Macroeconomics the development of modern methods for policy analysis by william scarth dr soc

Macroeconomics Macroeconomics The Development of Modern Methods for Policy Analysis William Scarth McMaster University, Canada Edward Elgar Cheltenham, UK • Northampton, MA, USA © William Scarth 2014 All rights reserved No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc William Pratt House Dewey Court Northampton Massachusetts 01060 USA A catalogue record for this book is available from the British Library Library of Congress Control Number: 2013946808 ISBN 978 78195 387 (cased) ISBN 978 78195 388 (paperback) ISBN 978 78195 389 (eBook) 03 Typeset by Servis Filmsetting Ltd, Stockport, Cheshire Printed and bound in Great Britain by T.J International Ltd, Padstow Contents in brief Preface                   10 11 12 Keynes and the Classics The first Neoclassical Synthesis Model-­consistent expectations The micro-­foundations of modern macroeconomics The challenge of New Classical macroeconomics The New Neoclassical Synthesis Stabilization policy controversies Structural unemployment Unemployment and low incomes: applying the theory Traditional growth theory New growth theory Growth policy References Index ix 22 39 67 96 122 150 184 203 228 253 276 303 317 Contents in full Preface ix   Keynes and the Classics 1.1 Introduction 1.2 The textbook Classical model: the labour market with flexible wages 1.3 The textbook Keynesian model: the labour market with money-­wage rigidity 1.4 Generalized disequilibrium: money-­wage and price rigidity 1.5 The New Classical model 1.6 Conclusions 1 10 13 18 20   The first Neoclassical Synthesis 2.1 Introduction 2.2 A simple dynamic model: Keynesian short-­run features and a Classical full equilibrium 2.3 The correspondence principle 2.4 Can increased price flexibility be destabilizing? 2.5 Monetary policy as a substitute for price flexibility 2.6 Conclusions 22 26 29 34 38   Model-­consistent expectations 3.1 Introduction 3.2 Uncertainty in traditional macroeconomics 3.3 Adaptive expectations 3.4 Rational expectations: basic analysis 3.5 Rational expectations: extended analysis 3.6 Conclusions 39 39 42 51 53 58 63   The micro-­foundations of modern macroeconomics 4.1 Introduction 4.2 The Lucas critique and related controversies 4.3 Household behaviour 4.4 Firms’ behaviour: factor demands 4.5 Firms’ behaviour: setting prices 4.6 Conclusions 67 67 67 75 84 89 93 22 22 Contents in full  ·  vii   The challenge of New Classical macroeconomics 5.1 Introduction 5.2 The original real business cycle model 5.3 Extending and using the real business cycle model 5.4 Optimal inflation policy 5.5 Harberger triangles versus Okun’s gap 5.6 Conclusions 96 96 97 100 111 116 121   The New Neoclassical Synthesis 6.1 Introduction 6.2 Phase diagram methodology 6.3 Stabilization policy analysis with a ‘new’ Phillips curve 6.4 Some precursors of the new synthesis 6.5 An integrated analysis: a ‘new’ IS curve and a ‘new’ Phillips curve 6.6 Conclusions 122 122 123 132 133   Stabilization policy controversies 7.1 Introduction 7.2 Commitment and dynamic consistency in monetary policy 7.3 A constraint on monetary policy: currency union 7.4 A constraint on monetary policy: the zero lower bound on nominal interest rates 7.5 The feasibility and desirability of bond-­financed government budget deficits 7.6 Conclusions 150 150 151 162   Structural