Economics
607
Fall 2006
Homework #6
[pdf version]
1. Problem 6.5 in Romer.
2. Problem 6.7 in Romer.
4. Problem 6.10 in Romer.
5. Problem 6.12 in Romer.
6. Problem 6.13 in Romer.
Economics
607
Fall 2006
Homework #6
[pdf version]
1. Problem 6.5 in Romer.
2. Problem 6.7 in Romer.
4. Problem 6.10 in Romer.
5. Problem 6.12 in Romer.
6. Problem 6.13 in Romer.
Posted by Mark Thoma on Tuesday, November 21, 2006 at 02:14 PM in Fall 2006, Homework | Permalink | Comments (0) | TrackBack (0)
[pdf file]
Posted by Mark Thoma on Tuesday, October 31, 2006 at 02:00 PM in Fall 2006, Homework | Permalink | Comments (0) | TrackBack (0)
[pdf file]
Posted by Mark Thoma on Tuesday, October 24, 2006 at 02:00 PM in Fall 2006, Homework | Permalink | Comments (0) | TrackBack (0)
Sargent, Thomas J. and Neil Wallace, Rational Expectations and the Theory of Economic Policy," Journal of Monetary Economics, 2, April, 1976, pp. 169-184.
Posted by Mark Thoma on Thursday, October 19, 2006 at 11:14 AM in Fall 2006, Required Reading | Permalink | Comments (0) | TrackBack (0)
Economics 607
Fall 2006
Homework #3
Due Oct. 17
(pdf version)
1. Given the following model:
y = E(y,r,g,t) goods market r = r(y, P) policy reaction function y=F(n,k0) production function W=Peg(n) labor supply
where Pe = the expected price level, y = real output, g = real government spending, t = real taxes, r = the real interest rate, π = the inflation rate, W0 = the fixed nominal wage, n = labor, and k0 = the fixed capital stock. All partials have their usual signs.
(a) Find dy/dt, dP/dt, dr/dt, dW/dt, dn/dt, and d(W/P)/dt.
2. Problem 5.11 in Romer.
3. Problem 5.12 in Romer.
4. Problem 5.13 in Romer.
Posted by Mark Thoma on Tuesday, October 10, 2006 at 02:00 PM in Fall 2006, Homework | Permalink | Comments (0) | TrackBack (0)
Economics 607
Fall 2006
Homework #2
Due Oct. 10
(pdf version)
1. Consider the model
y = c(y-t) + I(i-πe)+g IS Curve
M(i)/P = L(y,i) LM Curve
dy/dt = k1*EDG
di/dt = k2*EDM
For what values of Mi is the model unstable?
2. Given the model
y = c(y-t) + I(i-πe)+g(y) IS Curve
r = r(y, π) MP Curve
dy/dt = k1*EDG
dr/dt = k2*(r(y, π)-r)
where government spending depends upon the level of output, characterize the necessary conditions for stability mathematically (in terms of the admissible values of gy) and illustrate the conditions using phase diagrams. Is countercyclical fiscal policy stable?
3. Given the model
y = c(y-t,r) + I(i-πe)+g IS Curve
r = r(y, π) MP Curve
dy/dt = k1*EDG
dr/dt = k2*(r(y, π)-r)
where cr < 0 and all other partial derivatives have their usual signs. (a) Show that the model is stable. (b) Show graphically and explain intuitively how the effectiveness of fiscal policy changes when consumption becomes more responsive to changes in the interest rate.
4. Given the classical model
y* = c(y*-t,π) + I(i-πe)+g IS Curve
r = r(y*, π) MP Curve
dπ/dt = k1*EDG
dr/dt = k2*(r(y*, π)-r)
where cπ < 0 and all other partial derivatives have their usual signs (the natural rate of output, y*, is assumed to be fixed). (a) Show that the model is stable. (b) Show graphically (in i-π space with i on the vertical axis and π on the horizontal) how i and π change when g increases. Explain intuitively.
