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# MACROECN ANLYS I ECON 502

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This 12 page Class Notes was uploaded by Miss Adeline Weimann on Wednesday September 9, 2015. The Class Notes belongs to ECON 502 at University of Washington taught by Staff in Fall. Since its upload, it has received 10 views. For similar materials see /class/192481/econ-502-university-of-washington in Economcs at University of Washington.

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Date Created: 09/09/15

ECON 502 MIDTERM REVIEW SHEET Modi ed Oct 30 2008 TA Edwin Wong General Remark The goal of this handout is to start getting you prepared for the first exam The handout covers most of the main issues that we have discussed in class or in the book to this point Note that I have basically condensed the lectures notes and the readings from Romer s Advanced Macroeconomics However this is just a guide and is absolutely not a substitute for reading the notes or the book I have included no math The exam will also contain one or two long problems with multiple parts so you should be prepared for some math as well One warning is to not become too focused on the math The style of questions asked look to test your economic understanding of models pertaining to aggregate supply MAIN POINT of the First Half of the Class Our main goal has been to explain short run aggregate fluctuations in the economy by looking at nominal and real rigidities through agents wage and price setting decisions expectation formation menu costs labor markets imperfections etc In particular under different assumptions about the adjustment of prices and wages how do output employment the price level and other variables react to shocks especially monetary shocks 1 Main T enets at the Class Here are a few concepts that are critical for you to understand If you do not know these at a very intuitive level then it is highly likely that you will not understand the material 1 De nition monetary neutrality the concept that changes in the money supply do not affect real variables output employment etc 2 De nition classical dichotomy classical economic theory says that there exists a separation between nominal and real variables Monetary disturbances cause all nominal prices and wages to change proportionally leaving all real variables unchanged 3 What does it mean to quotsolvequot a model The solution of a model in economics is to solve a endogenous variables as functions of exogenous variables Notice that you are doing this in microeconomics as well 4 Every model in economics has some equilibrium concept associated with it There are many different types of equilibriums within models You will see what I mean as we go along Just be conscious of it 2 Main Questions That We Are Interested in Answering 1 Does monetary neutrality hold in the shortrun and in the longrun If monetary neutrality holds it implies a vertical AS curve 2 How do we model Aggregate Demand 3 How do we model Aggregate Supply 4 Many current decisions are based upon an agent39s belief or expectation about what will happen in the future How do we mathematically model an agent39s expectations 5 What is the nature of the nominal rigidity ie there are many reasons why nominal wages and prices may not adjust freely Why is the specific reason important What are its implications for policy 6 Can active monetary policy stabilize output even under rational expectations 7 What are some economic facts that appear in the data that we must explain real wages appear to be moderately procyclical if not acyclical real wages do not uctuate substantially relative to uctuations in the amount of unemployment this will be important in later models labor supply appears to be inelastic 3 Main Pagers Here is a list of papers or models we explicitly discussed in class I will review the main points of them as we continue 1 ISLM or ISMP model 2 The Phillips Curve and Friedman s 1968 address Lucas Supply model 1972 and the introduction of rational expectations Lucas Critique 1976 SargentWallace 1975 and policy irrelevance 3 4 5 6 Barro 7 Fischer 1977 contracting model 8 Taylor contracting model 9 Gray39s model of incomplete indexation 10 Mankiw 1985 and Romer menu cost models 11 BlanchardKiyotaki model monopolistic competition 12 Caplin Spulber CaplinLeahy state contingent pricing 13 ShapiroStiglitz s model efficiency wages Ask vourself the following7 questions about each model 1 What question was each author trying to answer when they built the model 2 From what perspective were they writing ie classical New Keynesian 3 What was their conclusion Especially on monetary neutrality issue 4 What are the main weaknesses with their models stories 4 Model I ISLM and ISMP Models 1 These models are models for Aggregate Demand 2 The ISLM and ISMP models say NOTHING about Aggregate Supply They assume a priori that the supply curve is elastic nonvertical over the shortrun This is a key point 3 The models ASSUME money is nonneutral but they DO NOT explicitly model it or provide a reason for it 4 Assuming nonneutrality can be a problem because as we will see in more advanced models why a model exhibits nonneutrality is really important 5 The