Macroeconomic Theory and Policy P re limin a ry D raft Da vid Andolfatto Simon Fraser U niversit y dandolfa@sfu.ca c ° August 2005 ii Conten ts Preface ix I Macroeconomic Theory: Basics 1 1 The Gross Domestic Product 3 1.1 Introduction 3 1.2 HowGDPisCalculated 5 1.2.1 TheIncomeApproach 5 1.2.2 TheExpenditureApproach 6 1.2.3 TheIncome-ExpenditureIdentity 7 1.3 WhatGDPDoesNotMeasure 8 1.4 NominalversusRealGDP 9 1.5 RealGDPAcrossTime 12 1.6 SchoolsofThought 14 1.7 Problems 16 1.8 References 17 1.A MeasuredGDP:SomeCaveats 18 2 Basic Neoclassical Theory 21 2.1 Introduction 21 2.2 TheBasicModel 22 2.2.1 TheHouseholdSector 23 2.2.2 TheBusinessSector 30 2.2.3 General Equilibrium . 31 2.3 RealBusinessCycles 35 2.3.1 TheWageCompositionBias 38 2.4 PolicyImplications 39 2.5 UncertaintyandRationalExpectations 41 2.6 AnimalSpirits 42 2.6.1 IrrationalExpectations 43 2.6.2 Self-Fu lfillingProphesies 44 2.7 Summary 47 2.8 Problems 49 iii iv CONTENTS 2.9 References 49 2.A AModelwithCapitalandLabor 50 2.B Schumpeter’sProcessofCreativeDestruction 53 3 Fiscal Policy 55 3.1 Introduction 55 3.2 GovernmentPurchases 55 3.2.1 Lump-SumTaxes 56 3.2.2 DistortionaryTaxation 59 3.3 GovernmentandRedistribution 60 3.4 Problems 64 4 Consumption and Saving 67 4.1 Introduction 67 4.2 ATwo-PeriodEndowmentEconomy 68 4.2.1 Preferences 68 4.2.2 Constraints 69 4.2.3 RobinsonCrusoe 70 4.2.4 IntroducingaFinancialMarket 71 4.2.5 Individual Choice w ith Access to a Financial Market . . . 74 4.2.6 SmallOpenEconomyInterpretation 76 4.3 Experiments 77 4.3.1 ATransitoryIncreaseinCurrentGDP 77 4.3.2 AnAnticipatedIncreaseinFutureGDP 79 4.3.3 APermanentIncreaseinGDP 82 4.3.4 AChangeintheInterestRate 84 4.4 BorrowingConstraints 86 4.5 DeterminationoftheRealInterestRate 89 4.5.1 General Equilibrium in a 2-Period E ndowment Economy . 90 4.5.2 ATransitoryDeclineinWorldGDP 92 4.5.3 APersistentDeclineinWorldGDP 93 4.5.4 Evidence 94 4.6 Summary 97 4.7 Problems 99 4.8 References 101 4.A AlexanderHamiltononRepayingtheU.S.WarDebt 103 4.B MiltonFriedmanMeetsJohnMaynardKeynes 104 4.C TheTermStructureofInterestRates 106 4.D The Intertemporal Substitution of Labor Hypothesis 108 5 Government Spending and Finance 111 5.1 Introduction 111 5.2 TheGovernmentBudgetConstraint 111 5.3 TheHouseholdSector 113 5.4 TheRicardianEquivalenceTheorem 114 5.5 GovernmentSpending 117 CONTENTS v 5.5.1 ATransitoryIncreaseinGovernmentSpending 118 5.6 Government Spending and Taxation in a Model with Production 119 5.6.1 RicardianEquivalence 120 5.6.2 GovernmentSpendingShocks 121 5.6.3 Barro’sTax-SmoothingArgument 121 5.7 U.S.FiscalPolicy 121 5.8 Summary 123 5.9 Problems 124 5.10References 125 6 Capital and Investmen t 127 6.1 Introduction 127 6.2 CapitalandIntertemporalProduction 128 6.3 RobinsonCrusoe 130 6.4 ASmallOpenEconomy 133 6.4.1 Stage1:MaximizingWealth 133 6.4.2 Stage 2: Maximizing Utility 136 6.4.3 ATransitoryProductivityShock 138 6.4.4 APersistentProductivityShock 140 6.4.5 Evidence 142 6.5 DeterminationoftheRealInterestRate 142 6.6 Summary 144 6.7 Problems 146 6.8 References 146 7 Labor Market Flows and Unemployment 147 7.1 Introduction 147 7.2 TransitionsIntoandOutofEmployment 147 7.2.1 AModelofEmploymentTransitions 149 7.3 Unemployment 153 7.3.1 AModelofUnemployment 155 7.3.2 GovernmentPolicy 158 7.4 Summary 159 7.5 Problems 160 7.6 References 160 7.A ADynamicModelofUnemployment 161 II Macroeconomic Theory: Mo ney 165 8 Money, Interest, and Prices 167 8.1 Introduction 167 8.2 WhatisMoney? 168 8.3 PrivateMoney 169 8.3.1 TheNeoclassicalModel 169 8.3.2 Wicksell’s Triangle: Is Evil the Root of All Money? 170 vi CONTENTS 8.3.3 GovernmentMoney 173 8.4 TheQuantityTheoryofMoney 173 8.5 TheNominalInterestRate 177 8.5.1 TheFisherEquation 179 8.6 ARateofReturnDominancePuzzle 181 8.6.1 TheFriedmanRule 183 8.7 InflationUncertainty 184 8.8 Summary 185 8.9 Problems 186 8.10References 186 9 The New-Keynesian View 189 9.1 Introduction 189 9.2 MoneyNon-Neutrality 189 9.2.1 ABasicNeoclassicalModel 190 9.2.2 ABasicKeynesianModel 191 9.3 TheIS-LM-FEModel 193 9.3.1 TheFECurve 193 9.3.2 TheISCurve 194 9.3.3 TheLMCurve 195 9.3.4 Response to a Money Supply Shock: Neoclassical Model . 195 9.3.5 Response to a Money Supply Shock: Keynesian Model . . 197 9.4 HowCentralBankersViewtheWorld 199 9.4.1 PotentialOutput 199 9.4.2 TheISandSRFECurves 201 9.4.3 ThePhillipsCurve 201 9.4.4 MonetaryPolicy:TheTaylorRule 203 9.5 Summary 205 9.6 References 206 9.A AreNominalPrices/WagesSticky? 