Lecture 1. Introduction to Third-year

Macroeconomics

ECON30009 Macroeconomics

Shuyun May Li

Department of Economics

The University of Melbourne

Semester 2, 2014

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Outline

1. What is Macroeconomics?

2. Evolution of Macroeconomic thought

3. How does this subject fit in the big picture?

Reading: Prologue of AK, Kocherlakotas speech

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1. What is Macroeconomics?

Macroeconomics is the study of the economys performance as

a whole and the governments role in altering that performance.

It departs from microeconomics in focusing on the whole

economy rather than its constituent parts.

Some important questions of Macroeconomics

Why do economies grow at different rates?

How do peoples saving and invest behaviour affect growth

and income?

How do foreign trade and investment affect the domestic

economy?

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What causes recessions and their attendant high

unemployment?

What is money and its economic function?

How do monetary and fiscal policies affect the economy in

the short and long runs?

What causes inflation? How does it relate to

unemployment?

What role banks play in the economy?

How do credit and insurance markets operate and alter

macroeconomic outcomes?

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Macroeconomics is a controversial discipline. Economists often

have different views regarding the important macro questions

listed above.

In particular, they can differ sharply about the causes, severity,

and cure for economic downturns, as well as the governments

role in the economy.

Different views form different schools of macroeconomic

thought. Macroeconomics is an ever-evolving area of research.

There have been many different schools formed in the evolution.

Next, we briefly review this evolution and introduce several

major schools of macroeconomic thought.

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2. Evolution of Macroeconomic thought

Classical Economics

The first modern school of economic thought, developed in

the 18th and 19th centuries, by economists such as Smith

(The Wealth of Nations, 1776), and Ricardo.

A theory of price was developed to investigate economic

dynamics

Main idea: Adjustments in prices would automatically

equate demand to supply - invisible hand.

Keynesian economics

Until the 1930s most economic analysis did not separate out

individual economics behaviour from aggregate behaviour.

With the Great Depression, the field of macroeconomics

began to expand.

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Particularly influential was the ideas of John Maynard

Keynes, as summarised in The General Theory of

Employment, Interest and Money, 1936.

Keynes emphasised the importance of aggregate demand

management by government, a departure from classical

economics.

In 1950-60s, Keyness ideas were widely accepted, and the

use of active fiscal and monetary counter-cyclical policies,

instructed by the IS-LM model and Phillips curve, had

been quite successful.

However, the stagflation experienced by many economies

in 1970s called for both expansionary and contractionary

policies.

This dilemma led to the collapse of the Keynesian

consensus.

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Monetarism

Began in the late 1940s with the work of Friedman.

Regards the supply of and demand for money as the

primary means by which economic activity is regulated.

Views inflation as determined by variations in money supply

rather than aggregate demand.

Rejects fiscal policy because it leads to crowding out of

the private sector.

Advocats a central bank policy aimed at keeping the supply

and demand for money at equilibrium so as to maintain

price stability.

Ideas of monetarism have been generally accepted in central

banking practice since late 1970s (e.g., Greenspan).

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Neoclassical Economics (methodology)

Refers to a general approach to economics, not a school of

economic thought.

Neoclassical economics is originated from classical

economics, further developed by Marshall, Walras, Hicks,

Arrow, Debreu, etc.

Emphasises an equilibrium analysisprices, outputs, and

incomes are determined through supply and demand, where

supply and demand are the collective outcome of the

individual optimising behaviour of households and firms.

There have been many critiques of neoclassical economics,

often incorporated into newer versions of neoclassical theory

and further strengthen its dominance status.

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Growth Theory and New Growth Theory

Concurrent with the emergence of Keynesian

macroeconomics was the research agenda of growth theory

initiated by Harrod and Domar in 1940s.

Fast development in 1950s and 60s, with several versions of

neoclassical growth models (Solow, Diamond, Ramsey).

Surprisingly, for a very long time the development in growth

theory and the corresponding developments in Keynesian

economics (focus on economic fluctuations) are divorced.

Growth theory faded in late 60s through 80s, but made a

strong comeback in late 80s, marked by the development of

New/Endogenous Growth Theory.

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New Classical Economics

Emerged in 1970s as a response to the failure of Keynesian

economics, motivated by Lucass work on Rational

Expectation and Lucas critique.

Lucas critique: It is naive to try to predict the effects of a

change in economic policy entirely on the basis of

relationships observed in historical data as such estimated

relationship could change as policy regime changes.

Lucas critique casted doubt on standard Keynesian models

built on reduced form equations as tools for macro policy

analysis.

How can macroeconomists get around the Lucas critique?

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The key is to build macro models based on more

fundamental features of the economy that are beyond the

control of the government, such as the technology of firms

and peoples preferences.

So the Lucas critique called for building microfoundations

for macro models, i.e., the macroeconomy must reflect the

sum of its partsthe rational behaviour of individual

housholds and firms.

A seminal development of this school is marked by the real

business cycle (RBC) theory in 1980s, first developed by

Kydland and Prescott.

The basic model of RBC theory incorporates stochastic

productivity shocks into a neoclassical growth model

(connects the studies of long-run growth and short-run

fluctuations for the first-time).

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A striking finding of early RBC economists is that a large

fraction of aggregate fluctuations could be understood as an

efficient response to productivity (supply-side) shocks that

affected the entire economy, implying that there was little

role for government stabilization policy.

Though its finding was quite controversial, the RBC theory

has pioneered the use of dynamic stochastic general

equilibrium (DSGE) models and a set of analytical and

computational tools in modern macro research.

