Slides 4 For the Final Exam

Homework A

Intertemporal Budget Constraint (IBC)

Preference

Dynamic Optimization

Calculus

Calculus Two

Euler Equation (First Order Condition)

Interpretation

Log Utility Function

Solution of Dynamic Optimization

Exercise

Ricardian Equivalence

Smooth Consumption

Random Walk

New-Keynesian Theory I

New-Keynesian Theory II

Let’s Summarize mTOc mTOc xCU xCU

History of Macroeconomics Classical model (Adam Smith, David Ricardo, Thomas Malthus) Markets clear by themselves Key assumption: prices are flexible Policies (and government) are not needed Policies can create inefficiency, e.g., tax, minimum wage, tariff

What’s Wrong?

Great Depression Widespread and sustained unemployment (surplus in labor market) Signal for market failure Classical model cannot explain Here comes Keynesian theory which focuses on insufficient demand (after stock market crash)

Model of Sticky Prices Keynes believes that one reason for unemployment is sticky nominal wage Keynes believes more spending is needed to raise the price level and lower real wage Can you draw a graph?

World War II Keynes believes WWII cut short of great depreciation Government expenditures rises Through multiplier effect, income rises more than the increase in G So broken window can be good. In long run we are all dead.

Phillips Curve Keynes ignores the role of expectation Therefore he believes in a negative relation between inflation and unemployment, i.e., a fixed Phillips curve Can you draw a graph? Then here comes stagflation in 1970s

What’s Wrong?

Stagflation In 1970 both unemployment rate and inflation rate rose can be explained by expectation-augmented Phillips curve Lucas critique: econometrics cannot be used to estimate Phillips curve because we cannot assume fixed expectation

Micro Foundation Hayek and Lucas emphasize the microeconomic foundation for macroeconomics, Keynes does not. The basic model is a two-period utility maximization problem

New Classical Theory Permanent income hypothesis Random walk hypothesis for consumption Ricardian equivalence Smooth consumption The new classical theory indicates very small multiplier effect.

Real Business Cycle Theory is built upon the new classical theory Emphasizes that markets clear by themselves, economy can be self-correcting Unemployment (intertemporal labor substitution) is voluntary Fluctuation in income (business cycle) is a Pareto Efficient. Government had better do nothing.

Dynamic Stochastic General Equilibrium (DSGE) models The simple two-period model can be generalized Multiple periods Random variables General equilibrium To much for this course

New Keynesian Theory Keynesian school is fighting back Micro foundation is used Market can still fail due to various reasons Borrowing constraints, sticky prices, etc So policy is needed to fix market failure

Who are they? Classical approach: Friedrich Hayek*, Robert Lucas*, Robert Barro, Edward Prescott* Keynesian approach: John Keynes, Paul Krugman*, Larry Summers, Ben Bernanke, Joseph Stiglitz*, Gregory Mankiw Extreme Keynesian approach: ?

Yeah. It’s Me!

Marxian Economics People are greedy Income gap and social instability are inevitable Widespread market failure (e.g., no health insurance market for the poor, great depression) Government needs to do everything (planned economy) Fatal drawback: incentives are ignored

(Most) People are Thin in Planned Economy AFkc AFkc

Truth? Somewhere in middle. Macroeconomics is still a growing baby. There are many unsettled issues For example, introduce game theory to Macro?