Intermediate Macroeconomics

Intermediate Macroeconomics

Julio Gar?in Claremont McKenna College

Robert Lester Colby College

Eric Sims University of Notre Dame

August 2, 2018

This Version: 3.0.0

This is a book designed for use in an intermediate macroeconomics course or a masters level course in macroeconomics. It could also be used by graduate students seeking a refresher in advanced undergraduate macroeconomics. This book represents a substantial makeover and extension of the course notes for intermediate macroeconomics which have been provided publicly on Eric Sims's personal website for several years.

There are many fine textbooks for macroeconomics at the intermediate level currently available. These texts include, but are certainly not limited to, Mankiw (2016), Williamson (2014), Jones (2013), Barro (1997), Abel, Bernanke, and Croushore (2017), Gordon (2012), Hall and Pappell (2005), Blanchard (2017), Dornbusch, Fischer, and Startz (2013), Froyen (2013), and Chugh (2015).

Given the large number of high quality texts already on the market, why the need for a new one? We view our book as fulfilling a couple of important and largely unmet needs in the existing market. First, our text makes much more use of mathematics than most intermediate books. Second, whereas most textbooks divide the study of the macroeconomy into two "runs" (the long run and the short run), we focus on three runs ? the long run, the medium run, and the short run. Third, we have attempted to emphasize the microeconomic underpinnings of modern macroeconomics, all the while maintaining tractability and a focus on policy. Fourth, we include a section on banking, bank runs, bond pricing, and the stock market. While this material is generally left to money, credit, and banking texts, the recent Great Recession has taught us the importance of thinking seriously about the implications of the financial system for the macroeconomy. Finally, we feel that a defining feature of this text is that it is, if nothing else, thorough ? we have tried hard to be very clear about mathematical derivations and to not skip steps when doing them.

Modern economics is increasingly quantitative and makes use of math. While it is important to emphasize that math is only a tool deployed to understand real-world phenomena, it is a highly useful tool. Math clearly communicates ideas which are often obfuscated when only words are used. Math also lends itself nicely to quantitative comparisons of models with real-world data. Our textbook freely makes use of mathematics, more so than most of the texts we cited above. An exception is Chugh (2015), who uses more math than we do. To successfully navigate this book, a student needs to be proficient at high school level algebra and be comfortable with a couple of basic rules of calculus and statistics. We have included Appendices A and B to help students navigate the mathematical concepts which are used throughout the book. While we find the approach of freely integrating mathematics into the analysis attractive, we recognize that it may not be well-suited for all students and all instructors. We have therefore written the book where the more involved mathematical analysis is contained in Part III. This material can be skipped at the instructor's discretion,

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which allows an instructor to spend more time on the more graphical analysis used in Parts IV and V.

Traditionally, macroeconomic analysis is divided into the "long run" (growth) and the "short run" (business cycles). We have added a third run to the mix, which we call the "medium run." This is similar to the approach in Blanchard (2017), although we reverse ordering relative to Blanchard, studying the long run first, then the medium run, then the short run. Our principal framework for studying the long run in Part II is the canonical Solow model. We are attracted to this framework because it clearly elucidates the important role of productivity in accounting for both long run growth and cross-country income differences. A drawback is that the Solow model does not formally model microeconomic decision-making, as we do throughout the rest of the book. To that end, we have also included Chapter 8 using an overlapping generations framework with optimizing agents. This framework touches on many of the same issues as the Solow model, but allows us to address a number of other issues related to efficiency and the role of a government.

Whereas growth theory studies the role of capital accumulation and productivity growth over the span of decades, we think of the medium run as focusing on frequencies of time measured in periods of several years. Over this time horizon, investment is an important component of fluctuations in output, but it is appropriate to treat the stock of physical capital as approximately fixed. Further, nominal frictions which might distort the short run equilibrium relative to an efficient outcome are likely not relevant over this time horizon. Our framework for studying the medium run is what we call the neoclassical model (or real business cycle model). In this framework, output is supply determined and the equilibrium is efficient. The microeconomic underpinnings of the neoclassical model are laid out in Part III and a full graphical treatment is given in Part IV.

