Handout 0. Introduction

Lecture 0: Introduction
Introduction to Modern Macroeconomics I
Hosein Joshaghani
Khatam University (TeIAS)
January 2020
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What is “Macroeconomics” about?
Questions of macroeconomics
What determines the level of income in the economy?

What determines the level of unemployment?
How does economic policy impact on the economy?
Optimal policy responses?
What determines long run growth rates?
What leads to fluctuations in the economy over time?
What typically happens during booms and recessions?
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Hosein Joshaghani Intro Modern Macro I
What is “Macroeconomics” about? Output per Capita
Ancient U.S. History
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Relative GDP per Capita: Cross Country
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Relative GDP per Capita
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Relative GDP per Capita
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Iran’s Economy: Real Output
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Iran’s Economy: Real and Nominal GDP
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What is “Macroeconomics” about? Government
Iran Government spending
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Iran Government spending
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Iran tax revenue, percent of GDP
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Iran tax revenue
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What is “Macroeconomics” about? Growth Economics
Growth experiences
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“catch-up” behavior of OECD countries since 1960
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Lack of convergence worldwide
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Iran’s growth experience
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What is “Macroeconomics” about? Business cycles
Real Business Cycles
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What is “Macroeconomics” about? Labor market
Unemployment
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Labor Market in Iran: Population
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Labor Market in Iran: Labor Force
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Labor Market in Iran: Labor Force Participation
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Labor Market in Iran: Unemployment
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Labor Market in Iran: Employment
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What is “Macroeconomics” about? Money and inflation
Inflation
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Distribution of cross country inflation
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Iran Money: M1 (Currency in the Hands of Non-Bank

Public)
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Iran Money: M1 (Demand Deposits)
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Iran Money: M2 (Savings Deposits)
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Iran Money: M2
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Iran Money Growth Rate
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Iran Inflation
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Theories and Models in Macroeconomics Theories and Models in Science
Theories and models
All model are:

1 simplification of real world
2 FALSE
3 But if they are good models, they will be helpful
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Evolution of Theories
Do NOT abandon models but understand their proper place and

incorporate complexity (in the sense of extremely complicated) into the
analysis and its limitations
Economists build models to capture salient aspects of social
interactions.
But what are economic models?
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Science and Models
In modern science we are trying to answer questions based on available

evidence based on available data.
Typical questions:
1 Causal
2 Mechanism
3 Prediction
All of these can be incorporated in models.
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Theories and Models in Macroeconomics Economic Models as Fables
What Are Economic Models?
The easiest way to understand them is as simplifications designed to

show how specific mechanisms work by isolating them from other,
confounding effects.
A model focuses on particular causes and seeks to show how they work
their effects through the system.
Models do more than warn us that results could go either way. They
are useful because they tell us precisely what the likely outcomes
depend on.
The answer to each question depends on some critical feature of the
real-world context. Models highlight those features and show how they
influence the outcome.
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Models as Fables: Dani Rodrik’s Economic Rules (2015)

One way to think of economic models is as fables. These short stories
often revolve around a few principal characters who live in an unnamed
but generic place (a village, a forest) and whose behavior and
interaction produce an outcome that serves as a lesson of sorts.
A fable makes little effort to be realistic or to draw a complete picture
of the life of its characters.
It sacrifices realism and ambiguity for the clarity of its story line.
Importantly, each fable has a transparent moral: honesty is best, he
laughs best who laughs last, misery loves company, don’t kick a man
when he’s down, and so on.
Economic models are similar. They are simple and are set in abstract
environments. They make no claim to realism for many of their
assumptions. 37/60
Models as Fables: Dani Rodrik’s Economic Rules (2015)
Ariel Rubinstein: “The word ‘model’ sounds more scientific than ‘fable’
or ‘fairy tale’ [yet] I do not see much difference between them.”
Hal Varian: “[An economic] model always tells a story.”
There are countless fables, and each provides a guide for action under
a somewhat different set of circumstances.
So we need to use judgment when selecting the fable that applies to a
particular situation.
Economic models require the same discernment.
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Natural versus Social Sciences
Why macroeconomics (social sciences) is a science?

