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An Overview of Modern Macroeconomics Intermediate Macroeconomics ECON-305 Spring 2013 Professor Dalton Boise State University Issues and Ideas Macroeconomics Study of structure, performance and behavior of economy as a whole Causes and impacts of short-run GDP fluctuations Business (trade) cycle Major determinants of long-run path of GDP Economic growth Macroeconomics and Politics Behavior of economy subject of citizen interest Performance and policy closely interconnected Post-war elections determined by inflation, unemployment, GDP growth Representative of ideological conflict Macroeconomic Theory Set of views of how economy operates organized into a model Economists differ over correct model Models have developed historically to take account of novel facts and new historical situations Great Depression (1930s) Great Inflation (1970s) Milton Friedman “There is wide agreement about the major goals of economic policy: high employment, stable prices, and rapid growth. There is less agreement that these goals are mutually compatible or, among those who regard them as incompatible, about the terms at which they can and should be substituted for one another. There is least agreement about the role that various instruments of policy can and should play in achieving the several goals.” - “The Role of Monetary Policy,” AER, March 1968 Two Fundamental Issues Self-adjusting properties of market economy Proper role of government Government Beneficial? NO YES Self-Adjusting? YES NO a b c d Business Cycle Facts Economic Fluctuations Pattern: Expansion-Peak-Contraction-TroughExpansion Trend Correlations with GDP1 Variable Direction Timing Industrial Production* Procyclical Coincident Consumption** Business Fixed Investment Residential Investment Inventory Investment Government Purchases Procyclical Procyclical Procyclical Procyclical Procyclical Coincident Coincident Leading Leading Undesignated Employment Unemployment Ave. Labor Productivity Real Wage Procyclical Countercyclical Procyclical Procyclical Coincident Not clear Leading Undesignated Correlations with GDP1 Variable Direction Timing Money Supply Inflation Procyclical Procyclical Leading Lagging Stock Prices Nominal interest rates Real interest rates Procyclical Procyclical Acyclical Leading Lagging Undesignated *durable more volatile than non-durable ** investment expenditures more volatile than consumption expenditures 1Abel and Bernanke Cycle Regularities2 Output movements across sectors have high conformity Producer and consumer durables exhibit greater amplitude than nondurables Production and prices of agricultural output and natural resources have lower than average conformity Business profits show high conformity and much greater amplitude than other series Prices generally procyclical Short-term nominal interest rates procyclical, long-term slightly so Monetary aggregates and velocity pro-cyclical 2Lucas, “Understanding Business Cycles” Therefore… Lucas: “Business Cycles Are All Alike.” - Attractive property – challenge to theorists - Suggests a general theory of cycles is possible Keynes and Cycles Keynes and Earlier Cycle Models - Keynesian models conform well to timeseries data, but not tied to general economic theory that output react to prices - Keynesian models invariant to policy - Policy changes don’t produce changes in decision rules of agents Earlier cycle models attempted to tie fluctuations to general theory Keynes and Cycles Keynes changed the focus of Business Cycle economics from a consideration of ebbs and flows of economic activity relative to changing prices, technology, and preferences Keynes asked a different question… - What determines aggregate output? Economic Stability Triumph of Keynes 1946 Employment Act Cursory investigation of time-series data suggests post-war prosperity due to purposeful macro policy Cursory view also indicates economy was more stable in the post-WW II era Was It? Romer: “Changes in Business Cycles: Evidence and Explanations” Series of influential papers What is evidence of changes in fluctuations? How measured? What series? Problems with data! Romer re-estimated pre-WW II data. Romer: “Changes in Business Cycles: Evidence and Explanations” Interwar period extremely volatile Little evidence pre-WW I period much more volatile in US than post-WW II Recessions less frequent and more uniform; Expansions longer Not much difference in average output loss per recession Policy dampened shocks that produced recessions in past; however, appearance of policy-induced recessions to fight inflation The Great Depression General Features World-wide phenomenon Output fell moderately in some countries, precipitously in others 47% decline US industrial production Nations with greater than 30% declines: Germany, France, Italy, Belgium, Netherlands, Czechoslovakia, Poland, Canada Central Questions How did the recession of 1929-1930, well within historical parameters, turn into the Great Depression of 19311933? Why did it last so long? When did it end? Why was their a recession within the Depression in the US (1937-38)? The Causes of the Great Depression Non-monetary/Non-financial hypothesis Monetary hypotheses Non-monetary/financial hypothesis Gold-Standard hypothesis Non-monetary real business cycle hypothesis Eichengreen: “The origins and nature of the Great Slump revisited” Bernanke: “The Macroeconomics of the Great Depression: A Comparative Approach” Structural Changes of 1920s Changes in Composition of Production Minor; except consumer durables and agricultural production in US Changes in Flexibility of Labor Markets Minor- high unemployment Europe, low rates unionization, unemployment benefits; except internal labor markets and personnel departments US Structural Changes of 1920s Changes in International Monetary System Rise of foreign exchange in international reserves made system subject