Macroeconomic Theory and Policy
[Pages:320]Macroeconomic Theory and Policy
Preliminary Draft
David Andolfatto Simon Fraser University
dandolfa@sfu.ca
?c August 2005
ii
Contents
Preface
ix
I Macroeconomic Theory: Basics
1
1 The Gross Domestic Product
3
1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
1.2 How GDP is Calculated . . . . . . . . . . . . . . . . . . . . . . . 5
1.2.1 The Income Approach . . . . . . . . . . . . . . . . . . . . 5
1.2.2 The Expenditure Approach . . . . . . . . . . . . . . . . . 6
1.2.3 The Income-Expenditure Identity . . . . . . . . . . . . . . 7
1.3 What GDP Does Not Measure . . . . . . . . . . . . . . . . . . . 8
1.4 Nominal versus Real GDP . . . . . . . . . . . . . . . . . . . . . . 9
1.5 Real GDP Across Time . . . . . . . . . . . . . . . . . . . . . . . 12
1.6 Schools of Thought . . . . . . . . . . . . . . . . . . . . . . . . . . 14
1.7 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
1.8 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
1.A Measured GDP: Some Caveats . . . . . . . . . . . . . . . . . . . 18
2 Basic Neoclassical Theory
21
2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2.2 The Basic Model . . . . . . . . . . . . . . . . . . . . . . . . . . . 22
2.2.1 The Household Sector . . . . . . . . . . . . . . . . . . . . 23
2.2.2 The Business Sector . . . . . . . . . . . . . . . . . . . . . 30
2.2.3 General Equilibrium . . . . . . . . . . . . . . . . . . . . . 31
2.3 Real Business Cycles . . . . . . . . . . . . . . . . . . . . . . . . . 35
2.3.1 The Wage Composition Bias . . . . . . . . . . . . . . . . 38
2.4 Policy Implications . . . . . . . . . . . . . . . . . . . . . . . . . . 39
2.5 Uncertainty and Rational Expectations . . . . . . . . . . . . . . . 41
2.6 Animal Spirits . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
2.6.1 Irrational Expectations . . . . . . . . . . . . . . . . . . . 43
2.6.2 Self-Fulfilling Prophesies . . . . . . . . . . . . . . . . . . . 44
2.7 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
2.8 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
iii
iv
CONTENTS
2.9 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 2.A A Model with Capital and Labor . . . . . . . . . . . . . . . . . . 50 2.B Schumpeter's Process of Creative Destruction . . . . . . . . . . . 53
3 Fiscal Policy
55
3.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
3.2 Government Purchases . . . . . . . . . . . . . . . . . . . . . . . . 55
3.2.1 Lump-Sum Taxes . . . . . . . . . . . . . . . . . . . . . . . 56
3.2.2 Distortionary Taxation . . . . . . . . . . . . . . . . . . . . 59
3.3 Government and Redistribution . . . . . . . . . . . . . . . . . . . 60
3.4 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
4 Consumption and Saving
67
4.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
4.2 A Two-Period Endowment Economy . . . . . . . . . . . . . . . . 68
4.2.1 Preferences . . . . . . . . . . . . . . . . . . . . . . . . . . 68
4.2.2 Constraints . . . . . . . . . . . . . . . . . . . . . . . . . . 69
4.2.3 Robinson Crusoe . . . . . . . . . . . . . . . . . . . . . . . 70
4.2.4 Introducing a Financial Market . . . . . . . . . . . . . . . 71
4.2.5 Individual Choice with Access to a Financial Market . . . 74
4.2.6 Small Open Economy Interpretation . . . . . . . . . . . . 76
4.3 Experiments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
4.3.1 A Transitory Increase in Current GDP . . . . . . . . . . . 77
4.3.2 An Anticipated Increase in Future GDP . . . . . . . . . . 79
4.3.3 A Permanent Increase in GDP . . . . . . . . . . . . . . . 82
4.3.4 A Change in the Interest Rate . . . . . . . . . . . . . . . 84
4.4 Borrowing Constraints . . . . . . . . . . . . . . . . . . . . . . . . 86
4.5 Determination of the Real Interest Rate . . . . . . . . . . . . . . 89
4.5.1 General Equilibrium in a 2-Period Endowment Economy . 90
4.5.2 A Transitory Decline in World GDP . . . . . . . . . . . . 92
4.5.3 A Persistent Decline in World GDP . . . . . . . . . . . . 93
4.5.4 Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . 94
4.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97
4.7 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99
4.8 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 101
4.A Alexander Hamilton on Repaying the U.S. War Debt . . . . . . . 103
4.B Milton Friedman Meets John Maynard Keynes . . . . . . . . . . 104
4.C The Term Structure of Interest Rates . . . . . . . . . . . . . . . . 106
4.D The Intertemporal Substitution of Labor Hypothesis . . . . . . . 108
5 Government Spending and Finance
111
5.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111
5.2 The Government Budget Constraint . . . . . . . . . . . . . . . . 111
