4.5 — Modern Macroeconomics

# 4.5 — Modern Macroeconomics

## ECON 452 • History of Economic Thought • Fall 2022

### Ryan Safner Associate Professor of Economics <a href="mailto:safner@hood.edu">safner@hood.edu</a> <a href="https://github.com/ryansafner/thoughtF22">ryansafner/thoughtF22</a> <a href="https://thoughtF22.classes.ryansafner.com"> thoughtF22.classes.ryansafner.com</a>

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# Outline

### [Hayek and Austrian Business Cycle Theory](#)
### [Neo-Keynesianism](#)
### [The New Classical (Counter) Revolution](#)

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# Hayek and Austrian Business Cycle Theory

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# Hayek and Austrian Business Cycle Theory

1899-1992

Economics Nobel 1974
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]
]

- Became the major competing theory of the business cycle and macroeconomics to Keynes in 1930s

- Focus on capital theory, building off of Mises’ theory of money and credit & Wicksell’s theory of the natural rate of interest

- Revival of Austrian Business Cycle Theory (and Keynesian theory) as possible explanation of 2008-2009 financial crisis

- 1931 *Prices and Production*

- 1941 *The Pure Theory of Capital*
]
]

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# Hayek and Austrian Business Cycle Theory

1899-1992

Economics Nobel 1974
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]
]

> “Mr. Keynes’ aggregates conceal the most fundamental mechanisms of change.”
		
> “Mr. Keynes’ assertion that there is no automatic mechanism in the economic system to keep the rate of saving and the rate of investing equal might with equal justification be extended to the more general contention that there is no automatic mechanism in the economic system to adapt production to any shift in demand. I begin to wonder whether Mr. Keynes has ever reflected upon the function of the rate of interest...”

]

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# Hayek and Austrian Business Cycle Theory

1899-1992

Economics Nobel 1974
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]
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- Focuses on the role of interest rates as prices that coordinate capital investment over time
  - Higher interest rates discourage longer term, riskier projects
  - Lower interest rates encourage longer term, riskier projects
  
- Recall, interest rates are determined by the supply (time preference of savers) and demand of loanable funds

- Hayek’s work is a little abstract and difficult to follow, better interpretted by some modern Austrians
  - Garrison, Roger, 2000, *Capital-Based Macroeconomics*
]

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# Hayek and Austrian Business Cycle Theory

1899-1992

Economics Nobel 1974
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]
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> “Before we can even ask how things might go wrong, we must first explain how they could ever go right.”

]

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# Structure of Production

.pull-left[
 
- Take Menger’s idea of higher-order goods and arrange an analytical “structure of production” through time
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# Theory of Capital

.pull-left[
.smallest[
 
- Capital is .hi[heterogeneous] — not one identical aggregate “blob” `$K$`, but a variety of goods
  - e.g. beer barrels, blast furnaces, computers, trucks, hammers, etc

- Capital is .hi[specific] to particular uses and not others, with a cost of switching uses
  - e.g. can’t turn a pencil factory into a tank factory

- Capital is .hi[complementary] to other goods that must be fit together into a single plan
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]

![](../images/playdoh.png)

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# Time Preferences

.pull-left[
.smallest[
- .hi[Time-preference]: make tradeoff between present consumption and saving/investment (in hopes of *higher* future consumption)
  - Decrease in time preference: `$(I,S_1, c_1) \rightarrow (I,S_2, c_2)$`
  - Increase in time preference: `$(I,S_1, c_1) \leftarrow (I,S_2, c_2)$`
]
]
.pull-right[
.center[
![](../images/time_preference_abct.png)
]
]

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# Time Preferences and the Structure of Production

- Structure of production determined by time preferences 
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# Time Preferences and the Structure of Production

- Structure of production determined by time preferences

- Decrease in time preferences (more investment, less consumption)
  - Decreases investment in 1st-order consumption goods
  - Increases investment in earlier, higher-order goods
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# Market for Loanable Funds

- Market for loanable funds
  - .red[Supply] of savings
  - .blue[Demand] to borrow
  - determines market interest rate `$r$`
]

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# Decrease in Time Preferences

- Decrease in time preference

- Increases .red[supply of savings]

- Lowers interest rates

- Increases investment in long-term projects, decreases investment in late-stage projects
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# Economic Growth

- Economic growth
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# Economic Growth

- Economic growth
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# Bad Monetary Policy Creates Boom-Bust Cycle

- Suppose through credit expansion (Central bank monetary policy), interest rates are artificially lowered tor `$r_2$`
  - below the “natural rate” determined by real savings & demand, `$r_1$`

- At `$r_2$`, investment `$I_2>S_2$` savings

]

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# Bad Monetary Policy Creates Boom-Bust Cycle

- Creates an .hi[artificial economic boom]
  - beyond the PPF!
  - more consumption and more investment than is possible
  
