Macroeconomic concerns:

- Business cycles: cyclical fluctuations in the economy (recessions, depressions and booms)

- Economic growth: long-run growth in aggregate output and incomes.

- Macroeconomic variables: GDP, price level, inflation, interest rates, wage level, employment, unemployment etc.

-Can we model and explain these variables and so address questions about

business cycles and economic growth?

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Early Economics:

- Pre-industrial revolution:

- economies dominated by agriculture

- cycles? boom: good harvest bust: bad harvest.

- no modern business cycle.

- Growth? not much of an issue pre-1800.

Here’s England (source: G. Clark Farewell to Alms):

- Long cycles in the standard of living but no long-run improvement.

- Classical/Malthusian model: tried to explain this; technological progress only increases population

in the long-run – no effect on living standards.

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- Macroeconomic ideas from early economics?

- The Classical model was concerned with aggregate outcomes but for a very different economy than ours.

- Some early ideas have survived in macroeconomics:

- David Hume: money supply and inflation (neutrality)

- Thomas Malthus: idea that a lack of aggregate demand could cause a ‘glut’ (recession).

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- Industrial revolutions: late 18th and through the 19th century

- Creates a new kind of economy (UK, W. Europe, US, offshoots)

- Larger manufacturing sectors, urbanization, more specialization, more market exchange, financial systems more important.

- Standards of living increasing: growth is normal!

- Cycles? booms, recessions and depressions in these new economies seem to be regular events.

e.g. United States 1854-1919: 16 business cycles !

http://www.nber.org/cycles/cyclesmain.html

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- Explaining the new industrial economy:

- Fall of the Classical model: can’t explain sustained growth in living standards.

- Rise of microeconomics:

- models of exchange through markets; model actions of individual buyers and sellers.

- results in a model of a self-regulating economy (prices adjust to coordinate decisions and clear markets)

- Early ideas on business cycles: several early theories, no dominant view

- Credit markets and finance seem important in early crises.

- credit to farmers, finance and speculation in new industries like railways.

e.g. “Austrians”: cycles of innovation and investment can give rise to booms and busts.

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- Empirical research on business cycles: Wesley Mitchell in the U.S. 1920s-40s

- Empirical definition of a business cycle; stages of business cycles; what happens during a business cycle?

(pre-cursor of NBER business cycle dating: see earlier link)

- Work on defining and measuring aggregate economic variables (GDP, Consumption, Investment, etc.): how do they change over the

cycle?

- Lucas (1980) “Methods and Problems of Business Cycle Behavior” Journal of Money, Credit and Banking summarizes Mitchell’s

findings:

“the central finding ... was the similarity of all peacetime cycles with one another .... in the sense that each cycle exhibits about the same pattern of co-

movements among variables as do the others”

- Others attempt to explain the regularities Mitchell and others documented.

- what underlies the typical cycle?

e.g. early-Keynes – a view focused on aggregate spending components (Treatise on Money, 1930)

- This line of research is displaced by the Great Depression: an atypically severe recession.

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The Great Depression of the 1930s:

- Severe, long-lasting depression in the industrialized countries.

- Seemed inconsistent with a self-regulating economy.

- New approaches needed to explain the Depression.

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- John Maynard Keynes: General Theory of Employment, Interest and Money (1936)

- Business cycles the focus.

- A model where a Depression is caused by a shortfall in Aggregate Demand.

- Causes? ‘animal spirits’, concerns about expecations and financial instability.

- Blanchard and Summers (2017): the lessons of the Great Depression

- The economy can implode

- Aggregate demand is central to such events.

- Need for aggressive demand management policies.

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Old-Style Macroeconomics:

- Keynesian economics: macroeconomics is a separate part of economics.

- Focus on business cycle fluctuations.

- Short to medium-run focus: length of the business cycle – economy in the next few years. (not long-term growth)

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US Output Gap as % of Potential GDP 1949-2013

[ Output gap: Actual GDP -Potential GDP (<0 recession) ]

- Arises as a response to the Great Depression of the 1930s.

