ECO2046 Intermediate

Macroeconomics 2
Introduction & Lecture 1
Cristiano Cantore

February 5, 2013

Course Organization
Contact time:
Lectures:
Tuesday, 15:00-17:00 LTD
Class:
Thursday, 10:00-11:00 (Group 1),
11:00-12:00 (Group 2), 13:00-14:00 (Group 3)

Lecturer: Cristiano Cantore

Email: c.cantore@surrey.ac.uk
Office hours: Tuesday, 11:00-12:00 and 14:00-15:00;
Class tutor: Marcelo Almeida

Assessment

Coursework:
mid-term on Tuesday 12th of March, Week 6

Exam:
2 hours, during the summer term

Final mark:
30% coursework mark
70% exam mark

Details on the module outline.

Reading
Textbook:
Srensen, Peter Birch and Hans Jrgen Whitta-Jacobsen
(2005): Introducing Advanced Macroeconomics: Growth
and Business Cycles, McGraw-Hill. (SWJ)

Supplementary readings:
Romer, David (2006): Advanced Macroeconomics, 3rd
Edition, McGraw-Hill.
Journal articles as indicated.

Lecture notes and additional material posted here:

http://surreylearn.surrey.ac.uk/

Module Prerequisites
This is an Advanced Module and requires hard and
weekly work.
If you dont feel comfortable with algebra, logs, derivatives
and the chain rule I suggest you to revise them soon.
Lectures and tutorial attendance is strongly recommended.
I will provide weekly exercises for you to practice on
lectures material plus a set of exercises to be solved every
two weeks in the tutorials. You are expected to work on
those before solution will be posted!
I encourage you to work in groups on the exercises!

Agenda I

What we want to do:

build a model of the macro economy based on solid (i.e.,
microeconomic) foundations
build a model of the macro economy that fits the facts (e.g.,
in the light of time-series data)
consider policy issues

What we dont want to do:

make ad-hoc assumptions
ignore empirical data

Agenda II

Introduction to Business Cycle

Consumption

Investment

Monetary Policy Rules

Incomplete Nominal Adjustment

The Phillips Curve

An Empirical AD/AS Model

Rational Expectations and Policy Ineffectiveness

Credibility and Policy Making - Delegation

Lecture 1: Introduction to Business Cycle

Main reading: SWJ, chapter 13

1

Historical perspective
*Blanchard (2000), QJE
*Blanchard (2008), NBER

Measuring business cycles

Stylized facts

Motivation
United States: Real GDP per Working-Age Person
12.499
800

index (1900=100)

11.499
400

10.499
200

100
9.499

50
8.499
1900

1910

1920

1930

1940

1950

1960

1970

1980

1990

year

Figure: Source: Kehoe and Prescott (2007).

2000

Motivation

Historical Perspective
Development of Modern Macroeconomics
Possible to identify three broad periods for
macroeconomics:
1

Pre-1940: right ideas, no integrated framework

1940-1980: development of the IS/LM framework and

business cycle models

Post-1980: role of market imperfections (i.e., the micro

behind the macro)

Somewhere in all of this are: Classicals, Keynesians,

Monetarists, New Classicals, RBCers and New
Keynesians
Very recently: much more quantitative approach to
macroeconomics

1. Pre-1940
The word Macroeconomics appeared for the first time in 1941!
Two largely unconnected strands of thought:
1

monetary theory, i.e., M V = P Y type reasoning

(Quantity theory: how changes in money lead to movements
in output and in prices.)

business cycle: statistics covering real and monetary

factors (one at the time) - largely descriptive.

The missing link was the difference between:

the natural rate of interest (i.e., the rate of return on
capital)
the money rate of interest (i.e., the rate of return on bonds)
A key to integrate the goods and the financial markets (and
monetary and business cycle theories).

Keynes General Theory

Keynes provided this connection.

Three markets:
Goods market: changes in S and I imply changes in Y ;
the vehicle: the consumption function and IS curve
Financial market: households have access to bonds and
money: the LM curve and the nominal interest rate
Labor market: there is some form of disequilibrium; e.g.,
wages are sticky and labor is demand determined

The Great Depression

Great depressions in the 1930s:
Detrended output per person
110

100

Germany

Index (1928 = 100)

France
90

United States
80

70

Canada
60

50
1928

1930

1932

1934

1936

Figure: Source: Kehoe and Prescott (2007).

1938

The Great Depression

Suddenly macro policies were needed to get the US and

other countries out of the slump.
Prior to that things had seemed to go along by themselves
pretty smoothly.
This naturally led to other applications of macro policy (in
less extreme circumstances).
In the UK, Keynes advocated the use of demand-side
policies, i.e., demand management of the economy.