5. Given the following model:
y = E(y,r,g,t) goods market
r = r(y, P) policy reaction function
y=F(n,k0) production function
W=W0 labor supply
where y = real output, g = real government spending, t = real taxes, r = the real interest rate, π = the inflation rate, W0 = the fixed nominal wage, n = labor, and k0 = the fixed capital stock. All partials have their usual signs.
(a) Find dy/dg, dP/dg, dr/dg, and d(W/P)/dg.
(b) Find dy/dW0, dP/dW0, dr/dW0, and d(W/P)/dW0.
Posted by Mark Thoma on Tuesday, October 03, 2006 at 02:00 PM in Fall 2006, Homework | Permalink | Comments (0) | TrackBack (0)
Economics 607
Fall 2006
Homework 1
Due Tuesday, October 3
[pdf file]
1. Problem 5.1 in Romer.
2. Problem 5.3 in Romer.
3. Using the model in the text, examine how the effectiveness of fiscal policy changes in response to changes in (a) ry and (b) rπ.
4. Using the model in the text, examine how the effectiveness of monetary policy changes in response to changes in (a) ry, (b) rπ, and (c) Er. Use a shift parameter to model changes in monetary policy.
For problems 3 and 4, explain your answers graphically, mathematically, and intuitively when the changes are non-trivial.
5. Consider the following IS-LM model
y = E(y, i - πe, g, t) IS Curve
M/P = L(y, i) LM Curve
a) Find the slopes of the IS and LM curves.
b) Show graphically and mathematically how the LM curve shifts when M
increases.
c) Show graphically and mathematically how the IS curve shifts when πe
increases.
d) Show graphically, mathematically, and intuitively how i and y
change when (i) there is an increase in g, and (ii) there is an
increase in M.
e) Find the slope of the aggregate demand curve (in this case, relating P
and y)
f) Does an increase in the absolute values of Li make
monetary and fiscal policy more or less effective? Explain graphically,
mathematically, and intuitively.
6. Answer the questions below based upon the following model:
y = C(y - t) + I(i- πe) + G + NX(i) IS Curve
M/P = L(i, y) LM Curve
a) Assuming NXi is negative, find the slope of the IS
curve.
b) Find dy/dM and di/dM. Show the changes graphically and explain them
intuitively.
c) Are monetary and fiscal policy more or less effective when NXi
increases? Explain your answer graphically and intuitively.
Posted by Mark Thoma on Thursday, September 28, 2006 at 03:32 PM in Fall 2006, Homework | Permalink | Comments (0) | TrackBack (0)
Syllabus for Core Macro I
Economics 607
Course Title: Seminar in Advanced Macroeconomic Theory
Instructor: Mark Thoma
Office: 471 PLC
Phone: 346-4673
Email: mthoma@uoregon.edu
Office Hours: T/Th 10:45-11:45 and by appointment
Web Page:
http://economistsview.typepad.com/economics607coremacro/
Tests: There are two midterm exams and a comprehensive final. The midterms will be given Tuesday, October 17th and Thursday, November 9th. The final exam is scheduled for Tuesday, December 5th at 1:00 p.m., but it is usually adjusted, if possible, to spread the three final exams more uniformly over final’s week. The final is comprehensive. No make-up exams will be given.
Homework: Homework is assigned periodically. Late homework will not be accepted.
Grading: Grades are based upon the following weights. Homework counts 15%, the two midterms are worth 50%, and the final is worth 35%. Contingent upon certain minimum standards of performance, grades are based upon your relative standing in the course.
Texts: Romer, David, Advanced Macroeconomics, 3nd edition (2001). There are a wide variety of intermediate level undergraduate texts that can be used as review and reference texts.
