**Unformatted text preview: **Intermediate Macroeconomics
Julio Gar´ın Robert Lester Eric Sims University of Georgia Colby College University of Notre Dame January 12, 2017 This Version: 1.0.1 This is a book designed for use in an intermediate macroeconomics course or a masters
level course in macroeconomics. It could also be used by graduate students seeking a refresher
in advanced undergraduate macroeconomics. This book represents a substantial makeover
and extension of the course notes for intermediate macroeconomics which have been provided
publicly on Eric Sims’s personal website for several years.
There are many fine textbooks for macroeconomics at the intermediate level currently
available. These texts include, but are certainly not limited to, Mankiw (2016), Williamson
(2014), Jones (2013), Barro (1997), Abel, Bernanke, and Croushore (2017), Gordon (2012),
Hall and Pappell (2005), Blanchard (2017), Dornbusch, Fischer, and Startz (2013), Froyen
(2013), and Chugh (2015).
Given the large number of high quality texts already on the market, why the need for
a new one? We view our book as fulfilling a couple of important and largely unmet needs
in the existing market. First, our text makes much more use of mathematics than most
intermediate books. Second, whereas most textbooks divide the study of the macroeconomy
into two “runs” (the long run and the short run), we focus on three runs – the long run, the
medium run, and the short run. Third, we have attempted to emphasize the microeconomic
underpinnings of modern macroeconomics, all the while maintaining tractability and a focus
on policy. Finally, we feel that a defining feature of this text is that it is, if nothing else,
thorough – we have tried hard to be very clear about mathematical derivations and to not
skip steps when doing them.
Modern economics is increasingly quantitative and makes use of math. While it is important to emphasize that math is only a tool deployed to understand real-world phenomenon,
it is a highly useful tool. Math clearly communicates ideas which are often obfuscated when
only words are used. Math also lends itself nicely to quantitative comparisons of models
with real-world data. Our textbook freely makes use of mathematics, more so than most
of the texts we cited above. An exception is Chugh (2015), who uses more math than we
do. To successfully navigate this book, a student needs to be proficient at high school level
algebra and be comfortable with a couple of basic rules of calculus and statistics. We have
included Appendices A and B to help students navigate the mathematical concepts which
are used throughout the book. While we find the approach of freely integrating mathematics
into the analysis attractive, we recognize that it may not be well-suited for all students and
all instructors. We have therefore written the book where the more involved mathematical
analysis is contained in Part III. This material can be skipped at the instructor’s discretion,
which allows an instructor to spend more time on the more graphical analysis used in Parts
IV and V.
Traditionally, macroeconomic analysis is divided into the “long run” (growth) and the
1 “short run” (business cycles). We have added a third run to the mix, which we call the
“medium run”. This is similar to the approach in Blanchard (2017), although we reverse
ordering relative to Blanchard, studying the long run first, then the medium run, then the
short run. Whereas growth theory studies the role of capital accumulation and productivity
growth over the span of decades, we think of the medium run as focusing on frequencies of
time measured in periods of several years. Over this time horizon, investment is an important
component of fluctuations in output, but it is appropriate to treat the stock of physical
capital as approximately fixed. Our framework for studying the medium run is what we call
the neoclassical model (or real business cycle model). In this framework, output is supply
determined, and the equilibrium is efficient. We think of the short run as focusing on periods
of time spanning months to several years. Our framework for studying the short run is a New
Keynesian model with either sticky prices or wages. Importantly, the only difference between
our medium and short run models is the assumption of price or wage rigidity – otherwise the
models are the same. With price or wage stickiness, demand shocks matter, and the scope
for beneficial short run monetary and/or fiscal policies becomes apparent.
Modern macroeconomics is simply microeconomics applied at a high level of aggregation.
To that end, we have devoted an entire part of the book, Part III, to the “Microeconomics of
Macroeconomics.” There we study an optimal consumption-saving problem, a firm profit
maximization problem in a dynamic setting, equilibrium in an endowment economy, and
discuss fiscal policy, money, and the First Welfare Theorem. The analysis carried out in Part
III serves as the underpinning for the remainder of the medium and short run analysis in the
book, but we have tried to write the book where an instructor can omit Part III should he or
she choose to do so.
