An Overview of An Overview of Modern Modern

MacroeconomicsMacroeconomicsIntermediate MacroeconomicsIntermediate Macroeconomics

ECON-305 Spring 2013ECON-305 Spring 2013Professor DaltonProfessor Dalton

Boise State UniversityBoise State University

Issues and IdeasIssues and Ideas

MacroeconomicsMacroeconomics

Study of structure, performance and Study of structure, performance and behavior of economy as a wholebehavior of economy as a whole Causes and impacts of short-run GDP Causes and impacts of short-run GDP

fluctuationsfluctuations Business (trade) cycleBusiness (trade) cycle

Major determinants of long-run path of Major determinants of long-run path of GDPGDP Economic growthEconomic growth

Macroeconomics and Macroeconomics and PoliticsPolitics

Behavior of economy subject of Behavior of economy subject of citizen interest citizen interest

Performance and policy closely Performance and policy closely interconnectedinterconnected

Post-war elections determined by Post-war elections determined by inflation, unemployment, GDP growthinflation, unemployment, GDP growth

Representative of ideological conflictRepresentative of ideological conflict

Macroeconomic TheoryMacroeconomic Theory

Set of views of how economy Set of views of how economy operates organized into a modeloperates organized into a model

Economists differ over Economists differ over correctcorrect model model Models have developed historically to Models have developed historically to

take account of novel facts and new take account of novel facts and new historical situationshistorical situations Great Depression (1930s)Great Depression (1930s) Great Inflation (1970s)Great Inflation (1970s)

Milton FriedmanMilton Friedman

““There is wide agreement about the major goals There is wide agreement about the major goals of economic policy: high employment, stable of economic policy: high employment, stable prices, and rapid growth. There is less prices, and rapid growth. There is less agreement that these goals are mutually agreement that these goals are mutually compatible or, among those who regard them compatible or, among those who regard them as incompatible, about the terms at which they as incompatible, about the terms at which they can and should be substituted for one another. can and should be substituted for one another. There is least agreement about the role that There is least agreement about the role that various instruments of policy can and should various instruments of policy can and should play in achieving the several goals.”play in achieving the several goals.”

- “The Role of Monetary Policy,” - “The Role of Monetary Policy,” AERAER, March , March 19681968

Two Fundamental IssuesTwo Fundamental Issues

Self-adjusting properties of market Self-adjusting properties of market economyeconomy

Proper role of governmentProper role of government

a b

c d

Self-Adjusting? YES NO

Govern

ment

Ben

efici

al?

YES

NO

Business Cycle Business Cycle FactsFacts

Economic FluctuationsEconomic Fluctuations

Pattern:Pattern:Expansion-Peak-Contraction-Trough-Expansion-Peak-Contraction-Trough-

ExpansionExpansion

Trend

Correlations with GDPCorrelations with GDP11

VariableVariable DirectionDirection TimingTiming

Industrial Production*Industrial Production* ProcyclicalProcyclical Coincident Coincident

Consumption**Consumption** ProcyclicalProcyclical Coincident Coincident

Business Fixed Investment Business Fixed Investment ProcyclicalProcyclical Coincident Coincident

Residential InvestmentResidential Investment ProcyclicalProcyclical Leading Leading

Inventory InvestmentInventory Investment ProcyclicalProcyclical Leading Leading

Government PurchasesGovernment Purchases ProcyclicalProcyclical Undesignated Undesignated

EmploymentEmployment ProcyclicalProcyclical CoincidentCoincident

UnemploymentUnemployment CountercyclicalCountercyclical Not clearNot clear

Ave. Labor ProductivityAve. Labor Productivity ProcyclicalProcyclical LeadingLeading

Real WageReal Wage ProcyclicalProcyclical UndesignatedUndesignated

Correlations with GDPCorrelations with GDP11

VariableVariable DirectionDirectionTimingTiming

Money SupplyMoney Supply ProcyclicalProcyclical LeadingLeading

InflationInflation ProcyclicalProcyclical LaggingLagging

Stock PricesStock Prices ProcyclicalProcyclical LeadingLeading

Nominal interest ratesNominal interest rates ProcyclicalProcyclical LaggingLagging

