Download AM II Basic Macroeconomic Model

Prof. Dr. Thomas Steger
Advanced Macroeconomics II | Lecture| SS 2013
1 Basic Macroeconomic Models
1.
 Textbook (static) macromodel
 Dynamic AS-AD model
 Basic dynamic macromodel with expectations
 Schools of macroeconomic thought
g
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
P li i i (1)
Preliminaries
 Macroeconomics: two defining characteristics
 studies the economic interactions in society as a whole
 aims at understanding empirical regularities in the behavior of aggregate
economic variables such as production, investment, unemployment, price
level…
 Macroeconomics: three purposes
 explain the level of the aggregate variables as well as their movement over
time in the short run and the long run
 make well
well-founded
founded forecasts possible
 provide foundations for rational macroeconomic policy
2
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
P li i i (2)
Preliminaries
 The short run…
 concentrates on the behavior of the macroeconomic variables within a time horizon of a few years.
 focuses on mechanisms that determine how fully an economy uses its productive capacity and are
typically demand dominated.
 shifts in aggregate demand tend to be accommodated by changes in the produced quantities
rather than in the prices of goods.
 The
Th long
l
run…
 deals with a time horizon long enough such that changes in the capital stock, population, and
technology have a dominating influence on the level of production.
 uses analytical frameworks which are supply dominated. Variations in the employment rate for
labor and capital due to demand fluctuations are ignored.
 The medium run
run…
 medium run models (business cycle models) attempt to understand the pattern of economic
fluctuations.
 focuses on the dynamic interaction between demand and supply factors
factors.
 equally important is the formation of expectations, and the adjustment of wages and prices.
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Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
T tb k ((static)
Textbook
t ti ) macromodel:
d l aggregate
t labor
l b market
k t
 The problem of the typical firm reads
W=Peg(NS)
{PF ( K , N ) − WN }
max
N
The firm can observe (hence knows) the going
price of its own output good (P) and the wage
rate (W).
W=PFN(K,N)
The demand schedule may be expressed as:
W/P=FN(K,N).
 The problem of the typical household is
max U (C ,,1 − N S ) s.t. P eC = WN S
C ,N S
The household cannot observe the prices of all
consumption goods and hence bases its decision
on the expected price level (Pe).
)
Optimal NS results from W/Pe=U1-N/UC=:g(NS).
The labor supply curve may be expressed as
W=Peg(NS) with g’(NS)>0, i.e. we assume that the
substitution effect dominates the income effect.
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Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
T tb k ((static)
Textbook
t ti ) macromodel:
d l aggregate
t goods
d supply
l (1)
 The adaptive expectations hypothesis (AEH)
P = Pt + (1 − λ )
e
t +1
−P )
(P

t
2,00
1,00
expectational error in t
ΔPt = P − Pt = λ ( Pt − Pt
e
e
t +1
e
e
)
4,00
3,00
e
t
5,00
0≤λ ≤1
0,00
1 3 5 7 9 11 13 15 17 19 21 23 25 27 29t
 Under the AEH the expected price level (Pe) is adjusted to correct for past expectational errors.
errors
 The problem with the AEH is that it may lead to permanent incorrect expectations.
 In the face of informational and cognitive constraints, the AEH may represent a valid approximation.
 The perfect foresight hypothesis (PFH)
Pt e = Pt
 The PFH simply states that households expect the price level that actually holds.
 The PFH is the deterministic counterpart to the rational expectations hypothesis (REH).
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Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
T tb k ((static)
Textbook
t ti ) macromodel:
d l aggregate
t goods
d supply
l (2)
nominal wage!
 The AS-curve under AEH
Suppose P0e=P0. HH make no
expectational
i
l error, supply
l the
h ““correct””
*
amount of labor (N ) and output is at its
potential level Y* (point E0).
Assume now that P increases to P1>P0,
while
hile P0e=P
P0 initially
initiall impl
implying
ing that the
labor supply curve is unchanged.
However, the demand for labor shifts up
so that labor market equilibrium is at
point A.
A Associated output is Y1>Y*.
Employment and output increase. The
reason is that the real wage decreased
such that firms demand more labor. HH
must accept this lower real wage (they
have underestimated P and
overestimated W/P).
curve under PFH
 The AS
AS-curve
Expected and actual P always coincide
and, hence, labor supply is always based
on correct estimations of W/P.
Employment is always N* and output
equals Y*. The AS curve is vertical.
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Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
T tb k ((static)
Textbook
t ti ) macromodel:
d l aggregate
t goods
d supply
l (3)
nominal wage!
 AS-curve under downward
nominal wage rigidity
The rigid nominal wage equals W0.
P0 is the price level such that full
employment holds (point E0).
The PFH is assumed to hold, i.e. Pte=Pt.
For P1>P0 , the nominal wage rises such
that the real wage and employment
remain constant (point B).
For P2<P0 , the demand for labor is
W=P2FN but the effective labor supply is
horizontal at the segment W0C (point A).
Since it is assumed that the wage is not
allowed to fall, employment equals N2
(<N*), while unemployment equals N2SN2.
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Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
T tb k ((static)
Textbook
t ti ) macromodel:
d l aggregate
t goods
d d
demand
d (1)
 The demand side of the economy can be described by means of the IS-LM model
IS :
= C (Y − T ) + I ( R ) + G