What makes it different from natural sciences?
There is no forward looking molecule, electron, circuit, fluid, metal, etc.
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Theories and Models in Macroeconomics Economic Models as Lab Experiments
Models as Experiments
Consider what a lab experiment really is. The lab is an artificial

environment built to insulate the materials involved in the experiments
from the environment of the real world.
The economics modeler in fact practices a similar method of insulation,
isolation, and identification.
Experimental results, too, may require significant extrapolation before
they can be applied to the real world. Something that worked in the
lab may not work outside it.
For example, a drug might fail in practice when it mixes with real-world
conditions that were left out of consideration—“controlled for”—under
the experimental setting.
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Theories and Models in Macroeconomics Economic Models as Lab Experiments
Internal versus External Validity
A well-designed experiment that successfully traces out cause and effect

in a specific setting is said to have a high degree of “internal validity.”
But its “external validity” depends on whether its conclusion can travel
successfully outside the experimental context to other settings.
As with real experiments, the value of models resides in being able to
isolate and identify specific causal mechanisms, one at a time.
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Models in Macroeconomics Dynamic General Equilibrium Models
Theories and Models of Modern Macroeconomics
Dynamic (sometimes stochastic), general equilibrium theories DSGE
1 micro-founded: We can address welfare, we can address the Lucas

critique
2 dynamic: We can say something about adjustment and growth
3 general equilibrium: The models are internally consistent
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Dynamic general EQUILIBRIUM Models
It reflects the collective decisions of rational individuals over a range of

variables that relate to both the present and the future.
1 People make decisions that appear to be optimal for them, and so do
not make persistent mistakes,
2 They behave rationally,
3 Errors, when they occur, are attributed to information gaps, such as
unanticipated shocks to the economy.
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Dynamic GENERAL Equilibrium Models
The equilibrium—short or long—is described as general because all

variables are assumed to be simultaneously in equilibrium,
not just some of them, or a particular market, which is a situation
known as partial equilibrium.
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DYNAMIC General Equilibrium Models
Individual decisions are assumed to be based on maximizing the

discounted sum of current and future expected welfare subject to
preferences and four constraints:
1 budget or resource constraints
2 endowments
3 the available technology
4 information
Central issue for DGE macro

Whether to consume today, or save today in order to consume more in the
future.
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Decisions
Three main types of decision are taken by economic agents. They

relate to:
1 goods and services
2 labor
3 assets
The firm determines the supply of goods and services, labor demand,
investment, productive and financial capital, and the use of profits.
Government determines its expenditure, taxation, transfers, base
money, and the issuance of public debt.
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Ramsey Model
The starting point for DGE macroeconomic models is a small general

equilibrium model, but one that includes the main macroeconomic
variables of interest.
It is based on a single individual who produces a good that can either
be consumed or invested to increase future output and consumption.
It is commonly known either as the Ramsey model or as the
representative agent model.
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Ramsey Model
The basic Ramsey model can be roughly interpreted as that of a closed

economy without a market structure in which the decisions are
coordinated by a central planner.
Steps toward greater realism:
1 allow decisions to be decentralized
2 include a government, and hence fiscal policy
3 introduce money, and hence a distinction between real and nominal
variables
4 allow a foreign dimension
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Dynamic General Equilibrium Model of Macroeconomy
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Models in Macroeconomics Traditional Macroeconomics
Traditional Macroeconomics
Under the influence of Keynesian macroeconomics, the emphasis was

on the short-run behavior of the economy:
Why the economy seemed to persist in a state of disequilibrium, and
how best to bring it back to equilibrium, i.e.,how to stabilize the
economy.
In studying these issues, it was common for each macroeconomic
variable to be modeled one at a time in separate equations; only then
were they combined to form a model of the whole economy.
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Traditional Macro and the Lucas Critique (1976)
Keynesian economics lead to large macroeconometric models, mostly

based on time series econometrics.
Lucas Critique: the decision rules of Keynesian models—such as the
consumption function—cannot be considered as structural in the sense
of being invariant with respect to changes in government policy
variables.
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Keynes, the Great Depression and Macro
The study of macroeconomics was prompted in large part by the Great

Depression—the worldwide recession of the 1930s.
From the beginning, therefore, interest was directed not so much to
how the economic system behaved in long-run equilibrium,
but to why it seemed to be misbehaving by generating long periods of
apparent disequilibrium—in particular, departures from full
employment—and to what, if anything, could be done about this.
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Traditional Macro and Disequilibrium
Until the last few years macroeconomic theory has focused mainly on
constructing models to explain this so-called disequilibrium behavior in
the economy with a view to formulating appropriate stabilization
policies to return the economy to equilibrium.
The aim of the policy intervention is to restore equilibrium, or to return
the economy to equilibrium (or close to equilibrium) more quickly.
1 focus on individual markets and not the system as a whole
2 emphasizes the demand side of the economy
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Models in Macroeconomics Traditional Macro vs DGE Macro
Traditional Macro vs DGE Macro
The traditional approach to macroeconomics may be contrasted with

the conception of DGE macroeconomics that economic agents are
continuously reoptimizing subject to constraints with the result that
the macroeconomy is always in some form of equilibrium, whether
short run or long run.
The only sense in which the economy can be in disequilibrium at any
point in time is through basing decisions on the wrong information.
DGE models assume that ex ante the economy is always in equilibrium.
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Traditional Macroeconomics vs DGE Macroeconomics
For most economies dominant feature is the growth in the trend of

potential output; the loss of output due to recessions is almost trivial
by comparison.
It is far more important to raise the rate of growth of potential output
through supply-side policies than to move the economy back toward
the trend path of potential output by demand-side stabilization policies.
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Origins of DGE macroeconomics
The origins of DGE macroeconomics lie in the work of Lucas (1975),