We think of the short run as focusing on periods of time spanning months to several years. Our framework for studying the short run is a New Keynesian model with sticky prices. This analysis is carried out in Part V. The only difference between our medium and short run models is the assumption of price rigidity, which makes the AS curve non-vertical ? otherwise the models are the same. We consider two different versions of the sticky price model ? one in which the price level is completely predetermined within period (the simple sticky price model) and another in which the price level is sensitive to the output gap (the partial sticky price model). With either form of price stickiness, demand shocks matter, and the scope for beneficial short run monetary and/or fiscal policies becomes apparent. Optimal monetary policy and complications raised by the zero lower bound (ZLB) are addressed. Appendix D develops a sticky wage model which has similar implications to the sticky price model.

Modern macroeconomics is simply microeconomics applied at a high level of aggregation.

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To that end, we have devoted an entire part of the book, Part III, to the "Microeconomics of Macroeconomics." There we study an optimal consumption-saving problem, a firm profit maximization problem in a dynamic setting, equilibrium in an endowment economy, and discuss fiscal policy, money, and the First Welfare Theorem. Whereas for the most part we ignore unemployment throughout the book and instead simply focus on total labor input, we also include a chapter on search, matching, and unemployment. The analysis carried out in Part III serves as the underpinning for the remainder of the medium and short run analysis in the book, but we have tried to write the book where an instructor can omit Part III should he or she choose to do so.

Relatedly, modern macroeconomics takes dynamics seriously. We were initially attracted to the two period macroeconomic framework used in Williamson (2014), for which Barro (1997) served as a precursor. We have adopted this two period framework for Parts III through V. That said, our experience suggested that the intertemporal supply relationship (due to an effect of the real interest rate on labor supply) that is the hallmark of the Williamson (2014) approach was ultimately confusing to students. It required spending too much time on a baseline market-clearing model of the business cycle and prevented moving more quickly to a framework where important policy implications could be addressed. We have simplified this by assuming that labor supply does not depend on the real interest rate. This can be motivated formally via use of preferences proposed in Greenwood, Hercowitz, and Huffman (1988), which feature no wealth effect on labor supply.

We were also attracted to the timeless IS-LM approach as laid out, for example, so eloquently by Mankiw (2016), Abel, Bernanke, and Croushore (2017), and others. Part V studies a short run New Keynesian model, freely making use of the commonly deployed IS-LM-AD-AS analysis. The medium run model we develop graphically in part IV can be cast in this framework with a vertical AS curve, which is often called the "long run supply curve" (or LRAS) in some texts. Because of our simplification concerning the dynamic nature of labor supply in Part IV, we can move to the short run analysis in Part V quicker. Also, because the medium run equilibrium is efficient and the medium run can be understood as a special case of the short run, the policy implications in the short run become immediately clear. In particular, policy should be deployed in such a way that the short run equilibrium (where prices are sticky) coincides with the medium run equilibrium. Price stability is often a good normative goal, and monetary policy ought to target the natural or neutral rate of interest, which is the interest rate which would obtain in the absence of price or wage rigidities. This "Wicksellian" framework for thinking about policy is now the dominant paradigm for thinking about short run fluctuations in central banks. Within the context of the IS-LM-AD-AS model, we study the zero lower bound and an open economy version of

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the model. Jones (2013) proposes replacing the LM curve with the monetary policy (MP) curve, which is based on a Taylor rule type framework for setting interest rates. We include an appendix, Appendix E, where the MP curve replaces the LM curve.

Finally, the recent Great Recession has highlighted the importance of thinking about connections between the financial system and the macroeconomy. Part VI of the book is dedicated to studying banking, financial intermediation, and asset pricing in more depth. We include chapters on the basics of banking and bank runs, as well as a chapter that delves into the money supply process in more detail. We also have detailed chapters on bond and stock pricing in a dynamic, optimizing framework based on the stochastic discount factor. Much of this material is traditionally reserved for money, credit, and banking courses, but we think that recent events make the material all the more relevant for conventional macroeconomics courses. Chapter 35 incorporates an exogenous credit spread variable into our medium/short run modeling framework and argues that exogenous increases in credit spreads are a sensible way to model financial frictions and crises. Chapter 36 provides an in-depth accounting of the recent financial crisis and Great Recession and deploys the tools developed elsewhere in the book to understand the recession and the myriad policy interventions undertaken in its wake.