output=income
t t i
Y
0 < CY < 1, I R ≤ 0
goods demand
LM :
M / P = L(Y , R ) ,


money supply
LY > 0, LR ≤ 0
money demand
d
d
 There are two endogenous
g
variables: Y ((aggregate
gg g
demand)) and R ((interest rate).
)
 These two equations define Y and R.
 Usually,
U ll th
the (i
(inverse)) AD curve iin (Y
(Y,P)-plane
P) l
iis negatively
ti l sloped.
l
d
 Provided that LR=-∞ (liquidity trap) and / or IR=0 (investments are insensitive w.r.t. R), the
AD curve is vertical in (Y,P)
(Y P)-plane
plane (→ goods market equilibrium may not exist)
exist).
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Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
T tb k ((static)
Textbook
t ti ) macromodel:
d l aggregate
t goods
d d
demand
d (2)
 Assume the following specific (linear) functional forms
Y = C + cY + I − bR,
IS :
LM :
M / P = kY − hR,
0 < c < 1, b ≥ 0
k > 0, h ≥ 0
 The (inverse) AD-curve then reads
bM
P=
[(1 − c)h + bk ]Y − h(C + I )
 Usually,
ll this
h is a h
hyperbola
b l in ((Y,P)-plane
) l
((we ffocus only
l on the
h positive b
branch).
h)
 For h=0 one gets P=M/(kY). This AD curve is basically the same as P=(VM)/Y (resulting from PY=VM).
 Two
T special
i l cases: AD curve iindependent
d
d
off P,
P i.e.
i AD iis vertical
i l iin (Y
(Y,P)-plane.
P) l
 For b=0, one gets Y=(C+I)/(1-c).
 For h=∞,, one gets
g (→
( q
quo ent rule))
∂Y
bM
=−
∂P
[(1 − c)h + bk ]P2
∂Y

= 0 for h = ∞
∂P
Y=
bM + h(C + I ) P
[(1 − c)h + bk ]P
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Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
D
Dynamic
i AS
AS-AD
AD model:
d l AD
AD-curve
 The goods market (IS-Curve)
C = C0 + b(1 − τ )Y
real interest rate (Fisher-equation)
I = I 0 − h(i − π e )
Y =C + I +G
For technical reasons we assume
that the demand for real money
balances is non-linear.
 The money market (LM-Curve)
ln M d = kY − qi
(⇔ M d = e kY − qi )
ln M s = ln M − ln P
(⇔ M s =
M
)
P
ln M s = ln M d
 The AD-Curve
Y=
C0 + I 0 + G + qh ⋅ ln ( MP ) + h ⋅ π e
1 − b(1 − τ ) +
h⋅k
q
= a0 + a1 ⋅ (ln M − ln P ) + a2 ⋅ π e
a0 :=
C0 + I 0 + G
1 − b(1 − τ ) + hq⋅k
a1 :=
h/q
1 − b(1 − τ ) + hq⋅k
a2 :=
h
1 − b(1 − τ ) + hq⋅k
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Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
D
Dynamic
i AS
AS-AD
AD model:
d l AS
AS-curve and
d iinflationary
fl ti
expectations
t ti
 The AS-Curve
π = α (Y − Yn ) + π e , α > 0
This AS-Curve results from a modified Phillips-Curve, π=πe-a(u-un), together with Okun‘s law of the
form u-un=-b(Y-Yn), where a,b>0.
 Inflationary expectations
π e = β (π − π e ),
) β >0
Definition
x(t):=dx(t)/dt
If the actual inflation rate exceeds the expected inflation rate, π-πe>0, inflationary expectations are
revised upwards,
upwards i.e.
i e πe>0.
>0
Written in time discrete form this expectations hypothesis can be expressed as
π te+1 − π te = β (π t − π te )

