Lecture Notes in Macroeconomics

Lecture Notes in Macroeconomics

John C. Driscoll Brown University and NBER1

December 21, 2003

1Department of Economics, Brown University, Box B, Providence RI 02912. Phone (401) 863-1584, Fax (401) 863-1970, email:John Driscoll@brown.edu, web:http:\\ econ.pstc.brown.edu\ jd. c Copyright John C. Driscoll, 1999, 2000, 2001. All rights reserved. Do not reproduce without permission. Comments welcome. I especially thank David Weil, on whose notes substantial parts of the chapters on Money and Prices and Investment are based. Kyung Mook Lim and Wataru Miyanaga provided detailed corrections to typographical errors. Several classes of Brown students have provided suggestions and corrections. All remaining errors are mine.

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Contents

1 Money and Prices

1

1.1 Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1.1.1 Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1.1.2 Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

1.2 The History of Money . . . . . . . . . . . . . . . . . . . . . . . . 3

1.3 The Demand for Money . . . . . . . . . . . . . . . . . . . . . . . 4

1.3.1 The Baumol-Tobin Model of Money Demand . . . . . . . 4

1.4 Money in Dynamic General Equilibrium . . . . . . . . . . . . . . 6

1.4.1 Discrete Time . . . . . . . . . . . . . . . . . . . . . . . . . 7

1.4.2 Continuous Time . . . . . . . . . . . . . . . . . . . . . . . 10

1.4.3 Solving the Model . . . . . . . . . . . . . . . . . . . . . . 13

1.5 The optimum quantity of money . . . . . . . . . . . . . . . . . . 14

1.5.1 The Quantity Theory of Money . . . . . . . . . . . . . . . 14

1.6 Seigniorage, Hyperinflation and the Cost of Inflation . . . . . . . 16

1.7 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

2 Nominal Rigidities and Economic Fluctuations

27

2.1 Old Keynesian Economics: The Neoclassical Synthesis . . . . . . 28

2.1.1 Open Economy . . . . . . . . . . . . . . . . . . . . . . . . 31

2.1.2 Aggregate Supply . . . . . . . . . . . . . . . . . . . . . . 33

2.2 Disequilibrium Economics . . . . . . . . . . . . . . . . . . . . . . 36

2.2.1 Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

2.2.2 The Walrasian Benchmark Case . . . . . . . . . . . . . . 37

2.2.3 Exogenously Fixed Price . . . . . . . . . . . . . . . . . . . 38

2.2.4 Exogenously Fixed Nominal Wage . . . . . . . . . . . . . 39

2.2.5 Both prices and wages inflexible . . . . . . . . . . . . . . 39

2.2.6 Analysis of this model . . . . . . . . . . . . . . . . . . . . 40

2.3 Imperfect Information Models . . . . . . . . . . . . . . . . . . . . 41

2.4 New Keynesian Models . . . . . . . . . . . . . . . . . . . . . . . . 43

2.4.1 Contracting Models . . . . . . . . . . . . . . . . . . . . . 43

2.4.2 Predetermined Wages . . . . . . . . . . . . . . . . . . . . 44

2.4.3 Fixed Wages . . . . . . . . . . . . . . . . . . . . . . . . . 47

2.5 Imperfect Competition and New Keynesian Economics . . . . . . 50

2.5.1 Macroeconomic Effects of Imperfect Competition . . . . . 50

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CONTENTS

2.5.2 Imperfect competition and costs of changing prices . . . . 51 2.5.3 Dynamic Models . . . . . . . . . . . . . . . . . . . . . . . 56 2.6 Evidence and New Directions . . . . . . . . . . . . . . . . . . . . 57 2.7 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

