1 st Lecture: Macroeconomics, Theory and Policy Nikolina Kosteletou 1 The Current State of Macroeconomics National and Kapodistrian University of Athens Department of Economics Master Program in Applied Economics UADPhilEcon

Macroeconomics: evolution and current state 2 What is it about? How it has evolved since beginning of previous century Is it useful? Policy measures Two poles of interest: Theory ↔ policies

Macro: What is it about? 3 P. Krugman 2009: the study of big-picture issues, like recession, inflation, unemployment… R. Cabarello 2010: “…the goal of macro is to explain and model the aggregate outcomes that arise from the decisions made by multiple and heterogeneous economic agents interacting through complex relationships and markets.”

Macro: What is it about? 4 -examines the economy as a whole and answers questions such as 'What causes the economy to grow over time?', 'What causes short-run fluctuations in the economy?' 'What influences the values various economic indicators and how do those indicators affect economic performance?economic indicators

Branch of economics concerned with 5 Fluctuations Stabilization policies Determinants of inflation Determinants of employment and unemployment Interest rates Exchange rates Effect of government policies( fiscal, monetary, exchange rate policies) Determinants of growth Performance of trade with other countries (i.e. the balance of payments)

Why do we study macroeconomics? is it useful? 6 Public: economics-macroeconomics Lively topic of debate-theoretical interest Revolutions-counter revolutions Role of government recent recession and crisis

Macroeconomics developed as a separate branch 7 20 th century: great depression, wars, reconstruction, growth, business cycles, stabilization policies, current economic crisis. 19 th cent.: Monetary economics (quantity theory of money, prices) Classical dichotomy between real and nominal variables Gold standard Origin: The “Wealth of Nations”. Adam Smith, 1776.

Before the crisis of 1930s 8 Emphasis on the markets and its inherent forces for equilibrium Business cycles theories Description of cycles (phases) No sign of policies Austrian school (A. Pigou, D. Robertson): monetary policy ineffective, public works desirable. Crisis of 1929 (Great depression): what to do about severe slump, role of the government.

The “Keynesian revolution” 9 Keynes challenged the notion that the free market economies can function without a minder Market mechanism is not enough for an economy to get out of depression Role of government 1936: “General Theory of Employment, Interest and Money” unemployment Slow adjustment of wages, Role of spending on public works Role of budget deficit in reviving the economy Effective demand Role of monetary policy (money is not neutral)

The “Keynesian revolution” 10 Main elements: Supply – demand Prices - quantities All markets do not clear Labor market: equilibrium with unemployment Rigidities: wage rigidity Government should intervene

The “Keynesian revolution” 11 Development of analytical framework Economic policy Role of government in implementing fiscal and monetary policy National accounts (components of national expenditure) Development of econometric models for the study of policy influence on income, consumption, investment. Prediction- Disputes about “microfoundations of macroeconomics” Keynesian economics as a special case of general equilibrium analysis

Classical economics 12 before Keynes: classical economics developed during a period in which capitalism was emerging from feudalism and in which the industrial revolution was leading to vast changes in society. Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus, John Stuart Mill. Adam SmithJean-Baptiste SayDavid RicardoThomas MalthusJohn Stuart Mill Keynes: General Theory (previous orthodoxy)

Classical economics: main elements 13 General equilibrium All markets clear → Efficient allocation of resources free markets can regulate themselves No role for government intervention Quantity theory of money: money is a veil Dichotomy: real and nominal values Say's Law: supply creates its own demand – that is, aggregate production will generate an income enough to purchase all the output produced.

Neoclassical synthesis 14 Synthesis of Keynes’s ideas with neoclassical models. Neo-Keynesians. Keynesian theory as a special case. John Hicks (IS/LM), Paul Samuelson. Neoclassical model, correct in the long run. Keynesian model, correct in the short run. Dynamics from the short to long run not well worked out. Economic policy effective in the short run-ineffective in the long run.

Neoclassical model 15 aim: explanation of how scarce resources are allocated among alternative ends. 3 basic assumptions: Rational preferences Individuals maximize utility Firms maximize profits Full information

Neoclassical model 16 Description: General equilibrium (all markets clear) Equilibrium prices and quantities determined within markets. Economic units: firm - household (consumer) Firm: produces goods It buys productive resources from households and sells goods aim of the firm: max of profit given prices Perfect competition

Neoclassical model 17 Household: possesses productive resources Buys goods from the firms Sells inputs to the firms Aim: max utility given prices Perfect competition also in the market of productive resources

Neoclassical model 18

Decades: -50s, 60s 19 Refinement of Keynesian models Critique on microfoundations new theories about special topics Consumption: Modigliani, Friedman, Dusenberry Liquidity preference: (Tobin, Baumol) 3 waves of critique: monetarism, rational expectations, real business cycles

Common points of critique on Keynesian economics 20 Skepticism about the benefits of active stabilization policy Self correcting mechanisms of the economy Question about the effect of public policy Fiscal policy → inflation Stagflation (-70s) Prices: question with assumption of their stability (effect of demand on prices)

Common points of critique on Keynesian economics 21 New phenomena and evolution in economic and social life: Demographic composition of workforce New labor saving technologies Changes in consumer preferences Liberalization of international trade Increase in the price of oil