π te+1 = π te + β (π t − π te )
11
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
D
Dynamic
i AS
AS-AD
AD model
d l (3)
 Reduced form
π e = βα (Y − Yn )
(*)
Y = a1Mˆ − α (a1 − a2 β )(Y − Yn ) − a1π e
((**))
 Equation (*) shows that a positive output gap, Y-Yn>0, induces an increase in expected inflation πe.
 Reason: According to the AS-Curve Y-Yn>0 requires π-πe>0. The latter induces a revision of inflationary
expectations.
 Equation (**) shows that
 Output
p increases,, Y>0,, if M>0: an increase of nominal moneyy supply
pp y increases AD.
 Output decreases, Y<0, if Y-Yn>0 and a1-a2β>0. Reason: Y-Yn>0 unfolds two opposing effects: (i) π increases, which reduces
M/P and hence AD falls, (ii) πe increases, which reduces the real interest rate and hence AD goes up.
 Steady State (Y, πe): time invariant solutions
π e = βα (Y − Yn ) = 0

Y = a1Mˆ − α (a1 − a2 β )(Y − Yn ) − a1π e = 0
Y = Yn

π e = π = Mˆ
12
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
D
Dynamic
i AS
AS-AD
AD model
d l (3
(3a))
 Determination of the reduced form: elimination of π
π e = β (
π
−π e)


π e = βα (Y − Yn )
(***)
α (Y −Yn )
Y = a0 + a1 ⋅ (ln M − ln P ) + a2 ⋅ π e

e
ˆ
Y = a1 ⋅ ( M
 − π ) + a2 ⋅ π
d ln M
dt
d ln P
dt
Y = a1[ Mˆ − (α (Y − Yn ) + π e )] + a2 βα (Y − Yn ) = a1Mˆ − α (a1 − a2 β )(Y − Yn ) − a1π e


π
(****)
π e
 Equ. (***) and (****) represent two linear differential equations in Y and πe.
 Boundary conditions are given by the steady state solutions.
 On M and π. Recall:
d ln x(t )
=
dt
1
x(t )

dx(t )
x (t )
=
=: xˆ (t )
dt
x(t )

outer derivative inner derivative
13
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
D
Dynamic
i AS
AS-AD
AD model
d l (4)
 Dynamic responses (1): expansionary monetary policy (permanent increase of M)
14
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
D
Dynamic
i AS
AS-AD
AD model
d l (5)
 Dynamic responses (2): expansionary fiscal policy (temporary increase of G)
15
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
D
Dynamic
i AS
AS-AD
AD model
d l (5)
 Dynamic responses (3): negative supply shock (permanent)
16
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
B i d
Basic
dynamic
i macromodel
d l with
ith expectations:
t ti
model
d l setup
t (1)
 Firms produces a homogenous output good under perfect competition using
Yt = Lαt , 0 < α < 1
 Firms are assumed to maximize profits given by
Π t = PY
t t − Wt Lt
 The first-order condition (FOC) for optimal labor input implies
α Lαt −1 =
Wt
 Lt = α
Pt
1
1−α
 Wt 
 
