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3. Macroeconomics as the study of aggregate dynamics
• Macroeconomics is interested in dynamics – the behavior of variables over time • We need not only a theory of comparative statics but one about how variables change with respect to time • First attempt to „dynamize“ static models were inductive in nature and ad-hoc in their theoretical motivation
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4. Bridge between classical and Keynesian views?
• Milton Friedman's famous critique of the old Neoclassical Synthesis: monetary neutrality is violated! • Friedman “rehabilitated” the Phillips curve by introducing explicitly inflationary expectations πe • Now more generally called “core inflation” – what is it?
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Excursion: Modern business cycle theory and visions of Slutsky and Wold
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Vision of Slutsky
Assumed propagation mechanism (input)
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Phillips Curves
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Okun’s Law
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Euroland
16 14 12 Inflation (%) 10 8 6 4 2 0 0 2 4 6 8 10 12 14 Unemployme nt (%)
Aggregate demand and supply under flexible exchange rates
LAS
AS
Money growth line
AD
Monetary authority chooses the rate of growth of money supply (thereby determining long-run inflation). Nominal exchange rate changes so that PPP holds.
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5. The AS-AD Model as a system of difference equations
• Solving the AS-AD model for the currentvalues: Substitution or matrix manipulation • Result: “Reduced form”: A vector-valued linear difference equation, a set of equations relating current values to their past plus exogenous influences • Still not a solution in the strict sense. We seek functions of time only
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„The natural rate of unemployment...
...is the level that would be ground out by the Walrasian system of general equilibrium equations, provided there is embedded in them the actual structural characteristics of the labor and commodity markets, including market imperfections, stochastic variability in demands and supplies, the costs of gathering information about job vacancies and labor availabilities, the costs of mobility, and so on.“ Milton Friedman (1968)
Aggregate Supply/Phillips Curve:
πt =πt + b1(Yt -Yt) + st
Core Inflation/Inflationary Expectations:
πt = λ πt + (1-λ) πt-1
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where: Yt = real GDP (constant prices) in t Yt = potential real GDP in t πt = inflation rate in t πt = core inflation (infl. expectations) in t dt = real demand shock in t st = supply shock in t µt = money supply growth in t
Random Shocks (input)
Cycles (output)
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5. The AS-AD Model as a system of difference equations
Aggregate Demand:
Yt = a1Yt-1 + a2(µt - πt) + dt
Inflation
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Output gap (Y -Y )
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5. The AS-AD Model as a system of difference equations
• Slutsky´s vision as a starting point • Role of economic theory for constructing the “black box” as well as identifying the shocks • Demonstration: AS-AD model • In case you don’t know about AS-AD…see e.g. Burda/Wyplosz Ch 12, 13 and 14, especially the appendix to Ch 14
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The long run
Inflation
Inflation Unemployment U (a) Phillips curve
Y Output (b) Aggregate supply
Figure 12.3
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Fig. 13.10
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Augmented Phillips and aggregate supply curves
Inflation
Inflation
B
AS
B
π
A C
U Unemployment (a) Phillips curve
π
A C
Output Y (b) Aggregate supply Figure 12.5
Yt
πt
=
a1 a1b1 1 + a2 b1 (1 − λ ) 1− λ 1 1 a2 a2 b1 1− λ 1 b1 1− λ
−µ t 1 − λ dt − b1 st 1− λ Y t
21
+
1 + a2 b1 (1 − λ )
− a2 1− λ 1 1− λ
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2. Extensions of static models not covered in course
• Monetary wealth and the „real side“ (outside money) • Interest rates, wealth and labor supply • Variations of static Keynesian model • Open economy, „balance of payments approach“ (classical) and Mundell-Fleming (Keynesian) approaches
Introduction to Advanced Macroeconomic Analysis (IAMA)
Lecture # 3 Ad hoc Dynamic Macroeconomics: The AS-AD Model
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Summary
• Review of last time • Extensions of static models not covered in course • Macroeconomics as the study of aggregate dynamics • The foundations of macro dynamics • The AS-AD Model as a vehicle for learning about dynamics of deterministic and stochastic difference equations