- Unsustainable, cannot last
  - Some investments are not backed by sufficient real resources!
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# Bad Monetary Policy Creates Boom-Bust Cycle

- Boom will burst, requiring liquidation of bad investments, fall in consumption

- Economy will retreat *inside* of PPF

- Capital has been misallocated to wrong sectors of the economy, costly to reallocate capital to different uses
]

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# Bad Monetary Policy Creates Boom-Bust Cycle

- Boom will burst, requiring liquidation of bad investments, fall in consumption

- Economy will retreat *inside* of PPF

- Capital has been misallocated to wrong sectors of the economy, costly to reallocate capital to different uses
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# Neo-Keynesianism

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# Simon Kuznets and National Income Accounts

1901-1985

Economics Nobel 1971
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.right-column[
.smallest[
- Student of Wesley Clair Mitchell (a famous American institutionalist)
  - Worked at NBER (founded by Mitchell), empirically studying business cycles
  - 15-25 year “Kuznets cycles”

- .hi-purple[National Income Accounts], first at NBER, later at U.S. Department of Commerce
  - GDP and GNP
  - Disapproved of it as a measure of welfare:

> “the welfare of a nation can scarcely be inferred from a measure of national income.”

]

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# Simon Kuznets and National Income Accounts

1901-1985

Economics Nobel 1971
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.right-column[
.smaller[
- Work in empirical macroeconomics, compiling data on income, output, consumption, and savings
  - helped fuel the Keynesian Revolution by testing Keynesian hypotheses

- Also known for the “Kuznets curve”: an upside-down U-shaped relationship between economic growth and income inequality
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# GDP

.pull-left[
.quitesmall[
- .hi[Gross Domestic Product (GDP)]: the market value of all final goods and services produced within a country in a year

`$$Y=C+I+G+(X-M)$$`

- `$Y$`: national income
- `$C$`: consumption
- `$I$`: investment
- `$G$`: government spending
- `$X$`: exports
- `$M$`: imports

- .hi[Gross National Product]: GDP + production by citizens *living abroad*
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.pull-right[
.center[
![](../images/gdp.jpg)
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# Income, Expenditures, and the Circular Flow

- Can calculate GDP or GNI as .hi-purple[expenditures] or as .hi-purple[income]

- As expenditures:
  - consumption + investment + government spending + net exports

- As income:
  - wages + rent + capital income

- For a country: `$\sum$` expenditures `$=$` `$\sum$` income
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.pull-right[
.center[
![](../images/gdp.jpg)
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# GDP as Expenditures

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# GDP as Income

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# The Circular Flow

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# Samuelson and Keynesian Cross

1915-2009

Economics Nobel 1970
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- Samuelson’s 1948 textbook, *Economics* incorporated Keynes’ insights into neoclassical models
  - “Keynesian Cross”
  - “Liquidity trap”
  - Aggregate demand aggregate supply analysis
  - Fiscal policy & multipliers
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# Samuelson and Keynesian Cross

- Aggregate planned expenditures (aggregate demand) as dependent variable

- 45* line: “aggregate supply” — if at less than full employment, anything demanded will be supplied

- Not all expenditures are planned (some inventories unsold)

- Equilibrium: where `$AE$` intersects 45* line
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# Hicks and IS-LM

1904-1989

Economics Nobel 1972
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# Aggregate Demand & Aggregate Supply

- Take the quantity theory of money
`$$\underbrace{MV}_{\text{nominal spending}}=\underbrace{Py}_{\text{nominal income}}$$`

- .hi-blue[Aggregate demand]: all combinations of `$P$` and `$y$` consistent with same `$MV$` (nominal spending)

- Downward-sloping
  - if `$\uparrow P$`, `$\downarrow y$` (and vice versa) to maintain `$MV$`
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# Aggregate Demand & Aggregate Supply

- .hi-red[Aggregate supply]: economy has potential output determined by production function
`$$Y=f(A,L,K)$$`

- In long run: vertical, determined by these **real factors**
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# Aggregate Demand & Aggregate Supply

- Equilibrium level of `$M$` and `$y$`

- Can talk about how major changes to the economy (.hi[“shocks”])  can cause changes in `$M$` (inflation) and `$y$` (real GDP growth)

- Two major sources of shocks:

]

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# Aggregate Demand & Aggregate Supply

- Equilibrium level of `$M$` and `$y$`

- Can talk about how major changes to the economy (.hi[“shocks”])  can cause changes in `$M$` (inflation) and `$y$` (real GDP growth)

- Two major sources of shocks:
  - .red[Aggregate Supply shocks]
]

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# Aggregate Demand & Aggregate Supply

- Equilibrium level of `$M$` and `$y$`

- Can talk about how major changes to the economy (.hi[“shocks”])  can cause changes in `$M$` (inflation) and `$y$` (real GDP growth)

- Two major sources of shocks:
  - .red[Aggregate Supply shocks]
  - .blue[Aggregate Demand shocks]
]

