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r Macroeconomic Theory I Economics 7020 University of Colorado at Boulder Professor JoAnne Feeney Course Description Topics Macroeconomics is the study of the behavior of the aggregate economic variables of a nation. These variables include aggregate output, consumption, investment, capital accumulation, and employment. The study of macroeconomics also covers the behavior of national price variables, such as the Consumer Price Index, real and nominal interest rates, and rates of inflation. We are interested in understanding how these quantities and prices interact. We want to know the determinants of the level of each at a point in time and the causes of their fluctuations over time. Not only do we want to explain aggregate behavior within a country, but we also want to explain the persistent differences that aggregate variables exhibit across countries. One area of primary importance to macroeconomists concerns cross-country disparity in the per capita level of income and in growth rates of income. By contrast, we are also faced with trying to explain the observed similarities in the properties of business cycles internationally. Finally, we want to understand how government fiscal and monetary policies influence the aggregate economy. Approach It is obvious that a firm's output next year is a function of the level of investment in new equipment that is undertaken this year. Similarly, a household's decision to borrow this year (to raise this year's consumption) depends on how much it will have to pay in interest payments in the future. In order to explain the behavior of output and consumption in the aggregate economy - which is comprised of lots of households and firms - we need to understand this intertemporal dimension of economic decisions. The study of macroeconomics thus becomes the study of intertemporal choices made in the aggregate. A major part of the course will be devoted to building simple models of economic activity. ('Simple' is, of course, a relative concept.) While the models will be simple, they will be relevant for understanding a more complex world. Model building provides us with an "artificial economy" in which to carry out experiments which are too costly (or impossible) to undertake in the actual economy. A simple model allows us to focus on one particular question, and those factors that are excluded are only those which are believed to be less important for resolving that particular question. In our models we will assume that all prices (of goods and assets) are flexible and that they adjust instantaneously so that there is never excess supply or demand (of goods or assets). We refer to this set of models as "market-clearing" models. We make this assumption not because we necessarily believe that it is true, but rather because it is useful first to understand the interdependence among macroeconomic variables in this benchmark economy before we proceed to a more .complex world where frictions exist. A thorough knowledge of how the market-clearing system behaves leaves us better prepared to determine the source of existing frictions, to capture these frictions accurately in our models, and to determine their implications. Relation to other Economics Fields The tools that you will learn in Macroeconomics will prepare you for future research in the areas of international trade and finance, resource economics, and environmental economics, to name just a few. In Macroeconomics you will gain a thorough understanding of intertemporal decision-making. In virtually all fields of economics, you will encounter problems of a dynamic nature. In resource economics and environmental economics, for example, the focus is on the depletion of some resource (oil, clean air, etc.) over time. In international finance we would like to understand international capital flows. To explain such cross-country investments we need to recognize that these investments take place in order to generate future income, and we need to apply a model that incorporates this intertemporal decisionmaking process. These are just two examples of many. You will find that the skills you learn this term will be exceedingly useful in your future economics courses as well. Course Requirements Problem sets will be assigned throughout the term. These assignments will draw from the packet of 'Review Questions' on file on the third floor . In addition, you will be asked to work through some problems from Blanchard and Fischer and others to be distributed in class. While these problem sets will not count in your final grade, it is imperative that you do them. The development of the skills needed to analyze macroeconomic (and other) issues requires practice in constructing and solving problems. The objective is to learn to understand an issue using the simplest appropriate economic model. I encourage you to form study groups and to work on these assignments with some of your classmates. Review sessions will be scheduled to go over each of these problem sets. There will be three examinations - an in-class midterm (35% of final grade), a take-home midterm (30%) and an in-class final (35%). The take-home exam allows you the opportunity to explore fully the technical aspects involved in examining the problem and to connect that technical analysis with its intuitive explanation. Some examples of past in-class exam questions can be found in the reviewquestions packet. All readings marked with an asterisk are required. The additional references are provided in the event that you wish to learn more about one of the topics. Questions and answers I will hold office hours on Tuesdays from 5pm-6pm and on Wednesdays from 3pm-4:30pm. My office is room 14B. r ( Course Details Textbooks Required: Olivier Blanchard and Stanley Fischer, Lectures on Macroeconomics, MIT Press, 1989. (BF) Recommmended: Robert Barro, Macroeconomics, 4th Edition, Wiley Press. (This book can be used as background reading throughout the course. Relevant chapters are given below in parentheses.) Robert Barro, Modern Business Cycle Theory, Harvard