Brief Outline:
I. Traditional Keynesian Theories of Fluctuations
Romer Ch. 5
1. The Traditional Keynesian Model
a. Aggregate Demand
b. Alternative Assumptions about Wage and Price Rigidity
c. Output-Inflation Tradeoffs
d. Empirical Applications
II. Microeconomic Foundations of Incomplete Adjustment
Romer Ch. 6
1. The Lucas Incomplete Information Model
a. Perfect Information
b. Imperfect Information
c. Implications and Limitations
2. New Keynesian Economics
a. A Model of Imperfect Price Competition and Price Setting
b. Are Small Frictions Enough?
c. Real Rigidity
d. Coordination-Failure Models and Real Non-Walrasian Theories
3. Dynamic New Keynesian Models and Staggered Price Adjustment
a. Building Blocks
b. Predetermined Prices
c. Fixed Prices
d. The Caplin-Spulber Model
e. Empirical Applications
f. The Mankiw-Reis Model
III. Inflation and Monetary Policy
We will cover this chapter as time permits (and it probably won’t). The sections we will cover will be announced later in the course.
Romer Ch. 10, sections TBA
Additional Reading: Traditional Keynesian Theories of Fluctuations
Keynes, John Maynard. 1936. The General Theory of Employment, Interest, and Money. London: Macmillan
Muth, "Rational Expectations and the Theory of Price Movements," Econometrica, vol. 29, No. 6, 1961
Friedman, Milton, and Schwartz, Anna J. 1963. A Monetary History of the United States, 1867-1960. Princeton, NJ: Princeton University Press
Phelps, "Phillips Curves, Expectations of Inflation, and Optimal Employment Over Time," Economica, Aug., 1967.
Friedman, M., "The Role of Monetary Policy," American Economic Review, March, 1968.
Phelps, Edmund S. 1968. “Money-Wage Dynamics and Labor Market Equilibrium.” Journal of Political Economy 76 (July/August, Part 2): 678-711.
Anderson, Leonall C., and Jordan, Jerry L., 1968. “Monetary and Fiscal Actions: A test of Their relative Importance in Economic Stabilization.” Federal Reserve Bank of St. Louis Review 50 (November): 11-24.
Hall, R.E., "Why is the Unemployment Rate So High at Full Employment?," Brookings Papers on Economic Activity, 1970, No. 3.
Poole, W., "Optimal Choice of Monetary Policy Instruments in a Simple Stochastic Macro Model," Quarterly Journal of Economics, 1970, 197-216.
Barro, R.J. and Grossman, H.I., "A General Disequilibrium Model of Income and Employment," American Economic Review, Mar.,1971.
Sargent, T. and Wallace, N., "Rational Expectations and the Theory of Economic Policy," Journal of Monetary Economics, Vol. 2, 1976.
Gordon, R.J., "Recent Developments in the Theory of Inflation and Unemployment," Journal of Monetary Economics, April, 1976.
Malinvaud, Edmund. 1977. The Theory of Unemployment Reconsidered. Oxford: Basil Blackwell.
Santomero and Seator, "The Inflation-Unemployment Tradeoff: A Critique of the Literature," Journal of Economic Literature, June, 1978.
Shiller, "Rational Expectations and the Dynamic Structure of Macroeconomic Models," Journal of Monetary Economics, Jan., 1978.
Kantor, B., "Rational Expectations and Economic Thought," Journal of Economic Literature, Dec., 1979.
Fischer, S., Rational Expectations and Economic Policy, University of Chicago Press, 1980.
McCallum, B.T., "Rational Expectations and Macroeconomic Stabilization Policy: An Overview," Journal of Money, Credit, and Banking, Nov., 1980, 716-745.
King, Robert G. and Plosser, Charles I. 1984. “Money, Credit and Prices in a Real Business Cycle.” American Economic Review 64 (June) : 363-380.
Christina D. Romer and David H. Romer., 1989. "Does Monetary Policy Matter? A New Test in the Spirit of Friedman and Schwartz," NBER Macroeconomics Annual 4: 121-170.
Staiger, Douglas, Stock, James H., and Watson, Mark W. 1997. “How Precise are Estimates of the Natural Rate of Unemployment?” In Christina D. Romer and David H. Romer , eds., Reducing Inflation: Motivation and Strategy, 195-242. Chicago: University of Chicago Press.