 Pt 
1
α −1
 The indirect production function, Y=F(W/P), is hence given by
Yt = α
α
1−α
 Wt 
P
 t 
α
α −1
17
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
B i d
Basic
dynamic
i macromodel
d l with
ith expectations:
t ti
model
d l setup
t (2)
 Labor unions have a target real wage, which is normalized to one, i.e. Wt/Pt=1. Moreover,
l b unions
labor
i
h
have th
the power tto sett Wt/Pt=1.
1 Hence,
H
llabor
b unions
i
sett Wt, negotiated
ti t d att th
the
beginning of each period t, such that
Wt = Pt e
 There is "substantial unemployment" at Wt/Pt=1. Accordingly, if the real wage falls below one, the additional labor
demand by firms can be satisfied.
satisfied
 This assumption is compatible with collective bargaining models of unemployment.
 The AS
AS-curve
curve can hence be expressed as
Yt = α
α
1−α
α
1−α
 Pt 
 Pe 
 t 
yt = 
y ∗ + a ( pt − pte )
α
α
= ln α 1−α
 Lower case letters denote
(natural) logarithms, i.e. xt:=lnXt.
=
1−α
18
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
B i d
Basic
dynamic
i macromodel
d l with
ith expectations:
t ti
model
d l setup
t (3)
 The AD-schedule is described by the quantity equation of money, MtVt=YtPt, expressed in
logarithms
mt + vt = yt + pt

=0
 nominal transaction volume per period, YtPt, must equal the nominal money supply times the velocity of money per period, MtVt.
 assuming that Vt=1 for all t, we have vt=0.
 Price expectations
p
are formed accordingg to an adaptive
p
expectations
p
scheme
pte = pte−1 + β ( pt −1 − pte−1 ), 0 ≤ β ≤ 1
 Alternatively, we consider the rational expectation hypothesis such that
pte = E ( pt  Ωt −1 )
E(.) denotes the expectations operator.
Ωtt-11 the information set at the end of p
period t-1.
 Monetary policy controls nominal money supply according to Mt=M*exp(εt) or
mt = m∗ + ε t
 εt represents an i.i.d. error term with E(εt)=0, V(εt)=const. and Cov(εt, εt+i)=0 for all t and i.
19
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
B i d
Basic
dynamic
i macromodel
d l with
ith expectations:
t ti
d
dynamic
i system
t
and
d steady
t d state
t t
 The complete dynamic system
AS : yt = y ∗ + a ( pt − pte ), 0 < a < 1
AD : mt = yt + pt
MP : mt = m∗ + ε t
Expectations : pte+1 = pte + β ( pt − pte ), 0 ≤ β ≤ 1
 Steady state
The steady state is defined by yt=yt-1, pt=pt-1, pte=pt-1e for all t.
t Letting x denote the (pseudo) steady state
value of variable xt (assuming εt=0 for all t), one can express the steady state as follows
y = y ∗ , p = m∗ − y ∗ , p e = p
20
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
B i d
Basic
dynamic
i macromodel
d l with
ith expectations:
t ti
reduced-form
d df
d
dynamic
i system
t
 Combining the AS curve, the AD curve, and the monetary policy schedule one gets
m∗ + ε t = y ∗ + a ( pt − pte ) + pt
The equilibrium price level
(AD=AS), given pte.
 Solving for pt gives
pt =
1
a e
m∗ + ε t − y ∗ ) +
pt
(
1+ a
1+ a
(*)
 Next, substitute pte by the RHS of the adaptive expectations scheme to yield
pt =
1
a
 pte−1 + β ( pt −1 − pte−1 ) 
m∗ + ε t − y ∗ ) +
(
1+ a
1+ a
 The reduced-form dynamic
y
system
y
then comprises
p
pte = pte−1 + β ( pt −1 − pte−1 )
pt =
(**)
1
a
 pte−1 + β ( pt −1 − pte−1 ) 
m∗ + ε t − y ∗ ) +
(
1+ a
1+ a
(***)
21
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
B i d
Basic
dynamic
i macromodel
d l with
ith expectations:
t ti
monetary
t
policy
li (1)
 Adaptive expectations
 Assuming that the economy is
i a steady
in
t d state
t t iinitially,
iti ll we
have the following initial
conditions p₀=p₀e=p.
 The complete time paths {pt}
and {pte} for t∈{0,…, ∞} can
then be traced out by
recursively solving (**) and
(***).
 The time path {yt} can be
calculated by evaluating the
AS-curve.
AS
 The associated excel file
illustrates the dynamic
consequences of an
expansionary policy in the
sense of a permanent
increase in m*.
22
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
B i d
Basic
dynamic
i macromodel
d l with
ith expectations:
t ti
monetary
t
policy
li (2)
 Rational expectations (RE)
R ti
Rational
l expectations
t ti
are ttaken
k tto representt model
d l consistent
i t t expectations.
t ti
To determine the expected price level under REH, we simply determine the equilibrium
price level, implied by the underlying model, and then form the expected value, denoted
E(p
( t).
)
Taking expectations on both sides of (*), noting that E(εt)=0 and that pte=E(pt) is a fixed
number, one gets
E ( pt ) =
1
a
∗
∗
−
y
+
E ( pt )
m
(
)
1+ a
1+ a
1
a 

