EC4102 Macroeconomic Analysis III
AY2014/2015 Semester 1, Lecturer: Aamir Rafique Hashmi
Course Coverage:
1. Ramsey-Cass-Koopmans Model (RCK)
2. Overlapping-Generations Model (OLG)
3. Research & Development Models (R&D)
4. Romer's Model
5. Real Business Cycle Model (RBC)
6. New Keynesian Models (NKM)
This most interesting module of the semester introduces macroeconomics in a very different light from EC2102 and EC3102. This module discards the popular IS-LM analysis framework right from the very beginning, delving into the dynamics of macroeconomics in a very quantitative manner. Throughout the module, different models were introduced for the analysis of problems in different settings. All these models are highly mathematical by nature, and this is the biggest difference between advanced and intermediate macroeconomics. In this module, both the derivation and understanding of the results of the standard models are crucial because most problem sets given by Dr. Hashmi require some form of derivation before the analysis of results. Thus, competency in mathematics is an advantage in this course.
At the very beginning of the module, Dr. Hashmi provided a brief recap of the Solow-Swan model, or more commonly known as Solow's Growth Model, pointing out that the model provides good economic intuitions but does not involve any consumption optimization. In short, the fixed saving rate in Solow's model says nothing about the households' saving behaviours. Subsequently, the RCK model was introduced as a comparison in continuous time. The RCK model is built on the assumption that household chooses a dynamically-optimal consumption bundle depending on a range of variables, including interest rate, technology growth rate and utility discount rate. The firms are assumed to be perfectly competitive in the model, resulting in a socially-optimum economic growth. Introduced together with this model is the phase diagram, which plots the dynamics of the model against the saddle path that leads to the stable equilibrium. Thus, the RCK model provides a solid framework for comparative dynamics, allowing the analysis of both short-run and long-run effects of shocks in the economy.
The second model introduced is the OLG model. The most important feature of this model is its multigenerational assumption, resulting in the population heterogeneity. The derivations are straightforward but the results are interesting because they introduce the possibility of dynamic inefficiency that arises from over-saving.
Also called Endogenous Growth Models, R&D models attempt to model endogenous technological growth in the economy. The basic R&D models, like the Solow-Swan model, provides a good economic intuition but lacks microeconomic-foundations. The Romer model constructs an endogenous growth model from microeconomic-foundations and argues that technology is not a public good but an intentional investment in research and development that needs to be paid for. Romer's model consists of 3 sectors. The research sector that drives technological growth by producing new designs, the intermediate sector that produces intermediate goods using the new designs in a monopolistic market and the final good sector that uses the intermediate goods as inputs to produce outputs consumed by households. The intermediate sector is formulated as a monopolistic market because each new design produced in the research sector has to be paid, and this can only be financed with the positive profits of the intermediate firm. Using Pontryagin's Maximum Principle, Romer then showed that a social planner unconcerned with prices will allocate more human capital to the research sector, resulting in a socially optimal economic growth rate higher than that derived in the market economy.
The last chapters cover the two main areas of macroeconomic research today: Real Business Cycle Theory and New Keynesian Economics. The RBC model was introduced by Kydland and Prescott in their 1982 work "Time to Build and Aggregate Fluctuations". The RBC theory suggests that the business cycle fluctuations observed in the data are efficient responses to the exogenous changes in the real environment. The corresponding model attempts to characterize this observation by introducing technological shocks to drive output in the economy. While Kydland and Prescott managed to correlate up to 70% of the fluctuations in output to changes and growth in technology, the model failed to explain a few key issues in macroeconomics. First, the model cannot pinpoint the specific shocks that drive the fluctuations. Second, the model simply attributes the high unemployment rates in the data to supply-side decisions in the market, ignoring the demand side of labour. Furthermore, non-Walrasian features such as labour market frictions and financial market frictions are ignored. Lastly, the model rejects monetarism despite overwhelming evidences of the slow adjustment in wages and prices. Nevertheless, the paper won Kydland and Prescott the Nobel Memorial Prize in Economic Sciences in 2004 for its way of modeling macroeconomics variables with microeconomic foundations.
On the other hand, New Keynesian Economics is the school of economics that integrates the RBC methodology into the traditional Keynesian Economics. The NKMs, developed as a response to the New Classical Macroeconomics represented by the RBC theory, incorporates a variety of market failures to account for the slow adjustment in wages and prices, and the need for monetary policies. Both the static and dynamic NKMs are used to investigate price rigidity in markets. In the static model, two plausible causes of price rigidity proposed are menu costs and labour market frictions. Firms are also assumed to operate in the monopolistic competition setting to justify their price setting abilities. In the dynamic version, expectations and information also contribute significantly to the incomplete nominal adjustments in the market. In particular, the two implications are (1) unexpected demand shift has real effects and (2) money-related information available between events affect output. These implications are highly significant as they explained the observations where the classical dichotomy has failed.
This module is very useful for undergraduates who wish to either conduct macroeconomic research or seek entry to central banks and public sectors. The module itself, though rich in its qualitative implications, is also highly quantitative. Thus, it is important to revise and practice the necessary mathematical skills and link them to the relevant content as the chapters progress.