Relatedly, modern macroeconomics takes dynamics seriously. We were initially attracted
to the two period macroeconomic framework used in Williamson (2014), for which Barro
(1997) served as a precursor. We have adopted this two period framework for Parts III through
V. That said, our experience suggested that the intertemporal supply relationship (due to
an effect of the real interest rate on labor supply) that is the hallmark of the Williamson
(2014) approach was ultimately confusing to students. It required spending too much time
on a baseline market-clearing model of the business cycle and prevented moving more quickly
to a framework where important policy implications could be addressed. We have simplified
this by assuming that labor supply does not depend on the real interest rate. This can be
motivated formally via use of preferences proposed in Greenwood, Hercowitz, and Huffman
(1988), which feature no wealth effect on labor supply.
We were also attracted to the timeless IS-LM approach as laid out, for example, so
eloquently by Mankiw (2016), Abel, Bernanke, and Croushore (2017), and others. Part V
2 studies a short run New Keynesian model, freely making use of the commonly deployed
IS-LM-AD-AS analysis. The medium run model we develop graphically in part IV can be
cast in this framework with a vertical AS curve, which is often called the “long run supply
curve” (or LRAS) in some texts. Because of our simplification concerning the dynamic nature
of labor supply in Part IV, we can move to the short run analysis in Part V quicker. Also,
because the medium run equilibrium is efficient and the medium run can be understood as a
special case of the short run, the policy implications in the short run become immediately
clear. In particular, policy should be deployed in such a way that the short run equilibrium
(where prices or wages are sticky) coincides with the medium run equilibrium. Monetary
policy ought to target the natural or neutral rate of interest, which is the interest rate which
would obtain in the absence of price or wage rigidities. This “Wicksellian” framework for
thinking about policy is now the dominant paradigm for thinking about short run fluctuations
in central banks. Within the context of the IS-LM-AD-AS model, we study the zero lower
bound and an open economy version of the model. Jones (2013) proposes replacing the LM
curve with the MP curve, which is based on a Taylor rule type framework for setting interest
rates. We include sections using the MP curve in place of the LM curve for instructors
attracted to that approach.
In writing this book, we have tried to follow the lead of Glenmorangie, the distillery
marketing itself as producing Scotch that is “unnecessarily well-made”. In particular, we
have attempted throughout the book to be unnecessarily thorough. We present all the steps
for various mathematical derivations and go out of our way to work through all the steps
when deriving graphs and shifting curves. This all makes the book rather than longer than
it might otherwise be. In a sense, it is our hope that a student could learn from this text
without the aid of a formal instructor, though we think this is suboptimal. Our preference
for this approach is rooted in our own experiences as students, where we found ourselves
frustrated (and often confused) when instructors or textbooks skipped over too many details,
instead preferring to focus on the “big picture”. There is no free lunch in economics, and
our approach is not without cost. At present, the book is short on examples and real-world
applications. We hope to augment the book along this dimension in the coming months and
years. The best real world examples are constantly changing, and this is an area for the
instructor contributes some value added, helping to bring the text material to life.
The book is divided into five parts. Part I serves as an introduction. Chapter 1 reviews
some basic definitions of aggregate macroeconomic variables. While most students should
have seen this material in a principles course, we think it is important for them to see it
again. Chapter 2 defines what an economic model is and why a model is useful. This chapter
motivates the rest of the analysis in the book, which is based on models. Chapter 3 provides
3 a brief overview of the history and controversies of macroeconomics.
