An Introduction to
Take Home Q
uestions for Final
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Topic 1: Current state of macroeconomic analysis
Oct 25 Topic
2: Static macroeconomic analysis (IS
LM model and the Neoclassical
Oct 30 Room 305
Topic 2: Static macroeconomic analysis (IS
LM model and the Neoclassical
Synthesis, Taylor rule, and some internationalization)
Topic 3: Descript
ive growth theory (Solow
Topic 3: Descriptive growth theory (Solow
Nov 15 Topic 4: Endogenous growth theory (AK model, Learning by Doing)
Nov 22 Topic 5: Optimal growth theory (Ramsey
Topic 6: Real business cycle theory
Topic 7: New Classical and New Keynesian theories
Dec 6 Final exam
g can be divided into two parts:
concepts and techniques
. The concepts are ideas. How is the economy structured? What are its
important components? How does the economy as a whole operate, or some sub
it? All of these are conceptual qu
estions. Techniques, which are usually mathematical, allow
ideas to be expressed and analyzed in a careful and systematic manner. How can we represent a
consumer’s choice problem? How can we capture the impacts of capital accumulation? These
que questions. Modern macroeconomic analysis involves using techniques to model
ideas about how an economic system operates. Progress in macroeconomic understanding
comes as researchers demonstrate that ideas embedded in models do seem to explain how rea
world economies are operating.
To enhance your training in macroeconomics, you must learn more ideas and
more techniques. To learn new ideas, you must first be exposed to them. The text for the
course provides a systematic exposur
e to various sets of ideas. Individual academic papers tend
to focus on one idea or on a more limited set of ideas. When you read the text or individual
papers, make it your goal to identify key ideas. Do your best to incorporate any new ideas into
existing macroeconomic understanding. This is how you make new ideas your own. To
learn new techniques, there is no substitute for “learning by doing.” It is good to not only do the
assigned problems, but it is also good to rework a technical procedure
presented in class, in the
text, or in a paper. When you rework something you have already seen or something you have
already done before, you reinforce the technique in your mind, and what at first seems quite
difficult can become quite easy. (Think ab
out how difficult driving a car was when you first did
it, compared to how difficult you find driving now.) The last tip is to
. While the
student is responsible for his or her own learning, the professor is valuable resource. When you
’t understand, it is often difficult to frame a question, and it is natural to not want to admit
you do not understand. However, no good teacher, who is challenging you, would expect you to
understand everything immediately. Good students are willing to
humble themselves to ask
questions, and willing to work hard to figure out what to ask, because they know that intellectual
growth happens when questions are asked and then answered.
Current State of Macroeconomic Analysis:
lysis has evolved
over time. Mutations
have led to new macroeconomic paradigms.
As different paradigms have
favored some approaches over others.
readings below provide
perspective on the development of macroeconomic analysis
Akerlof, George A., 2002.
Behavioral economics and macroeconomic behavior, American Economic
Review 92(3), 411
In his nobel prize address, Profe
ssor Akerlof discusses how macroeconomic
analysis has been and can be enhanced by considering microeconomic behavior, organized under the
"behavioral economics" umbrella.
Blanchard, Oliver, 2000.
What do we know ab
out macroeconomics that Fisher and Wicksell did not?,
De Economist 148(5), 571
Professor Blanchard gives a historical look at research in
macroeconomics, helping put
recent research into perspective.
Toward a model of innovation and performance along the lines of Knight,
Keynes, Hayek, and M. Polanyi, mimeo.
This paper, and the associated
Center on Capitalism and
es the idea that high economic performance depends upon having a dynamic, innovative
society, where new ideas are welcomed rather than hindered.
The fundamental question is "What
institutions promote the creation and development of new ideas?"
more pointed question of
interest is "How much does capitalism, based upon private property, generate new ideas relative
socialism, based upon public ownership?"
Sims, Christopher A. 1996.
Macroeconomics and Methodo
logy, Journal of Economic Perspectives
While discussing the methods used in macroeconomic analysis in general, Professor
the role of
econometrics and empirical analysis in macroeconomics, especially relative
to the real b
usiness cycle theory research paradigm.
Static Macroeconomic Analysis (IS
LM Model and the NeoClassical Synthesis)
The 1936 publication of Keynes' General Theory of Employment, Interest, and Money is
regarded by many as start of macroeconom
The 1937 IS
LM formulation of Hicks
a modeling framework that
provided a way to using mathematics to characterize the
Keynes used in his general theory. This framework was the
workhorse of macroeconomic theory
for the next 4 decades.
LM framework lacks a
microfoundation, in that the objectives of consumers, producers, and governments are not
explicitly recognized, and the static
nature of the model means
we must "fudge" matters in order
to look at dyna
mic issues, like the effects of capital accumulation.
For these reasons and others,
LM static framework is no longer used much by macroeconomic researchers.
still tends to be a primary reference point for
it offers insight into how various markets (i.e., goods market, money market, and labor market)
interact; and it provides a context for learning comparative static analysis, a type of analysis that
can fruitfully be applied to steady stat
es in more complex dynamic models.
