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Econ 503

Advanced Macroeconomics

Prof. Dr. Durmuş Özdemir

Introduction

• Prerequisits:

Economics – 101,102, 201,202

Math – Algebra, Multi-Variable Calculus,

Linear Algebra Math Econ

• You need to be familiar AND comfortable with this level

of mathematics to do well in the course.

Some Macro Facts and Issues

• Key Measures of Macroeconomic activity:

(1) GDP (level and per capita)

(2) Productivity

(3) Prices and Inflation

U.S. Output, 1869-2005

Figure 1.1 Per Capita Real GDP (in 2000

dollars) for the United States, 1900–2005

GDP Growth: 1970-2008

Macroeconomic Data and Growth

Rates

• Data collected over time is often referred to as time series

data. Most macro data is time series.

• Let yt = an economic variable recorded at date t

• The growth rate of y from date (t-1) to (t) is given by

• If g is a small number (even 5% is 0.05), then

111

1

t

t

t

ttt

y

y

y

y

y

yyg

gg )1ln(

• Using this, we have

)ln()ln()ln( 1 yyyg ttt

Example

Year GDP g =y/y g=ln(y)

2000 10

2001 10.25 2.5% 2.46%

2002 10.50 2.44% 2.40%

Figure 1.1 Per Capita Real GDP (in 2000

dollars) for the United States, 1900–2005

Figure 1.2 Natural Logarithm of Per

Capita Real GNP

• GDP movement can be divided into two parts: trend and cyclical.

• Trend GDP and productivity growth measures long-term economic growth.

Annual Productivity Growth

1955-73 2.12%

1973-98 1.67%

What determines long-term growth and what are the implications for policy?

Figure 1.2 Natural Logarithm of Per

Capita Real GNP

Figure 1.3 Natural Logarithm of Per

Capita Real GNP and Trend

Figure 1.4 Percentage Deviations from

Trend in Per Capita Real GNP

Figure 1.10 Percentage Deviations from

Trend in GDP, 1947–2003

• Cyclical (detrended GDP) measures the

business cycle.

(i) Largest recession was GD.

(ii) Wartimes are usually associated with

expansion. 1991-01 was longest peace time

expansion.

(iii) Historical observations:

- Okun’s Law

- Phillip’s Curve

cycles

(iv) Business cycles are similar in terms of co-

movement and timing.

Questions: What causes business cycles and

what’s the role of government stabilization

policy? What explains short-run versus long-run

tradeoff between inflation and unemployment?

Macro Economic Theory

• Y = set of macroeconomic variables (facts)

(needs measurement)

X = set of given variables, assumptions about

how economy works.

• Construction of theory: X Y

• Validation of Theory

Ability to explain facts (statistical)

Theories need not be completely correct to

be useful!

Economics as Social Science

• Difference between hard-sciences and

social science is the lack of natural or

controlled experiments.

• Models can be used to design artificial

economies or economic laboratories.

“applied” and “modern”

• Gap between “applied” and “modern” macro theory.

Applied IS-LM, Phillips Curve

Used in textbooks, forecasters, public policy making.

Modern Developments in macro research (“academic”) of the past 30-40 years.

• At some level, gap is also caused by the degree

of complexity and rigor of models and the tools

of analysis.

• Copernicus (heilocentric) versus Ptolemy

(geocentric)

- Ultimately modern developments will change

the way macroeconomists view the world and

economic policy is conducted.

• Market Economics (Classical - 18th, 19th

Centuries)

- Adam Smith, David Ricardo

- Free market adjustment of prices

- Classical Dichotomy

- Invisible hand, government non-

intervention

• Keynesian Revolution (1930s)

- “Birth” of Macroeconomics

- J.M Keynes, P. Samuelson, J. Tobin

- Great Depression

- Failure of Markets and price system

- Need for active stabilization policy

- Development of basic IS-LM model and amended to include Phillips Curve

(The “consensus” or “neoclassical synthesis” from 1930-70)

• 1970s: Breakdown of the consensus.

- Empirical: Failure to account for high

inflation and unemployment

(Philips Curve breakdown).

- Theoretical: Gap between macro and

microeconomic principles.

Fails to account for how

expectations affects behavior

(the “Lucas Critique”)

IS-LM model is, at best, incomplete.

• Monetarism & New Classical Macroeconomics

- M. Friedman , R. Lucas, T. Sargent, N.

Wallace, R. Barro.

- Economic decisions are dynamic.

- Rational expectations

- Microeconomic foundations & Market-

Clearing

- Intertemporal General Equilibrium Macro

Models (“Modern Macro Models”)

• Microfoundations? Another parable of

Friedman and the billiard player.

• New Classical Theories

- imperfect information and money

- real business cycles

- Sectoral shifts (search unemployment)

• New Keynesian Macroeconomics

- L. Ball, G. Mankiw, D. Romer.

- Also incorporates dynamic decision

making and rational expectations.

- Microeconomic foundations of sticky

wages and prices (labor contracts,

monopolistic competition).

• New Neoclassical Synthesis (1990s-

Present)?

* Integration of Keynesian and Classical

ideas into modern macro models.

* Market Clearing “Keynesian” Models

(e.g., coordination failure)

* Emphasis on both real and nominal

shocks.

Relation to Econ 201

• Used IS-LM model to explain both Classical

& Keynesian Theories by distinguishing

between short-run and long-run.

• IS-LM as an analytical tool is at best

incomplete.

* Micro-foundations for individual behavior

* Static versus dynamic

* No explicit treatment of expectations

• Objective of this course: Develop the

foundations of modern macro theory and

apply them to studying growth, business

cycles, and economic policy.

• New Classical macro models will be

emphasized:

* Benchmark model

* Led to the development of modern

macro theory.

• Things you should know about measurement

- Definition and measurement of basic concepts:

GDP, GNP prices, interest rates, budget

deficit, unemployment rate, ect.

- Real versus nominal and the price index as a

deflator.

- Measurement of saving and wealth and

relationship to investment.

Math Review

• Functions and Differentiation

• Matrices

• Systems of Equations

• Unconstrained Optimization

• Constrained Optimization

• Others