∗
∗
−
=
−
(
p
)
m
y
1
E
(
)
t
 1 + a 
1+ a
E ( pt ) = m∗ − y ∗
23
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
B i d
Basic
dynamic
i macromodel
d l with
ith expectations:
t ti
monetary
t
policy
li (3)
 Rational expectations
 Assume that the economy is in
a steady state initially,
initially i.e.
i e y=y*,
p=m*-y*, pe=p.
 Monetary authorities increase
the moneyy supply
pp y from m* to
m**>m* at the end of period t.
 Agents can anticipate this
policy action. Initially,
E(pt)=m*-y*=pt.
 Right after the monetary
expansion, the expected price
l l jjumps up such
h that
h
level
E(pt+1)= m**-y*=pt+1.
 As a result, an expected
expansionary policy does not
exert any real effects under
the REH, but increases only
the price level. The adjustment
to the new steady state is
immediate.
24
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
S h l iin M
Schools
Macroeconomics:
i Cl
Classical
i lM
Macroeconomics
i
 Demand side: Quantity theory of money implies a demand function like L=kPY.
 Money demand is not interest sensitive.
 The velocity of circulation (V=1/k) is constant.
 The (inverse) AD curve reads: P
P=M/(kY).
M/(kY).
 Supply side: Strong belief in markets and the efficacy of the price mechanism.
 Wages and prices are flexible,
flexible there is perfect foresight.
foresight
 The labor market clears (at every instant of time), such that N=N*, the AS curve is vertical at Y=Y*.
 Fiscal and monetary policy cannot affect output and employment.
 Policy implications
 LR=0 implies that the LM-curve is vertical.
 Expansionary fiscal policy crowds out, via an increase in R, private investment (no shift in AD).
 Expansionary monetary policy shifts AD, but does not exert any real effects (only P rises).
25
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
S h l iin M
Schools
Macroeconomics:
i K
Keynesianism
i i
 One prominent Keynes interpretation is based on
the liquidity trap.
 Suppose that R is so low that the economy is on the
horizontal part of the LM-curve.
 Suppose also that the level of spending is too low to
support full
f ll employment
l
and
d that
h prices
i
and
d wages are
flexible.
 The interest rate is RMIN and output is Y0<Y*.
 AS is vertical at Y=Y*, but demand falls short of Y*, and
no price/wage change can restore equilibrium (goods
market).
 Monetary policy would be ineffective in increasing AD.
Fiscall policy,
l
on the
h other
h h
hand,
d is effective
ff
in
increasing AD.
 Pigou pointed out that this result (no equilibrium in
ggoods market)) disappears
pp
once wealth effects are taken
into account. The position of the IS curve then depends
on M/P, the AD curve will slope downward and full
employment will be restored provided that P and W are
flexible.
26
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
S h l iin M
Schools
Macroeconomics:
i N
Neoclassical
l i l SSynthesis
th i
 A synthesis of short run Keynesian elements and long run
classical elements.
elements There are different versions of the
Neoclassical Synthesis.
 The 1st version maintains that nominal wages are rigid
downwards.
 The AS curve has an upward sloping branch.
 To get some adjustment over time, one can add a Phillips curve,
i.e. W=α(NS-N)/NS with α<0.
 There
h
may b
be temporary unemployment,
l
b
but ffullll employment
l
willll
be restored over time.
 The 2nd version allows nominal wages to be fully flexible,
but uses the AEH to make P a slowlyy movingg variable.
 The model comprises the AS curve, the AD curve and the AEH (see
figure on the left).
 For instance, an increase in bond financed public spending G
shifts the AD curve outwards
outwards.
 Output rises temporarily above Y* and the price level increase
from P0 to P1. The increased P implies a contraction in M/P such
that AD falls.
 Since P has increased, the short run AS curve shifts up as soon as
Pe rises. This process lasts until Y=Y*.
27
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
S h l iin M
Schools
Macroeconomics:
i M
Monetarism
t i
 Monetarism: basic “assumptions and tenets”
The interest sensitivity of investment is very high (IR≤0 large in absolute value) so that the IS curve is flat.
The interest sensitivity of money demand is very low (LR≈0), i.e. money demand looks like, say, L=kPY.
Expectations
p
follow the AEH.
 Monetarism: policy implications
Fiscal policy is largely ineffective in increasing AD
AD. An increase in G leads to a strong crowding out of
private investment.
Monetary policy may exert real effects: M=kPY implies that dM>0 leads to d(PY)=(1/k)dM>0.
The relative importance of real effects
effects, dY,
dY and nominal effects
effects, dP,
dP depends on the assumptions made
about the labor market and the formation of expectations.
Under AEH there are temporary effects on real output and employment. Policy makers may be tempted
to use monetary expansion to combat unemployment.
unemployment Policymakers are,
are however,
however not very good at
timing monetary policy and there are long and variable lags.
As a result, monetary policy is likely to accentuate business cycle fluctuations. Hence, Friedman
suggested
gg
that the central bank should follow a constant growth
g
rate rule for some monetaryy aggregate.
gg g
28
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
S h l iin M
Schools
Macroeconomics:
i N
New Cl
Classical
i l and
dN
New K
Keynesian
i EEconomics
i
 New Classical Economics: basic “assumptions and tenets”
 Prices and wages are flexible.
flexible
 Expectations are formed rational.
 Macroeconomic theory should be based on microeconomic principles.
 New Classical Economics: main implications
 The decentralized allocation of resources is efficient and full employment prevails.
 Observed fluctuations are not caused by nominal rigidities. Instead rational agents respond to (possibly changing)
economic incentives.
 Policy ineffectiveness proposition (PIP) applies: Either policy makers cannot (strong version of the PIP) or should not
(weak version of the PIP) use countercyclical policy to smooth business cycle fluctuations.
 New Keynesian Economics: basic “assumptions
assumptions and tenets”
tenets




