Macroeconomics

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Macroeconomics

History and Historical Issues

UNO, ECON 6204, Summer
2008, Dr. Tufte

1

Macroeconomics: History and Historical
Issues

Classical Economics


Prior to 1935


There was no field of macroeconomics


There were occasional things written on topics
we now regard as macroeconomic.


Analysis of macroeconomic issues was based
on supply and demand analysis grounded in
microeconomics

o
There was a bit of an increase in interest in this
from 1910 onwards

UNO, ECON 6204, Summer
2008, Dr. Tufte

2

Macroeconomics: History and Historical
Issues

Human Well
-
Being


Around the globe, the well
-
being of people
through history looks like a hockey stick

o
Flat for most of history

o
Improving steadily in recent history


There are big differences across locations in when this
started


There are smaller differences in the rate of
improvement across locations.

UNO, ECON 6204, Summer
2008, Dr. Tufte

3

Macroeconomics: History and Historical
Issues

Business Fluctuations


Not cycles

o
Irregular magnitude

o
Irregular length


Not seasonal


they’re longer

o
So, these aren’t agricultural in nature


We’re not sure when these started, but there
isn’t any consensus that they existed before
1840

UNO, ECON 6204, Summer
2008, Dr. Tufte

4

Macroeconomics: History and Historical
Issues

Economic Growth


Increased production that leads to sustained
improvements in the quality of life


We’re not sure when this started either

o
We think the earliest growth was 1660
-
80

o
Not all places started at the same time


Increasingly, macroeconomists think this
started because of a shift towards social
institutions that encouraged planning for the
future

UNO, ECON 6204, Summer
2008, Dr. Tufte

5

Macroeconomics: History and Historical
Issues

Growth
-
Compatible Institutions


A lot of what we take for granted in modern
society got started in the late 17
th

century

o
Trusting strangers in voluntary exchange

o
Freedom of association

o
Freedom of speech

o
Freedom of religion

o
Courts more interested in facts than class

o
Honest police

o
Civilian control of the military

o
Limited Liability

UNO, ECON 6204, Summer
2008, Dr. Tufte

6

Macroeconomics: History and Historical
Issues

The Industrial Revolution


Starts around 1770


Watt

o
Improved the steam engine


Boulton

o
Developed the factory as a central location for large
-
scale production


Boulton

financed Watt who built steam engines


initially for tin mines


and then coached the
mine owners how to scale up their production

UNO, ECON 6204, Summer
2008, Dr. Tufte

7

Macroeconomics: History and Historical
Issues

The Sequence of Events


The ordering we understand now is:

o
Institutions Change

o
Growth Starts

o
Industrial Revolution

o
Business Cycles Start


Classical economics was fairly ignorant of all of
these

o
Smith, Malthus, Ricardo and Marx don’t talk about
these much

UNO, ECON 6204, Summer
2008, Dr. Tufte

8

Macroeconomics: History and Historical
Issues

Politicians Discover Macroeconomics


Macroeconomics events have had historical
consequences for thousands of years


But, no one needed to worry about them too
much before:

o
There was a sense that life was or could be better

o
They could vote

o
They could have some certainty that civilian
authorities wouldn’t use the military to quell
dissent

UNO, ECON 6204, Summer
2008, Dr. Tufte

9

Macroeconomics: History and Historical
Issues

Politics and Macroeconomics in the
19
th

Century


Revolution changes

o
America in the 1770’s and France in the 1790’s are
about control

o
Widespread urban unrest in 1830 and 1848 is also
about visible disparities in wealth that aren’t
related to class or lineage

o
Agglomeration to capture bigger markets in the
1860’s


Elections start turning on macroeconomics

o
Mostly in the U.S. and England

UNO, ECON 6204, Summer
2008, Dr. Tufte

10

Macroeconomics: History and Historical
Issues

What Was New About Business
Fluctuations?


Countries have had agricultural, military, and
trade fluctuations for thousands of years


Business fluctuations were a new thing
because there were mismatches between
people who should have been able to
cooperate

o
Unemployment of willing workers

o
Underutilization of available capital

UNO, ECON 6204, Summer
2008, Dr. Tufte

11

Macroeconomics: History and Historical
Issues

What Classical Economists Had to
Offer Politicians


Not too much


With supply and demand, the only way you can
get a “recession” is if

o
Prices are below equilibrium, and

o
Exchange is voluntary, so that quantity transacted falls
on demand

o
Combined, these yield excess supply


Excess supply is either:

o
Short
-
lived, and recessions should end quickly

o
Enforced by some legal mechanism, yet this is absent

UNO, ECON 6204, Summer
2008, Dr. Tufte

12

Macroeconomics: History and Historical
Issues

Europe In the 1920’s


World War I wrecked many countries

o
The Treaty of Versailles didn’t help


Europe didn’t really recover economically
from World War I


Classical economists said that this couldn’t last
more than a few years, but it did

