TI Macro I

Fall 2013

Notes, Chapter 1

Bjorn Brugemann

Last revision of this document: October 29, 2014

Chapter 1

Introduction

In this chapter I give a brief introduction to Macro I, and discuss its place in the Tinbergen

macro sequence.

1.1 Introduction to Macro I

This course introduces you to stochastic neoclassical growth models. These are basic mod-

els of the macroeconomy which build on general equilibrium theory. Standard consumer

and producer theory is used to model the behavior of households and firms. Markets are

perfectly competitive and complete in these models, and typically bring about an efficient

allocation of resources. In this sense there are no frictions or market failures. This class

of models has been used to study a large variety of issues in macroeconomics, including

business cycles, growth, and asset pricing. These models are useful for several reasons.

First, they are useful in understanding the efficient allocation of resources. Second, if in

the context of a particular application the relevant empirical evidence appears inconsis-

tent with an efficient allocation of resources, then the precise nature of the discrepancy

can indicate what type of frictions ought to be included in the model. Third, elements of

the neoclassical growth model are important building blocks of macroeconomic models

with frictions. For example, so-called Dynamic Stochastic General Equilibrium (DSGE)

models are a class of models that is widely used to study monetary and fiscal policy, and

they are constructed by introducing a variety of frictions into basic stochastic neoclas-

sical growth models. We will start by studying elements of general equilibrium theory

needed for macroeconomics, with a focus on modeling dynamics and uncertainty. Having

covered these basics, we will study different versions of the neoclassical growth model,

specifically a version with infinitely-lived households and a version with overlapping gen-

erations of finitely-lived households. We will use these models to take a first pass at some

applications. Applications vary from year to year as I teach the course, and may include

business cycles, growth, asset pricing, inequality and fiscal policy. To study quantitative

implications we need to solve the models numerically. You will practice basic techniques

for doing so in problem sets, specifically dynamic programming and linearization.

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1.2 Place of Macro I in Macro Sequence

The defining characteristic of mainstream macroeconomics is that it builds on microe-

conomic theory to develop models of the macroeconomy, in particular consumer and

producer theory, as well as general equilibrium theory. Thus a typical model will consist

of a specification of the set of commodities produced and consumed, the preferences of

households over these commodities, commodity endowments, and the technologies avail-

able. These are all elements of the physical environment of the model. Furthermore, a

model needs to specify the mechanism through which resources are allocated, that is, how

it is decided what is being produced and who consumes what. A common assumption in

mainstream macroeconomics is that resources are allocated through perfectly competi-

tive and complete markets. This assumption is common but not universal. The standard

toolbox of mainstream macroeconomics includes various departures from perfectly com-

petitive and complete markets. This includes ways of modeling market incompleteness,

as well as departures from perfect competition such as monopolistic competition and

search frictions. Much current research in macroeconomics relies on these departures.

A common situation is that a given model uses search frictions in some markets while

maintaining perfect competition for other markets. Furthermore, the allocation that

would be generated with perfectly competitive and complete markets constitutes a use-

ful benchmark for understanding the impact of frictions. Thus being able to work with

macroeconomic models with perfectly competitive and complete markets is necessary first

step in order to be able to read or participate in current research in mainstream macroe-

conomics. For this reason, the primary objective of this course is to get you to a point

at which you are comfortable working with macroeconomic models that have perfectly

competitive and complete markets.

The basic core models of mainstream macroeconomics, the neoclassical growth models

with infinitely-lived households and with overlapping generations, are essentially special

cases of the general equilibrium models you have studied in Micro I. Importantly, macroe-

conomics is primarily concerned with the dynamic behavior of the economy, both in the

short run (business cycles) or the long run (growth). Thus in our models agents face

dynamic decision problems. Additionally, agents face uncertainty when making their de-

cisions. The resulting dynamic decision problems have a special structure which enables

us to solve them using methods such as dynamic programming and optimal control. You

already encountered these methods in Math II. We will review them and apply them to

the basic core models of macroeconomics.