New Classical economics builds its analysis on an entirely

neoclassical framework. Two key assumptions: rational

expectations and perfect flexibility of prices and wages.

Other new classical economists: Sargent, Wallace, Barro.

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New Keynesian Economics

Developed partly in response to the critique of Keynesian

economics by new classicals.

Strives to provide microeconomic foundations to Keynesian

economics by showing how imperfect markets can justify the

demand management by government or its central bank.

The main assumption that distinguishes it from new

classical economics is that wages and prices do not adjust

instantly to allow the economy to attain full employment,

thus non-clearing markets can exist and persist, even when

rational expectations apply.

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New Keynesians attempt to explain the nominal stickiness

with microeconomic analysis of price adjustment.

At the same time, New Keynesian economists also adopt the

same modeling framework (DSGE) as new classical

economists and emphasise microfoundations.

In recent years, a lot of central banks, including the RBA

and RBNZ, start to apply New Keynesian models for

monetary policy analysis.

Economists: Samuelson, Tobin, Modigliani, Mankiw,

Christiano, Woodford, etc.

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Modern Macro researchtowards an integration

The New Classicals and New Keynesians often had

disagreements in 1980s-1990s.

By 2000, a synthesis was developing, building on the

neoclassical approach adopted by RBC and new growth

theory, but also allowing for the imperfections emphasised

by New Keynesians.

The basic modeling framework: DSGE

Emphasise a quantitative anlaysis: assign values to model

parameters to match certain dimensions of the data and

conduct simulations to yield quantitative predictions of the

model

Hinge on heavy use of computers to compute, simulate and

estimate the model

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3. How does this subject fit in the big picture?

Structure of Macroeconomics subjects at Uni. Melbourne

First year and second year Macro

Focus on definitions, data facts, and relationships among

aggregate variables

The relationships among aggregate variables are presented

using reduced-form models of Keynesian economics

Aiming at fostering economic intuitions

Third year and Honours (first-year Masters) Macro

Introduction to advanced study in macroeconomics

Using simplified versions of neoclassical macro models to

address macro questions

Aiming at deepening understanding and improving

analytical skills

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Ph.D. Macro:

Focus on a comprehensive set of analytical, computational

and estimation skills to work with modern macro models

Presenting seminal articles in the literature (new classical,

New Keynesian)

Aiming at fostering professional researchers in the field of

macroeconomics.

The goal of the development of macroeconomics as a discipline

is to be able to answer the important macro questions in a

more complete and more precise way.

This is why verbal intuitions are not enough and why we need

a mathematical formalisation of the economymodels.

Economists build models to simplify reality to understand it.

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A classification of Macro models

Macroeconometric or observational models: directly specify

concrete functional forms describing a reduced form

relationship among variables for estimation.

A traditional approach, often take the form of system of

equations or regressions.

IS-LM, AS-AD, and Phillips curve all fall in this category.

Policy analysis based on this approach is subject to the

Lucas critique.

Theoretical or structural models

Toy model: simple, highly-stylised models, illustrate

intuitions and yield qualitative insights

Quantitative model: relatively realistic, estimated with

data, draw quantitative implications

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A good model captures key relationships, that is, economists

focus on the most important factors that are relevant for the

question to be addressed, while ignoring what they believe to

be minor details.

The focus of 3rd and Honours year macro is to use simple but

formal theoretical macro models to analyse the central macro

questions.

The central macro questions listed earlier are closely linked:

The ability to borrow through credit market influences how

much a society saves;

The amount of saving in turn governs how much it invests

and how fast it grows;

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Economic growth alters the publics demand for money and

the rate of price inflation;

And the inflation rate influences the choice of monetary and

fiscal policies;

The policies have their own independent effects on the

economys saving, investment and growth.

The connection of the macro questions requires a theoretical

framework capable of linking the answers to each question to

those of the others.

Such an integrated approach is the hallmark of AK. It uses a

single framework, the life-cycle model, to explore and connect

the major issues of macroeconomics.

Well start with the basic form, then gradually add more

elements to enrich the model to address further topics.

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Despite its simplicity, the life-cycle model fits in the

neoclassical approach and DSGE framework for modern

macro models

micro-founded: aggregate supply and demand are collective

outcomes of decisions of households and firms

dynamic: it describes the evolution of the economy over

time (recall that IS-LM and AS-AD are both static)

individual rationality: firms and households both optimise

forward looking or rational expectation: households predict

future rate of return to capital when they make

consumption and saving decisions

heterogeneous agents: young households work and save

while old households spend

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In other words, the simple model is dynamic and general

equilibrium, but not stochastic.

The life-cycle model well work with sits between a toy mode

and a fully quantitative model.

Besides the main focus, a lot of time will also be devoted to

Definitions, data facts (updated with more recent and

Australia-relevant data), and economic intuitions

Literature review

Applications of the theories and policy discussions around

the models

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Review Questions

Understand what Macroeconomics is about, and what kind of

questions it aims to address

Have a general understanding of the evolution of macroeconomics

and several major schools of macroeconomic thought

Understand the difference of the neoclassical approach from the

Keynesian models in Intermediate Macroeconomics (the general

equilibrium analysis in third year micro is neoclassical)

Have some idea of current state of macro research, and think for

yourself what you will need to learn to get there.

Understand the classifications of macro models

Have a general understanding of how the macro subjects at

Melbourne are structured and where this subject stands.

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