unemployment 8.1 Introduction 8.2 Asymmetric information in the labour market: efficiency wages 8.3 Imperfect competition in the labour market: unions 8.4 Transaction frictions in the labour market: search theory 8.5 Related issues in New Keynesian economics: real versus nominal rigidities 8.6 Conclusions 184 184   Unemployment and low incomes: applying the theory 9.1 Introduction 9.2 Tax reform: direct versus indirect taxation 9.3 The globalization challenge: is mobile capital a bad thing to tax? 203 203 203 141 148 167 172 182 185 189 193 197 201 208 viii  ·  Macroeconomics 9.4 9.5 9.6 Low-­income support policies in developing economies Multiple equilibria Conclusions 216 219 226 10 Traditional growth theory 10.1 Introduction 10.2 The Solow model 10.3 Exogenous growth with micro-­foundations 10.4 A benefit–cost analysis of debt reduction 10.5 Natural resources and the limits to growth 10.6 Conclusions 228 228 229 234 239 245 252 11 New growth theory 11.1 Introduction 11.2 Endogenous growth: the basic model 11.3 Endogenous growth: human capital 11.4 Endogenous growth: R&D 11.5 An evaluation of endogenous growth analysis 11.6 Conclusions 253 253 253 257 266 272 275 12 Growth policy 12.1 Introduction 12.2 Tax reform: income taxes versus the progressive expenditure tax 12.3 Economic growth and subjective happiness 12.4 Unemployment and growth 12.5 The ageing population and future living standards 12.6 Conclusions 276 276 References Index 303 317 277 289 292 298 302 Preface Thirty-­five years ago, Robert Lucas and Thomas Sargent argued that conventional macroeconomic methods were ‘fatally flawed’ During the last five years, since the financial crisis in the United States and the recession throughout the Western world, the modern macroeconomics that Lucas and Sargent have championed has been roundly criticized, with Paul Krugman (2011) referring to this period of the subject’s development as ‘dark age macroeconomics’ Perhaps partly because of this level of controversy, macroeconomics has been a most exciting part of our discipline throughout this period After all, it is stimulating to be involved in the initiation of new research agendas But, while this activity is exciting for researchers in the field, it can be frustrating for students and their instructors Journal articles by original researchers rarely represent the best pedagogic treatment of a subject, especially when the analysis becomes quite technical Thus, a fundamental purpose of this book is to bridge the gap between intermediate macro texts and the more advanced analysis of graduate school But I have two other goals as well – to draw attention to the work of macroeconomists who have been trying to integrate two quite different schools of thought, and to highlight the work that can be, and has been, used to directly address policy debates Concerning the integration of alternative paradigms, there have been two themes On the one hand, there is the rigour and explicit micro-­foundations provided by the New Classical approach, and, on the other hand, the concern with policy that stems from the Keynesian tradition of focusing on the possibility of market failure The problem in the 1970s and 1980s was that the Classicals achieved their rigour by excluding market failure, while the Keynesians achieved their intended policy relevance by excluding explicit micro-­foundations So both schools of