Kydland and Prescott (1982), and Long and Plosser (1983) on real
business cycles.
Their aim was to explain the dynamic behavior of the economy based
on a competitive rational-expectations equilibrium model that took its
inspiration from models of economic growth.
The initial focus was on the role of technology shocks in generating the
business cycle.
Subsequent work extended the model in various ways in order to
examine the effects of other types of shocks.
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Critics
Macroeconomics employs models that are far too simple to capture the
full complexity of the economy, and as a result are of dubious value.
Macroeconomic models are far too complex to be useful.
Macroeconomic models are far too mathematical to be useful.
Macroeconomists disagree with each other.
Macroeconomists missed the financial crisis of 2008.
Macroeconomists are liberal, neo-classical, new Keynesian, etc.
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Caballero (2010) JEP
The subject of macroeconomics is immensely complex (both for

researchers and economic agents)
The core of the field (DSGE) has become so mesmerized with its own
internal logic that it has began to confuse the precision it has achieved
about its own world with that it has about the real one
The periphery (intersection of macroeconomics and corporate finance)
has been chasing many of the issues that played a central role during
the financial crisis
We have a tension between a type of answer we aspire to but that has
limited connection with reality (the core), and more sensible but
incomplete answers (the periphery).
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Hayek (1974)
“Of course, compared with the precise predictions we have learnt to

expect in the physical sciences, this sort of mere pattern predictions is
a second best with which one does not like to have to be content.
Yet the danger of which I want to warn is precisely the belief that in
order to have a claim to be accepted as scientific it is necessary to
achieve more. This way lies charlatanism and worse.
To act on the belief that we possess the knowledge and the power
which enable us to shape the process of society entirely to our liking,
knowledge which in fact we do not possess, is likely to make us do
much harm.”
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Lecture 0: Introduction

Introduction to Modern Macroeconomics I

Khatam University (TeIAS)

What is “Macroeconomics” about?

What determines the level of income in the economy?

Ancient U.S. History

What is “Macroeconomics” about? Output per Capita

Relative GDP per Capita: Cross Country

Relative GDP per Capita

What is “Macroeconomics” about? Output per Capita

Relative GDP per Capita

Iran’s Economy: Real Output

What is “Macroeconomics” about? Output per Capita

Iran’s Economy: Real and Nominal GDP

Iran Government spending

What is “Macroeconomics” about? Government

Iran Government spending

Iran tax revenue, percent of GDP

What is “Macroeconomics” about? Government

Iran tax revenue

What is “Macroeconomics” about? Growth Economics

“catch-up” behavior of OECD countries since 1960

Lack of convergence worldwide

What is “Macroeconomics” about? Growth Economics

Iran’s growth experience

Real Business Cycles

What is “Macroeconomics” about? Labor market

Labor Market in Iran: Population

What is “Macroeconomics” about? Labor market

Labor Market in Iran: Labor Force

Labor Market in Iran: Labor Force Participation

What is “Macroeconomics” about? Labor market

Labor Market in Iran: Unemployment

Labor Market in Iran: Employment

What is “Macroeconomics” about? Money and inflation

Distribution of cross country inflation

What is “Macroeconomics” about? Money and inflation

Iran Money: M1 (Currency in the Hands of Non-Bank

Iran Money: M1 (Demand Deposits)

What is “Macroeconomics” about? Money and inflation

Iran Money: M2 (Savings Deposits)

What is “Macroeconomics” about? Money and inflation

Iran Money Growth Rate

Theories and Models in Macroeconomics Theories and Models in Science

Theories and models

All model are:

Do NOT abandon models but understand their proper place and

Theories and Models in Macroeconomics Theories and Models in Science

Science and Models

In modern science we are trying to answer questions based on available

What Are Economic Models?

The easiest way to understand them is as simplifications designed to

Theories and Models in Macroeconomics Economic Models as Fables

Models as Fables: Dani Rodrik’s Economic Rules (2015)

Models as Fables: Dani Rodrik’s Economic Rules (2015)

Theories and Models in Macroeconomics Economic Models as Fables

Natural versus Social Sciences

Why macroeconomics (social sciences) is a science?

Consider what a lab experiment really is. The lab is an artificial

Theories and Models in Macroeconomics Economic Models as Lab Experiments

Internal versus External Validity

A well-designed experiment that successfully traces out cause and effect

Theories and Models of Modern Macroeconomics