University Press, 1989. (MBCT) Avinash Dixit, Optimization in Economic Theory, Oxford University Press, 2nd Edition, 1990. Robert Lucas, Studies in Business Cycle Theory, MIT, 1981. Thomas Sargent, Dynamic Macroeconomic Theory, Harvard, 1987. Nancy Stokey and Robert Lucas, Recursive Methods in Economic Dynamics, Harvard, 1989. (SL) Requirements Readings: Required readings are marked with an asterisk. One copy of each article on this list is on file in the filing cabinet in the graduate student lounge on the third floor. Exams: There will be two midterms and a final exam. Make-up exams will be given only under extremely extenuating circumstances. Notification and arrangements must be made bfiloie the exam. The final exam is scheduled for Tuesday, December 13, 3:30pm - 6:30pm. Problem Sets; Problem sets will be assigned throughout the course, but will not count towards your final grade. Review sessions on these assignments will be conducted by your TA for this class, Don Morrow. Don Morrow's office hours are 9am-10am and lpm-2pm MW. His office is room 309B. Abbreviations AER: American Economic Review CJE: Canadian Journal of Economics EMA: Econometrica JEP: Journal of Economic Perspectives JET: Journal of Economic Theory JME: Journal of Monetary Economics JPE: Journal of Political Economy QJE: Quarterly Journal of Economics RES: Review of Economic Studies Course Outline and Readine List I. Introduction *. BF, Cb. 1 * Barro MBCT, Introduction II. Review of the Basic Market-Clearing Model A. The Role of Individual Choice in Production and Consumption Patterns (Barro, Chs. 1-3) * Supplemental Notes, sections I and II. * Denslow and Rush, "Supply Shocks and the Interest Rate," Economic Inquiry, 1989, pp. 501-510. Dixit, Chs. 1,2,4 B. Money and Inflation (Barro, Chs. 4,5,7 ,8) * Cagan, "The Monetary Dynamics of a Hyperinflation," in M. Friedman, Studies in the Quantity Theory of Money. * BF, Ch. 4.7 Barro and Fischer, "Recent Developments in Monetary Theory," JME, April 1976. Sections 3,4 Friedman, "The Optimum Quantity of Money," in The Optimum Quantity of Money and Other Essays. · Sargent, "The Ends of Four Big Inflations, " in R. Hall, Inflation: Causes and Effects. Bailey, "The Welfare Cost of Inflationary Finance," JPE, April 1956. Barro, "Inflationary Finance under Discretion and Rules," CJE, January 1983. III. Investment and Growth A. Non-Monetary Models (Barro, Chs. 9,10) * Supplemental Notes, sections III and IV. * BF, Ch. 2.1-2.2 (p.37-52) * Solow, "A Contribution to the Theory of Economic Growth," QJE, Feb. 1956. * Lucas, "On the Mechanics of Economic Development," JME, 1988, 3-42. SL, Ch. 2 (A more detailed analysis is contained in Chs. 4-6) Romer, "Increasing Returns and Long-Run Growth, " JPE, 1986, 1002-1037. Dix it, Chs. 10, 11 Romer, "Capital Accumulation and the Theory of Long-Run Growth," Ch. 2 in Barro MBCT. B. Monetary Models * Stockman, "Anticipated Inflation and the Capital Stock in a Cash-in-Advance Economy," JME, 1981, 387-393. * Sidrauski, "Rational Choice and Patterns of Growth in a Monetary Economy," AER, May 1967. Johnson, "Money in a Neo-Classical, One-Sector Growth Model," in Essays in Monetary ~conomics, Ch. 4. Brock, "A Simple Perfect Foresight Monetary Model," JME, 1975, 133-150. C. Uncenainty and Asset Pricing Lucas, "Interest Rates and Currency Prices in a Two-Country World," JME, 1982, 335-359. (Sections 1 and 2 only) BF, Ch. 6.1-6.3 (p. 275-301) and Ch. 10.1 (p. 505-512) Sandmo, "The Effect of Uncertainty on Saving Decisions," RES, July 1970. Levhari and Srinivasan, "Optimal Savings under Uncertainty," RES, 1969. Dixit, Ch. 9 . IV. Public Policy A. Government Expenditures, Taxes, and Debt (Barro, Chs. 12-14) * BF, Ch. 2.3 * Barro, "The Neoclassical Approach to Fiscal Policy," Cb. 5 in Barro MBCT. Barro, "Government Spending in a Simple Model of Endogenous Growth," JPE, 1990, Sl03-Sl25. * King and Rebelo, "Public Policy and Economic Growth: Developing Neoclassical Implications," JPE, 1990, S126-Sl50. Barro, "Output Effects of Government Purchases," JPE, December 1981. Barro, "Public Debt and Taxes, " Ch. 10 in Barro, Money, Expectations. and Business Cycles, Academic Press, 1981. Barro, "Are Government Bonds Net Wealth?" JPE, November 1974. Barro, "On the Determination of the Public Debt," JPE, October 1979. Plosser, "Government Financing Decisions and Asset Returns," JME May 1982 B. Rational Expectations and Policy Evaluation * Lucas, "Econometric Policy Evaluation: A Critique," in The Phillps Curve and Labor Markets, eds. K. Brunner and A. Meltzer, Carnegie-Rochester Conference Series on Public Policy, vol. 1, North-Holland, 1976, pg. 19-46. Reprinted in Robert Lucas, Studies in Business Cycle Theory, MIT Press, 1981. Lucas, "Rules, Discretion, and the Role of the Economic Advisor," in Rational Expectations and Economic Policy, ed. Stanley Fischer, University of Chicago Press, 1980. Reprinted in Lucas (1981). Chari, Kehoe, and Prescott, "Time Consistency and Policy," Ch. 7 in MBCT. V. An Introduction to Equilibrium Models of Business Cycles King, Plosser, and Rebelo, "Production, Growth, and Business Cycles: I. The Basic Neoclassical Model," JME, 1988, 195-232. Kydland and Prescott, "Time to Build and Aggregate Fluctuations," EMA 50, 1982. Prescott, "Theory Ahead of Business Cycle Measurement," Quarterly Review (Federal Reserve Bank of Minneapolis), Fall 1986, 9-22. . ,, r Lucas, "Understanding Business Cycles," Carnegie-Rochester Series on Public Policy, 19n. Nelson and Plosser, "Trends and Random Walles in Macroeconomic Time Series," JME 10, 1982. Long and Plosser, "Real Business Cycles," JPE 91, 1983. Barro and King, "Time-Separable Preferences and Intertemporal Substitution Models of Business Cycles," QJE, 1984, 817-823. Cooley and Hansen, "The Inflation Tax in a Real Business Cycle Model," AER, 1989, 733-748. Hansen, "Indivisible Labor and the Business Cycle," JME, 1985, 309-28. McCallum, "Real Business Cycle Models," Ch. 2 in Barro MBCT. Plosser, "Understanding Real Business Cycles," JEP, Summer 1989. Solow, "Technical Change and the Aggregate Production Function," RES 39, 1957.