207 10 The Demand for Fiat Money 209 10.1Introduction 209 10.2ASimpleOLGModel 210 10.2.1 ParetoOptimalAllocation 211 10.2.2 MonetaryEquilibrium 213 10.3GovernmentSpendingandMonetaryFinance 217 10.3.1 The InflationTaxandtheLimittoSeigniorage 219 10.3.2 The Inefficiency of InflationaryFinance 222 10.4Summary 225 10.5References 225 CONTENTS vii 11 International Monetary Systems 227 11.1Introduction 227 11.2NominalExchangeRateDetermination:FreeMarkets 229 11.2.1 Understanding Nominal Exchange Rate Indeterminacy . . 231 11.2.2 AMultilateralFixedExchangeRateRegime 233 11.2.3 SpeculativeAttacks 236 11.2.4 CurrencyUnion 239 11.2.5 Dollarization 239 11.3 Nominal Exchange Rate Determination: Legal Restrictions . . . 240 11.3.1 FixingtheExchangeRateUnilaterally 242 11.4Summary 242 11.5References 244 11.ANominalExchangeRateIndeterminacyandSunspots 245 11.BInternationalCurrencyTraders 247 11.CTheAsianFinancialCrisis 248 12 Money, Capital and Banking 251 12.1Introduction 251 12.2AModelwithMoneyandCapital 251 12.2.1 The Tobin Effect 254 12.3Banking 255 12.3.1 ASimpleModel 256 12.3.2 Interpreting Money Supply Fluctuations 258 12.4 Summary 260 12.5 References 260 III Economic G rowth and Dev elopment 261 13 Early Economic Developmen t 263 13.1Introduction 263 13.2TechnologicalDevelopments 264 13.2.1 ClassicalAntiquity(500B.C 500A.D.) 264 13.2.2 The Middle Ages (500 A.D. - 1450 A.D.) 265 13.2.3 The Renaissance and Baroque Periods (1450 A.D. - 1750 A.D.) 267 13.3ThomasMalthus 267 13.3.1 TheMalthusianGrowthModel 269 13.3.2 Dynamics 271 13.3.3 TechnologicalProgressintheMalthusModel 272 13.3.4 AnImprovementinHealthConditions 273 13.3.5 ConfrontingtheEvidence 274 13.4 Fertility Choice 275 13.4.1 PolicyImplications 281 13.5Problems 282 13.6References 283 viii CONTENTS 14 Modern Economic Development 285 14.1Introduction 285 14.2TheSolowModel 289 14.2.1 SteadyStateintheSolowModel 292 14.2.2 DifferencesinSavingRates 293 14.2.3 DifferencesinPopulationGrowthRates 295 14.2.4 DifferencesinTechnology 296 14.3ThePoliticsofEconomicDevelopment 296 14.3.1 A SpecificFactorsModel 297 14.3.2 HistoricalEvidence 300 14.4EndogenousGrowthTheory 302 14.4.1 ASimpleModel 303 14.4.2 InitialConditionsandNonconvergence 306 14.5References 308 Preface The field of macroeconomic theory has evolved rapidly over the last quarter century. A quick glance at the discipline’s leading journals reveals that virtu- ally the entire academic profession has turned to interpreting m a croeconomic data with models that are based on micr oeconomic foundations. Unfortunately, these models often require a relatively high degree of mat hematical sophistica- tion, leaving them largely inaccessible to the interested lay person (students, newspaper columnists, business economists, and policy m akers). For this rea- son, most public commentary continues to be cast in terms of a language that is based on simpler ‘old generation’ models learned by policymakers in under- graduate classes attended long ago. To this day, most introductory and intermediate textbooks on macroeco- nomic theory continue to employ old generation models in expositing ideas. Many of these textbooks are written by leading academics who would not be caugh t dead using any of these models in their research. This discrepancy can be explained, I think, by a widespread belief among academics that their ‘new generation’ models are simply too complicated for the average undergraduate. The use of these older models is further justified by the fact that they do in some cases possess hidden microfoundations, but that revealing these microfounda- tions is more likely to confuse rather than enlighten. Finally, it could be argued that one virtue of teaching the older models is that it allows students to better understand the language of contemporary policy discussion (undertaken by an old generation of former students who were taught to converse in the language of these older models). While I can appreciate such arguments, I do not in general agree with them. It is true that the models employed in leading research journals are complicated. But m uch of the basic intuition embedded in these models can often be exposited with simple diagrams (budget sets and indifference curves). The tools required for such