thought were limited in a fundamental way This book draws attention to the analyses of macroeconomists who saw the merit in both traditions, and who were, therefore, developing models that could score well on both the criteria for judging model usefulness (consistency with empirical observation and consistency with constrained maximization principles) In many important ways, this drive toward integration has succeeded Indeed, the integrated approach has acquired a title – the ‘New Neoclassical Synthesis’ – and it now occupies centre stage in the discipline It is high time that an accessible book should 310  ·  Macroeconomics Koskela, E and R Schöb (2002), ‘Why governments should tax mobile capital in the presence of unemployment’, Contributions to Economic Analysis and Policy, Kremer, M (1993a), ‘The O-­ring theory of economic development’, Quarterly Journal of Economics, 108, 551–75 Kremer, M (1993b), ‘Population growth and technical change: One 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balanced growth path 229 Ball, L 114, 146, 151, 159, 178, 200 Barbie, M 177 Barlevy, G 120 Barro, R.J 13, 153, 181, 224, 259, 261, 283, 299 Barsky, R 13 basic income see guaranteed annual income Basu, S 47 Baumol, W.J 249 behavioural economics 75 benefit-cost analysis 114, 238, 242 Benhabib, J 102 Bernanke, B.S 25, 109 Bettendorf, L.J.H 299 Bhagwati, J 215 Bhattarai, S 31 big trade-off: equity and efficiency 266, 292 Blackburn, K 120 Blake, A.P 172 Blanchard, O.J 80, 93, 94, 138, 160, 178, 222, 223, 298, 301 Blinder, A.S 8, 16, 108, 277 Bohn, H 178 Boianovsky, M 16 Bouakez, H 101, 105 Brainard, W 46 Brock, W.A 46 bubble 136 built-in stabilizer 45, 50, 150, 166, 180 Buiter, W 31 Burbidge, J.B 176 Cagan, P 40 calibration 99, 108 Calvo, G.A 89, 121, 163, 166, 238 Cambridge controversy 73 Campbell, J 224 Cardia, E 101 Carlstrom, C 109 Caroli, E 267 Carroll, C.D 65, 84 cash-in-advance constraint 112 CES production function 219, 251 chaos 48 Chari, V 94 Chiang, A.C 52, 104, 165 Christiano, L 102, 105, 146 Classical dichotomy 6, 8, 11, 50, 57, 103, 106 318  ·  Macroeconomics Classical model 5, 97 Cobb-Douglas 74, 92, 99, 110, 163, 192, 217, 230, 246, 251, 294 Coenen, G 25 Cogley, T 94 commitment 150, 169 confidence 18, 168 consumer surplus 111, 117 convergence hypothesis 234 Cooley, T.F 115 Cooper, R 105, 223 coordination failure 223 core inflation 23 correction 136 Correia, I 172 correspondence principle 26, 28, 60, 62, 128, 236, 256 cost disease of the service sector 249 cost minimization 14 cost-increasing effect of interest rate 147 Cover, J.P 103 creative destruction 266 credibility 64,156 currency union 150, 162 cyclical behaviour of prices 104 cyclical behaviour of real wages 12, 97 Das, S.P 268 De Long, J.B 31, 181 De Vroey, M 94 death probability (inverse of life expectancy) 80 deficit and debt reduction 81, 151, 172, 239, 301 Denes, M 169 depletion effect 247 developing economies 216 Devereux, M 105, 166 Diamond, P.A 194, 221, 299 disinflation 158, 160 Dixon, H.D 139 Domeij, D 211 Dornbusch, R 138 Drazen, A.162 Driskill, R 63 DSGE model 58, 94, 141 Duarte, P 94 Durlauf, S.N 46 dynamic consistency 150, 169, 182, 238 dynamic efficiency 176 dynamic programming 194 dynamic stochastic general equilibrium model see DSGE model Easterly, W 274 Edwards, S 166 efficiency wage 18, 93, 185 Eggertsson, G 25, 31, 37, 167, 169, 171 Eichenbaum, M 102, 105, 146 