ISLM and ISMP build justifications for Aggregate Demand by modeling how some key variables in the economy are determined consumption investment government expenditures etc 6 Since the AS curve is not vertical the AD curve determines output and the price level 41 Problems with the model 1 No forward looking agents It does not explicitly have expectations 2 No microfoundations It assumes adhoc relationships among variables in the sense that they are NOT derived from optimizing agents ie pro t maximization utility maximization welfare loss functions etc 42Mv Best Guess at What You ShouldKnow 1 Know the basic ISLM and ISMP equations 2 What are the endogenous and exogenous variables within each model 3 Know how to derive the IS LM and MP curves 4 Know how slopes of these curves matter 5 Know how to do comparative statics and use it to analyze policy This means that you should feel comfortable solving the model by Cramer39s Rule 5 Model II Friedman 1968 and the 39 1 Phillips Curve Early models of nominal stickiness included wage and price setting rules that depended on the wages and prices set in previous periods This led to the discovery of the Phillips Curve which implies a tradeoff between unemployment and in ation The problem with early models was that it implied a permanent tradeoff that policymakers could always exploit As Friedman pointed out the Phillips Curve went against classical economic theory Friedman predicted that the Phillips Curve could not be correct It implied that monetary neutrality did not hold in the longrun Think about what this says the government could literally continue to print money and output would keep rising inde nitely This led to two things 1 Friedman s natural rate hypothesis in the longrun real variables such as output are determined by real factors in the economy such as productivity natural resources technology etc Hence in the longrun real variables will tend back towards their quotnatural ratequot 2 Expectations augmented Phillips Curve 75 f 73956 5 Kev Points to make sure vou know 1 In the shortrun people s expectations of future in ation are xed 2 However over the longrun expectation will equal actual in ation as people will adjust their expectations 3 Researchers at this time started estimating the following regression 7T 17 YEW 4 Friedman39s hypothesis about the adjustment of expectations meant that y 1 5 y is the rate at which people s expectations affect current in ation 6 If the Phillip39s Curve is vertical then 7 1 7 Potential problem 73956 is an unobserved variable How do we model 73956 mathematically Does it matter 8 Friedman suggested quotadaptive expectationsquot where you set 73956 equal to lags of past in ation 52Mv Best Guess at What You Need to Know 1 Know Friedman s critique of the Phillip39s Curve 2 Know what Friedman39s natural rate hypothesis is A 3 Know the regression people were running Can you explain the intuition behind the slope of the Phillips Curve 6 Model III Lucas and the Introduction of Rational F Beginning with Friedman39s results on the formation of expectations Lucas showed that how a researcher models expectations is critical Using adaptive expectations meant that the results many results researchers were getting were wrong Rational expectations is a mathematical method of modeling 6 Lucas39Main Points 1 Under rational expectations the Friedman regression that people were running was meaningless Researchers weren39t estimating y in the model You should know the difference between adaptive expectations and rational expectations 2 Lucas Critique for Policy Evaluation A researcher must acknowledge that policy is NOT an exogenous variable in a model as it is in the ISLM It is an endogenous variable and it affects how people form their expectations 3 Expectations are formed endogenously in rational expectations models This is what makes it quotrationalquot The theory of rational expectations assumes that agents are rational enough to know the quottrue modelquot and can use it to form expectations Secondly agents are quotrationalquot enough that they can use the conditional expectations operator from stats to form expectations 4 When a policymaker changes policy the model must be resolved to determine how an individual will reformulate their expectations 5 One must focus on structural equations where policy is a function of past predetermined variables to understand a policy39s effects 6 NOTE The Lucas Critique DOES NOT imply that policy is irrelevant 62 Know how to solve a rational 39 model 1 Identify whether each variable in the model is endogenous or exogenous 2 Note any variables that are determined by agent39s expectations For example wages may be set as an expected future price 3 Solve for all endogenous variables that are expectations 4 Solve for any remaining endogenous variables as functions of exogenous variables g Q What are the three tenets of RE that Professor Chen discussed in class 7M0del IV Lucas Island Model and theAggregate 14221 Curve Lucas developed this model to explain why the aggregate supply curve is NOT vertical in the short run ie why monetary neutrality does not hold in the SR The idea is that agents have imperfect information about the shocks hitting the economy There are