5.3 The Household Sector . . . . . . . . . . . . . . . . . . . . . . . . 113
5.4 The Ricardian Equivalence Theorem . . . . . . . . . . . . . . . . 114
5.5 Government Spending . . . . . . . . . . . . . . . . . . . . . . . . 117
CONTENTS
v
5.5.1 A Transitory Increase in Government Spending . . . . . . 118 5.6 Government Spending and Taxation in a Model with Production 119
5.6.1 Ricardian Equivalence . . . . . . . . . . . . . . . . . . . . 120 5.6.2 Government Spending Shocks . . . . . . . . . . . . . . . . 121 5.6.3 Barro's Tax-Smoothing Argument . . . . . . . . . . . . . 121 5.7 U.S. Fiscal Policy . . . . . . . . . . . . . . . . . . . . . . . . . . . 121 5.8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 5.9 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 124 5.10 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125
6 Capital and Investment
127
6.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
6.2 Capital and Intertemporal Production . . . . . . . . . . . . . . . 128
6.3 Robinson Crusoe . . . . . . . . . . . . . . . . . . . . . . . . . . . 130
6.4 A Small Open Economy . . . . . . . . . . . . . . . . . . . . . . . 133
6.4.1 Stage 1: Maximizing Wealth . . . . . . . . . . . . . . . . 133
6.4.2 Stage 2: Maximizing Utility . . . . . . . . . . . . . . . . . 136
6.4.3 A Transitory Productivity Shock . . . . . . . . . . . . . . 138
6.4.4 A Persistent Productivity Shock . . . . . . . . . . . . . . 140
6.4.5 Evidence . . . . . . . . . . . . . . . . . . . . . . . . . . . 142
6.5 Determination of the Real Interest Rate . . . . . . . . . . . . . . 142
6.6 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 144
6.7 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
6.8 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 146
7 Labor Market Flows and Unemployment
147
7.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147
7.2 Transitions Into and Out of Employment . . . . . . . . . . . . . 147
7.2.1 A Model of Employment Transitions . . . . . . . . . . . . 149
7.3 Unemployment . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153
7.3.1 A Model of Unemployment . . . . . . . . . . . . . . . . . 155
7.3.2 Government Policy . . . . . . . . . . . . . . . . . . . . . . 158
7.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 159
7.5 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
7.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160
7.A A Dynamic Model of Unemployment . . . . . . . . . . . . . . . . 161
II Macroeconomic Theory: Money
165
8 Money, Interest, and Prices
167
8.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167
8.2 What is Money? . . . . . . . . . . . . . . . . . . . . . . . . . . . 168
8.3 Private Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . 169
8.3.1 The Neoclassical Model . . . . . . . . . . . . . . . . . . . 169
8.3.2 Wicksell's Triangle: Is Evil the Root of All Money? . . . . 170
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CONTENTS
8.3.3 Government Money . . . . . . . . . . . . . . . . . . . . . 173 8.4 The Quantity Theory of Money . . . . . . . . . . . . . . . . . . . 173 8.5 The Nominal Interest Rate . . . . . . . . . . . . . . . . . . . . . 177
8.5.1 The Fisher Equation . . . . . . . . . . . . . . . . . . . . . 179 8.6 A Rate of Return Dominance Puzzle . . . . . . . . . . . . . . . . 181
8.6.1 The Friedman Rule . . . . . . . . . . . . . . . . . . . . . . 183 8.7 Inflation Uncertainty . . . . . . . . . . . . . . . . . . . . . . . . . 184 8.8 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185 8.9 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186 8.10 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
9 The New-Keynesian View
189
9.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 189
9.2 Money Non-Neutrality . . . . . . . . . . . . . . . . . . . . . . . . 189
9.2.1 A Basic Neoclassical Model . . . . . . . . . . . . . . . . . 190
9.2.2 A Basic Keynesian Model . . . . . . . . . . . . . . . . . . 191
9.3 The IS-LM-FE Model . . . . . . . . . . . . . . . . . . . . . . . . 193
9.3.1 The FE Curve . . . . . . . . . . . . . . . . . . . . . . . . 193
9.3.2 The IS Curve . . . . . . . . . . . . . . . . . . . . . . . . . 194
9.3.3 The LM Curve . . . . . . . . . . . . . . . . . . . . . . . . 195
9.3.4 Response to a Money Supply Shock: Neoclassical Model . 195
9.3.5 Response to a Money Supply Shock: Keynesian Model . . 197
9.4 How Central Bankers View the World . . . . . . . . . . . . . . . 199
9.4.1 Potential Output . . . . . . . . . . . . . . . . . . . . . . . 199
9.4.2 The IS and SRFE Curves . . . . . . . . . . . . . . . . . . 201
9.4.3 The Phillips Curve . . . . . . . . . . . . . . . . . . . . . . 201
