Download Economics 3307

Economics 3307
Fall 2002
The Rest of Macroeconomics
This course has covered Chapters 1-11 in the Mankiw text. We have addressed the determination in the
long-run of employment, real wages, output, inflation, the unemployment rate, net exports, net foreign
investment, the real interest rate, and the nominal interest rate. We have also considered the determinants
of short-run fluctuations in output (and therefore unemployment through Okun’s Law), inflation, and
interest rates.
The purpose of this handout is to provide a necessarily cursory overview of some of the ideas and topics
that we have not been able to address in detail this semester.
Much of the rest of macro can be thought of as more detailed theories of why the curves of our models
shift. That is, more advanced theories look more carefully at the ultimate exogenous forces that drive the
economy.
Short-Run Aggregate Supply
Our discussion of short-run aggregate supply has been very simplistic: we have simply assumed the price
level is “sticky” for a while and then “eventually” begins to adjust. The notion of short-run price stickiness
is still an area of much disagreement among modern macroeconomists. I will use this opportunity to make
just a few points:
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There are many alternative ways to model price stickiness. Some imply a horizontal SRAS curve
(like the one we have been using), and some imply an upward-sloping SRAS curve.
Some short-run SRAS studies are based on “incomplete information.” In these stories, a change in
AD is not met with a fully compensating change in P (thereby keeping the economy on LRAS)
because economic agents are not fully aware of what is going on. This formulation has the
interesting implication that effect on Y of changes in AD depends on the extent to which the
change in AD is accurately expected and/or perceived.
More generally, the nature of price stickiness is not well understood. Prices appear to be more
sticky some times than others. Macroeconomists do not have a very good understanding of
exactly what determines how quickly prices adjust to long-run equilibrium. Thus it is hard to
predict how, or in some cases even whether, a change in AD will affect Y.
The Phillips Curve graph has inflation on the vertical axis and the unemployment rate on the
horizontal axis. The short-run Phillips curve slopes downward, and the long-run Phillips Curve is
vertical. Essentially, the Phillips Curve is just an aggregate supply curve. The long-run Phillips
Curve is vertical just as the LRAS curve is vertical. Changes in AD have no effect on output or
unemployment in the long-run, but they can have an effect in the short-run. In the 1960s, some
policymakers viewed the short-run Phillips Curve as a “policy menu,” but that idea now has little
overt acceptance. While economists differ in their opinions as to how policy-induced changes in
AD affect Y, few would argue that AD policy can come even remotely close to controlling Y
perfectly.
The idea of short-run price stickiness is hard to reconcile with basic micro concepts such as utility
and profit maximization. If a market is not clearing, there are foregone gains from trade (that is,
there are trades not being made that if undertaken would make both buyer and seller better off).
There are two responses to this difficulty. One group of economists try to find better justifications
for price stickiness. This is New Keynesian macroeconomics. The other tries to see how much
can be explained without resorting to the assumption of price stickiness. This is the Real Business
Cycle (RBC) Theory. The RBC theory in effect assumes there are only LRAS and AD curves –
the SRAS does not exist. Fluctuations in Y must therefore reflect shifts in LRAS, which are
primarily due to “technology shocks.” Economists disagree about how well RBC theories explain
the observed facts of modern macroeconomic fluctuations.
The Open Economy in the Short-Run
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International trade affects aggregate demand because of fluctuations in net exports. This can
easily be viewed as other sources of shifts in AD.
To the extent that intermediate goods (goods used in the production of final goods and
services) are imported, changes in the prices of imports can affect the economy like a supply
shock. Changes in the nominal exchange rate can also have this kind of affect.
Open economy considerations complicate policy. Monetary policy will often face an
irresolvable conflict between domestic policy goals (e.g., an expansionary policy to prevent a
recession) and international policy goals (e.g., tighten policy to prevent one’s currency from
losing value). Fiscal policy actions in an open economy can end up having more effect on the
exchange rate than on AD.
Other Points
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There are advanced macro theories about all the basic behavioral functions (consumption,
investment, money demand). Most of these theories link the behavior in question more
explicitly to utility and profit maximization.
One interesting branch of advanced theories involves the so-called permanent income/lifecycle hypothesis (PI/LCH) of consumption. The idea is that consumption today depends not
just on income today, but also on expectations of future income. The theory implies that
changes in income perceived to be permanent will have a bigger effect on consumption than
changes in income that are perceived to be temporary.
The PI/LCH means that the effects of fiscal policy depend on expectations about future taxes.
If taxes are cut today but people expect them to be increased in the future, AD will not change
as much as we thought.
The idea of Ricardian Equivalence says that decreases in government saving today (say with
lower T or higher G) will be EXACTLY offset by increases in private saving as people expect
higher future taxes. Thus fiscal policy does not shift the IS or AD curves, and government
deficits do not affect interest rates. There is actually some empirical evidence in support of
Ricardian equivalence.
Growth Theory: endogenous technical change; cross-country studies
Sources of Information: NBER (esp. email update); FRBSF (esp. weekly letter)