analysis do not extend beyond what is regularly taught in a good undergraduate microeconomics course. And while i t is true that many of the older generation models possess hidden microfoundations, I think that it is mistake to hide these foundations from students. Among other things, a good understanding of a model’s microfoundations lays bare its otherwise hidden assumptions, which is useful since it renders clearer the model’s limitations and ix x PREFACE forces the student to think more carefully. A qualified professional can get away with using ‘short cut’ models with hidden microfoundations, but in the hands of a layman, such models can be the source of much mischief (bad policy advice). I am somewhat more sympathetic to the last argument concerning language. A potential pitfall of teaching macroeconomics using a modern language is that studen ts may be left in a position that leaves them unable to decipher the older language still w idely employed in policy debates. Here, I think it is up to the instructor to draw out t he mapping between old and new language whenever it migh t be useful to do so. Unfortunately, translation is time-consuming. But it is arguably a necessary cost to bear, at least, until the day the old technology is no longer widely in use. To understand why the new generation models constitute a better technol- ogy, one needs to understand the basic difference between the two methodologi- cal approaches. The old generation models rely primarily on assumed behavioral relationships that are simple to analyze and seem to fit the historical data rea- sonably well. No formal explanation is offered as to why people might rationally choose follow these rules. The limitations of this approach are tw ofold. First, the assumed behavioral relations (which can fit the historical data well) often seemed to ‘break down’ when applied to the task of predicting the consequences of new government policies. Second, the behavioral relations do not in them- selves suggest any natural criterion by which to judge whether any given policy makespeoplebetterorworseoff. To circumvent this latter problem, various ad hoc welfare criteria emerged throughout the literature; e.g., more unemploy- ment is bad, more GDP is good, a current account deficitisbad,businesscycles are b ad, and so on. While all of these statements sound intuitively plausible, they constitute little more than bald assertions. In contrast, the new generation of models rely more on the tools of microeco- nomic theory (including game theory). This approach assumes that economic decisions are made for a reason. People are assumed to hav e a well-defined objective in life (represented by preferences). Various constraints (imposed by nature, markets, the government, etc.) place restrictions on how this objec- tive can be achiev ed. By assuming that people try t o do the best they can subject to these constraints, optimal behav ioral rules can be derived instead of assumed. Macroeconomic variables can then be computed by summing up the actions of all individuals. This approach has at least two main benefits. First, to the extent that the deep parameters describing preferences and constraints are approximated reasonably well, the theory can provide reliable predictions over any number of hypothetical policy experiments. Second, since preferences are modeled explicitly, one can easily evaluate how different policies may af- fect the welfare of individuals (although, the problem of constructing a social welfare function remains as always). As it turns out, more unemployment is not always bad, more GDP is not always good, a current account deficit is not always bad, and business cycles are not necessarily bad either. While these results m ay sound su rprising to those who are used t o thinking in t erms of old generation models, they emerge as logical outcomes with intuitive explanations [...]... ‘chain-weighting’ procedures to mitigate this problem 12 CHAPTER 1 THE GROSS DOMESTIC PRODUCT 1. 5 Real GDP Across Time Figure 1. 3 plots the time path of real (i.e., corrected for inflation) per capita GDP for the United States and Canada since the first quarter of 19 61 FIGURE 1. 3 Real per capita GDP United States and Canada 19 61. 