UNO, ECON 6204, Summer
2008, Dr. Tufte

13

Macroeconomics: History and Historical
Issues

The World In the 1930’s


The Great Depression is really the U.S.,
Canada and Japan joining Europe


On their own, some governments start trying
policies we now regard as Keynesian:

o
Increasing spending

o
Cutting taxes

o
Reducing interest rates

UNO, ECON 6204, Summer
2008, Dr. Tufte

14

Macroeconomics: History and Historical
Issues

Keynes


Keynes is already famous before he writes
The
General Theory …

o
He thought of his theory as general because it
included 2 specific cases


Full employment, where classical analysis worked


Less than full employment, where classical analysis
failed


Keynes formulated a theory for the latter that
wasn’t at all like supply and demand

UNO, ECON 6204, Summer
2008, Dr. Tufte

15

Macroeconomics: History and Historical
Issues

Keynesians


Keynesians rapidly expand on Keynes book in
the late 1930’s

o
Alvin Hansen at Harvard

o
Sir John Hicks at the LSE


Neo
-
Keynesian synthesis

o
Formalized as the IS
-
LM model

o
Captured sensible observations about the
economy in equations

o
Not based on optimization of a function

UNO, ECON 6204, Summer
2008, Dr. Tufte

16

Macroeconomics: History and Historical
Issues

WARNING!


The
Keynsian

model that follows is no longer
considered to be very informative about how
the
macroeconomy

works.


But, it is instructive for 4 reasons

o
Techniques are always useful

o
It underlies principles texts to this day

o
It underlies a lot of policy to this day

o
It will be easier to figure out what is wrong with it
if we know what it says

UNO, ECON 6204, Summer
2008, Dr. Tufte

17

Macroeconomics: History and Historical
Issues

Mathematics of a Basic Keynesian
Model


Six equations

o
Y=F(K,N), a
non
-
linear

production function

o
w/p = F
N
, a
non
-
linear

labor supply

o
C=C(Y
-
T), a
non
-
linear

consumption function

o
I=I(r), an
non
-
linear

investment function

o
Y=C+I+G, a national income identity

for a closed
economy

o
m
/p =
M
(
y,r
), equilibrium in the asset market
, with
a non
-
linear liquidity preference function on the
right

UNO, ECON 6204, Summer
2008, Dr. Tufte

18

Macroeconomics: History and Historical
Issues

Mathematics of a Basic Keynesian
Model


Variable conventions

o
Real variables are in capitals

o
Nominal variables are in lower case

o
Letter preceding parentheses are functions

o
A prime is used for a derivative of a function of
one variable

o
A subscript is used for a derivative of a function of
more than one variable

UNO, ECON 6204, Summer
2008, Dr. Tufte

Macroeconomics: History and Historical
Issues

19

Mathematics of a Basic Keynesian
Model


(Real and nominal) variable definitions

o
Y is GDP

o
K is capital

o
N is labor

o
W is the wage

o
P is a price index

o
C is consumption

o
T is taxes

o
I is investment

o
R is an interest rate

o
G is government spending

o
M is a money stock

UNO, ECON 6204, Summer
2008, Dr. Tufte

Macroeconomics: History and Historical
Issues

20

Mathematics of a Basic Keynesian
Model


Note that:

o
Keynesian aren’t specific about the functional form of
production, other than output depends positively on
capital and labor

o
Labor is supplied so that nominal wages and prices change
until their ratio equals the marginal product of labor (but
the real wage itself is not a variable of interest).

o
Consumption depends on disposable income

o
Liquidity preference is such that the amount of nominal
money needed for transactions depends positively on
income and negatively on interest rates.

o
Dividing nominal money by prices ensures a one
-
to
-
one
relationship between them.