Real interest ratesReal interest rates AcyclicalAcyclical UndesignatedUndesignated

*durable more volatile than non-durable*durable more volatile than non-durable

** investment expenditures more volatile than consumption expenditures** investment expenditures more volatile than consumption expenditures11Abel and BernankeAbel and Bernanke

Cycle RegularitiesCycle Regularities22

Output movements across sectors have high conformityOutput movements across sectors have high conformity Producer and consumer durables exhibit greater amplitude Producer and consumer durables exhibit greater amplitude

than nondurablesthan nondurables Production and prices of agricultural output and natural Production and prices of agricultural output and natural

resources have lower than average conformityresources have lower than average conformity Business profits show high conformity and much greater Business profits show high conformity and much greater

amplitude than other seriesamplitude than other series Prices generally procyclicalPrices generally procyclical Short-term nominal interest rates procyclical, long-term Short-term nominal interest rates procyclical, long-term

slightly soslightly so Monetary aggregates and velocity pro-cyclicalMonetary aggregates and velocity pro-cyclical

22Lucas, “Understanding Business Cycles”Lucas, “Understanding Business Cycles”

Therefore…Therefore…

Lucas: “Business Cycles Are Lucas: “Business Cycles Are All Alike.”All Alike.”- Attractive property – challenge - Attractive property – challenge to theoriststo theorists

- Suggests a - Suggests a generalgeneral theory of theory of cycles is possiblecycles is possible

Keynes and CyclesKeynes and Cycles

Keynes and Earlier Cycle ModelsKeynes and Earlier Cycle Models- Keynesian models conform well to time-- Keynesian models conform well to time-

series data, but not tied to general series data, but not tied to general economic theory that output react to economic theory that output react to pricesprices

- Keynesian models invariant to policy- Keynesian models invariant to policy- Policy changes don’t produce changes in Policy changes don’t produce changes in

decision rules of agentsdecision rules of agents

Earlier cycle models attempted to tie Earlier cycle models attempted to tie fluctuations to general theoryfluctuations to general theory

Keynes and CyclesKeynes and Cycles

Keynes changed the focus of Keynes changed the focus of Business Cycle economics from a Business Cycle economics from a consideration of ebbs and flows of consideration of ebbs and flows of economic activity relative to economic activity relative to changing prices, technology, and changing prices, technology, and preferencespreferences

Keynes asked a different question…Keynes asked a different question…- What determines aggregate output?- What determines aggregate output?

Economic StabilityEconomic Stability

Triumph of KeynesTriumph of Keynes 1946 Employment Act1946 Employment Act

Cursory investigation of time-series Cursory investigation of time-series data suggests post-war prosperity due data suggests post-war prosperity due to purposeful macro policyto purposeful macro policy

Cursory view also indicates economy Cursory view also indicates economy was more stable in the post-WW II erawas more stable in the post-WW II era

Was It?Was It?

Romer: “Changes in Business Romer: “Changes in Business Cycles: Evidence and Cycles: Evidence and

Explanations”Explanations” Series of influential papersSeries of influential papers What is evidence of changes in What is evidence of changes in

fluctuations?fluctuations? How measured?How measured? What series?What series? Problems with data!Problems with data! Romer re-estimated pre-WW II data.Romer re-estimated pre-WW II data.

Romer: “Changes in Business Romer: “Changes in Business Cycles: Evidence and Cycles: Evidence and

Explanations”Explanations” Interwar period extremely volatileInterwar period extremely volatile Little evidence pre-WW I period much more Little evidence pre-WW I period much more

volatile in US than post-WW IIvolatile in US than post-WW II Recessions less frequent and more uniform; Recessions less frequent and more uniform;

Expansions longerExpansions longer Not much difference in average output loss Not much difference in average output loss

per recessionper recession Policy dampened shocks that produced Policy dampened shocks that produced

recessions in past; however, appearance of recessions in past; however, appearance of policy-induced recessions to fight inflationpolicy-induced recessions to fight inflation

The Great The Great DepressionDepression

General FeaturesGeneral Features

World-wide phenomenonWorld-wide phenomenon Output fell moderately in some Output fell moderately in some

countries, precipitously in otherscountries, precipitously in others 47% decline US industrial production47% decline US industrial production Nations with greater than 30% Nations with greater than 30%

declines: Germany, France, Italy, declines: Germany, France, Italy, Belgium, Netherlands, Belgium, Netherlands, Czechoslovakia, Poland, CanadaCzechoslovakia, Poland, Canada

Central QuestionsCentral Questions

How did the recession of 1929-1930, How did the recession of 1929-1930, well within historical parameters, well within historical parameters, turn into the Great Depression of turn into the Great Depression of 1931-1933?1931-1933?