economy wide shocks and there are shocks that are specific to the firm However if individual firms cannot distinguish between the two then money will have real effects 71 Ke 0mm 0 this model 1 Producer s optimal price depends on his price relative to the prices of other firms in the economy Only relative prices matter Hooray for micro 2 Hence economy wide shocks would not alter relative prices only sectoral shocks would if there were perfect information However under imperfect information assumption individuals might respond to wrong signals even if they are behaving rationally 3 This creates nominal stickiness in the price level and also monetary shocks have real effects 4 Lucas Supply Curve 2 T y elipr Et lpt Where 6 3912 02 It states that the departure of output from its normal level is an increasing function of the surprise in the price level 5 Hence a systematic monetary rule would have no effect on real economy 6 Moreover there is no exploitable tradeoff between high output and low in ation in the long run since the monetary shocks that are unexpected in the short run would become a part of the information set in the long run 7 Lucas 1973 AER tested the signal to noise ratio in 6 by comparing high in ation countries with unstable monetary policies eg Argentina and Paraguay and low in ation countries with more stable policies The study showed that the countries in the first group has a steeper AS that is AD shocks are less effective in these countries 72 Problems with the Model 1 Employment uctuations in the model arise from changes in labor supply in response to changes in the bene ts of working Hence it requires a signi cant amount of shortrun elasticity of labor supply The data does not support highly elastic labor supply 2 It is highly unlikely that producers will have signi cant imperfect information about the general price level especially in developed countries 3 Another critique There are many cases where credible announced monetary policy has been effective against in ation 73 Mv Best Guess at What You Need to Know 1 Know what certainty equivalence is and how Lucas uses it in his model Also know how to solve a basic model like in the PS3 Q6l 2 Know how rational expectations ts into the derivation of the model 3 Know the signal extraction idea Know what happens to signaltonoise ratio when variance of money or the variance of AD shock is at the extreme ie very small or very big 8 Model V Sargent Wallace Model of Policy Irrelevance At this point in economic history researchers became interested in the following What is the relationship between anticipated and unanticipated money Can rational expectations eliminate the stabilizing effect of policy suggested by Keynesian theory Sargent and Wallace claimed that under RE systematic policy will have no effect on output Instead output is a function of surprise or unexpected money Their key equation is y MM EM1v Ev1 where e 12 02 This means that the central bank can only affect the output by being erratic ie only unexpected money matters 83 Mv Best Guess at What You Need to Know 1 How does Sargent and Wallace incorporate rational expectations and the Lucas supply function in showing their policy irrelevance result 2 Sargent s Observational Equivalence idea and how he showed it Refer to PS3 Q63 7 3 Barro s rebuttal of the OE and how he proposed to test the effects of unexpected and expected money 9 Model VI Fischer Contractin Model 0fPredetermined Wages Fischer s one main contribution is that he showed that RE wasn t enough to conclude that systematic money is ineffective as suggested by SargentWallace His model shows that when wage contracts are long enough a deterministic monetary rule CAN stabilize the output and the employment over the shortrun Predetermined Qrices Prices or wages are set ahead of time for future periods but the price for each period may be different 9 Key Points 1 This is a nonmarket clearing model 2 Under simplistic assumptions first it demonstrates that one can generate SW result of policy irrelevance 3 Then under a slightly more complicated contract structure where contracts are staggered the model demonstrates that output is a function of money 4 Monetary policy can t change average output ie it can not change the natural rate of output ie Friedman 5 However monetary policy m systematically stabilize output around the natural rate of output 6 There is persistence in output for as long as there are sticky contracts 7 The paper implies that the length of sticky contracts should be investigated 92 Problems with the Fischer model 1 This model implies that the real wage should be countercyclical Empirically the real wage is acyclical if not possibly procyclical 2 The end result is that modeling a procyclical real wage is difficult One generally needs to assume some form of imperfect competition see Romer 281 3 The Fischer model also forces a fixed percentage of firms to adjust prices each period In essence if a radical event happened then the model would still allow only a fixed percentage to change This is unrealistic 93 M 1 best guess at what you should know 1 In a rational quot framework key words in conjunction with a contracting model how do we get policy relevance What must the model