Thus, it is good to
have an understanding of how to construct and analyze a static macroeconomic model.
: Romer, Chapter 5
5.3, 5.7, 5.8
Some useful notes
Handout: Some notes on functions and notation
e static analysis
Keynes, John Maynard, 1936.
The General Theory of Employmen
t, Interest and Money
under the “essence of the General Theory” in Keynes own words by reading Chapter 3.
Hicks, John R., 1937.
Mr. Keynes and the Classics, Econometric
a 5, 74
See Hicks comment on
what Keynes accomplished, and see Hicks introduce the IS
LM apparatus, which he called IS
Pingle Classnotes Chapter 7
Development of the IS
LM apparatus, and comparative static analysi
within the IS
Pingle Classnotes Chapter 8
LM framework to characterize the Essence of Keynes’ General
Keynes original notation translated into modern notation, with further discussion of wha
Extension of Keynes model so as to relate Keynes work to the Classical
Bordo, Michael D. and Schwartz, Anna J. IS
LM and Monetarism, History of Political Economy 36
pplement 1): 217
Examine the relationship between the development of Keynesian
theory in the IS
LM framework and the development of monetarism.
Things to Learn
how the economy
if we think of a complete macroeconomic model as including capital market, money
market, labor market, and product market, how did Keynes differ from the classical
with regard to how these markets worked.
adjustments put these various markets into equilibrium according to Keynes, and how
does this differ from the classical view?
Keynes says the idea that “supply creates its own demand
underlies all orthodox
But, he disputes thi
Can you explain Keynes’ perspective?
What does Keynes perceive as the driving force of the economy?
In particular, what
fundamentally determines the employment and output levels for the economy.
What is “effective” demand, as opposed to just d
What is the essence of Keynes’ General Theory as he describes it in his Chapter 3?
should see that, in terms of modeling, the essence of the General Theory is and IS
equation and a production function.)
Hicks indicated that, when Keynes
added the interest rate to the money demand function,
it was a significant innovation.
Why was it significant?
Why does Hicks indicate that the LM curve (or what he calls the LL curve) is vertical
when the real income level (i.e., output level) is high
but horizontal when income level is
Keynesianism versus Monetarism
(Examining the old debate provides an opportunity to practice
model building, practice comparative static analysis and practice interpreting
comparative static multipliers)
tereotypical Keynesian Perspective:
What assumptions about economic behavior will
make the IS curve closer to vertical and the LM curve closer to horizontal?
aggregate demand be more sensitive to changes is fiscal policy than changes in moneta
Why might the simple quantity theory of money, where the velocity of money is
constant, fail to hold.
Stereotypical Monetarist Perspective:
What assumptions about economic behavior will
make the IS curve closer to horizontal and the LM curve c
loser to vertical? When will
aggregate demand be more sensitive to changes is monetary policy than changes in fiscal
What assumptions about money demand will generate a simple quantity theory
of money, where the velocity of money is constant.
One type of crowding out occurs entirely on the demand
side of the economy, because
the economy’s money supply is constrained.
Be able to use and IS
LM framework to
identify when this type of crowding out is minimal and when it is substantial.
Be able to
explain how this type of crowding out relates to the Keynesian
Understand why this type of crowding out can be mitigated by the economy’s central
A second type of crowding out occurs when aggregate supply and aggrega
interact, because the economy’s resources are constrained.
Show how what is going on
in the money market can “crowd out” the impact of an initial increase in spending.
Explain why this type of crowding out is more serious that the other, and
why it makes
Keynesian debate less important.
How does the “Neoclassical Synthesis,” which claims to reconcile the Monetarist
Keynesian debate, relate to crowding out.
The Sticky Wage Neoclassical Synthesis model
Be able to write down a
sticky wage static macroeconomic model.
Be able to use this model to explain why fluctuations in aggregate demand will tend to
affect employment, unemployment, and output.
Be able to use this model to explain why monetary policy and fiscal policy may
role to play in mitigating short term economic fluctuations caused by changes in
Be able to use this model to show that changes in the real wage are counter
Understand that this model is discounted in the profession becaus
e changes in the real
wage have tended to be procyclical
LM approach versus Taylor’s IS
MP approach makes money supply endogenous, assuming central bank adjusts
the money supply to achieve an interest rate tar
Interest rate target is assumed to depend upon output level and inflation rate
AD diagram in output
Effect of fluctuations in aggregate demand depend upon responsiveness of output
to inflation rate
Perfect capital mobili
ty versus imperfect capital mobility
Fixed versus flexible exchange rates
Wage and Price Rigidities
What assumptions will yield
real wage movements?
Phillips Curve (Output
Why might the
be an output
at can disrupt this tradeoff?
Supply shocks rather than demand shocks
Expectations augmented Phillips curve
Descriptive Growth Theory (Solow
Because wealth comes from
production, it is important to understand why an economy grows.
model offers an explanation for growth that recognizes the dynamic impact of capital
Saving at one point in time finds its way into investment, which enhances the
ability to produce at later points in time.
ngs rate, population growth rate, capital
depreciation rate, and rate of technical progress are key factors recognized as explaining growth.