Why did it last so long? When did it Why did it last so long? When did it end?end?

Why was their a recession within the Why was their a recession within the Depression in the US (1937-38)?Depression in the US (1937-38)?

The Causes of the Great The Causes of the Great DepressionDepression

Non-monetary/Non-financial Non-monetary/Non-financial hypothesishypothesis

Monetary hypothesesMonetary hypotheses Non-monetary/financial hypothesisNon-monetary/financial hypothesis Gold-Standard hypothesisGold-Standard hypothesis Non-monetary real business cycle Non-monetary real business cycle

hypothesishypothesis

Eichengreen: “The Eichengreen: “The origins and nature of origins and nature of

the Great Slump the Great Slump revisited”revisited”

Bernanke: “The Bernanke: “The Macroeconomics of the Macroeconomics of the

Great Depression: A Great Depression: A Comparative Approach”Comparative Approach”

Structural Changes of Structural Changes of 1920s1920s

Changes in Composition of ProductionChanges in Composition of Production Minor; except consumer durables and Minor; except consumer durables and

agricultural production in USagricultural production in US Changes in Flexibility of Labor MarketsChanges in Flexibility of Labor Markets

Minor- high unemployment Europe, low Minor- high unemployment Europe, low rates unionization, unemployment rates unionization, unemployment benefits; except internal labor markets benefits; except internal labor markets and personnel departments USand personnel departments US

Structural Changes of Structural Changes of 1920s1920s

Changes in International Monetary Changes in International Monetary SystemSystem Rise of foreign exchange in international Rise of foreign exchange in international

reserves made system subject to greater reserves made system subject to greater destabilization (dollar and pound sterling)destabilization (dollar and pound sterling)

Changes in Pattern of International Changes in Pattern of International SettlementsSettlements Expansion of US and Japan international Expansion of US and Japan international

business interests during WW I; US business interests during WW I; US becomes net creditor; War reparationsbecomes net creditor; War reparations

Onset of DepressionOnset of Depression Restrictive US monetary policy to Restrictive US monetary policy to

counteract stock market bubble in 1928counteract stock market bubble in 1928 Rising US interest rates reduce international Rising US interest rates reduce international

credit; capital and gold inflowscredit; capital and gold inflows Fed sterilization of gold inflows prevent US Fed sterilization of gold inflows prevent US

prices from risingprices from rising To maintain exchange rates foreign central To maintain exchange rates foreign central

banks adopt contractionary monetary banks adopt contractionary monetary policiespolicies

Spread of DepressionSpread of Depression

EichengreenEichengreen Role of Stock Market CrashRole of Stock Market Crash 1930-31 Bank Runs1930-31 Bank Runs Role of Gold StandardRole of Gold Standard Was US constrained from reflating under Was US constrained from reflating under

gold standard?gold standard? BernankeBernanke

EvidenceEvidence Gold Standard and recoveryGold Standard and recovery

Real Effects of Nominal Real Effects of Nominal ShocksShocks

Why did process of adjustment to Why did process of adjustment to monetary shocks take so long to monetary shocks take so long to work themselves out?work themselves out? Anticipated v. Unanticipated policyAnticipated v. Unanticipated policy

Both Eichengreen and Bernanke Both Eichengreen and Bernanke concentrate on two aspectsconcentrate on two aspects Debt-deflation processDebt-deflation process Nominal wage and price rigidityNominal wage and price rigidity

Debt-deflationDebt-deflation Falling asset prices force nominal Falling asset prices force nominal

debtors into distress sales that further debtors into distress sales that further drop asset prices and increase drop asset prices and increase pressures on nominal debtorspressures on nominal debtors Counter-argument: simply a redistribution Counter-argument: simply a redistribution

debtors to creditors – should have no real debtors to creditors – should have no real effectseffects

Bernanke presents evidence that bank Bernanke presents evidence that bank panics negatively correlated with panics negatively correlated with output, employment and wages. Why?output, employment and wages. Why?