- Recessions and depressions occur due to a shortfall of demand,

- Stabilization policy: governments can manage aggregate demand to prevent or cure recessions

- Fiscal policy (government spending, tax and transfer policies)

- Monetary policy: money supply control & short-term interest rates.

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- Key figures in the development of the model late-1930s to late 1960s:

J.M. Keynes (1936) General Theory of Employment, Interest and Money.

J.Hicks (1937) “Mr.Keynes and the Classics” Econometrica. IS-LM model.

Paul Samuelson (1948): Keynesian macroeconomics in a first-year text.

Samuelson, James Tobin, Franco Modigliani, Milton Friedman:1950s-1960s

Macroeconometric forecasters e.g. Duesenberry, Klein, Cowles Foundation

- Parts of the resulting model:

Aggregate Demand: - Model the components of aggregate spending (Consumption;

Investment; Government spending and Net Exports).

- Goods market equilibrium: production adjusts to meet aggregate spending while allowing for the interdependence of output,

income and spending)

- IS-LM allows for effects of interest rates and money on spending.

- Price level affects demand via real money supply and interest rates.

Aggregate Supply: - Rigid nominal wage: is above market clearing level.

- Price level changes affect real wages, employment and supply of

output (via aggregate production function)

- Together AD and AS give rise to short-run equilibrium.

Phillips curve relationship and longer run effects: - describes how wages that are rigid in the short-run adjust (respond to

level of unemployment or the output gap)

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- Methods and Modelling approaches:

- Focus on aggregate relationships

- modelling the spending components of the National income constraint (Y=C+I+G+X-M).

- “sensible”, "intuitive" stories justifying relationships

- relationships suggested by the data

e.g. Phillips Curve.

- wage rigidity: also suggested by the data

- Typically these relationships were not derived from models of individual behavior.

i.e. no, or limited, “microfoundations”. Is this "ad hoc"?

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An example: Income-Expenditure Model (underlies IS curve in IS-LM)

AE = C(Y,r) + I(r) + G

AE = aggregate expenditures on final goods and servicesC = consumption spending by householdsI = investment spending by businessesG = government spending on final goods and servicesY = Total Income in the economy (GDP), r=interest rateC(Y,r) is the consumption function (an aggregate relationship)I(r) investment function also an aggregate relationship.

Equilibrium: AE = Y

Gives: Y = C(Y,r) + I(r) + G

(relationship between Y and r where goods market is in equilibrium -- IS curve! )

LM curve: starts with another aggregate relationship the real money demand function. MD/P=MD(Y,r).

etc.

- Econometric methods used to fit aggregate relationships to the data: gives rise to forecasting models.

Klein and Goldberger (1955) An Econometric Model of the United States, North Holland Press. A famous early example.

A current example is Ray Fair’s (Yale U.) US Model see especially the equations by sector starting on page 9:

https://fairmodel.econ.yale.edu/wrkbook/yavapa.pdf

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- Tensions:

Demand-side focus -- can supply changes create cycles too?

Short-run focus: what about the macroeconomy in the long-run? (growth)

Active role for government: unattractive to some (political views and this)

Methods: logically unsatisfactory? "ad hoc" relationships.

Missing pieces? Financial instability and expectations – both important to Keynes but not key in the Keynesian model.

- Keynesian model: models an economy in recession.

- too focused on the Great Depression? is it a good model of a typical cycle?

- what about economies that are near full employment?

Are simple Keynesian models inadequate for such economies?

Are Supply-side issues more important near full-employment?

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Problems of the 1970s: a Challenge to the Traditional Keynesian Approach

- 1970s: rising inflation:

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- Stagflation and the OPEC oil price shocks

- rising unemployment and inflation: vs. Phillips curve.

- supply-side changes might explain it ! (supply-side recession?)

- Productivity slowdown later 1970s:

US Labour Productivity Average Annual growth rate:1947-55 3.4% 1975-85 1.7% 2005-15 1.51955-65 2.7% 1985-95 1.6%1965-75 2.4% 1995-05 3.0%

- more interest in economic growth and the long-run.

- growth models needed. Supply-side explanations of productivity?