eigenvalues 36, 61 Elmendorf, D.W 178 employment subsidy 215, 293 endogenous variable equity premium 84 Estralla, A 146 European Stability Pact 179 Evans, C 146 excess burden 111 exchange-rate overshooting 138 exchange-rate pass through 166 exogenous variable expectations 39 adaptive expectations 23, 40, 51, 101 static expectations 40, 86 rational (model-consistent) expectations 41 expectations theory of the term structure 167 externality trading 211 natural resources 247, 250 human capital 253 research and development 266 factor-intensity reversal 73 fair wage 192 Farhi, E 167, 172 Farmer, R.E.A 17, 161, 223 Faruqee, H 299 Fatas, A 120, 180 Favero, C.A 47 Fillion, J.-F 241 financial accelerator 109 fiscal austerity 181 fiscal devaluation 167 fiscal dividend 175 Fischer, S 80, 156, 159, 160 Fisher effect 17 Fisher, F.M 73 Fisher, I 17 fishing-out effect 270 Fleming, J.M 138, 166, 242 Index  flexible exchange rate 138, 150 forward guidance 167, 169 Frank, R.H 276, 289 free lunch 144, 181 free parameter 3, 65, 87, 100, 101 Freeman, R 215, 298 Friedman, M 23, 34, 40, 65, 69, 76, 182, 183 Frydman, R 224 Fuerst, T 109 Fuhrer, J 146 fundamentals 63, 224 Galí, J 93, 146 Galor, O 268 Garcia-Penalosa, C 267, 283 Geary, R.C 249 generalized disequilibrium 13 Gertler, M 109, 146, 299 Geweke, J 72 Ghate, C 268 Giannitsarou, C 63 Gilbukh, S 169 Gilchrist, S 109 globalization 208 globalization constraint 211, 226 golden rule 232 Goodfriend, M 90, 106 Gopinath, G 167 Gorbet, F 180 Gordon, D.B 153 government budget constraint 113, 114, 211, 218, 235, 255, 260, 278 gradual learning 63 Graham, B.S 268 Granger causality test 136 Gravelle, J.G 238 Grieve, R 20 Groezen, B van, 301 Grossman, H.I 13 guaranteed annual income 215 habits 101 Hagedorn, M 177 Hahn, F.H 29 Hall, R.E 193, 196, 206, 249 Hamiltonian 78, 82, 85, 87 hand-to-mouth 285 Hansen, G.D 98–9, 102, 106, 115 Harberger triangle 116 ·  319 Hartley, J.E 72 Head, A.C 105 Heijdra, B.J 299 Helliwell, J 180 Helpman, E 266 Henderson, D.W 147 heterogeneity 37, 84 Hill, G 168 Hofmann, B 169 home production 102 Honkapohja, S 63 Hotelling, H 246 Howitt, P 33, 94–5, 168, 194, 221, 222, 225, 266, 269 Huang, K.X.D 13 human capital 257 hybrid model 144–8 hypothetical compensation 238 hysteresis 223 indexation 157 indivisible labour 101 inequality and growth 267 inflation surprise 155 inflation-rate targeting 35, 59, 62, 144 147 initial conditions constraint 128 insiders 223 instability see stability interest rate, real/nominal 26 intermediate imports 163 inter-temporal substitution of the labour supply 19, 97, 107 inventories 16 inverse-elasticity rule 111 Ireland, P.N 106 IS/LM 6, 22, 56, 103 iso-profit curve 189 Itskhoki, O 167 Jackson, A.L 145 Jensen, H 146, 299 job vacancy 193 John, A 223 Johri, A 105 Jones, C.I 249, 266, 268, 274 Judd, K.L 265, 288 jump variable 124, 128, 166, 256 Kano, T 105 Kara, E 139 320  ·  Macroeconomics Kaul, A 177 Kehoe, P 94 Keynes 1, 10, 17 Keynes, J.M 88 Keynesian model 10 Kim, J 147 Kimball, M.S 47 King, R.G 90, 96, 106, 148, 162 Kirman, A.P 72 Kirsanova, T 166, 172 Kiyotaki, N 222 Knight, F.H.20 Koskela, E 211 Kotlikoff, L 299 Kremer, M 219, 268 Krugman, P 37 Kydland, F.E 99, 159 labour market Laffer curve 213 Lam, J.