2. 1940-1980 I

In one way or another, four big issues were addressed:

1

The further development of the IS/LM model:

M
P
Y

L (Y, i)

C (Y T ) + I (r) + G

Conceptual issues:
Classical dichotomy
Walras Law
Loanable funds vs. liquidity preference

2. 1940-1980 II
3

Dynamics:
central to the further development of the consumption
function - saving decision is intertemporal
paved the way to help model the business cycle (as opposed
to describe it)

Expectations formation was reconsidered:

concept of rational expectations was introduced
in the context of this course, this helped (i) clarify the
differences between anticipated and unanticipated policies
and (ii) highlight the role of credibility

2. 1940-1980 III

More Generally...
Move away from static ad-hoc/descriptive models to
dynamic optimizing models with shocks and rational
agents
Shift away from qualitative to quantitative analysis
Example: explain by how much the interest rate changes
and not just whether the interest rate falls when the money
supply rises

Unresolved Issues
Basic Problem: Keynesian models postulated that the
nominal wage was rigid; there was no reason to assume
this, i.e., no justification other than casual observation.
More generally, the careful analysis of savings and
investment didnt match with the ad-hoc approach to the
labor market.
With the introduction of rational expectations, there was a
split:
New Classicals wanted to know how much they could
achieve without market imperfections.
Keynesians thought rigidities were the right way to go.

Why 1940-1980?

The 1970s saw a series of exceptional events which

changed ideas about the macro economy.
The most obvious example are the oil shocks and
subsequent stagflation (i.e., high inflation and high
unemployment) in many countries.
Message: some of the big changes in macro came about
precisely because our models couldnt explain the facts
We couldnt explain the Great Depression (we still struggle),
and we couldnt explain the reaction of the economy to
shocks that occurred in the early to mid 1970s (ditto).

3. Post-1980
Two major issues were dealt with:
Why does money affect output, and what role do nominal
rigidities play?
What are the major shocks that affect output, and what is
the propagation mechanism?

The key to both of these is developing a model based on

micro-foundations.
Market imperfections are crucial:
nominal rigidities
incomplete markets
asymmetric information
search and bargainning
increasing returns

More on the Significance of

Micro-Foundations

Micro-founded models do not only allow us to justify

Keynesian-type assumptions:
agents make utility/profit maximizing decisions
budget constraints are respected
can evaluate the welfare implications of macro policies
models are internally consistent

Figure
20.7: The
volatility of real GDP in the United States,
The
Great
Moderation
195898

Source: Bureau of Economic Analysis. The time series for real GDP has been detrended by HP filtering.

Figure: Volatility of real GDP in the United States, 1958-1998.

The McGraw-Hill Companies, 2005

Slide 1/9

Table 1
Changes in Volatility of Four-Quarter Growth of Real GDP per Capita
in the G7, 1960 1983 and 1984 2002.

The Great Moderation

Canada
France
Germany
Italy
Japan
UK
US

Standard
deviation,
1960 1983
2.3
1.8
2.5
3.0
3.7
2.4
2.7

Standard
deviation,
1984 2002
2.2
1.4
1.5
1.3
2.2
1.7
1.7

std. dev. 84-02

std. dev. 60-83

variance 84-02
variance 60-83

.96
.71
.60
.43
.59
.71
.63

.91
.51
.36
.19
.35
.50
.40

Notes: Entries in the first two columns are the standard deviations of the four-quarter growth in GDP over
the indicated time periods. The third column contains the ratio of standard deviation in the second column
Figure:
Changes
in column
the presents
volatility
ofof 4Q
growth
(real
inof G7
to that in
the first; the final
the square
this ratio,
which is the
ratio of GDP)
the variances
four-quarter
GDP growthStock
in the twoand
periods.Watson
Data sources (2003).
are given in the Data Appendix
countries.
Source:

The estimates in
in Table
1 use the
1984 date of
volatility
shift innow
the US,than
but this in
Fluctuations
output
appear
tothebe
smaller
date
or
the
single-break
model
might
not
be
appropriate
for
other
countries.
In
addition,
the past.
the standard deviations in Table 1 might confound changes in the trend growth rate of

The
variance
ofwith
four-quarter
GDP
growth in
G7Germany,
countries
output in
these countries
changes in business
cycle fluctuations.
In fact,
France,
Italy, andby
Japan
grew to
much80%.
more rapidly in the 1960s, when postwar
has
fallen
50%
Question: Is the Great Moderation the result of good
The literature on the great moderation has grown rapidly. Blanchard and Simon (2001) and Stock and
Watson (2002) or
survey
studies using
US data. Studies using international data include Dalsgaard, Elmeskov
policies
good
luck?
2

and Park (2002), Del Negro and Otrok (2003), Doyle and Faust (2002a), van Dijk, Osborn, and Sensier

Taking Stock
Things to Remember
The 1930s: depression (and deflation)
The 1970s: inflation (and recession)
Post 1990s: moderation
Now, More Formal Approach
Business cycles
Time-series approach
Stylized facts

Business Cycles and Stylized Facts

What We Want to Explain

GDP, unemployment, investment, consumption, inflation
etc...
their comovement (correlation)
and how they change across time (auto-correlation)

Throughout this course, will focus on closed economy:

Y =C +I +G

Business Cycles
Business Cycles
If we are interested in the business cycle, then we are
interested in time-series.
Most important example - behaviour of GDP:
trend growth
fluctuations around this trend

The difference between the trend and the fluctuation is the

cyclical component.
in levels:
in logs:

Yt = Ytg Ytc
yt = gt + ct

Hodrick-Prescott filter allows to separate growth trend

from cyclical component.