→ Keynesian model insufficient 22 New ideas and theories: Natural rate of unemployment: rate above which labor market tightens. Any attempt of the authorities to lower unemployment creates inflation. Expectations (endogenous) Supply side comes to the center of discussions- supply costs

monetarism 23 Milton Friedman, Karl Brunner, Allan Meltzer(-60s). Basic points of critique on Keynesian economics: Downgraded role of monetary policy and excessive emphasis on fiscal policy. Monetarists place emphasis on long run results Basic hypothesis: In the long run money is neutral. An increase in Ms → increase in P

monetarism 24 Increase in prices is caused by increased spending that derives from increased circulation of money: Changes in the quantity of money affects spending – money matters in the short run. in the short run monetary policy can be effective (Keynesian view) Emphasis on the final long run effect

monetarism 25 Monetarists: do not deny real effects of monetary policy during the transitional period (from the short run to the long run). stress the eventual inflationary consequence of successive monetary expansions. emphasize the inability of fiscal policy to stimulate economy for a long period of time. sustained stimulus to aggregate demand → inflation.

monetarism 26 → Skepticism about “fine tuning” of demand management policies. Fine tuning: small adjustments to certain policy variables in order to improve a nation’s economy. Emphasis on low inflation over the long run. Proper policy: Determination of the inflation target and then determination of money growth. Policies: popular in the -70s. F.E.D., E.C.B.

Monetarism and expectations 27 Keynes: expectations important, but exogenous. Monetarists: expectations are endogenous and depend on past experience. Adaptive expectations If expectations about inflation change, then the Phillips curve shifts. Phillips curve can be vertical and consistent with the natural rate of unemployment. Neutrality of money is verified.

Contribution of monetarists to theory and policy 28 Manipulation of M1, M2 or M3 by central banks. Monetary targeting as an approach to monetary policy. Monetary policy through pegging of C.B. basic interest rate. Understanding that increased spending is related to inflation. IS-LM framework: monetary and fiscal policy determine demand, output and unemployment. Expectations.

Monetarists’ methodology 29 Statistical methods. Models of one equation to describe the economy. Methodology of monetarists did not last. on the contrary Keynesian models encompassed monetarist ideas about the role of monetary policy.

Rational expectations and the New Classical economics 30 Counterrevolution or revolution. -70s (2 nd wave of critique for the Keynesian approach) Representatives: Robert Lucas, Thomas Sargent, Neil Wallace. Economists put forward looking behavior in the linear IS/LM model. Basic assumption: equilibrium (all expectations are fulfilled). Rational expectations: there is perfect information. consumers and policy makers (economic agents) have in mind the same model about the functioning of the economy.

Rational expectations and the New Classical economics 31 Equilibrium: “a state in which no one has any reason to act differently, given a correct understanding of the environment in which they act, as determined by the collective actions of others” (expectations are fulfilled) Rational expectations: John Muth (1961) Price of agricultural products. Prices of financial markets.

Consequences of rational expectations 32 The government cannot affect economic activity, with fiscal or monetary policy. Microfoundations are important. Individuals maximize utility, firms maximize profits. Intertemporal models of general equilibrium. All markets clear instantaneously. Efficiency: perfect information, zero transaction costs, no frictions. If economic agents don't have perfect information → expectations are not rational and policy can be effective.

33 Economic policy can affect the real economy only if expectations are not rational. In practice: economic policy influences expectations → economic behavior is changed instantly. There is no trade off between inflation and unemployment.(Phillips curve is vertical) Central Banks: target on inflation

New Classical Economic Theory 34 Theory of rational expectations has limits: it cannot: explain fluctuations of economic activity. explain economic crisis. suggest policies to stimulate the economy. Efficiency assumption doesn't hold in practice, especially in financial markets

Real Business Cycles 35 New classical economics -80s. F. Kydland, E. Prescott, C. Plosser. Households maximize utility Firms maximize profits The cycle is caused by a technological shock Economic activity adjusts to external shocks (such as new technology, increase in the price of oil) Monetary issues do not matter. Classical dichotomy exists. Analysis is true for the long as well as the short run.

The empirical side of business cycles 36 Special emphasis on quantitative analysis. Extensive use of statistical data. Methods of prediction have improved. Emphasis on statistical characteristics of aggregate economic variables. Supply side matters for the economic activity.

Contribution of business cycles 37 Markets are characterized by imperfections. Emphasis on the study of the supply side. Supply side is added to a theoretical model. Alternative policy measures for the reduction of unemployment. Potential output: output that is produced when markets function perfectly.

New Keynesian Theories 38 In the meantime: Keynes core ideas matched with various strands of neoclassical economics gave rise to new Keynesian theories. assumptions about rational expectations have become part of Keynesian models. Rigidities + rational expectations: new Keynesian models. Rigidities: price and wage stickiness There is a role for the government and the Central Bank to control the economy.

New Keynesian Theories s Return to the IS/LM and the Phillips curve New version of the Phillips curve: “Triangle Model” Stagflation: NAIRU theory. Non Accelerating Inflation Rate of Unemployment: it refers to a level of unemployment below which inflation rises. Stagflation Natural rate of unemployment Cost of getting unemployment too low: accelerating inflation.

New synthesis 40 New Keynesian approach with real business cycles. Microfoundations are important. Price and wage rigidities are important. They cause deviations of actual production from its potential magnitude. There is scope for government intervention. Emphasis for the proper functioning of efficient markets.

DSGE models 41 State of the art policy model is a New Keynesian DSGE model with sticky prices and a Taylor type rule for interest rates. Wage and price rigidities are reconsidered and incorporated in real business cycle models. Monetary policy can be effective and may cause output and employment fluctuations. D: dynamic. These models predict transition paths for the economy when it is disturbed away from steady state. S: stochastic. Random shocks to parameters are included. GE: General equilibrium

Post-Keynesians 42 Demand matters in the long run as well as in the short run. There is no automatic tendency towards full employment. Rigidity of sticky prices or wages is not the basic cause of the market failure to provide full employment. IS/LM is rejected. Emphasis on monetary policy: CB can choose either the quantity of money or the interest rate to influence demand.