-P 180 Lancaster, K 214 Lane, P.R 166 Lapham, B.J 105 Laubach, T 146 learning by doing 105 Legrange multiplier 83, 85, 87 Leijonhufvud, A 33, 95 Leith, C 166 Leontief production function 213 Levinson, A 180 Levy, Y.E 166 limit cycle 49 Lipsey, R.G 30, 214 liquidity constraint 80 liquidity trap 25 Loh, S 162 López-Salido, J.D 146 Lucas critique 3, 67, 75, 228 Lucas, R.E., Jr 67, 108, 118, 148, 257 Majundar, S 47 Malik, H.A 147 Malinvaud, E 13 Mankiw, N.G 9, 47, 84, 146, 148, 167, 177, 178, 198, 200, 201, 224, 232, 234, 261, 265, 285, 294 Manning, A 223 Mansoorian, A 112–13 marginal cost 91 Marrero, G 283 Masson, P.R 162 matching function 194 McAfee, R.P 168, 225 McCallum, B 63, 68, 83, 147, 159, 163, 176, 197 McDonald, I 90 McGrattan, E.R 94, 102 Meadows, D 245 Mehra, Y.P 146 Meijdam, L 301 menu costs 197, 200 Metzler, L.A 16 micro-foundations 67 Mihov, I 180 Milani, F 47 Milbourne, R.D 220 Miller, M 31 Minford, P 64 minimal set of state variables 63 Mishkin, F.S 166 Mitra, K 63 Mohsin, M 112–13 monetarism 71 monetary-aggregate targeting 32 money-wage rigidity 10 monopoly 12, 89, 105, 214, 223, 264, 288 Moseley, F 20 Moutos, T 209, 217, 249 Mukand, S.W 47 Mulligan, C 110 Mullineux, A.51 multi-period overlapping wage contracts 139 multiple equilibria 1,17, 49, 61, 63, 95, 168, 194, 202, 219, 223, 267 multiplier 181 Mundell, R.A 138, 166, 242 Mussa, M 68 Nash arbitrator objective function 191 natural rate 10, 23 Nelson, E, 146, 147, 163 Neoclassical Synthesis New Classicals 18, 96 New IS relationship 59, 83, 124, 162 New Keynesians 18, 58, 94, 141, 184, 197, 226 New Neoclassical Synthesis 66, 122, 141 New Phillips curve 59, 89 Nicolini, J.P 172 Nielsen, S 298–301 Index  nominal rigidity 10, 96, 106, 197 nominal-income targeting 34, 59 no-motion loci 125 nonlinearity 50, 267 of Phillips curve 152 non-renewable resources 245 non-uniqueness see multiple equilibria Nordhaus, W.D 249 nourishment effect 218 Novales, A 283 Obstfeld, M 238 OECD 180 Oh, S 223 Ohanian, L 109–11 Okun, A.M 116, 266, 292 Okun’s gap 116 old-age dependency ratio 298 operation twist 168 optimal inflation 111 O-ring 217 Orphanides, A 25 output loss 31 overlapping generations 81, 238, 299 Pareto improvement 211, 214 Parker, J.A 13 participation rate 11 payment lag 105 Pecorino, P 103 Peel, D 64 Pelloni, A 120 Pemberton, J 119 Peng, W 51 percolate-up 277 perfect capital mobility 138, 163, 211, 240, 301 perfect foresight 39, 40 permanent income 65, 76, 169 Persson, T 162 Pesaran, M.H 225 Phaneuf, L 13, 108 phase diagram 122, 123, 237 Phelps, E 213, 215, 224, 298 Phillips curve 22, 152, 163 Pigou effect 17, 83 Pigou, A 17 Pissarides, C.A 191, 206 Ploeg, F van der 298 ·  321 policy irrelevance 57 positional goods 289 positive versus normative 108 Post Keyesians 20, 73 poverty trap 268 pre-existing distortion see second best Prescott E.C 99, 159 President’s Advisory Panel on Federal Tax Reform (2005) 276 price flexibility 29 price-level targeting 35, 62, 144, 147 primitive parameter 70, 235 production-possibility frontier 85 progressive expenditure tax 207, 277, 285 propagation mechanism 99, 101, 105, 109 Purvis, D.D 220 quantitative easing 167 Ramaswami, V 215 Ramsey, F.P 78, 300, 301 rational expectations 41, 53, 58 rationing: equities and loans 88, 109 Ravenna, F 93,147 reaction function 34, 56 Reaganomics real business cycle model 96 real rigidities 96, 184, 190, 197 Rebelo, S 108 reduced form equation Reinhart, V.R 25 Reis, R 146, 201 representative agent 72 research and development 266 retirement age 298 Ricardian equivalence 80 risk aversion 