UNO, ECON 6204, Summer
2008, Dr. Tufte

Macroeconomics: History and Historical
Issues

21

Mathematics of a Basic Keynesian
Model


Six variables are endogenous (the model can
be solved for these)

o
p, Y, N, r, C, I


The exogenous variables (that cause other
variables) are:

o
w, m
, G, T, K

o
Sometimes called causal variables

UNO, ECON 6204, Summer
2008, Dr. Tufte

22

Macroeconomics: History and Historical
Issues

Mathematics of a Basic Keynesian
Model


The solution method is called comparative
statics

o
Take a linear approximation to the model (with
total derivatives)

o
Solve the linear approximation using Cramer’s rule


Make sure that sensible values of the derivatives yield
an unambiguously signed determinant

o
Analyze the resulting derivatives for policy
implications

UNO, ECON 6204, Summer
2008, Dr. Tufte

23

Macroeconomics: History and Historical
Issues

Mathematics of a Basic Keynesian
Model


Linearize the system by taking total derivatives

o
dY=F
K
dK + F
N
dN, a production function
, in the
short
-
run, dK=0

o
p
-
1
dw
-
wp
-
2
dp = F
NN
, a labor supply

o
dC=
C’
dY
-
C’
dT, a consumption function

o
dI=I’dr, and investment function

o
dY=dC+dI+dG, a national income identity

o
p
-
1
d
m
-
m
p
-
2
dp =
M
y
dy+
M
r
dr, equilibrium in the
asset market

UNO, ECON 6204, Summer
2008, Dr. Tufte

24

Macroeconomics: History and Historical
Issues

Mathematics of a Basic Keynesian
Model


Organize the
linearized

model using linear
algebra as AB=
X
, where

o
A is a 6x6 matrix composed of these row vectors
of coefficients on the endogenous variables


[1

F
N

0 0 0 0]


[0
F
NN

0 0 0 wp
-
2
]


[
-
C’ 0 1 0 0 0]


[0 0 0 1

I’ 0]


[1 0
-
1
-
1 0 0]


[M
y

0 0 0
M
r

m
p
-
2
]

UNO, ECON 6204, Summer
2008, Dr. Tufte

25

Macroeconomics: History and Historical
Issues

Mathematics of a Basic Keynesian
Model


B is a 6x1 column vector of first derivatives of
the endogenous variables [dY,dN,dC,dI,dr,dp]


X

is a 6x1 column vector of the linearized
exogenous variables:

o
[0,
dw/p
,
-
C’dT,0,dG,d
m
/p]

UNO, ECON 6204, Summer
2008, Dr. Tufte

26

Macroeconomics: History and Historical
Issues

Mathematics of a Basic Keynesian
Model


Cramer’s Rule for solving AB=
X

o
Determine the determinant of A

o
Make assumptions to sign it unambiguously (
(this is a
key step that has big problems because of the Lucas’
Critique)

o
To solve for the
n’th

endogenous variable


Substitute
X

for the
n’th

column of A


Obtain the determinant of that new matrix


The solution for the
n’th

endogenous variable is that
determinant divided by the determinant of A


Take partial derivatives to obtain multipliers

UNO, ECON 6204, Summer
2008, Dr. Tufte

27

Macroeconomics: History and Historical
Issues

Mathematics of a Basic Keynesian
Model


Hicks’ Method

o
Collapse the
third through fifth

equations to yield an
IS curve


a
downward
-
sloping

relationship between r
and Y shifted by G and T


Substitute the third and fourth equations into the fifth,
eliminating
dC

and
dI

from the system

o
Collapse the first, second, and last equation to yield
an LM


an
upward
-
sloping

relationship between r
and Y shifted by M


Solve the first equation for
dN


Solve the first and second for
dp


Substitute into the last equation, eliminating
dN

and
dp

from
the system

UNO, ECON 6204, Summer
2008, Dr. Tufte

28

Macroeconomics: History and Historical
Issues

Mathematics of a Basic Keynesian
Model


With either method, signing the partial
derivatives so you can sign the determinants is a
key step. These are the standard assumptions,
and they guarantee unambiguously signed
determinants in this particular model:

o
F
N
>0

o
F
NN
<0

o
0<C’<1

o
I’<0

o
M
y
>0

o
M
r
<0

UNO, ECON 6204, Summer
2008, Dr. Tufte

Macroeconomics: History and Historical
Issues

29

Mathematics of a Basic Keynesian
Model


Either way, the solution is a total derivative of an
endogenous variable in terms of exogenous variables. For
example, assuming sticky wages
(
dw
=0)
:

o
(1
-
C’
-
I’)
dY
=
-
C’
dT+dG
+(I’/
p
M
r
) d
m


From this, we obtain multipliers

o
∂Y/∂T=
-
C’

/(1
-
C’
-
I’)<0, or taxes are contractionary

o
∂Y/∂G=1/(1
-
C’
-
I’)>0, or spending is expansionary

o
∂Y/∂M=I’/[
p
M
r
(1
-
C’
-
I’)] >0, or printing money is expansionary


Note that:

o
The first two imply that deficit spending is expansionary

o
Unless investment is really sensitive to interest rates, or liquidity
holdings are insensitive to interest rates, then monetary policy
will be weaker than fiscal policy