Debt-deflationDebt-deflation Principal-agent literature and Principal-agent literature and

imperfect informationimperfect information Net worth/balance sheet plays important role Net worth/balance sheet plays important role

in aligning incentives of lenders and borrowersin aligning incentives of lenders and borrowers Deterioration of net worth causes risk of Deterioration of net worth causes risk of

lending to rise, reducing lendinglending to rise, reducing lending World of imperfect information, some World of imperfect information, some

opportunities known to some will go opportunities known to some will go unexploited due to lack of access to fundsunexploited due to lack of access to funds

Sufficiently severe debt-deflation imposes Sufficiently severe debt-deflation imposes bank balance-sheet problemsbank balance-sheet problems

Nominal Wages and Nominal Wages and PricesPrices

Again, Bernanke presents evidence of Again, Bernanke presents evidence of nominal price and wage rigidity. Why?nominal price and wage rigidity. Why?

EichengreenEichengreen USUS

Hoover’s voluntary programHoover’s voluntary program AAA – agricultural pricesAAA – agricultural prices NIRA labor and business provisionsNIRA labor and business provisions

NLRA (Wagner Act)NLRA (Wagner Act)

EnglandEngland Unemployment benefits lagged price and wage Unemployment benefits lagged price and wage

reductionsreductions

Monetary and Fiscal Monetary and Fiscal PolicyPolicy

Eichengreen- international Eichengreen- international comparisonscomparisons Monetary policy led recovery in every Monetary policy led recovery in every

instanceinstance No nation suffered a liquidity trapNo nation suffered a liquidity trap Fiscal policy was small and often Fiscal policy was small and often

ocunter-productiveocunter-productive Hoover’s 1932 massive income tax increaseHoover’s 1932 massive income tax increase

New Deal UncertaintyNew Deal Uncertainty

Did the New Deal help the recovery Did the New Deal help the recovery process?process? New Deal instituted policies and programs New Deal instituted policies and programs

that had been “lying about” for decadesthat had been “lying about” for decades Uncertainty in business environmentUncertainty in business environment

Congress pass general law and Roosevelt and Congress pass general law and Roosevelt and agencies sort out detailsagencies sort out details

FDR sign executive order and Congress would FDR sign executive order and Congress would later ratifylater ratify

Businessmen’s correspondenceBusinessmen’s correspondence

Development of Development of Modern Modern

MacroeconomicsMacroeconomics

KeynesKeynes

General Theory of Employment, General Theory of Employment, Interest and Money Interest and Money (1936)(1936) Treatise on Money Treatise on Money (1930)(1930)

Fundamental flaw in operation of Fundamental flaw in operation of market as coordinating devicemarket as coordinating device

Fundamental misunderstanding of Fundamental misunderstanding of economistseconomists

KeynesKeynes

Major discovery: Principle of Effective Major discovery: Principle of Effective DemandDemand

Rejection of “laissez-faire”Rejection of “laissez-faire” New Deal and KeynesianismNew Deal and Keynesianism Post WW II commitment to Activist Post WW II commitment to Activist

policypolicy

Macroeconomics Macroeconomics DevelopsDevelops

Orthodox KeynesianismOrthodox Keynesianism Hicks, Hicks, “Mr. Keynes and the Classics” “Mr. Keynes and the Classics”

(1937)(1937) Modigliani, Modigliani, “Liquidity Preference and the “Liquidity Preference and the

Theory of Interest and Money” Theory of Interest and Money” (1944)(1944) IS-LM ModelIS-LM Model Theoretical SchizophreniaTheoretical Schizophrenia

Macroeconomics Macroeconomics DevelopsDevelops

Monetarist Response and Monetarist Response and Neoclassical SynthesisNeoclassical Synthesis Friedman, Friedman, “The Quantity Theory of “The Quantity Theory of

Money: A Restatment” Money: A Restatment” (1956)(1956) Patinkin, Patinkin, Money, Interest and Prices Money, Interest and Prices