If these factors are the same for two economies, then any observed differences must be because
one economy is furt
her along than the other on the capital accumulation path.
If the two
economies are headed toward the same ultimate state, then we should observe “convergence,”
meaning the two economies become more alike.
This model is the most important model in
n macroeconomics because it is often the foundation, or starting point, for many other
For example, “new growth theory” seeks to endogenize, or explain, the rate of
technical change in the Solow
Differential equations or
difference equations can
be used to capture the capital accumulation dynamics in the Solow
These are the
basic tools for modeling dynamic economic systems, where an action at one point in time, or in
one period, affects an outcome at another p
oint in time, or in another time period.
: Romer, Chapter 1
Some useful notes
Growth Theory Notes
Modeling production in aggregate and per capita form in the neoclas
sical way, where
technological improvement is labor augmenting.
Modeling the capital market using a differential equation to model capital accumulation.
Auxiliary conditions: Predicting real wage and real interest rate levels by assuming
producer profit m
aximization. Consumption level is the residual of savings
Summary presentations of the neoclassical growth model in aggregate and per capita
Steady state comparative static analysis
Stability of the steady state
Using a phase diagram to describe dyn
amics outside the steady state
Golden rule consumption and possible dynamic inefficiency
Using a Taylor series expansion to examine growth rate near steady state
How well does the neoclassical growth model explain the growth observed in real world
Endogenous Growth Theory (AK Model, Learning by Doing and Knowledge
In the standard Solow
Swan growth model, the rate of technical change is
this exogenous rate of technical change is the primary determinant of th
improvement in the average standard of living.
Thus, we learn from the Solow
improved living standards are not explained by capital accumulation or population
The improvements come from something else, which we label technical chang
Swan model does not tell us what causes the technical change.
This is the objective of
: Romer, Chapter 3
Some useful notes
The AK model
The intensive form of the AK model
Analyzing the intensive form of the AK model
A generalized AK model
The intensive form of the generalized AK model
Analyzing the intensive form of the generalized AK model
arch and development model
Special case of the research and development model
General case of the research and development model
Learning by doing model
Analyzing the learning by doing model
Deriving an AK model from the learning by doing model
estimation of growth models
Optimal Growth Theory (Ramsey
In the standard
Swan growth model, the savings rate is exogenous.
It turns out that a given savings rate
can be inefficient in the sense that there are othe
r savings rates that, if they were chosen, would
lead to enhanced welfare.
“Optimal growth theory” addresses this issue by assuming the
consumer chooses a savings rate that is best over some time horizon.
This problem can be
modeled using “calculus of
variations” techniques or “optimal control” techniques.
saving by consumers can rescue the economy from dynamic inefficiency, though it can also be
shown that optimal saving will not always ensure dynamic efficiency.
Optimal saving has
ate implications that are of interest.
The techniques used in this type of analysis are
good to have in your toolkit, for they can be used to characterize the implications of the
assumption that people do the best they can (or at least seek to do so) as
they make decisions
: Romer, Chapter 2 (pages 48
Some useful notes
A Neoclassical (Ramsey
Koopmans) Optimal Growth Model
Learn how to
take a standard aggregated circular flow model and convert it into an
“intenstive form” or “per capita form” optimal growth model
Learn how to formulate an optimal growth model
Learn how to solve an optimal growth problem using Optimal Control Theory or t
Calculus of Variations
Learn how to characterize the optimal growth path described by two differential
equations using a two dimension phase diagram
Learn of the implications of this optimal growth model for the path followed by the
economy’s real inter
est rate level
Real Business Cycle Theory
Real business cycle theory seeks to explain the
observed fluctuations in aggregate economic measures, like output.
The Real Business Cycle
method is to see how much of the observe fluctuations can
be accounted for with a model that
assumes agents optimize (or do the best they can in their circumstances) and markets remain in
This approach is popular, at least in part, because the macroeconomic model
microeconomic foundation, mea
ning we see the problems that individual decision makers solve
as they interact in the economy.
While many would the assumption that markets remain in
equilibrium (A Walrasian approach) is questionable, there is no unanswered question as to why
is not in equilibrium, or how fast it is adjusting.
Real business cycle models show
that we need not have disequilibrium or agent sub
optimization to have economic fluctuations.
The economic flucturations in a real business cycle economy are optimal re
through markets in equilibrium.
The source of any fluctuations is clearly identified, usually
some type of assumed shock to technology
: Romer, Chapter 4
New Classical and New Keynesian Theories
The New Classical and New
Keynesian approaches seek macroeconomic understanding in models that have a microeconomic
foundation. As with real business cycle theory, there is a commitment to assuming decision
makers optimize. Typically, it is assumed tha
t agents form their expectations rationally, which
implies the expectations are consistent with how the economy actually works so that the agents
are not consistently fooled. A primary topic of interest is why changes in a nominal variable,
like the money
supply, might have real economic effects.
The New Classical approach tends to
impose market clearing, while the New Keynesian approach is often aimed at understanding why
a market may not clear.
Either approach can offer explanations for economic fluct
explain why nominal shocks may have real consequences.
: Romer, Chapter 6