Katz, Lawrence F., Krueger, Alan B. 1999. “The High-Pressure U.S. labor Market of the 1990s.” Brookings Papers on Economic Activity, no. 1, 1-87.
Rotenberg, Julio J. and Woodford, Michael. 1999. “The Cyclical Behavior of Prices and Costs.” In John B. Taylor and Michael Woodford, eds., Handbook of Macroeconomics, 1052-1135. Amsterdam: Elsevier
Empirical Evidence:
Phillips, A.W., "The Relationship Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957," Economica, Nov., 1958
Lipsey, "The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1862-1957: A Further Analysis," Economica, Feb., 1960.
Sims, C.A. 1972. "Money, Income, and Causality," American Economic Review, 62 (4),540-552.
Lucas, R., "Some International Evidence on Output-Inflation Tradeoffs," American Economic Review 63 (June) 1973.
Lucas, R., "Econometric Policy Evaluation: A Critique," Journal of Monetary Economics, (supplement), 1976.
Sims, C.A. 1980. "Comparison of Interwar and Postwar Business Cycles: Monetarism Reconsidered" American Economic Review, vol. 70, No. 2 250-257.
Bernanke, Ben S. and Blinder, Alan S., "The Federal Funds Rate and the Channels of Monetary Transmission," American Economic Review (volume 82, no. 4), September 1992, 901-921.
Solon, Gary & Barsky, Robert & Parker, Jonathan A, 1994. "Measuring the Cyclicality of Real Wages: How Important Is Composition Bias?," The Quarterly Journal of Economics, vol. 109(1), pages 1-25.
Kuttner, Kenneth D. “Monetary Policy Surprises and Interest Rates: Evidence from the Fed Funds Futures Market,” Journal of Monetary Economics, Volume 47 No. 3, June 2001, pp. 523-644.
Microeconomic Foundations of Incomplete Nominal Adjustment
Phelps, E.S., ed., Microeconomic Foundations of Employment and Inflation Theory, Norton Press, 1970.
Lucas, Robert E., Jr. "Expectations and the Neutrality of Money." Journal of Economic Theory, 1972, 4 (2), pp. 103-24.
Barro, Robert J., 1972. "A Theory of Monopolistic Price Adjustment," Review of Economic Studies, Blackwell Publishing, vol. 39(1), pages 17-26.
Barro, Robert J., "Rational Expectations and the Role of Monetary Policy," Journal of MonetaryEconomics, 2 January 1976 (reprinted in R. Lucas and T. Sargent, Rational Expectations and Econometric Practice).
Sheshinski Eytan, Weiss Yoram. 1977. Inflation and Costs of Price Adjustment. Review of Economic Studies. 44:287-303.
Fischer, S. 1977. Long term contracts, rational expectations and the optimal money supply rule. Journal of Political Economy, 85 (February): 191-205.
Phelps, Edmund S., and John B. Taylor, 1977, Stabilizing powers of monetary policy under. rational expectations, Journal of Political Economy 85 (February): 163-190.
Taylor, J. 1979. ``Staggered Wage Setting in a Macro Model.'' American Economic Review 69:108-113.
Taylor, John, "Aggregate Dynamics and Staggered Contracts," Journal of Political Economy 88, 1-24 (1980).
Rotemberg, Julio, "Sticky Prices in the United States", Journal of Political Economy 90, 1187-1211, (1982).
Diamond, Peter, "Aggregate Demand Management in Search Equilibrium," Journal of Political Economy, 90, 881-894, (1982).
Mankiw, Gregory, "Small Menu Costs and Large Business Cycles: A Macroeconomic Model of Monopoly," Quarterly Journal of Economics 100, 529-539, (1985).
Blanchard, O. J., and N. Kiyotaki, 1987, Monopolistic Competition and the Effects of Aggregate Demand, American Economic Review 77, 647–666.
Rotemberg, Julio, "The New Keynesian Microfoundations," NBER Macroeconomics Annual, 1987. [See also comments by Mankiw and Prescott]
Andrew Caplin and Daniel Spulber, "Menu Costs and the Neutrality of Money," Quarterly Journal of Economics, November 1987, pp. 703-725.