In writing this book, we have tried to follow the lead of Glenmorangie, the distillery marketing itself as producing Scotch that is "unnecessarily well-made." In particular, we have attempted throughout the book to be unnecessarily thorough. We present all the steps for various mathematical derivations and go out of our way to work through all the steps when deriving graphs and shifting curves. This all makes the book rather than longer than it might otherwise be. In a sense, it is our hope that a student could learn from this text without the aid of a formal instructor, though we think this is suboptimal. Our preference for this approach is rooted in our own experiences as students, where we found ourselves frustrated (and often confused) when instructors or textbooks skipped over too many details, instead preferring to focus on the "big picture." There is no free lunch in economics, and our approach is not without cost. At present, the book is short on examples and real-world applications. We hope to augment the book along these dimensions in the coming months and years. The best real world examples are constantly changing, and this is an area where the instructor contributes some value added, helping to bring the text material to life.

The book is divided into six main parts. Part I serves as an introduction. Chapter 1 reviews some basic definitions of aggregate macroeconomic variables. While most students should have seen this material in a principles course, we think it is important for them to see it again. Chapter 2 defines what an economic model is and why a model is useful. This chapter motivates the rest of the analysis in the book, which is based on models. Chapter 3 provides a brief overview of the history and controversies of macroeconomics.

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We study the long run in Part II. We put the long run first, rather than last as in many textbooks, for two main reasons. First, growth is arguably much more important for welfare than is the business cycle. As Nobel Prize winner Robert Lucas once famously said, "Once you start to think about growth, it is difficult to think about anything else." Second, the standard Solow model for thinking about growth is not based on intertemporal optimization, but rather assumes a constant saving rate. This framework does not fit well with the remainder of the book, which is built around intertemporal optimization. Nevertheless, the Solow model delivers many important insights about both the long run trends of an economy and the sizeable cross-country differences in economic outcomes. Chapter 4 lays out some basic facts about economic growth based on the contribution of Kaldor (1957). Chapter 5 studies the textbook Solow model. Chapter 6 considers an augmented version of the Solow model with exogenous productivity and population growth. Chapter 7 uses the Solow model to seek to understand cross-country differences in income. In the most recent edition of the book, we have also included a chapter using a dynamic, optimizing, overlapping generations framework (Chapter 8). While touching on similar issues to the Solow model, it allows to discuss things like market efficiency and potentially beneficial roles of a government. Though it ends up having similar implications as the Solow model, because the OLG economy features optimizing households in the context of a growth model, it provides a nice bridge to later parts of the book.

Part III is called the "Microeconomics of Macroeconomics" and studies optimal decision making in a two period, intertemporal framework. This is the most math-heavy component of the book, and later parts of the book, while referencing the material from this part, are meant to be self-contained. Chapter 9 studies optimal consumption-saving decisions in a two period framework, making use of indifference curves and budget lines. It also considers several extensions to the two period framework, including a study of the roles of wealth, uncertainty, and liquidity constraints in consumption-saving decisions. Chapter 10 extends this framework to more than two periods. Chapter 11 introduces the concept of competitive equilibrium in the context of the two period consumption-saving framework, emphasizing that the real interest rate is an intertemporal price which adjusts to clear markets in equilibrium. It also includes some discussion on heterogeneity and risk-sharing, which motivates the use of the representative agent framework used throughout the book. Chapter 12 introduces production, and studies optimal labor and investment demand for a firm and optimal labor supply for a household. Chapter 13 introduces fiscal policy into this framework. Here we discuss Ricardian Equivalence, which is used later in the book, but also note the conditions under which Ricardian Equivalence will fail to hold. Chapter 14 introduces money into the framework, motivating the demand for money through a money in the utility function

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assumption. Here we do not go into detail on the money creation process, instead reserving that material for later in the book (Chapter 31). Chapter 15 discusses the equivalence of the dynamic production economy model laid out in Chapter 12 to the solution to a social planner's problem under certain conditions. In the process we discuss the First Welfare Theorem. Although we are mostly silent on unemployment, Chapter 16 includes a microeconomically founded discussion of unemployment using the Diamond-Mortensen-Pissarides framework.