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Growth or Cycles? US Real GDP vs. Potential GDP 1949-2013

- Is economic growth more important than cycles?

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Response 1: Adapt "Traditional Macroeconomics"

- Alter the models to address tensions above and new problems in the data.

- More attention to "Aggregate Supply": adapt the traditional models.

- Late 1960s Phelps and Friedman: thinking about inflation expectations and the Phillips curve.

(Expectations-Augmented Phillips curve)

- Lucas, Sargent in the early 1970s: how are expectations formed?

- Late 1970s-early 1980s and new consensus Aggregate Demand – Aggregate Supply model is developed.

- Dornbusch and Fischer intermediate macroeconomics text.

- models with a Keynesian short-run and a self-regulating, supply response in the long-run.

- models with a long-run equilibrium ‘natural rate of unemployment’ determined by ‘frictions and imperfections’ of the labour market.

- Macroeconometric forecasting models.

- incorporated and still often incorporate this structure.

- fit aggregate relationships to the data.

- simultaneous equation forecasting models.

(see for example Ray Fair’s site: http://fairmodel.econ.yale.edu/mmm1.htm)

- success for a macroeconomist: to have their equation included in standard forecasting models (Prescott, 2004)

- This approach still dominates much of undergraduate and policy macro.16

Response 2: Abandon Traditional Macroeconomics

- Tensions, issues raised by the 1970s, 1980s lead to new types of models. Why?

- Logical dissatisfaction

- Ad hoc nature of aggregate relationships

- Ad hoc expectations assumptions: should be forward-looking and rational.

- Lucas critique:

- parameters of aggregate relationships are unstable.

(reflect decision-makers' responses to the environment they face)

- parameters change as environment (including policy rules) changes

- Consequence: models are not useful for forecasting.

Robert Lucas (U. Chicago)

- Indeed old-style macroeconometric models are ‘inconsistent with dynamic microeconomic theory’.

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- Logical appeal of a macroeconomic model built from the ground up.

- model each decision-maker in the economy.

- economy is the outcome of interaction between these individuals.

- Looks to the successes of general equilibrium modelling 1950s-60s(microeconomics): Arrow-Debreu model, methods.

- Inconsistencies with microeconomics: also motivate new approaches

- different methods

- different results:

- invisible hand (micro) vs. Keynesian stabilization policy.

- old macroeconomics: greater government role.

- Political leanings affect attitudes to traditional macroeconomics.

- Technical and computational methods

- these had advanced significantly since Keynes’ day.

- had expanded our ability to construct model economies with microfoundations. (see Lucas, 1980)

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The Rise of Modern Macroeconomics:

- Early work in 1970s: rational expectations; initial attempts at ‘Equilibrium Business Cycle’ models (e.g. Lucas, 1972)

- 1980s to early 1990s new approach develops and spreads

- Becomes the dominant approach in: theoretical macroeconomic researchPh.D. level macroeconomics trainingbut not in forecasting and often not in policy

- Some major figures:

Edward Prescott Robert Lucas

- Focus on "microfoundations":

- microeconomic approach to macroeconomics

- models of rational behavior by households and businesses

- macroeconomic relationships should be derived from individual behavior.

- Azariadis (2018): Models stress market clearing and rational expectations.

- Dynamic stochastic general equilibrium (DSGE) models. 19

- Models are dynamic (D in DSGE):

- focus on decision-making over time: current decisions depend on past decisions and expectations about the future.

- optimal intertemporal adjustment to shocks.

- explanations of economic growth a natural part of a dynamic model.

- Models are typically stochastic (S):

- uncertainty: economies are subject to stochastic shocks.

- expectations and expectations formation important.

- focus is on forward-looking decision making with ‘rational expectations’.

- Early models are equilibrium models (GE):

- market-clearing assumptions; focus on flexible prices and market-clearing.

- Lucas wants an equilibrium model of business cycles: cycles are optimal, dynamic responses to shocks

- Real Business Cycle (RBC) approach:

- can supply (productivity) or other real shocks explain business cycles?(vs. Keynesian views that highlight aggregate demand)

- focus is on the typical cycle (was Keynesian focus on the Great Depression a wrong turn? )

- cycles in these models will be equilibrium cycles and will reflect decisions of rational decision-makers acting optimally.