Cooper, Russell & John, Andrew, 1988. "Coordinating Coordination Failures in Keynesian Models," The Quarterly Journal of Economics 103 (August) : 441-463.
Laurence Ball, N. Gregory Mankiw, and David Romer (1988), "The New Keynesian
Economics and the Output-Inflation Tradeoff," Brookings Papers on Economic
Activity, no. 1, 1-65.
Bernanke, Ben and Mark Gertler, "Agency Cost, Net Worth, and Business Fluctuations", American Economic Review, 79, 14-31 (1989).
Ball, Lawrence and David Romer, 1990. "Real Rigidities and the Non-Neutrality of Money," Review of Economic Studies 57, 183-203.
Caplin, Andrew & Leahy, John, 1991. "State-Dependent Pricing and the Dynamics of Money and Output," The Quarterly Journal of Economics, 106 (3), 683-708.
Caballero, Ricardo J & Engel, Eduardo MRA, 1993. "Heterogeneity and Output
Fluctuations in a Dynamic Menu-Cost Economy," Review of Economic Studies,60(1), January 1993, 95-120.
Kiyotaki, Nobuhiro and John Moore, "Credit Cycles", Journal of Political Economy, 105, 211-48 (1997).
Rotemberg, Julio J. and Woodford, Michael D., "The Cyclical Behavior of Prices and Costs" (January 1999) in Handbook of Macroeconomics, 1052-1135. Amsterdam: Elsevier.
Benhabib, Jess, and Roger E.A. Farmer. (1999). “Indeterminacy and Sunspots in Macroeconomics,” in J. Taylor and M. Woodford, eds., Handbook of Macroeconomics, 387-448. Amsterdam: North Holland.
N. Gregory Mankiw & Ricardo Reis, 2002. "Sticky Information Versus Sticky Prices: A Proposal To Replace The New Keynesian Phillips Curve," The Quarterly Journal of Economics, vol. 117(4), pages 1295-1328.
Woodford, Michael. 2003. Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton: Princeton University Press.
Posted by Mark Thoma on Monday, September 25, 2006 at 06:51 PM in Fall 2006, Syllabus | Permalink | Comments (0) | TrackBack (0)
Why we start the way we do - with IS-LM. Paul Krugman expresses it well:
There's Something about Macro, by Paul Krugman: It's holiday season, and my thoughts have turned to ... course preparation. Classes don't begin until February, but books must be ordered, reading packets must receive copyright clearance and go to Graphic Arts, and background notes must be prepared.
This spring I have a new assignment: to teach Macroeconomics I for graduate students. Ordinarily this course is taught by someone who specializes in macroeconomics; and whatever topics my popular writings may cover, my professional specialties are international trade and finance, not general macroeconomic theory. However, MIT has a temporary staffing problem, which is itself revealing of the current state of macro, and I have been called in to fill the gap.
Here's the problem: Macro I (that's 14.451 in MIT lingo) is a quarter course, which is supposed to cover the "workhorse" models of the field - the standard approaches that everyone is supposed to know, the models that underlie discussion at, say, the Fed, Treasury, and the IMF. In particular, it is supposed to provide an overview of such items as the IS-LM model of monetary and fiscal policy, the AS-AD approach to short-run versus long-run analysis, and so on. By the standards of modern macro theory, this is crude and simplistic stuff, so you might think that any trained macroeconomist could teach it. But it turns out that that isn't true.
You see, younger macroeconomists - say, those under 40 or so - by and large don't know this stuff. Their teachers regarded such constructs as the IS-LM model as too ad hoc, too simplistic, even to be worth teaching - after all, they could not serve as the basis for a dissertation. Now our younger macro people are certainly very smart, and could learn the material in order to teach it - but they would find it strange, even repugnant. So in order to teach this course MIT has relied, for as long as I can remember, on economists who learned old-fashioned macro before it came to be regarded with contempt. For a variety of reasons, however, we can't turn to the usual suspects this year: Stan Fischer has left to run the world, Rudi Dornbusch is otherwise occupied, Olivier Blanchard is department head, Ricardo Caballero - who is a bit young for the role, but can swallow his distaste if necessary - is on leave. All of which leaves me.