1 - 2003.4 United States Canada 32000 19 97 CDN$ Per Annum 36000 44000 2000 US$ Per... in 19 67; and we are four times as rich as those who lived here in 19 31 Since our current high living standards depend in large part on past growth, and since our future living standards (and those of our children) will depend on current and future growth rates, understanding the phenomenon of growth is of primary importance The branch of macroeconomics concerned with the 1. 5 REAL GDP ACROSS TIME 13 ... (either directly, through ownership of homes, land, stock, and corporate debt, or indirectly through company pension plans) 1 There is also a third way, called the value-added or product approach, that I will not discuss here 6 CHAPTER 1 THE GROSS DOMESTIC PRODUCT FIGURE 1. 1 GDP Income Components United States and Canada 19 61. 1 - 2003.4 United States Canada 10 0 10 0 Percent of GDP 80 80 Wage Income Wage... economic meaning (in particular, note that P1997 = 1 by construction) Nevertheless, the GDP deflator is useful for making comparisons in the price level across time That is, even if P1997 = 1 and P1998 = 1. 10 individually have no meaning, we can still compare these two numbers to make the statement that the price level rose by 10 % between the years 19 97 and 19 98 The methodology just described above is... Bob Delorme and Janet Hua I am also grateful for the thoughtful suggestions offered by several anonymous reviewers This text is still very much a work in progress and I remain open to further comments and suggestions for improvement If you are so inclined, please send them to me via my email address: dandolfa@sfu.ca Part I Macroeconomic Theory: Basics 1 Chapter 1 The Gross Domestic Product 1. 1 Introduction... trade balance FIGURE 1. 2 GDP Expenditure Components United States and Canada 19 61. 1 - 2003.4 United States Canada 10 0 80 Percent of GDP 10 0 80 Consumption 60 60 Consumption 40 40 Investment 20 20 Government Net Exports 0 65 1. 2.3 70 75 80 85 90 95 00 Investment Government Net Exports 0 65 70 75 80 85 90 95 00 The Income-Expenditure Identity So far, we have established that GDP ≡ GDI and GDP ≡ GDE From... microeconomic foundations of macroeconomic theory to an undergraduate textbook An early attempt is to be found in: Macroeconomics: A Neoclassical Introduction, by Merton Miller and Charles Upton (Richard D Irwin, Inc. ,19 74) This is still an excellent text, although it is by now somewhat dated More recent attempts include: Macroeconomics, by Robert Barro (John Wiley and Sons, Inc., 19 84); Macroeconomics: An Integrated... bread and that year after year, bread production is equal to 10 0 loaves Suppose that the price of bread ten years ago was equal to $1. 00 per loaf, so that the nominal GDP then was equal to $10 0 Suppose further that the price of bread has risen by 10 % per annum over the last ten years The nominal GDP after ten years is then given by (1. 10 )10 ( $10 0) = $260 Observe that while the nominal GDP is 2.6 times... (2003) Price (2003) Quantity (2004) Price (2004) Bananas 10 0 $0.50 11 0 $0.50 Bread 50 $1. 00 60 $1. 50 (a) Compute the GDP in each year using current prices Compute the growth rate in nominal GDP (b) Compute the real GDP in each year first using 2003 as the base year and then using 2004 as the base year How does the rate of growth in 1. 8 REFERENCES 17 real GDP depend on which base year is used? Explain... GDP in economy A compared to economy B? 1. 8 References 1 Keynes, John M (19 36) The General Theory of Employment, Interest and Money, MacMillan, Cambridge University Press 2 Schumpeter, Joseph A (19 39) Business Cycles: A Theoretical, Historical and Statistical Analysis of the Capitalist Process, New York, McGraw-Hill 18 1. A CHAPTER 1 THE GROSS DOMESTIC PRODUCT Measured GDP: Some Caveats Have you ever . 10 8 5 Government Spending and Finance 11 1 5 .1 Introduction 11 1 5.2 TheGovernmentBudgetConstraint 11 1 5.3 TheHouseholdSector 11 3 5.4 TheRicardianEquivalenceTheorem 11 4 5.5 GovernmentSpending 11 7 CONTENTS. GovernmentSpendingShocks 12 1 5.6.3 Barro’sTax-SmoothingArgument 12 1 5.7 U.S.FiscalPolicy 12 1 5.8 Summary 12 3 5.9 Problems 12 4 5 .10 References 12 5 6 Capital and Investmen t 12 7 6 .1 Introduction 12 7 6.2 CapitalandIntertemporalProduction. 207 10 The Demand for Fiat Money 209 10 .1Introduction 209 10 .2ASimpleOLGModel 210 10 .2 .1 ParetoOptimalAllocation 211 10 .2.2 MonetaryEquilibrium 213 10 .3GovernmentSpendingandMonetaryFinance 217 10 .3.1