Macro I is focused on models with perfectly competitive and complete markets. We

will see that markets work very well in these models in the following sense: the allocation

of resources achieved through markets is socially efficient. This is not to say that nothing

bad can happen in these models. The models allow for the possibility that an economy

is very poor due to a lack of resources or due to poor technology. But for given resources

and technology, markets insure an optimal allocation of resources. Similarly, an economy

can experience a recession due to shocks to technology, resources, or preferences, but

the response of the economy to these shocks is socially efficient. In particular, financial

markets work perfectly in these models. Thus these models are not designed to think

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about market failures in financial markets.

The neoclassical growth models are the most basic members of a class of models often

referred to as Dynamic Stochastic General Equilibrium models (DSGE). Other members

of this class depart from the neoclassical growth models by introducing so-called frictions

that, loosely speaking, make the economy function less well. You will encounter DSGE

models with frictions in the other courses of the macro sequence. Macro II will at first

continue to work with the frictionless neoclassical growth model, using it to study fiscal

and monetary policy. But it will also introduce a first type of friction, so-called nominal

rigidities. These are frictions that interfere with changing nominal prices (the prices of

goods in terms of money). As you will see, these frictions have important implications for

monetary and fiscal policy. Macro III will introduce further frictions in labor, capital, and

product markets, including informational asymmetries and search frictions, and examine

how they affect the allocation of resources. Macro IV focusses on financial frictions, which

are also based on informational asymmetries.

A very common approach to a research question in mainstream macroeconomics is

to start with a neoclassical growth model and to add the frictions that are relevant for

the research question at hand. For example, suppose your research question is: What

monetary policy is socially optimal? In this case you may want to consider a model with

nominal rigidities. If you want to understand fluctuations in unemployment, you may

want to include search frictions. In the latter case you may decide to leave out nominal

rigidities, unless you believe that they are of first-order importance for the results. The

reason is that including too many unneeded frictions can make the model difficult to work

with. However, there is also an area of research on DSGE models which simultaneously

introduces a large number of frictions and then estimates the resulting model. Some

large-scale DSGE models have become popular with central banks as one way to think

about monetary policy. Sometimes the term DSGE is interpreted narrowly to refer to

this type of model.

The DSGE approach has been used to study a large variety of research questions. Be-

fore the financial crisis that started in 2008, most research in macroeconomics focused on

problems other than frictions in financial markets. Thus many DSGE models developed

during this period did not include financial frictions. In the course of the financial crises,

macroeconomics was criticized by many observers, and this criticism frequently included

claims that DSGE models are useless. When thinking about this criticism, it is important

to keep in mind that macroeconomics does not aim to develop a single all-encompassing

model of the macroeconomy that can then be used to answer all macroeconomic research

questions. Instead, typically macroeconomists develop a customized model for each spe-

cific research question. Most DSGE models were never intended to think about potential

problems in the financial sector. Hence it should not come as a surprise that they are

not useful for this purpose. Macroeconomists have developed a variety of models with

financial frictions , and you will encounter many of them in Macro IV. Usually these

models also build on microeconomic theory, but drawing more on contract theory. While

a lot of recent work on other research questions has explored quantitative implications

of the models used, much of the research on financial frictions has remained qualitative.

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Whether one would still refer to these models as DSGE depends on how narrowly or

widely one defines DSGE. In any case, it is probably not very useful to criticize specific

models for not addressing questions they were not intended to address. A potentially

more useful and valid criticism would be that before the crisis macroeconomics as a field

did not allocate enough research effort to improving models of financial frictions and un-

derstanding potentially problematic developments in financial markets. The allocation

of research effort has certainly changed in recent years, and recent efforts to better un-

derstand financial crises has taken a variety of forms. Some work has focused on models

that are specifically focused on financial crisis. Other work has attempted to capture

financial frictions in a sufficiently simple way such that they can be incorporated in the

large-scale DSGE models mentioned above, which may be useful for understanding the

role of monetary and fiscal policy in a financial crisis.

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1 Introduction1.1 Introduction to Macro I1.2 Place of Macro I in Macro Sequence