118 risk neutrality 192 Roberts, J.M 146 Rogerson, R 102 Romer, C 30, 106 Romer, D 106, 193, 198, 234, 274 Romer, P 268 Rosser, J.B., Jr 51 Rowe, N 222 Rudd, J 146 Rudebusch, G.D 71 Ruge-Murci, F.J 101 322  ·  Macroeconomics rule of thumb 145 rules versus discretion 159 Svensson, L 25, 62, 144 Swan, T.W 229 sacrifice ratio 131 saddle path 129, 135, 236, 256 Saint-Paul, G 267 Sala-i-Martin, X 259, 261, 283, 299sales constraint 13 Samuelson, P 2, 28 Sargent, T.J 65, 71, 148, 182 savings 19 scale effect 268 Scarth, W 20, 180, 209, 216, 217, 293, 299, 301 Schöb, R 211 Schoenle, R 31 Schumpeter, J.A 266, 269 Scoones, D 220 search theory 193 second best 214, 226, 247, 250, 283, 289, 293 self-correction 25, 32, 245 self-fulfilling cycle 225 Shiller, R 94 shirking 187 sine curve 52, 104, 163 skill-biased technological change 208, 249 Smets, F 146 Smyth, D.J 180 Soderstrom, U 147 Solon, G 13 Solow growth model 229 Solow residual 99, 107 Solow, R.M 18, 29, 73, 90, 93, 94, 107, 185, 215, 229 269 298 Souare, M 299 stability 1, 24, 26, 29 stability corridor 33, 37, 95 sticky information 146, 201 sticky variable see jump variable Stiglitz, J.E 88, 222 stochastic shocks 42, 58, 141 stock market 87, 134 Stone, R 249 Stoneman, P 16 strategic complementarities 96, 223 structural equation subjective happiness 289 Summers, L.H 31, 107, 156, 177, 181,185, 192, 201, 212, 223, 232 sunspots 61 supply-side economics Tabellini, G 162 tax reform 203 capital income taxes 269 payroll taxes 203 progressive expenditure tax 207, 277, 285 sales taxes 170, 204 Taylor principle 61 Taylor, J.B 61, 63, 139 technology shocks 97 Teles, Pedro 172 Temple, J.R.W 268 temporary shocks 45 term structure of interest rates 137, 168 time preference 75, 238 Tobin, J 17, 29, 88, 117, 134, 220 Tobin’s q 85, 134 Touffut, J.-P 94 trial solution 36, 142, 165 trickle-down 242, 277 Turnovsky, S.J 283, 298 uncertainty 42 undetermined coefficients 36, 104, 142 unemployment insurance 188, 215 unemployment (involuntary) 20, 93, 154, 210, 293 unemployment rate 11, 184, 203, 292 unemployment (structural) 184 union indifference curve 189 unions 184, 189 seniority-based versus utilitarian 191 utility function 75 utilization of capital 111 Van Parijs, P 215 Verbon, H.A.A 301 volatility trade-off 57 Waldman, M 223 Wallace, N 182 Walsh, C.E 60, 61 62, 64, 93, 143, 144, 146, 147 wedges 110 Weil, D.N 47, 234 Weil, P 178 Weinzierl, M 9, 167, 261, 265 West, K.D 46 Whelan, K 146 Index  Wieland, V 25, 47 Woglam, G 222 Wolfson, P 21 Woodford, M 25, 62, 63, 98, 148, 168, 225 Wouters, R 146 Wren-Lewis, S 166 Wright, R 98–99, 102, 106 Xu, J 166 Yagihashi, T 94 Yellen, J 198 yield curve 137, 167 see term structure of interest rates Zeckhauser, R.J 177, 232 Zeira, J 268 zero lower bound 17, 25, 37, 150, 167 Zheng, L 13 ·  323 .. .Macroeconomics Macroeconomics The Development of Modern Methods for Policy Analysis William Scarth McMaster University, Canada Edward Elgar Cheltenham, UK • Northampton, MA, USA © William Scarth. .. simultaneously It also means that the form of at least some of the structural equations, and therefore the overall structure of the model itself, depends on the assumed time paths of the exogenous variables... both the historical development of the subject and the ability to apply the analysis to ongoing policy debates Concerning application, some of the highlighted topics are: the Lucas critique of