Markets may not be as perfect as classical economics suggests.
Early New Keynesians accepted the REH but stressed nominal wage rigidities (e.g., “multi-period wage contracts”).
The most recent wave of New Keynesian
y
economics is more micro-based.
The predominance of imperfect competition, coordination failures and credit constraints are stressed.
 New Keynesian Economics: main implications
 The decentralized allocation of resources may be inefficient and full employment may not prevail
prevail.
 The PIP is invalidated: The government can and should stabilize the economy, even under REH.
29
Basic Macroeconomic Models
Institut für Theoretische Volkswirtschaftslehre
Makroökonomik
N t ti and
Notation
d abbreviations
bb i ti
Notation
0<c<1
p
rate
consumption
0<λ<1
constant parameter
b≥0
sensitivity of I w.r.t. R
β>0
sensitivity of I w.r.t. π
C
consumption
h≥0
sensitivity of L w.r.t. R
I
investment
K
physical capital
k>0
sensitivity of L w.r.t. Y
L
money demand
M
money
N
labor
NS
labor supply
P
price level
Pe
expected price level
τ
t rate
tax
t
R
interest rate
U
utility
V
velocity of circulation
W
nominal wage
W :=dW/dt
rate of change of W per period dt
Y
output
α>0
constant parameter
Abbreviations
AD
aggregate demand
AEH
adaptive expectations hypothesis
AS
aggregate supply
IS
goods market equilibrium condition
LM
money market equilibrium condition
PFH
perfect foresight hypothesis
PIP
policy ineffectiveness proposition
REF
rational expectations hypothesis
30