to greater destabilization (dollar and pound sterling) Changes in Pattern of International Settlements Expansion of US and Japan international business interests during WW I; US becomes net creditor; War reparations Onset of Depression Restrictive US monetary policy to counteract stock market bubble in 1928 Rising US interest rates reduce international credit; capital and gold inflows Fed sterilization of gold inflows prevent US prices from rising To maintain exchange rates foreign central banks adopt contractionary monetary policies Spread of Depression Eichengreen Role of Stock Market Crash 1930-31 Bank Runs Role of Gold Standard Was US constrained from reflating under gold standard? Bernanke Evidence Gold Standard and recovery Real Effects of Nominal Shocks Why did process of adjustment to monetary shocks take so long to work themselves out? Anticipated v. Unanticipated policy Both Eichengreen and Bernanke concentrate on two aspects Debt-deflation process Nominal wage and price rigidity Debt-deflation Falling asset prices force nominal debtors into distress sales that further drop asset prices and increase pressures on nominal debtors Counter-argument: simply a redistribution debtors to creditors – should have no real effects Bernanke presents evidence that bank panics negatively correlated with output, employment and wages. Why? Debt-deflation Principal-agent literature and imperfect information Net worth/balance sheet plays important role in aligning incentives of lenders and borrowers Deterioration of net worth causes risk of lending to rise, reducing lending World of imperfect information, some opportunities known to some will go unexploited due to lack of access to funds Sufficiently severe debt-deflation imposes bank balance-sheet problems Nominal Wages and Prices Again, Bernanke presents evidence of nominal price and wage rigidity. Why? Eichengreen US Hoover’s voluntary program AAA – agricultural prices NIRA labor and business provisions NLRA (Wagner Act) England Unemployment benefits lagged price and wage reductions Monetary and Fiscal Policy Eichengreen- international comparisons Monetary policy led recovery in every instance No nation suffered a liquidity trap Fiscal policy was small and often ocunterproductive Hoover’s 1932 massive income tax increase New Deal Uncertainty Did the New Deal help the recovery process? New Deal instituted policies and programs that had been “lying about” for decades Uncertainty in business environment Congress pass general law and Roosevelt and agencies sort out details FDR sign executive order and Congress would later ratify Businessmen’s correspondence Development of Modern Macroeconomics Keynes General Theory of Employment, Interest and Money (1936) Treatise on Money (1930) Fundamental flaw in operation of market as coordinating device Fundamental misunderstanding of economists Keynes Major discovery: Principle of Effective Demand Rejection of “laissez-faire” New Deal and Keynesianism Post WW II commitment to Activist policy Macroeconomics Develops Orthodox Keynesianism Hicks, “Mr. Keynes and the Classics” (1937) Modigliani, “Liquidity Preference and the Theory of Interest and Money” (1944) IS-LM Model Theoretical Schizophrenia Macroeconomics Develops Monetarist Response and Neoclassical Synthesis Friedman, “The Quantity Theory of Money: A Restatment” (1956) Patinkin, Money, Interest and Prices (1956) Macroeconomics Develops Phillips Curve Phillips, “The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the Untied Kingdom, 1861-1957” (1958) Samuelson and Solow, “Analytical Aspects of Anti-Inflationary Policy” (1960) Macroeconomics Develops Orthodox Monetarism Friedman and Scwartz, A Monetary History of the United States, 1867-1960 (1963) Natural Rate Hypothesis Phelps, “Phillips Curves, Expectations of Inflation and Optimal Unemployment over Time” (1967) Friedman, “The Role of Monetary Policy” (1968) Macroeconomics Develops Rational Expectations and New Classical Economics Lucas, “Some International Evidence on Output-Inflation Tradeoffs” (1973) Lucas, “An Equilibrium Model of the Business Cycle” (1975) Real Business Cycle Theory Kydland and Prescott, “Time to Build and Aggregate Fluctuations” (1982) Macroeconomics Develops New Keynesian Response Mankiw, “Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly” (1985) Akerlof and Yellen, “A Near-rational Model of the Business Cycle, with Wage and Price Inertia” (1985) Growth Economics Endogenous growth theory MACRO SCHOOLS Dominant source of instability PostKeynesian Fluctuations in Autonomous Expenditures Expectations Price Adjustment Market Adjustment Very weak Loanable Funds Market Notion of Equilibrium Dominant Time Frame Rules v. Discretion Role of Incomes Policy No joint State of rest probably below full employment Short Discretion Essential and beneficial Predominantly short No clear consensus Predominately against Reasonable Sticky New Keynesian Demand and supply shocks (eclectic) Rational Emphasis on Price Rigidities Slow No clear consensus Consistent with involuntary unemployment Orthodox Keynesian Fluctuations in Autonomous Expenditures Adaptive Inflexible below Full employment Weak No joint State of rest probably below full employment Short run Discretion Some support Austrian Monetary Disturbances Reasonable Flexible Strong Loose joint Tendency towards market clearing Short and Long Rules Harmful and distorting Orthodox Monetarist Monetary Disturbances Adaptive Flexible Strong Tight joint Market clearing at natural rate Short and Long Rules Irrelevant and distorting New Classical Monetary Disturbances Rational Extremely Flexible Very strong Tight joint Market clearing at natural rate Long = short Rules Irrelevant and distorting Real Business Cycle Supply shocks (mainly technological) Rational Extremely Flexible Very strong Tight joint Market clearing at moving natural rate Long = short Rules Irrelevant and distorting