UNO, ECON 6204, Summer
2008, Dr. Tufte

30

Macroeconomics: History and Historical
Issues

Mathematics of a Basic Classical Model


Without going into details, you can make the
Keynesian model classical by adding
one equation

-

a labor market equilibrium condition like:

o
N=N(w/p)

o
You’ll need to solve for one more variable, and that is
assumed to be
an endogenous

real wage


This model uses the real wage and the price level but drops
the nominal wage from consideration

o
This subtle difference has the huge effect of making Y
depend only on K, rather than the other exogenous
variables

UNO, ECON 6204, Summer
2008, Dr. Tufte

31

Macroeconomics: History and Historical
Issues

What’s Wrong with the Keynesian
Model?


It turns out, there’s quite a lot that could be
improved, and the profession spent a lot of
time from the late 40’s to the late 70’s figuring
out these
microfoundations

o
Lots of Nobel Prize winners did their work on this
stuff: Friedman, Klein, Tobin, Modigliani,
Haavelmo
,
Mundell

and Phelps


But, the one fatal flaw was the Lucas’ Critique

o
To get to that, we have to talk a bit about
expectations

UNO, ECON 6204, Summer
2008, Dr. Tufte

32

Macroeconomics: History and Historical
Issues

Expectations In Keynesian Models


In the basic model, expectations are omitted

o
But, expectations of price are there implicitly
because they are an important basis for
determining interest rates


Cagan got people thinking about this by
working on how expectations of inflation
could lead to even more inflation

UNO, ECON 6204, Summer
2008, Dr. Tufte

33

Macroeconomics: History and Historical
Issues

Adaptive Expectations


State of the art at this time were expectations
that were formed by looking at the past
history of the data exclusively


The problem with these is that they could be
systematically wrong, for example:

o
If inflation was accelerating, its expectations
would to, but because they were looking only at
where the data had been instead of where it was
going, they’d never catch up

UNO, ECON 6204, Summer
2008, Dr. Tufte

34

Macroeconomics: History and Historical
Issues

Rational Expectations


Suggested by Muth in 1960


The idea is that expectations are formed not
only on the basis of past data, but on the
structure of the model itself

o
Agents determine the expectations that is optimal
given past information and the structure of the
model

o
This amounts to, on average, people
understanding how their world works

UNO, ECON 6204, Summer
2008, Dr. Tufte

35

Macroeconomics: History and Historical
Issues

The Literature on Expectations


The
expecations

debate was huge from the late
60’s through the very early 90’s

o
There were lots of results people thought were huge
at the time, that have been forgotten now


The big result


the Lucas’ Critique


was subtle

o
Essentially it implied that macroeconomists needed to
throw out just about everything and start over.
Policymakers haven’t really caught up to this, which is
why the Keynesian model still works for thinking
about how policymakers act

UNO, ECON 6204, Summer
2008, Dr. Tufte

36

Macroeconomics: History and Historical
Issues

A Cartoon


This is off subject, but it’s useful for thinking
about why economics is different from hard
sciences. In those, the components don’t
think and react, in economics, they do.

UNO, ECON 6204, Summer
2008, Dr. Tufte

37

Macroeconomics: History and Historical
Issues

The Lucas’ Critique


Keynesians assume their multipliers are useful
because they are fixed numbers


Lucas asserted that:

o
With rational expectations,

o
The Keynesian partial derivatives depend on policy

o
So that a policy that is chosen based on a
multiplier can change that multiplier leading to an
effect that can’t be envisioned from the Keynesian
model

UNO, ECON 6204, Summer
2008, Dr. Tufte

38

Macroeconomics: History and Historical
Issues

How Did Macroeconomists Proceed
Once They Understood the Lucas’
Critique?


It was necessary to start out with models of
agents who optimized, so that their
expectations could be rational from the
beginning

o
Instead of appending rational expectations onto a
Keynesian models that had no optimization at all.


Basically, macroeconomics had to start looking
a lot more like microeconomics

o
It needed to be “new classical”

UNO, ECON 6204, Summer
2008, Dr. Tufte

39

Macroeconomics: History and Historical
Issues

What Happened to Expectations In
Macroeconomic Models?


By and large, it turned out that the “interesting”
results about expectations were related to the
imperfections of the Keynesian model

o
We still use rational expectations, but

o
A lot of times it is good enough to make the seemingly
extreme assumption of perfect foresight (that people
know the future)


you can do a lot of math only to
find out that you’re rational expectations solution isn’t
too different from a perfect foresight solution.

UNO, ECON 6204, Summer
2008, Dr. Tufte

40

Macroeconomics: History and Historical
Issues