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# Keynesian Aggregate Demand Management

.pull-left[
.smaller[
- .hi-purple[(Neo)-Keynesians] emphasize .hi-purple[insufficient aggregate demand]
  - Consumption affected by MPC
  - Investment driven by “animal spirits”

- Government spending can makeup shortfalls in C, I, to achieve high nominal spending `$(MV)$`
  - public works programs
  - fiscal policy
  - “priming the pump” and “steering the economy”

]
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.pull-right[
.center[
![](../images/ad_shocks.png)
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# Keynesian Models of the Macroeconomy

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- Many Neo-Keynesian economists focused on making large-scale (macro)econometric models of the economy

- Deriving optimal fiscal policies by exploiting past empirical relationships

- Left: [Bill Phillips with the hydraulic computer “modeling” the macroeconomy](https://www.econ.cam.ac.uk/economics-alumni/drip-down-economics-phillips-machine)

]

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# Neo-Keynesian Models of the Macroeconomy

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- Most famous example, the .hi[Phillips curve]
  - William Phillips discovered the apparent empirical relationship between historical levels of unemployment and wages in U.K. (1861-1913)

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# Neo-Keynesian Models of the Macroeconomy

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- Samuelson & Solow made this empirical discovery an **explicit** functional relationship in the economy between unemployment and inflation

- Assume this relationship is exploitable by policymakers, who can “choose” the tradeoff between unemployment and inflation for the macroeconomy

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# The New Classical (Counter) Revolution

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# Friedman and Monetarism

1912-2006

Economics Nobel 1976
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- Work on consumption function: permanent income hypothesis, consumption smoothing

- Many macroeconomic problems are caused by bad monetary policy
  - Great Depression prolonged by bad Federal Reserve policy

- “Inflation is always and everywhere a monetary phenomenon”

- Importance of rules vs. discretion

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# New Classical Macroeconomics

1937—

Economics Nobel 1995
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- .hi[“Lucas Critique”]: relationships that *appear* to hold in a model cannot be *exploited* by policymakers, because changing policy *changes the relationships* in the real world
  - Macroeconomic relationships are endogenous to policy
  - .hi-green[Example:] “the Phillips curve”: cannot derive an econometric model of the macroeconomy *and then use it* to make policy

- Begins the call for .hi-purple[microfoundations of macroeconomics]
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# New Classical Macroeconomics

R: Finn Kydland
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- .hi[“New Classical” Macroeconomics]
  - rejection of Keynesian aggregate demand theory and macroeconometric modeling
  - focus on **real** determinants of economic growth and fluctuations
  - .hi-purple[microfoundations of macroeconomics]

- Rational expectations

- Real business cycle theory

- Representative agents
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# New Classical Macroeconomics

- .hi[“Real Business Cycle” Theory]
  - most recessions in history (even pre-capitalism) came from negative supply shocks
  - war, famine, bad weather, **pandemics**, bad harvest, oil shocks, etc.

- Only changes in real productivity (short run and long run) determine outcomes
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# DSGE Models

- Most modern macroeconomic models, following the New Classical approach, are some variant of .hi[Dynamic Stochastic General Equilibrium (DSGE)] model
  - **Dynamic**: model the change over time from individual choices made from expectations formed under uncertainty
  - **Stochastic**: introduce random shocks into the model to see how people react, changing their behaviors, and how this affects the economy
  - **General equilibrium**: Walrasian-style simultaneous determination of price and output levels across markets
  
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# DSGE Models

- .hi-purple[Microfoundations]: model from individual level and aggregate upwards
  - households own and supply labor (and other resources) and demand output
  - firms hire labor (and other factors) and produce output to sell to households
  - assume competitive markets, flexible prices, rational expectations, etc.
  
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# *“New Keynesian”* DSGE Models

- .hi[New Keynesians] (Mankiw, Krugman, Stiglitz, Bernanke, Yellen, Summers) criticize the assumptions of New Classicals/DSGE modeling, and update it with more Keynesian assumptions:
  - imperfect competition, firms have monopsony power/monopoly power
  - wages and prices are sticky, don't change easily, “menu costs”
  - .hi-purple[“macrofoundations of microeconomics”]

- .hi[New Neoclassical synthesis]: mainstream macro today largely DSGE with insights of New Classicals with New Keynesian assumptions

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# What Are We Leaving Out (For Time)?

- Among other important things...

- Cambridge capital controversy
  - can’t aggregate capital
  - Robinson & Sraffa (Cambridge, UK) vs. Samuelson & Solow (Cambridge, Mass)

- Growth theory
  - Exogenous growth model (Harrod-Domar, Solow)
  - Endogenous growth model (Romer)

- Post-Keynesianism
  - coordination failures, disequilibrium expectations
  - Robinson, Leijonhufvud, Davidson
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# A Good Summary