Now you might say, if this stuff is so out of fashion, shouldn't it be dropped from the curriculum? But the funny thing is that while old-fashioned macro has increasingly been pushed out of graduate programs - it takes up only a few pages in either the Blanchard-Fischer or Romer textbooks that I am assigning, and none at all in many other tracts - out there in the real world it continues to be the main basis for serious discussion. After 25 years of rational expectations, equilibrium business cycles, growth and new growth, and so on, when the talk turns to Greenspan's next move, or the prospects for EMU, or the risks to the Brazilian rescue plan, it is always informed - explicitly or implicitly - by something not too different from the old-fashioned macro that I am supposed to teach in February.
Why does the old-fashioned stuff persist in this way? I don't think the answer is intellectual conservatism. Economists, in fact, are in general neophiles, always looking for something radical and different. Anyway, I have seen over and over again how young economists, trained to regard IS-LM and all that with contempt if they even know what it is, find themselves turning to it after a few years in Washington or New York. There's something about primeval macro that pulls us back to it; if Hicks hadn't invented IS-LM in 1937, we would end up inventing it all over again.
But what is it that makes old-fashioned macro so compelling? To answer that question, I find it helpful to think about where it came from in the first place.
Afficionados know that much of what we now think of as Keynesian economics actually comes from John Hicks, whose 1937 article "Mr. Keynes and the classics" introduced the IS-LM model, a concise statement of an argument that may or may not have been what Keynes meant to say, but has certainly ended up defining what the world thinks he said. But how did Hicks come up with that concise statement? To answer that question we need only look at the book he himself was writing at the time, Value and Capital, which has in a low-key way been as influential as Keynes' General Theory.
Value and Capital may be thought of as an extended answer to the question, "How do we think coherently about the interrelationships among markets - about the impact of the price of hogs on that of corn and vice versa? How does the whole system fit together?" Economists had long understood how to think about a single market in isolation - that's what supply-and-demand is all about. And in some areas - notably international trade - they had thought through how things fitted together in an economy producing two goods. But what about economies with three or more goods, where some pairs of goods might be substitutes, others complements, and so on?
This is not the place to go at length into the way that Hicks (and others working at the same time) put the story of "general equilibrium" together. But to understand where IS-LM came from - and why it continues to reappear - it helps to think about the simplest case in which something more than supply and demand curves becomes necessary: a three good economy. Let us simply call the goods X, Y, and Z - and let Z be the "numeraire", the good in terms of which prices are measured.
![]()
Now equilibrium in a three-good model can be represented by drawing curves that indicate combinations of prices for which each of the three markets is in equilibrium. Thus in Figure 1 the prices of X and Y, both in terms of Z, are shown on the axes. The line labeled X shows price combinations for which demand and supply of X are equal; similarly with Y and Z. Although there are three curves, Walras' Law (if all markets but one are in equilibrium, that market is in equilibrium too) tells us that they have a common intersection, which defines equilibrium prices for the economy as a whole. The slopes of the curves are drawn on the assumption that "own-price" effects are negative, cross-price effects positive - thus an increase in the price of X increases demand for Y, driving the price of Y up, and vice versa; it is also, of course, possible to introduce complementarity into such a framework, which was one of its main points.
This diagram is simply standard, uncontroversial microeconomics. What does it have to do with macro?
Well, suppose you wanted a first-pass framework for thinking coherently about macro-type issues, such as the interest rate and the price level. At minimum such a framework would require consideration of the supply and demand for goods, so that it could be used to discuss the price level; the supply and demand for bonds, so that it could be used to discuss the interest rate; and, of course, the supply and demand for money.