We study the long run in Part II. We put the long run first, rather than last as in many
textbooks, for two main reasons. First, growth is arguably much more important for welfare
than is the business cycle. As Nobel Prize winner Robert Lucas once famously said, “Once you
start to think about growth, it is difficult to think about anything else”. Second, the standard
Solow model for thinking about growth is not based on intertemporal optimization, but
rather assumes a constant saving rate. This framework does not fit well with the remainder
of the book, which is built around intertemporal optimization. Nevertheless, the Solow model
delivers many important insights about the both the long run trends of an economy and
the sizeable cross-country differences in economic outcomes. Chapter 4 lays out some basic
facts about economic growth based on the timeless contribution of Kaldor (1957). Chapter 5
studies the textbook Solow model. Chapter 6 considers an augmented version of the Solow
model with exogenous productivity and population growth. Chapter 7 uses the Solow model
to seek to understand cross-country differences in income.
Part III is called the “Microeconomics of Macroeconomics” and studies optimal decision
making in a two period, intertemporal framework. This is the most math-heavy component
of the book, and later parts of the book, while referencing the material from this part, are
meant to be self-contained. Chapter 8 studies optimal consumption-saving decisions in a two
period framework, making use of indifference curves and budget lines. It also considers several
extensions to the two period framework, including a study of the roles of wealth, uncertainty,
and liquidity constraints in consumption-saving decisions. Chapter 9 extends this framework
to more than two periods. Chapter 10 introduces the concept of competitive equilibrium in the
context of the two period consumption-saving framework, emphasizing that the real interest
rate is an intertemporal price which adjusts in equilibrium. It also includes some discussion on
heterogeneity and risk-sharing, which motivates the use of the representative agent framework
used throughout the book. Chapter 11 introduces production, and studies optimal labor
and investment demand for a firm and optimal labor supply for a household. Chapter 12
introduces fiscal policy into this framework. Here we discuss Ricardian Equivalence, which
is used later in the book, but also note the conditions under which Ricardian Equivalence
will fail to hold. Chapter 13 introduces money into the framework, motivating the demand
for money through a money in the utility function framework. Chapter 14 discusses the
equivalence of the dynamic production economy model laid out in Chapter 11 to the solution
to a social planner’s problem. In the process we discuss the First Welfare Theorem.
The medium run is studied in Part IV. We refer to our model for understanding the medium
run as the neoclassical model. It is based on the intertemporal frictionless production economy
studied in more depth in Chapter 11, though the material is presented in such a way as to be
4 self-contained. Most of the analysis is graphical in nature. The consumption, investment,
money, and labor demand schedules used in this part come from the microeconomic decisionmaking problems studied in Part III, as does the labor supply schedule. Chapter 15 discusses
these decision rules and presents a graphical depiction of the equilibrium, which is based
on a traditional IS curve summarizing the demand side and a vertical curve which we will
the Y s curve (after Williamson (2014)) to describe the supply-side. Chapter 16 graphically
works through the effects of changes in exogenous variables on the endogenous variables of
the model. Chapter 17 presents some basic facts about observed business cycle fluctuations
and assesses the extent to which the neoclassical model can provide a reasonable account
of those facts. In Chapter 18 we study the connection between the money supply, inflation,
and nominal interest rates in the context of the neoclassical model. Chapter 19 discusses
the policy implications of the model. The equilibrium is efficient, and so there is no scope
for policy to attempt to combat fluctuations with monetary or fiscal interventions. This
forms the basis for our analysis in Part V where we consider policy in a model where some
friction impedes the efficient equilibrium from obtaining. In this chapter we also include an
extensive discussion of criticisms which have been levied at the neoclassical / real business
cycle paradigm for thinking about economic policy. Chapter 20 considers an open economy
version of the neoclassical model, studying net exports and exchange rates.