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(Welfare economics: competitive equilibria are efficient, so are cycles efficient?)

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- RBC seminal paper: F. Kydland and E. Prescott (1982) “Time to Build and Aggregate Fluctuations” Econometrica v. 50,

1345-1370.

- three innovations (according to Rebelo, 2005):

(1) Business cycles can be studied with dynamic general equilibrium models (rationality, optimizing decision-makers,

competition);

(2) Unifies business cycles and growth theory: business cycle models must be consistent with empirical regularities of long-run growth;

(3) Evaluation: - calibrate models with parameter estimates drawn from

microeconomic literature or using long-run properties of the economy;

- use the calibrated model to create artificial data that can be compared to patterns in actual data.

- Much of modern macroeconomics follows this approach.

- Prescott’s (2004) Nobel Prize lecture:

“Models after the transformation are dynamic, fully articulated model economies

in the general equilibrium sense of the word economy. Model people maximize

utility given the price system, policy, and their consumption possibility set;

firms maximize profits given their technology set, the price system, and policy;

and markets clear. Preferences, on the one hand, describe what people choose

from a given choice set. Technology, on the other hand, specifies what outputs

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can be produced given the inputs. Preferences and technology are policy invariant.

They are the data of the theory and not the equations as in the system-of-equations

approach. With the general equilibrium approach, empiricalknowledge is organized around preferences and technology, in sharp

contrastto the system-of-equations approach, which organizes knowledge

aboutequations that specify the behavior of aggregations of households and

firms.”

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New Keynesian models:

- Dissatisfaction with the new RBC approach growing in 1990s/2000s:

- RBC approach seems to be insufficient to explain actual business cycles.

- recessions are too persistent;

- money and monetary factors: empirically important but not in RBCs.

- Shocks in RBC models: productivity, depreciation and taste shocks

- are these plausible causes of actual recessions?

- Are RBC "microfoundations" the right "microfoundations"?

- RBC: competitive equilibrium models

rational expectations or perfect foresight

representative agent models etc.

- New Keynesian approach

- adopt approaches and tools of "modern macroeconomics"( Dynamic Stochastic General Equilibrium approach )

- Add sticky prices and or wages.

- "microfoundations" for these are provided.- models of price setting under imperfect competition. - contracting models.

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- Monetary policy receives much attention: interest rate setting rules; non-neutrality and characterizing optimal policy (low or zero inflation)

- Recent years: attempts to develop New Keynesian DSGE forecasting models.

e.g. a seminal paperSmets and Wouters (2007) “Shocks and Frictions in US Business

Cycles: A Bayesian DSGE Approach." American Economic Review, 97(3).

- The RBC - New Keynesian debate is ongoing.

- Modellers are extending and adapting the models to deal with shortcomings

(major efforts since the Financial crisis and recession of 2008-10; see Blanchard (2016) ‘Do DSGE Models Have a

Future’) .

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A Last Word? US and Europe -- Financial crisis 2007-08 and resulting recession

- Did old-style macroeconomics proved more useful in thinking about the recession?

- Paul Krugman (NY Times and Economics Nobel) says yes.

(http://krugman.blogs.nytimes.com/2011/09/26/lucas-in-context-wonkish/?_r=0)

- Was this an atypical recession? (like the Great Depression)

- origins in a financial crisis (like the Great Depression);

- Is Japan 1990s-2000s another such atypical recession?

- Is this the new normal? ‘secular stagnation’ (http://larrysummers.com/category/secular-stagnation/ )

- Changes in DSGE approach underway:

- versions with fuller models of the financial sector

O. Blanchard: usual pre-crisis model -- financial sector just a set of arbitrage

conditions.

More focus on financial instability as a source of recessions (a move back to Keynes according to Akerlof)

- will we see new and better DSGE models in the next few years?

- Another revolution in macroeconomics?

- will other approaches arise?

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