Introduction to Modern Macroeconomics

Dr. Zeeshan Atiq

zatique@uok.edu.pk

Departmetn of Economics
University of Karachi

PhD course work

Introduction

I On the surface, macroeconomics appears to be a field divided

among schools, Keynesians, monetarists, new classical, and
others.
I Their disagreements, which often appear to be as much about
methodology as about results, leave outsiders bewildered and
skeptical.
I Macroeconomics is a science which is young, hesitant, and
difficult one.

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Introduction

I Macroeconomics studies the the phenomena of economywide

movements in output, unemployment, and inflation.
I Despite the fact that the countries have attained the growth
rates higher than ever, still they are prone to large
fluctuations.
I Expansions follows the recessions and recessions follow the
expansions.
I Occasionally, recessions turn into depression, such as the great
depression of the 1930s in the U.S. And long period of high
unemployment in Europe in the 1980s.

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Introduction Contd...

I The birth of macroeconomics can be traced back to 1930s.

I In Britain the rate of unemployment never fell below 10 per
cent between 1921 and 1938, and actually exceeded 20 per
cent in 1931 and 1932.
I In the United States unemployment reached a peak of 25 per
cent in 1933.
I Writing against this background Keynes (1936) put forward a
new and revolutionary theory to explain, and provide a remedy
for, the then-prevailing persistent and severe unemployment.
I In doing so Keynes was responding to what undoubtedly was
the most significant macroeconomic event of the twentieth
century; the Great Depression gave birth to macroeconomics.

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Keynesian School Vs. Other Schools

I The classical school emphasizes the optimization of private

economic actors, the adjustment of relative prices to equate
supply and demand, and the efficiency of unfettered markets.
I The Keynesian school believes that understanding economic
fluctuations requires not just studying the intricacies of
general equilibrium, but also appreciating the possibility of
market failure on a grand scale.

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Keynesian School Vs. Other Schools contd...

I Hence, although it is possible to distinguish between orthodox

Keynesians, new Keynesians and post-Keynesians, all three
groups are united in the belief that aggregate economic
instability represents ‘some sort of market failure on a grand
scale’ (Mankiw 1990).
I In contrast the majority of economists who have been
prominent in the monetarist, new classical, real business cycle
and Austrian schools have tended to place their faith in
market forces as an equilibrating mechanism and question the
capacity and desirability of government intervention as a
means of achieving the major macroeconomic objectives.

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Keynesian School Vs. Other Schools contd...

I A central theme of Keynes’s analysis is the contention that

capitalist market economies are inherently unstable and are
capable of coming to rest ‘in a chronic condition of
sub-normal activity for a considerable period without any
marked tendency, either towards recovery or towards complete
collapse’ (Keynes 1936:249)
I This instability was in Keynes’s view predominantly the result
of fluctuations in aggregate demand and the Great Depression
resulted from a sharp fall in investment expenditure
‘occasioned by a cyclical change in the marginal efficiency of
capital’.

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Keynesian School Vs. Other Schools contd...

I The resulting unemployment was involuntary and reflected a

state of deficient aggregate demand.
I Given the weak equilibrating powers of the market mechanism
in these circumstances the implication of Keynes’s analysis
was that fiscal and monetary policy could correct the
aggregate instability exhibited by market economies and help
stabilize the economy at full employment.
I Once full employment is restored Keynes accepted that ‘the
classical theory comes into its own again’ and Keynes was
optimistic that limited government intervention could remedy
the shortcomings of the invisible hand (see Keynes 1936:379).

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Keynesian School Vs. Other Schools contd...

I Managed capitalism, with a commitment to full employment,

was the kind of system Keynes had in mind when in the
concluding section of his famous essay The End of
Laissez-Faire (1924) he argued that:
For my part I think that capitalism, wisely managed,
can probably be made more efficient for attaining economic
ends than any alternative yet in sight, but that in itself it
is in many ways objectionable. Our problem is to work out
a social organisation which shall be as efficient as possible
without offending our notions of a satisfactory way or life.

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Recent Developments

I Until 1970s it was easier being a student of macroeconomics.

I Macroeconomists felt more sure of the answers they gave to
questions such as, “What causes output and employment to
fluctuate?” and “How should policy respond to these
fluctuations?”
I the accepted model of the economy was the IS– LM model.
I It was little changed from John Hicks’s (1937) interpretation
of John Maynard Keynes’s (1936) once revolutionary vision of
the economy.
I Because the IS–LM model took the price level as given, a
Phillips curve of some sort was appended to explain the
adjustment of prices.

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Recent Developments

I Today, macroeconomists are much less sure of their answers.

I The IS–LM model rarely finds its way into scholarly journals;
some economists view the model as a relic of a bygone age
and no longer bother to teach it.
I However, the way economists analyze the economy has not
changed much. The IS–LM model, augmented by the Phillips
curve, continues to provide the best way to interpret
discussions of economic policy in the press and among
policy-makers.