![]()
What, then, could be more natural than to think of goods in general, bonds, and money as if they were the three goods of Figure 1? Put the price of goods - aka the general price level - on one axis, and the price of bonds (1 divided by 1+i, if they are one-period bonds) on the other; and you have something like Figure 2 - or, more conventionally putting the interest rate instead of the price of bonds on the vertical axis, something like Figure 3. And already we have a picture that is essentially Patinkin's flexible-price version of IS-LM.
![]()
If you try to read pre-Keynesian monetary theory, or for that matter talk about such matters either with modern laymen or with modern graduate students who haven't seen this sort of thing, you quickly realize that this seemingly trivial formulation is actually a powerful tool for clarifying thought, precisely because it is a general-equilibrium framework that takes the interactions of markets into account. Here are some of the things it suddenly makes clear:
1. What determines interest rates? Before Keynes-Hicks - and even to some extent after - there has seemed to be a conflict between the idea that the interest rate adjusts to make savings and investment equal, and that it is determined by the choice between bonds and money. Which is it? The answer, of course - but it is only "of course" once you've approached the issue the right way - is both: we're talking general equilibrium here, and the interest rate and price level are jointly determined in both markets.
2. How can an investment boom cause inflation (and an investment slump cause deflation)? Before Keynes this was a subject of vast confusion, with all sorts of murky stuff about "lengthening periods of production", "forced saving", and so on. But once you are thinking three-good general equilibrium, it becomes a simple matter. When investment (or consumer) demand is high - when people are eager to borrow to buy real goods - they are in effect trying to shift from bonds to goods. So as shown in Figure 4, both the bond-market and goods-market equilibrium schedules, but not the money-market schedule, shift; and the result is both inflation and a rise in the interest rate.
![]()
3. How can we distinguish between monetary and fiscal policy? Well, in a fiscal expansion the government sells bonds and buys goods - producing the same shifts in schedules shown in Figure 4. In a monetary expansion it buys bonds and "sells" newly printed money, shifting the bonds and money (but not goods) schedules as shown in Figure 5.
![]()
Of course, this is all still a theory of "money, interest, and prices" (Patinkin's title), not "employment, interest, and money" (Keynes'). To make the transition we must introduce some kind of price-stickiness, so that incipient deflation is at least partly translated into output decline; and then we must consider the multiplier impacts of that output decline, and so on. But the basic form of the analysis still comes from the idea of a three-good general-equilibrium model in which the three goods are "goods in general", bonds, and money.
Sixty years on, the intellectual problems with doing macro this way are well known. First of all, the idea of treating money as an ordinary good begs many questions: surely money plays a special sort of role in the economy. Second, almost all the decisions that presumably underlie the schedules here involve choices over time: this is true of investment, consumption, even money demand. So there is something not quite right about pretending that prices and interest rates are determined by a static equilibrium problem. (Of course, Hicks knew about that, and was quite self-conscious about the limitations of his "temporary equilibrium" method). Finally, sticky prices play a crucial role in converting this into a theory of real economic fluctuations; while I regard the evidence for such stickiness as overwhelming, the assumption of at least temporarily rigid nominal prices is one of those things that works beautifully in practice but very badly in theory.
But step back from the controversies, and put yourself in the position of someone who must reach a judgement about the likely impact of a change in monetary policy, or an investment slump, or a fiscal expansion. It would be cumbersome to try, every time, to write out an intertemporal-maximization framework, with microfoundations for money and price behavior, and try to map that into the limited data available. Surely you will find yourself trying to keep track of as few things as possible, to devise a working model - a scratchpad for your thoughts - that respects the essential adding-up constraints, that represents the motives and behavior of individuals in a sensible way, yet has no superfluous moving parts. And that is what the quasi-static, goods-bonds-money model is - and that is why old-fashioned macro, which is basically about that model, remains so useful a tool for practical policy analysis.
Posted by Mark Thoma on Monday, September 25, 2006 at 06:51 PM in Fall 2006, Required Reading | Permalink | Comments (0) | TrackBack (0)