Business Cycles
Real GDP - quarterly data
8

7.8

7.6

7.4

7.2

6.8

6.6
20

40

60

80

100

120

140

Figure: HP filter.

160

180

200

Business Cycles
Real GDP and trend - lam=1600
8
trend
data
7.8

7.6

7.4

7.2

6.8

6.6
20

40

60

80

100

120

140

Figure: HP filter.

160

180

200

Business Cycles
Deviations of real GDP from trend - quarterly data, lam=1600
0.04

0.03

0.02

0.01

-0.01

-0.02

-0.03

-0.04

-0.05
20

40

60

80

100

120

140

Figure: HP filter.

160

180

200

Terminology
When GDP at its highest point above trend, in a given
period, it is at its peak.
When GDP is at its lowest point below trend, in a given
period, it is at its trough.
The length of time between two subsequent peaks is the
business cycle.
peak to trough phase: recession (contraction)
trough to peak phase: boom (expansion)

For there to be a recession, GDP needs to be below trend

for a given period of time (NBER uses at least 2 quarters).

Terminology
Deviations of real GDP from trend - quarterly data, lam=1600
0.04

0.03

0.02

0.01

-0.01

-0.02

-0.03

-0.04

-0.05
20

40

60

80

100

120

140

160

180

200

The standard deviation is used to measure the

amplitude of the fluctuation (i.e., the volatility). That is,
for some variable y:
v
u
T
u 1 X
t
y =
(yt y)2
T 1
t=1

Terminology
Other Variables - Correlation
If corr (x, y) > 0, then x and y move in the same direction.
If y is GDP, then we say x is procyclical.
If corr (x, y) < 0, then x and and y move in opposite
directions, and x is countercyclical.
If corr (x, y) ' 0, then x and y are independent, and x is
acyclical.
Finally, corr (x, y) (1, 1). The larger the absolute
value, the more synchronized the variables are.

AR(1) Process I
Suppose we want to build a model of the economy based on
the behaviour of GDP.
Two questions:
1
2

What caused GDP to move from its trend?

How long will it take before GDP reverts to its trend?

First guess: use todays GDP to predict tomorrows GDP;

probably we will be wrong, so we can also suppose there is
some random error; GDP then evolves in the following way:
yt = yt1 + Dt

for t = 0, 1, 2, ..., where < 1

(1)


The shock term is Dt N 0, 2 ; that is, it is a normally
distributed random variable so that we may over- or underestimate actual GDP.

AR(1) Process II
Equation (1) is referred to as an autoregressive process of
order one.
Order one reflects there being one lagged term.

This is our first real model. Why? For some given level of
GDP, y1 , we can figure out y0 , y1 , y2 etc.
We know this model isnt the best, but if we graph
equation (1), we get something that looks like what we see
in the data.
That makes figuring out Dt and very important.

AR(1) Process - Volatility

Consider the shock Dt ; from our model we can see the
pattern of the business cycle; i.e., the ups (Dt > 0) and
downs (Dt < 0).
AR(1) process: y(t) = rho*y(t-1) + eps(t)
1.05

1.04

1.03

1.02

1.01

0.99

0.98

0.97

20

40

60

80

100

120

This picture, although simulated on artificial data, looks

much like the behaviour of GDP.

AR(1) Process - Persistence

Persistence: AR(1) Process
That isnt all we can do; imagine there was a one-off shock
in period t = 0; we want to know how long it takes for
GDP to get back to trend; the parameter determines this.
propagation of one-off shock for AR(1) process: y(t) = rho*y(t-1) + eps(t)
1.007
rho = 0.8
rho = 0.9
1.006

rho = 0.95

1.005

1.004

1.003

1.002

1.001

20

40

60

80

100

120

Structural Interpretation
The Dt s and the s
There is a follow-up problem; say we believe that our
model is a good one.
Where do the Dt s come from? Example: A contraction
in the money supply (i.e., contractionary monetary policy)
could make Dt < 0.
Where does come from? Example: can be high if
labor market institutions are rigid.

We need some theory to restrain our guesses about Dt and

.