The medium run is studied in Part IV. We refer to our model for understanding the medium run as the neoclassical model. It is based on the intertemporal frictionless production economy studied in more depth in Chapter 12, though the material is presented in such a way as to be self-contained. Most of the analysis is graphical in nature. The consumption, investment, money, and labor demand schedules used in this part come from the microeconomic decisionmaking problems studied in Part III, as does the labor supply schedule. Chapter 17 discusses these decision rules and presents a graphical depiction of the equilibrium, which is based on a traditional IS curve summarizing the demand side and a vertical curve which we will the Y s curve (after Williamson 2014) to describe the supply-side. The Y s curve is vertical, rather than upward-sloping in a graph with the real interest rate on the vertical axis and output on the horizontal, because of our assumption of no wealth effects on labor supply. Appendix C carries out the analysis where the Y s curve is instead upward-sloping, as in Williamson (2014). Chapter 18 graphically works through the effects of changes in exogenous variables on the endogenous variables of the model. Chapter 19 presents some basic facts about observed business cycle fluctuations and assesses the extent to which the neoclassical model can provide a reasonable account of those facts. In Chapter 20 we study the connection between the money supply, inflation, and nominal interest rates in the context of the neoclassical model. Chapter 21 discusses the policy implications of the model. The equilibrium is efficient, and so there is no scope for policy to attempt to combat fluctuations with monetary or fiscal interventions. In this chapter we also include an extensive discussion of criticisms which have been levied at the neoclassical / real business cycle paradigm for thinking about economic policy. Chapter 22 considers an open economy version of the neoclassical model, studying net exports and exchange rates.

Part V studies a New Keynesian model. This model is identical to the neoclassical model, with the exception that the aggregate price level is sticky. This stickiness allows demand shocks to matter and means that money is non-neutral. It also means that the short run equilibrium is in general inefficient, opening the door for desirable policy interventions. Chapter 23 develops the IS-LM-AD curves to describe the demand side of the model. What differentiates the New Keynesian model from the neoclassical model is not the demand side, but rather the supply side. Hence, the IS-LM-AD curves can also be used to describe the

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demand side of the neoclassical model. We prefer our approach of first starting with the IS-Y s curves because it better highlights monetary neutrality and the classical dichotomy. Chapter 24 develops a theory of a non-vertical aggregate supply curve based on price stickiness. An appendix develops a New Keynesian model based on wage stickiness rather than price stickiness, Appendix D. Chapter 25 works out the effects of changes in exogenous variables on the endogenous variables of the New Keynesian model and compares those effects to the neoclassical model. Chapter 26 develops a theory of the transition from short run to medium run. In particular, if the short run equilibrium differs from what would obtain in the neoclassical model, over time pressure on the price level results in shifts of the AS relationship that eventually restore the neoclassical equilibrium. On this basis we provide theoretical support for empirically observed Phillips Curve relationships. In Chapter 27 we study optimal monetary policy in the Keynesian model. The optimal policy is to adjust the money supply / interest rates so as to ensure that the equilibrium of the short run model coincides with the equilibrium which would obtain in the absence of price rigidity (i.e. the neoclassical, medium run equilibrium). Here, we talk about the Wicksellian "natural" or "neutral" rate of interest and its importance for policy. We also discuss the benefits of price stability. Chapter 28 studies the New Keynesian model when the zero lower bound is binding. Chapter 29 considers an open economy version of the New Keynesian model.

Recent events have highlighted the important connection between finance and macroeconomics. Part VI is dedicated to these issues. Chapter 30 discusses the basic business of banking and focuses on bank balance sheets. There we also discuss how banking has changed in the last several decades, discussing the rise of a so-called "shadow banking" sector. Chapter 31 studies the creation of money and defines terms like the monetary base and the money multiplier. Chapter 32 discusses the usefulness of the liquidity transformation in which financial intermediaries engage and the sensitivity of financial intermediaries to runs. To that end, we provide a simplified exposition of the classic Diamond and Dybvig (1983) model of bank runs. This material proves useful in thinking about the recent financial crisis. Chapters 33 and 34 study asset pricing in the context of a microeconomically founded consumption capital asset pricing model (CAPM) based on the stochastic discount factor. Chapter 33 studies the risk and term structures of interest rates and provides a framework for thinking seriously about both conventional and unconventional monetary policy. Chapter 34 studies the stock market and seeks to understand the equity premium. We also discuss the possibility of bubbles and whether policy ought to try to prevent them.

Although much research has been recently done, it is not straightforward to incorporate a non-trivial financial system in a compelling and tractable way into an otherwise standard macroeconomic framework. In Chapter 35, we argue that a convenient short cut is to include

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