include 1 Bigger information sets on the part of policymakers 2 Predetermined wages 3 There must be first order serial correlation in terms of AD shocks 2 Know that real rigidity alone does not cause monetary disturbances to have real effects Prices have to be rigid see Romer 10 Model VII Grav s model of 39 39 39 1 The model Professor Chen derived in class was simple and pretty selfexplanatory I m not going to bother writing much Basically the key point of the model is that in an economy with both real and nominal shocks it would not be optimal to have full indexation Nominal pricing ie lack of fullindexation provides insulation against nominal shocks In addition to understanding the implications of indexing think about how the optimal 6 is actually set The results and implications in Romer s problem 69 as well as the corresponding truefalse questions should give you a good feel for the implications of the model Make sure you go back and take a look 11 Model VIII T avlor s model of preset wages and prices See Key Point 1 for why this model was a contribution beyond the Fischer model Preset wages prices wages are specified in contracts and are the same for each period that the contract is in effect 1 11 Key Points l Wheras the predetermined wage model predicts persistence in output during the period of adjustment this model implies that shocks to aggregate demand have longlasting effects on outputeffects that persist even after all pricesetters have changed their prices See the notes from section for an example of this 2 This is an important point for Keynesian Theory 3 See page 323 of Romer for more on this and also problem 615 0 4 How do rational expectations play a role in this model specifically in the manner in which rms set prices 112Mv best guess at what you should know 1 Know the difference between preset and predetermined contracts 2 Know Key Point 1 11 Model IX Menu Cost Models Mankiw and BlanchardKilgotaki The problem with nominal rigidities in the Lucas Fischer and Taylor models is that they are imperfections that could be overcome rather easily Menu cost models try to solve this problem by showing that small imperfections at the micro level have large macroeconomic effects The idea is that firms may maintain a rigid price that is suboptimal if there exists a fixed cost to changing price See Romer for motivation behind why menu cost models are important 11 Problems with the model 1 The problem with the menu cost story alone is that empirically real wages don t fall significantly when output and labor demand fall This means that menu cost models need labor supply to be very elastic And empirically labor supply seems to be inelastic N Menu costs must be large E It seems that for menu cost models to work a researcher must add a labor market imperfection This leads to models of real rigidity see Romer page 294 112Mv best guess at what you should know 1 Know the intuition behind Monopolistic competition Professor Chen gave a nice definition in class and see her notes on the subject 2 Why must the model have imperfect competition 3 Know what an aggregate demand extemality is 4 Know the reasoning behind why menu costs alone can not work as an explanation for monetary nonneutrality 12 Model X State Contingent Pricing CaninSgulber This model is in response to menu cost models and introduces the element of endogeneity in price setting The idea is that rms are indifferent between the existing price and the optimal price p provided that the different between the two prices is within a range S Only when the price fall out of range does the rm incur the menu cost and change price Under strict assumptions Caplin and Spulber show that anticipated changes in money have no effect on aggregate output 12 M 1 best guess at what you should know 1 Understand why these models are so called elevator models 2 In the basic CaplinSpulber model how does a firm set price Why 3 The result of monetary neutrality is based on strict assumptions which are not completely plausible Consider other conditions which may result in nonneutrality Conditions include twosided shocks convex costs of price adjustment large discrete shocks 13 Model XI Models of real rigidity ShaQiroStiglit After the menu cost literature we need to find a real rigidity The point of this line of research We need an explanation for why we see large movements in employment and small movements in the real wage see Romer the bottom of page 442 Professor Chen listed 3 common sources of real rigidity l efficiency wages 2 unionsearchmatching 3 implicit contracts In the ShapiroStiglitz model monitoring costs create a real wage an efficiency wage that is above the Walrasian perfect competition equilibrium which implicitly assumes that firms have the ability to perfectly monitor workers Since wages are above the equilibrium they may be efficient for the firm but are inefficient from a macro point of view 12 M 1 best guess at what vou should know 1 Know the reasoning behind why neither real rigidity sticky wages nor menu costs nominal rigidity alone give nonneutrality You need both to get monetary nonneutrality 2 Know the basics behind how the ShapiroStiglitz model works 11

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