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Lecture Notes in Macroeconomics

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Course
ECO3131

Institution
Brown University And NBER1

Department of Economics, Brown University, Box B, Providence RI 02912. Phone (401) 863-1584, Fax (401) 863-1970, email:John , web:http: ∼jd. °c Copyright John C. Driscoll, 1999, 2000, 2001. All rights reserved. Do not reproduce without permission. Comments welcome. I especially thank David ...

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Uploaded on April 8, 2023
Number of pages 143
Written in 2004/2005
Type Class notes
Professor(s) John c. driscoll
Contains Class 11th

economics
macroeconomics
brown university
john c driscoll
brown university and nber1
lecture notes in macroeconomics

Institution
Brown University and NBER1
Course
ECO3131

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Lecture Notes in Macroeconomics

John C. Driscoll
Brown University and NBER1

December 21, 2003

1
Department of Economics, Brown University, Box B, Providence RI 02912. Phone
(401) 863-1584, Fax (401) 863-1970, email:John Driscoll@brown.edu, web:http:\\
c
econ.pstc.brown.edu\ ∼jd. °Copyright John C. Driscoll, 1999, 2000, 2001. All rights
reserved. Do not reproduce without permission. Comments welcome. I especially
thank David Weil, on whose notes substantial parts of the chapters on Money and
Prices and Investment are based. Kyung Mook Lim and Wataru Miyanaga provided
detailed corrections to typographical errors. Several classes of Brown students have
provided suggestions and corrections. All remaining errors are mine.

,ii

,Contents

1 Money and Prices 1
1.1 Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.1.1 Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.1.2 Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 The History of Money . . . . . . . . . . . . . . . . . . . . . . . . 3
1.3 The Demand for Money . . . . . . . . . . . . . . . . . . . . . . . 4
1.3.1 The Baumol-Tobin Model of Money Demand . . . . . . . 4
1.4 Money in Dynamic General Equilibrium . . . . . . . . . . . . . . 6
1.4.1 Discrete Time . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.4.2 Continuous Time . . . . . . . . . . . . . . . . . . . . . . . 10
1.4.3 Solving the Model . . . . . . . . . . . . . . . . . . . . . . 13
1.5 The optimum quantity of money . . . . . . . . . . . . . . . . . . 14
1.5.1 The Quantity Theory of Money . . . . . . . . . . . . . . . 14
1.6 Seigniorage, Hyperinflation and the Cost of Inflation . . . . . . . 16
1.7 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

2 Nominal Rigidities and Economic Fluctuations 27
2.1 Old Keynesian Economics: The Neoclassical Synthesis . . . . . . 28
2.1.1 Open Economy . . . . . . . . . . . . . . . . . . . . . . . . 31
2.1.2 Aggregate Supply . . . . . . . . . . . . . . . . . . . . . . 33
2.2 Disequilibrium Economics . . . . . . . . . . . . . . . . . . . . . . 36
2.2.1 Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
2.2.2 The Walrasian Benchmark Case . . . . . . . . . . . . . . 37
2.2.3 Exogenously Fixed Price . . . . . . . . . . . . . . . . . . . 38
2.2.4 Exogenously Fixed Nominal Wage . . . . . . . . . . . . . 39
2.2.5 Both prices and wages inflexible . . . . . . . . . . . . . . 39
2.2.6 Analysis of this model . . . . . . . . . . . . . . . . . . . . 40
2.3 Imperfect Information Models . . . . . . . . . . . . . . . . . . . . 41
2.4 New Keynesian Models . . . . . . . . . . . . . . . . . . . . . . . . 43
2.4.1 Contracting Models . . . . . . . . . . . . . . . . . . . . . 43
2.4.2 Predetermined Wages . . . . . . . . . . . . . . . . . . . . 44
2.4.3 Fixed Wages . . . . . . . . . . . . . . . . . . . . . . . . . 47
2.5 Imperfect Competition and New Keynesian Economics . . . . . . 50
2.5.1 Macroeconomic Effects of Imperfect Competition . . . . . 50

iii

, iv CONTENTS

2.5.2 Imperfect competition and costs of changing prices . . . . 51
2.5.3 Dynamic Models . . . . . . . . . . . . . . . . . . . . . . . 56
2.6 Evidence and New Directions . . . . . . . . . . . . . . . . . . . . 57
2.7 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

3 Macroeconomic Policy 65
3.1 Rules v. Discretion . . . . . . . . . . . . . . . . . . . . . . . . . . 66
3.1.1 The Traditional Case For Rules . . . . . . . . . . . . . . . 66
3.2 The Modern Case For Rules: Time Consistency . . . . . . . . . . 68
3.2.1 Fischer’s Model of the Benevolent, Dissembling Government 69
3.2.2 Monetary Policy and Time Inconsistency . . . . . . . . . 73
3.2.3 Reputation . . . . . . . . . . . . . . . . . . . . . . . . . . 75
3.3 The Lucas Critique . . . . . . . . . . . . . . . . . . . . . . . . . . 77
3.4 Monetarist Arithmetic: Links Between Monetary and Fiscal Policy 79
3.5 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80

4 Investment 87
4.1 The Classical Approach . . . . . . . . . . . . . . . . . . . . . . . 87
4.2 Adjustment Costs and Investment: q Theory . . . . . . . . . . . 88
4.2.1 The Housing Market: After Mankiw and Weil and Poterba 91
4.3 Credit Rationing . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
4.4 Investment and Financial Markets . . . . . . . . . . . . . . . . . 95
4.4.1 The Effects of Changing Cashflow . . . . . . . . . . . . . 98
4.4.2 The Modigliani-Miller Theorem . . . . . . . . . . . . . . . 99
4.5 Banking Issues: Bank Runs, Deposit Insurance and Moral Hazard 100
4.6 Investment Under Uncertainty and Irreversible Investment . . . . 103
4.6.1 Investment Under Uncertainty . . . . . . . . . . . . . . . 107
4.7 Problems: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 110

5 Unemployment and Coordination Failure 117
5.1 Efficiency wages, or why the real wage is too high . . . . . . . . . 117
5.1.1 Solow model . . . . . . . . . . . . . . . . . . . . . . . . . 118
5.1.2 The Shapiro-Stiglitz shirking model . . . . . . . . . . . . 118
5.1.3 Other models of wage rigidity . . . . . . . . . . . . . . . . 120
5.2 Search . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
5.2.1 Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
5.2.2 Steady State Equilibrium . . . . . . . . . . . . . . . . . . 122
5.3 Coordination Failure and Aggregate Demand Externalities . . . . 123
5.3.1 Model set-up . . . . . . . . . . . . . . . . . . . . . . . . . 123
5.3.2 Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . 125
5.3.3 Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . 126
5.3.4 Propositions . . . . . . . . . . . . . . . . . . . . . . . . . 126
5.4 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127

Continuous-Time Dynamic Optimization 131

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