Lecture Notes in Macroeconomics

1 Lecture Notes in MacroeconomicsJohn C. DriscollBrown University and NBER1 December 21, 20031 Department of Economics, Brown University, Box B, Providence RI 02912. Phone(401) 863-1584, Fax (401) 863-1970, web:http:\\ \ Copyright John C. Driscoll, 1999, 2000, 2001. All rightsreserved. Do not reproduce without permission. Comments welcome. I especiallythank David Weil, on whose Notes substantial parts of the chapters on Money andPrices and Investment are based. Kyung Mook Lim and Wataru Miyanaga provideddetailed corrections to typographical errors. Several classes of Brown students haveprovided suggestions and corrections. All remaining errors are Money and Definitions .. Prices .. Money .. The History of Money .. The Demand for Money.

2 The Baumol-Tobin Model of Money Demand .. Money in Dynamic General Equilibrium .. Discrete Time .. Continuous Time .. Solving the Model .. The optimum quantity of money .. The Quantity Theory of Money .. Seigniorage, Hyperinflation and the Cost of Inflation .. Problems .. 212 Nominal Rigidities and Economic Old Keynesian Economics: The Neoclassical Synthesis .. Open Economy .. Aggregate Supply .. Disequilibrium Economics .. Setup .. The Walrasian Benchmark Case .. Exogenously Fixed Price .. Exogenously Fixed Nominal Wage .. Both prices and wages inflexible .. Analysis of this model .. Imperfect Information Models .. New Keynesian Models .. Contracting Models.

3 Predetermined Wages .. Fixed Wages .. Imperfect Competition and New Keynesian Economics .. Macroeconomic Effects of Imperfect Competition .. Imperfect competition and costs of changing prices .. Dynamic Models .. Evidence and New Directions .. Problems .. 583 Macroeconomic Rules v. Discretion .. The Traditional Case For Rules .. The Modern Case For Rules: Time Consistency .. Fischer s Model of the Benevolent, Dissembling Government monetary policy and Time Inconsistency .. Reputation .. The Lucas Critique .. Monetarist Arithmetic: Links Between monetary and Fiscal policy Problems .. 804 The Classical Approach .. Adjustment Costs and Investment:qTheory .. The Housing Market: After Mankiw and Weil and Poterba Credit Rationing.

4 Investment and Financial Markets .. The Effects of Changing Cashflow .. The Modigliani-Miller Theorem .. Banking Issues: Bank Runs, Deposit Insurance and Moral Hazard Investment Under Uncertainty and Irreversible Investment .. Investment Under Uncertainty .. Problems: .. 1105 Unemployment and Coordination Efficiency wages, or why the real wage is too high .. Solow model .. The Shapiro-Stiglitz shirking model .. Other models of wage rigidity .. Search .. Setup .. Steady State Equilibrium .. Coordination Failure and Aggregate Demand Externalities .. Model set-up .. Assumptions .. Definitions .. Propositions .. Problems .. 127 Continuous-Time Dynamic Optimization131 CONTENTSvStochastic Calculus133 IntroductionCourse Mechanics Requirements: Two exams, each 50% of grade, each covers half of materialin class.

5 First exam: on Tuesday, March 12th. Second and final exam: onTuesday, April 30th. Problem sets: will be several, which will be handed in and corrected, butnot 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 every-thing. That is fine, as not everything is essential. I may cut material as Igo along, and will try to give you fair warning when that happens. The lectures will very closely follow my Lecture Notes . There are twoother general textbooks available: Romer, which should be familiar andBlanchard and Fischer. The latter is harder but covers more Lecture Notes combine the approaches of and adapt materials in bothbooks. References in the Notes refer to articles given on the reading list.

6 Withfew exceptions, the articles are also summarized in Romer or Blanchardand Fischer. It is thus not necessary to read all or even most of the ar-ticles on the list. Since articles are the primary means through whicheconomists communicate, you should read at least one. Some of the ar-ticles are in the two recommended volumes by Mankiw and Romer, NewKeynesian Economics, both of which will eventually be in the about all articles prior to 1989 are available via the internet at thesite , provided one connects through a computer connectedto Brown s network. I would ask that everyone not individually print outevery article, since that would take a lot of paper, energy and computingpower. Students considering Macroeconomics as a field are strongly encouragedto attend the Macroeconomics Workshop, on Wednesdays from 4:00-5:30in Robinson the handout labeled The First Measured Century.

7 It presents graphsfor the of the three most important macroeconomic statistics, output, un-employment and inflation, since 1900. Essentially, Ec 207 tried to explain whythe graph of real GDP sloped upwards. It also tried to explain why there werefluctuations around the trend, via real business cycle theory, but was much lessviCONTENTS successful. This course will explain the trend in and growth rates of inflationand unemployment, and fluctuations in real GDP. It will also explain why thesevariables move together- that is, unemployment tends to be low when outputgrowth is high, and inflation is often (but not always) low when output growthis low.[Omitted in Spring 2002: An important distinction that I have made implic-itly above is the separation of variables into atrendcomponent and acyclicalcomponent.]

8 The trend component can be thought of informally as the long-runaverage behavior of the variable, and the cyclical component deviations fromthat trend. For inflation and unemployment, the trend components appear tobe horizontal lines (with possible shifts in the level of the line for both overtime). When one assumes that a model like the Solow growth model explainsthe long-run growth rate of output, but not the short run, one is already doingsuch a division. There has been a debate in recent years over whether it isappropriate to do such a division; some claim that variables like output, ratherthan having adeterministic trend, as is claimed in the Solow model (where thetrend component, in log terms, is just proportional to time), instead have astochastic trend.

9 Algebraically, the two cases are:yt= + t+ t(1)for the deterministic trend case, andyt= +yt 1+ t(2)in the stochastic trend case (a random walk with drift).1yt= ln(GDP) mea-sured at time t. In the first case, tis the trend component or GDP and tis the deviation around the trend. Changes in tcause temporary variationsin GDP, but do not affect the long-run level ofyt, which is only determinedby + t, trend growth. In contrast, in the second specification changes in tpermanently affect the level the stochastic-trend case, it may be more appropriate in some instances tostudy the long-run and the short-run together. This was one of the motivationsof the RBC literature. For the purposes of this course, I am going to sidestepthis debate, partly because it requires some heavy-duty econometrics to fullyunderstand, but primarily because many macroeconomists have concluded thateven if output does have a stochastic trend, analyzes assuming it has a deter-ministic trend will give many of the right answers.

10 This is because computing yt=yt yt 1gives the same answer in both cases, so that any finite-sampletime series with average growth rate of can be represented by both more information, see the first chapter of Blanchard and Fischer.]We will cover the following topics in this course: Money and Prices: In Ec 207, although you may have occasionally referredto variables denominated in dollars, the fact that transactions required a1 This is a special case of what is known as aunit rootprocess. See any time series textbookfor further of exchange wasn t mentioned, and played no role in any of theanalyses you went through. This section will define what money is (whichturns out to be less obvious a question than one might immediately think),describe theories of money demand, and describe the long-run behavior ofmoney and the price level.