Additional Variables - V AR(p, q) Model I

The AR(1) model looks nothing like the macro economy;
but we can get closer.
Suppose:


yt
t


=

11 12
21 22



yt1
t1


+

Dt
St


,

(2)

where t is a new variable and St is a new shock that has

properties similar to Dt .
Equation (2) is a vector autoregression of order one.
Generally, in V AR(p, q), the p represents the number of
variables, while the q represents the number of lags.

Additional Variables - V AR(p, q) Model II

Comments
The V AR(2, 1) is simply a model in output and inflation,
similar to an AD/AS model; however, the simplest version
of that model has no dynamics (i.e., lagged terms).
The same basic ideas hold in this more general model vs.
the AR(1); this model is simply more realistic and we
would expect it to perform better when confronted with
the data.
You might want to think of the entire economy as a
V AR(p, q) model.
Again, we need to figure out where the s and shocks come
from.

V ar(p, q) - Impulse Responses

W L 89 NO I
1,

GAL^

I ~ C H I W L O G YLMPLOYMElVT,
,
AND THE BU5f1VE,SS C YC%L
NonteehnologyShock

Technology Shoek
- - - - - - --

261
-

F I C ~ ~2.J R ESTIMATED
E
I M P ~ J RESPONSES
LS~
FROM A BIVAKIA~L;
MODEL.:
U.S. DATA,FIKSI.-~)II:P~R~N(:ED
HOIJKS
(POINT
EIIKOK
CONFII)~NCE
INTERVALS)
ES'r1~A'rb.sA N D 2 2 S'I'ANDAKI)

Figure: Source:
Gali (1999).
bivariate model: a positive technology shock

Table 2 displays the corresponding estimates of the productivity-labor input correlations conditional on each type of shock. As
before, I report results using both An, and ii,
in the estimated VAR. The estimates largely
confirm the results from the bivariate model:
technology shocks induce a high, statistically
significant negative correlation between productivity and hours (or employment), whereas
the (composite) nontechnology component of
the same variables shows a positive correlation
(also significant in three out of the four
specifications).
Figure 4 displays the responses of a number
of variables to a technology ,\hock. The pattern
of responses of productivity, output, and employment is very similar to that obtained in the

leads to an immediate increase in productivity

that is not matched by a proportional change
in output (the latter's response building up
more slowly over time), implying a transitory-though persistent-decline in hours.
One snlall difference vis-a-vis Figures 2 and 3
can be detected, however: the initial negative
effect on hours is now more than fully reversed
over time, leading to a positive, though quantitatively small long-terrri effecL2'

We can think of St as the technology shock and Dt as the

non-technology shock; GDP responds differently to
different shocks.
" That "reversal" does not occur, however, when employ~nentis used as a labor-input measure (impulse responses xiot reported here).

Business Cycle Statistics

Table 14.2a: Macroeconomic volatility in the United
Kingdom and the United States

1 Standard deviation relative to standard deviation of GDP.

Note: Based on quarterly data from 1947Q1 to 2003Q4. 24 end-point
observations excluded.

Figure:Sources:
Business
cycle statistics.
Bureau of Economic Analysis, Bureau of Labor Statistics, Federal Reserve Bank of St. Louis.

The McGraw-Hill Companies, 2005

Slide 1/17

Business
Statistics correlations, leads and
TableCycle
14.3a: Macroeconomic
lags in the United Kingdom and the United States

Note: Based on quarterly data from 1947Q1 to 2003Q4. 24 end-point observations excluded.

Figure: Business cycle statistics.

The McGraw-Hill Companies, 2005

Sources: See Table 14.2

Slide 1/23

Business Cycles and Stylized Facts I

Investment is more volatile than GDP.

Employment/unemployment are less volatile than GDP.

Private consumption and investment are strongly positively

correlated with GDP.

Employment is procyclical and real wages are weakly

correlated with GDP.

Inflation tends to be positively correlated with GDP.

GDP and private consumption are persistent (i.e., a high ,

a high autocorrelation).

Employment is even more persistent.

Business Cycles and Stylized Facts II

Summary Statistics
x
corr (x, y) x /y
Consumption
>0
<1
Investment
>0
>1
Employment
>0
<1
Hrs. per Worker
>0
<1
Total Hrs.
>0
.1
Price Level
<0
<1
Money Supply
>0
.1
Real Wage
>0
<1
Av. Labor Prody
>0
<1
Real Int. Rate
>0
<1
Note: corr (x, y) > 0 implies a variable is procyclical and
x /y > 1 implies a variable is more volatile than GDP.

Outlook

Recap on the AD/AS Model

Our goal is to get a micro-founded AD/AS model that can
rationalize the empirical findings.
Recall:
Goods Market (consumption and investment) IS
Money Market (money and bonds) LM
IS and LM (with well-specified monetary policy) AD
Labor market (price and wage setting curves) AS