Workload: Heavy
Difficulty: Difficult
Grade: A
Course Coverage:
1. Ramsey-Cass-Koopmans Model (RCK)
2. Overlapping-Generations Model (OLG)
3. Research & Development Models (R&D)
4. Romer's Model
5. Real Business Cycle Model (RBC)
6. New Keynesian Models (NKM)
This most interesting module of the semester introduces macroeconomics in a very different light from EC2102 and EC3102. This module discards the popular IS-LM analysis framework right from the very beginning, delving into the dynamics of macroeconomics in a very quantitative manner. Throughout the module, different models were introduced for the analysis of problems in different settings. All these models are highly mathematical by nature, and this is the biggest difference between advanced and intermediate macroeconomics. In this module, both the derivation and understanding of the results of the standard models are crucial because most problem sets given by Dr. Hashmi require some form of derivation before the analysis of results. Thus, competency in mathematics is an advantage in this course.
At the very beginning of the module, Dr. Hashmi provided a brief recap of the Solow-Swan model, or more commonly known as Solow's Growth Model, pointing out that the model provides good economic intuitions but does not involve any consumption optimization. In short, the fixed saving rate in Solow's model says nothing about the households' saving behaviours. Subsequently, the RCK model was introduced as a comparison in continuous time. The RCK model is built on the assumption that household chooses a dynamically-optimal consumption bundle depending on a range of variables, including interest rate, technology growth rate and utility discount rate. The firms are assumed to be perfectly competitive in the model, resulting in a socially-optimum economic growth. Introduced together with this model is the phase diagram, which plots the dynamics of the model against the saddle path that leads to the stable equilibrium. Thus, the RCK model provides a solid framework for comparative dynamics, allowing the analysis of both short-run and long-run effects of shocks in the economy.
The second model introduced is the OLG model. The most important feature of this model is its multigenerational assumption, resulting in the population heterogeneity. The derivations are straightforward but the results are interesting because they introduce the possibility of dynamic inefficiency that arises from over-saving.
Also called Endogenous Growth Models, R&D models attempt to model endogenous technological growth in the economy. The basic R&D models, like the Solow-Swan model, provides a good economic intuition but lacks microeconomic-foundations. The Romer model constructs an endogenous growth model from microeconomic-foundations and argues that technology is not a public good but an intentional investment in research and development that needs to be paid for. Romer's model consists of 3 sectors. The research sector that drives technological growth by producing new designs, the intermediate sector that produces intermediate goods using the new designs in a monopolistic market and the final good sector that uses the intermediate goods as inputs to produce outputs consumed by households. The intermediate sector is formulated as a monopolistic market because each new design produced in the research sector has to be paid, and this can only be financed with the positive profits of the intermediate firm. Using Pontryagin's Maximum Principle, Romer then showed that a social planner unconcerned with prices will allocate more human capital to the research sector, resulting in a socially optimal economic growth rate higher than that derived in the market economy.
The last chapters cover the two main areas of macroeconomic research today: Real Business Cycle Theory and New Keynesian Economics. The RBC model was introduced by Kydland and Prescott in their 1982 work "Time to Build and Aggregate Fluctuations". The RBC theory suggests that the business cycle fluctuations observed in the data are efficient responses to the exogenous changes in the real environment. The corresponding model attempts to characterize this observation by introducing technological shocks to drive output in the economy. While Kydland and Prescott managed to correlate up to 70% of the fluctuations in output to changes and growth in technology, the model failed to explain a few key issues in macroeconomics. First, the model cannot pinpoint the specific shocks that drive the fluctuations. Second, the model simply attributes the high unemployment rates in the data to supply-side decisions in the market, ignoring the demand side of labour. Furthermore, non-Walrasian features such as labour market frictions and financial market frictions are ignored. Lastly, the model rejects monetarism despite overwhelming evidences of the slow adjustment in wages and prices. Nevertheless, the paper won Kydland and Prescott the Nobel Memorial Prize in Economic Sciences in 2004 for its way of modeling macroeconomics variables with microeconomic foundations.
On the other hand, New Keynesian Economics is the school of economics that integrates the RBC methodology into the traditional Keynesian Economics. The NKMs, developed as a response to the New Classical Macroeconomics represented by the RBC theory, incorporates a variety of market failures to account for the slow adjustment in wages and prices, and the need for monetary policies. Both the static and dynamic NKMs are used to investigate price rigidity in markets. In the static model, two plausible causes of price rigidity proposed are menu costs and labour market frictions. Firms are also assumed to operate in the monopolistic competition setting to justify their price setting abilities. In the dynamic version, expectations and information also contribute significantly to the incomplete nominal adjustments in the market. In particular, the two implications are (1) unexpected demand shift has real effects and (2) money-related information available between events affect output. These implications are highly significant as they explained the observations where the classical dichotomy has failed.
This module is very useful for undergraduates who wish to either conduct macroeconomic research or seek entry to central banks and public sectors. The module itself, though rich in its qualitative implications, is also highly quantitative. Thus, it is important to revise and practice the necessary mathematical skills and link them to the relevant content as the chapters progress.
Workload: Heavy
Difficulty: Difficult
Grade: A