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The Breakdown of the Consensus
I The Keynesian consensus in macroeconomics that prevailed
until the early 1970s faltered because of two flaws, one
empirical and one theoretical.
I The empirical flaw was that the consensus view could not
adequately cope with the rising rates of inflation and
unemployment experienced during the 1970s.
I The theoretical flaw was that the consensus view left a chasm
between microeconomic principles and macroeconomic
practice that was too great to be intellectually satisfying.
I These two flaws came together most dramatically and most
profoundly in the famous prediction of Milton Friedman
(1968) and Edmund Phelps (1968).
I According to the unadorned Phillips curve, one could achieve
and maintain a permanently low level of unemployment
merely by tolerating a permanently high level of inflation.
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The Breakdown of the Consensus

I In the late 1960s, when the consensus view was still in its
heyday, Friedman and Phelps argued from microeconomic
principles that this empirical relationship between inflation
and unemployment would break down if policy-makers tried to
exploit it.
I They reasoned that the equilibrium, or natural, rate of
unemployment should depend on labor supply, labor demand,
optimal search times, and other microeconomic
considerations, not on the average rate of money growth.
I Subsequent events proved Friedman and Phelps correct:
inflation rose without a permanent reduction in
unemployment.

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The Focus of Recent Macroeconomic Models
I The standard macroeconomics models of general equilibrium
have very limited recognition of the inherent inefficiencies in
the system, so as the need of government to correct the
inefficiencies (Stiglitz 2011).
I The models in macroeconomics derive from microeconomic
foundations. Stiglitz points out that the derivation should be
based on right microeconomic foundations taking into account
information asymmetries and market imperfections.
I Economic models behave differently when we incorporate the
imperfect information.
I According to Stiglitz the outcomes of labor, product and
capital markets will be quite different if we allow imperfect
information in macroeconmic models.

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Other Issues

I Standard macroeconomic models assumes shocks such as

productivity shocks as exogenous, which in reality are not.
I For instance the recent sub-prime mortgage crisis was the
result of the ineptitudes of the bankers.
I The model of rational expectation on the one hand is better
in the sense that it is not prone to Lucas critique1 , which
emphasized that behavior itself was endogenous to policy.

1
The ’Lucas critique’ is a criticism of econometric policy evaluation
procedures that fail to recognize that optimal decision rules of economic agents
vary systematically with changes in policy.
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What is wrong with representative agent models??

I The representative agent problem does not take into account

the asymmetric information unless we assume that our
representative agent has acute schizophrenia which is against
the assumption of rationality.
I Because there are no agency problems, there is no scope for
problems of corporate governance.
I Because there can be no externalities, there is no role for
government intervention to align social and private interests.
I Because there are no distributive issues, there is no scope for
exploitations–for example by the banks of uninformed
borrowers.

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Markets are not rational....

I “[T]hose of us who have looked to the self-interest of lending

institutions to protect shareholders [sic] equity, myself
especially, are in a state of shocked disbelief.” (Allen
Greenspan)
I Committee on Oversight and Government Reform 2008.
Greenspan also said: “I made a mistake in presuming that the
self-interest of organizations, specifically banks and others,
were such . . . that they were best capable of protecting their
own shareholders and their equity in the firms.”

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Flaws in incentive structure...

I Banks manage the risks associated with their decisions in such

a way that it benefit to them more than it benefits to
anybody else.
I Standard macroeconomics models do not incorporate
incentive distortions in their analysis.

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Flaws in incentive structure...
I Stiglitz also raises questions about the theory of rational
expectations.
I He questions since the world has not faced crisis of the
magnitude of 2007-08 for the last three-quarter of the
century, how come rational expectation can take thinking into
the directions of such a huge crisis.
I Moreover, another flaw in standard macroeconomic theory is
that it strongly combines theory with empirics.
I The combination of empirics with macroeconomic models is
based on the belief that present is similar to the past and
world is as same as before, but the world changes. Therefore,
there is need to be cautious about the behaviors that carry
over and those that do not.

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Role of Institutions

I Standard models in macroeconomics assume that institutions

do not matter, whereas, the truth is different.
I Institutional details in different phenomena play important
role in understanding diversities in the results between
different situations and different countries (Stiglitz 2011).

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Dynamic Stochastic General Equilibrium Models
I DSGE model and specifically New Keynesian DSGE models
have overcome many problems highlighted before.
I Introducing monopolistic competition and nominal rigidities
means the market equilibrium is not, in general, Pareto
efficient, monetary policy can have real effects, and, more
broadly, government intervention can be welfare enhancing
(see for example Gal´ı 2008).
I Still, advocates of the various variants of DSGE have
themselves emphasized the over all similarities.
I As Chari et al. (2009) note, the various versions of the DSGE
models even agree on the central policy: “optimal monetary
policy. . .keep[s] inflation low and stable in order to avoid
sectoral misallocations” (p. 246).

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Summary of the criticism agains standard macroeconomic
models
In the methodological issues.
I Standard macroeconomics make bigger problems by assuming
endogenous variables as exogenous, such as productivity
shocks.
I On further methodlogical issues Korinek (2010d) puts the
criticism well:
I “First, the set of moments chosen to evaluate the model is
largely arbitrary. . .
I Second, for a given set of moments, there is no well-defined
statistic to measure the goodness of fit of a DSGE model or
to establish what constitutes an improvement in such a
framework.”)
I Moreover, they did not look at all the predictions of the
theory, only a selected subset, ignoring the fact that some of
the testable predictions could be rejected. 22/23
Summary Contd..

I Methodologically other flaws occur when standard models

make special assumptions.
I For instance, the assumption about reducing risks through
diversification is a special assumption.

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