(1956)(1956)

Macroeconomics Macroeconomics DevelopsDevelops

Phillips CurvePhillips Curve Phillips, Phillips, “The Relation Between “The Relation Between

Unemployment and the Rate of Change Unemployment and the Rate of Change of Money Wage Rates in the Untied of Money Wage Rates in the Untied Kingdom, 1861-1957” Kingdom, 1861-1957” (1958)(1958)

Samuelson and Solow, Samuelson and Solow, “Analytical “Analytical Aspects of Anti-Inflationary Policy” Aspects of Anti-Inflationary Policy” (1960)(1960)

Macroeconomics Macroeconomics DevelopsDevelops

Orthodox MonetarismOrthodox Monetarism Friedman and Scwartz, Friedman and Scwartz, A Monetary A Monetary

History of the United States, 1867-1960History of the United States, 1867-1960 (1963)(1963)

Natural Rate HypothesisNatural Rate Hypothesis Phelps, Phelps, “Phillips Curves, Expectations of “Phillips Curves, Expectations of

Inflation and Optimal Unemployment over Inflation and Optimal Unemployment over Time” Time” (1967)(1967)

Friedman, Friedman, “The Role of Monetary Policy” “The Role of Monetary Policy” (1968)(1968)

Macroeconomics Macroeconomics DevelopsDevelops

Rational Expectations and New Rational Expectations and New Classical EconomicsClassical Economics Lucas, Lucas, “Some International Evidence on “Some International Evidence on

Output-Inflation Tradeoffs”Output-Inflation Tradeoffs” (1973) (1973) Lucas, Lucas, “An Equilibrium Model of the “An Equilibrium Model of the

Business Cycle” Business Cycle” (1975)(1975) Real Business Cycle TheoryReal Business Cycle Theory

Kydland and Prescott, Kydland and Prescott, “Time to Build “Time to Build and Aggregate Fluctuations” and Aggregate Fluctuations” (1982)(1982)

Macroeconomics Macroeconomics DevelopsDevelops

New Keynesian ResponseNew Keynesian Response Mankiw, Mankiw, “Small Menu Costs and Large “Small Menu Costs and Large

Business Cycles: A Macroeconomic Business Cycles: A Macroeconomic Model of Monopoly” Model of Monopoly” (1985)(1985)

Akerlof and Yellen, Akerlof and Yellen, “A Near-rational “A Near-rational Model of the Business Cycle, with Wage Model of the Business Cycle, with Wage and Price Inertia” and Price Inertia” (1985)(1985)

Growth EconomicsGrowth Economics Endogenous growth theoryEndogenous growth theory

MACRO SCHOOLS 

Dominant source of instability

Expectations

Price Adjustment

Market Adjustment

Loanable Funds Market

Notion of Equilibrium

Dominant Time Frame

Rules v. Discretion

Role of Incomes Policy

                   

Post- Keynesian

Fluctuations in Autonomous Expenditures

Reasonable

Sticky Very weak No joint

State of rest probably below full employment

ShortDiscretion

Essential and beneficial

                   

New Keynesian

Demand and supply shocks (eclectic)

RationalEmphasis on Price Rigidities

SlowNo clear consensus

Consistent with involuntary unemploy-ment

Predomi-nantly short

No clear consensus

Predominately against

                   

Orthodox Keynesian

Fluctuations in Autonomous Expenditures

Adaptive

Inflexible below Full employ-ment

Weak No joint

State of rest probably below full employment

Short runDiscretion

Some support

                   

Austrian Monetary Disturbances

Reasonable

Flexible StrongLoose joint

Tendency towards market clearing

Short and Long

RulesHarmful and distorting

                   

Orthodox Monetarist

Monetary Disturbances

Adaptive Flexible StrongTight joint

Market clearing at natural rate

Short and Long

RulesIrrelevant and distorting

                   

New Classical

Monetary Disturbances

RationalExtremely Flexible

Very strong

Tight joint

Market clearing at natural rate

Long = short RulesIrrelevant and distorting

                   

Real Business Cycle

Supply shocks (mainly technological)

RationalExtremely Flexible

Very strong

Tight joint

Market clearing at moving natural rate

Long = short RulesIrrelevant and distorting