Part V studies a New Keynesian model. This model is identical to the neoclassical model,
with the exception that prices or wages are sticky. This stickiness allows demand shocks to
matter and means that money is non-neutral. It also means that the short run equilibrium is
in general inefficient, opening the door for desirable policy interventions. Chapter 21 develops
the IS-LM-AD curves to describe the demand side of the model. What differentiates the
New Keynesian model from the neoclassical model is not the demand side, but rather the
supply side. Hence, the IS-LM-AD curves can also be used to describe the demand side
of the neoclassical model. We prefer our approach of first starting with the IS-Y s curves
because it better highlights monetary neutrality and the classical dichotomy. Chapter 22
develops two different theories of a non-vertical aggregate supply relationship, one based
on sticky prices and the other on sticky wages. Some instructors may see fit to focus only
on one version of the model (e.g. sticky prices or sticky wages), rather than both. Chapter
23 works out the effects of changes in exogenous variables on the endogenous variables of
the New Keynesian model and compares those effects to the neoclassical model. Chapter
24 develops a theory of the transition from short run to medium run. In particular, if the
short run equilibrium differs from what would obtain in the neoclassical model, over time
pressure on prices and/or wages results in shifts of the AS relationship that eventually restore
the neoclassical equilibrium. On this basis we provide theoretical support for empirically
5 observed Phillips Curve relationships. In Chapter 25 we study optimal monetary policy in
the Keynesian model. The optimal policy is to adjust the money supply / interest rates
so as to ensure that the equilibrium of the short run model coincides with the equilibrium
which would obtain in the absence of price or wage rigidity (i.e. the neoclassical, medium
run equilibrium). Here, we talk about the Wicksellian “natural” or “neutral” rate of interest
and its importance for policy. Chapter 26 studies the New Keynesian model when the zero
lower bound is binding. Chapter 27 considers an open economy version of the New Keynesian
model.
Part VI is titled “Specialized Topics” and considers several different topics which do not
necessarily fit well into other parts of the book. At present, this part of the book is a work in
progress. In Chapter 28 we study the recent Great Recession. We present facts, talk about
the conventional wisdom concerning the origins of the crisis, map those origins into our New
Keynesian framework, and then use that framework to think about the myriad unconventional
policy measures which were deployed. The only other completed chapter in this part is
Chapter 31, which studies a search and matching framework to think about unemployment.
Throughout the rest of the book, we avoid a discussion of unemployment and instead focus
on total labor hours. In the future, we plan to add content on the importance of commitment
for macroeconomic policymaking (Chapter 29), a chapter on fiscal imbalances facing the
U.S. and other developed countries (Chapter 30), a chapter on the role of heterogeneity and
inequality in macroeconomics (Chapter 32), and a chapter on the rise of China and its role
in the global economy (Chapter 33).
We realize that there is likely too much material presented here for a normal one semester
course. It is our hope that our approach of presenting the material in as thorough as possible
a manner will facilitate moving through the material quickly. As alluded to above, there are
a number of different ways in which this book can be used. Part I could be skipped entirely,
an instructor could have a teaching assistant work through it, or an instructor could require
students to read the material on their own without devoting scarce class time to it. For
studying growth, it may suffice to only focus on Chapter 5, skipping the augmented Solow
model with exogenous productivity and population growth. Chapter 7 is written in such a
way that the material in Chapter 6 need not have previously been covered.
Some instructors may see fit to skip all or parts of Part III. One option for condensing this
material would be to skip Chapters 9 (which considers a multi-period extension of the two
period consumption-saving model), 10 (which studies equilibrium in an endowment economy),
or parts of Chapters 13 through 14. In Parts IV and V, one can condense the material by
skipping the open economy chapters, Chapters 20 and 27. As this book is a work in progress,
we too are experimenting with how to best structure a course based on this book, and would
6 appreciate any feedback from instructors who have tried different course structures elsewhere.
Throughout the book, we include hyperlinked references to academic papers and other
readings. These are denoted in blue and appear in the format “Name (year of publication).”
For many publications, the references section includes hyperlinks to the papers in question.
We also include hyperlinks to other external readings, in many cases Wikipedia entries
on topics of interest. These are also indicated in blue, and in the online version can be
navigated to with a simple click. At the conclusion of each chapter, we include two sets of
problems – one is called “Questions for Review” and requires mostly short written responses
which simply review the material presented in the text, while the other is called “Exercises”
and typically features longer problems requiring students to work through mathematical or
graphical derivations, often times including extensions of the models ...

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- Fall '08
- NAGY,KRISZTINA
- Economics, Macroeconomics, Neoclassical Model