9.4.4 Monetary Policy: The Taylor Rule . . . . . . . . . . . . . 203
9.5 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 205
9.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 206
9.A Are Nominal Prices/Wages Sticky? . . . . . . . . . . . . . . . . . 207
10 The Demand for Fiat Money
209
10.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209
10.2 A Simple OLG Model . . . . . . . . . . . . . . . . . . . . . . . . 210
10.2.1 Pareto Optimal Allocation . . . . . . . . . . . . . . . . . . 211
10.2.2 Monetary Equilibrium . . . . . . . . . . . . . . . . . . . . 213
10.3 Government Spending and Monetary Finance . . . . . . . . . . . 217
10.3.1 The Inflation Tax and the Limit to Seigniorage . . . . . . 219
10.3.2 The Inefficiency of Inflationary Finance . . . . . . . . . . 222
10.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
10.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225
CONTENTS
vii
11 International Monetary Systems
227
11.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 227
11.2 Nominal Exchange Rate Determination: Free Markets . . . . . . 229
11.2.1 Understanding Nominal Exchange Rate Indeterminacy . . 231
11.2.2 A Multilateral Fixed Exchange Rate Regime . . . . . . . 233
11.2.3 Speculative Attacks . . . . . . . . . . . . . . . . . . . . . 236
11.2.4 Currency Union . . . . . . . . . . . . . . . . . . . . . . . 239
11.2.5 Dollarization . . . . . . . . . . . . . . . . . . . . . . . . . 239
11.3 Nominal Exchange Rate Determination: Legal Restrictions . . . 240
11.3.1 Fixing the Exchange Rate Unilaterally . . . . . . . . . . . 242
11.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242
11.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
11.A Nominal Exchange Rate Indeterminacy and Sunspots . . . . . . 245
11.B International Currency Traders . . . . . . . . . . . . . . . . . . . 247
11.C The Asian Financial Crisis . . . . . . . . . . . . . . . . . . . . . . 248
12 Money, Capital and Banking
251
12.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 251
12.2 A Model with Money and Capital . . . . . . . . . . . . . . . . . . 251
12.2.1 The Tobin Effect . . . . . . . . . . . . . . . . . . . . . . . 254
12.3 Banking . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 255
12.3.1 A Simple Model . . . . . . . . . . . . . . . . . . . . . . . 256
12.3.2 Interpreting Money Supply Fluctuations . . . . . . . . . . 258
12.4 Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
12.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260
III Economic Growth and Development
261
13 Early Economic Development
263
13.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263
13.2 Technological Developments . . . . . . . . . . . . . . . . . . . . . 264
13.2.1 Classical Antiquity (500 B.C. - 500 A.D.) . . . . . . . . . 264
13.2.2 The Middle Ages (500 A.D. - 1450 A.D.) . . . . . . . . . 265
13.2.3 The Renaissance and Baroque Periods (1450 A.D. - 1750
A.D.) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
13.3 Thomas Malthus . . . . . . . . . . . . . . . . . . . . . . . . . . . 267
13.3.1 The Malthusian Growth Model . . . . . . . . . . . . . . . 269
13.3.2 Dynamics . . . . . . . . . . . . . . . . . . . . . . . . . . . 271
13.3.3 Technological Progress in the Malthus Model . . . . . . . 272
13.3.4 An Improvement in Health Conditions . . . . . . . . . . . 273
13.3.5 Confronting the Evidence . . . . . . . . . . . . . . . . . . 274
13.4 Fertility Choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275
13.4.1 Policy Implications . . . . . . . . . . . . . . . . . . . . . 281
13.5 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 282
13.6 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 283
viii
CONTENTS
14 Modern Economic Development
285
14.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 285
14.2 The Solow Model . . . . . . . . . . . . . . . . . . . . . . . . . . . 289
14.2.1 Steady State in the Solow Model . . . . . . . . . . . . . . 292
14.2.2 Differences in Saving Rates . . . . . . . . . . . . . . . . . 293
14.2.3 Differences in Population Growth Rates . . . . . . . . . . 295
14.2.4 Differences in Technology . . . . . . . . . . . . . . . . . . 296
14.3 The Politics of Economic Development . . . . . . . . . . . . . . . 296
14.3.1 A Specific Factors Model . . . . . . . . . . . . . . . . . . 297
14.3.2 Historical Evidence . . . . . . . . . . . . . . . . . . . . . . 300
14.4 Endogenous Growth Theory . . . . . . . . . . . . . . . . . . . . . 302
14.4.1 A Simple Model . . . . . . . . . . . . . . . . . . . . . . . 303
14.4.2 Initial Conditions and Nonconvergence . . . . . . . . . . . 306
14.5 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 308
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