3 Macroeconomic Policy

65

3.1 Rules v. Discretion . . . . . . . . . . . . . . . . . . . . . . . . . . 66

3.1.1 The Traditional Case For Rules . . . . . . . . . . . . . . . 66

3.2 The Modern Case For Rules: Time Consistency . . . . . . . . . . 68

3.2.1 Fischer's Model of the Benevolent, Dissembling Government 69

3.2.2 Monetary Policy and Time Inconsistency . . . . . . . . . 73

3.2.3 Reputation . . . . . . . . . . . . . . . . . . . . . . . . . . 75

3.3 The Lucas Critique . . . . . . . . . . . . . . . . . . . . . . . . . . 77

3.4 Monetarist Arithmetic: Links Between Monetary and Fiscal Policy 79

3.5 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

4 Investment

87

4.1 The Classical Approach . . . . . . . . . . . . . . . . . . . . . . . 87

4.2 Adjustment Costs and Investment: q Theory . . . . . . . . . . . 88

4.2.1 The Housing Market: After Mankiw and Weil and Poterba 91

4.3 Credit Rationing . . . . . . . . . . . . . . . . . . . . . . . . . . . 93

4.4 Investment and Financial Markets . . . . . . . . . . . . . . . . . 95

4.4.1 The Effects of Changing Cashflow . . . . . . . . . . . . . 98

4.4.2 The Modigliani-Miller Theorem . . . . . . . . . . . . . . . 99

4.5 Banking Issues: Bank Runs, Deposit Insurance and Moral Hazard 100

4.6 Investment Under Uncertainty and Irreversible Investment . . . . 103

4.6.1 Investment Under Uncertainty . . . . . . . . . . . . . . . 107

4.7 Problems: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110

5 Unemployment and Coordination Failure

117

5.1 Efficiency wages, or why the real wage is too high . . . . . . . . . 117

5.1.1 Solow model . . . . . . . . . . . . . . . . . . . . . . . . . 118

5.1.2 The Shapiro-Stiglitz shirking model . . . . . . . . . . . . 118

5.1.3 Other models of wage rigidity . . . . . . . . . . . . . . . . 120

5.2 Search . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120

5.2.1 Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121

5.2.2 Steady State Equilibrium . . . . . . . . . . . . . . . . . . 122

5.3 Coordination Failure and Aggregate Demand Externalities . . . . 123

5.3.1 Model set-up . . . . . . . . . . . . . . . . . . . . . . . . . 123

5.3.2 Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . 125

5.3.3 Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . 126

5.3.4 Propositions . . . . . . . . . . . . . . . . . . . . . . . . . 126

5.4 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127

Continuous-Time Dynamic Optimization

131

CONTENTS

v

Stochastic Calculus

133

Introduction

Course Mechanics

? Requirements: Two exams, each 50% of grade, each covers half of material in class. First exam: on Tuesday, March 12th. Second and final exam: on Tuesday, April 30th.

? Problem sets: will be several, which will be handed in and corrected, but not graded. Good way to learn macro, good practice for exams and core.

? On the reading list: It is very ambitious. We may well not cover everything. That is fine, as not everything is essential. I may cut material as I go along, and will try to give you fair warning when that happens.

? The lectures will very closely follow my lecture notes. There are two other general textbooks available: Romer, which should be familiar and Blanchard and Fischer. The latter is harder but covers more material. The lecture notes combine the approaches of and adapt materials in both books.

? References in the notes refer to articles given on the reading list. With few exceptions, the articles are also summarized in Romer or Blanchard and Fischer. It is thus not necessary to read all or even most of the articles on the list. Since articles are the primary means through which economists communicate, you should read at least one. Some of the articles are in the two recommended volumes by Mankiw and Romer, New Keynesian Economics, both of which will eventually be in the bookstore. Just about all articles prior to 1989 are available via the internet at the site , provided one connects through a computer connected to Brown's network. I would ask that everyone not individually print out every article, since that would take a lot of paper, energy and computing power.

? Students considering macroeconomics as a field are strongly encouraged to attend the Macroeconomics Workshop, on Wednesdays from 4:00-5:30 in Robinson 301.

Motivation

Consider the handout labeled "The First Measured Century." It presents graphs for the U.S. of the three most important macroeconomic statistics, output, unemployment and inflation, since 1900. Essentially, Ec 207 tried to explain why the graph of real GDP sloped upwards. It also tried to explain why there were fluctuations around the trend, via real business cycle theory, but was much less

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