Macroeconomic Theory and Policy (ECON0016) (ECON0016)
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ECON0016 (Macroeconomic Theory and Policy) Term 1 Summary - UCL Economics BSc Second Year
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Macroeconomic Theory and Policy (ECON0016) (ECON0016)
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University College London (UCL)
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Macroeconomics
Summary of Term 1 (Closed Economy) taught in ECON0016 (Year 2021/2022)
Detailed notes from lecture notes, textbooks and other materials.
Topics covered centre on the closed economy model: 1) Introduction and The Demand Side, 2) The Demand Side Part 2, 3) The Supply Side, 4) Macroeconomic Dyna...
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UNIVERSITY COLLEGE LONDON
DEPARTMENT OF ECONOMICS
Economics BSc (Econ)
Second Year – Term 1
MACROECONOMIC
THEORY AND POLICY
ECON0016
Rodrigo Antón García
rodrigo.garcia.20@ucl.ac.uk
London, 2021
,
, Contents
Topic 1 – Introduction and The Demand Side. Carlin and Soskice Chapter 1.
o Topic 1.1 – Introduction. 1
o Topic 1.2 – The Demand Side Part 1. 3
Topic 2 – The Demand Side Part 2. Carlin and Soskice Chapter 1.
o Topic 2.1 – PIH and its Modification. 11
o Topic 2.2 – The Multiplier. 13
o Topic 2.3 – Investment. 15
o Topic 2.4 – The IS Curve. 18
Topic 3 – The Supply Side. Carlin and Soskice Chapter 2.
o Topic 3.1 – The Labour Market under Perfect Competition. 20
o Topic 3.2 – The Labour Market when the Assumptions of Perfect Competition
do not apply – WS, PS, PC. 21
o Topic 3.3 – Timing and Expectations. 27
Topic 4 – Macroeconomic Dynamics. Carlin and Soskice Chapter 3.
o Topic 4.1 – The Central Bank’s Objective. 28
o Topic 4.2 – The Three-Equation Model. 31
o Topic 4.3 – Using the Three-Equation Model. 33
Topic 5 – Expectations and Policy Effectiveness. Carlin and Soskice Chapter 4.
o Topic 5.1 – Expectations. 50
o Topic 5.2 – Expectations in the Model and in Practice. 54
,Topic 6 – Monetary policy. Carlin and Soskice Chapter 13.
o Topic 6.1 – Costs of Inflation and Deflation. 62
o Topic 6.2 – Bringing Inflation Down – Disinflation. 63
o Topic 6.3 – Monetarism Framework: Theory and Practice. 65
o Topic 6.4 – The Modern Pre-crisis Monetary Policy Framework: Independent
Central Banks, Inflation Targeting and Short-term Nominal Interest Rates. 67
Topic 7 – Fiscal Policy. Carlin and Soskice Chapter 14.
o Topic 7.1 – Automatic Stabilisers. (Passive Fiscal Policy). 71
o Topic 7.2 – Discretionary Fiscal Policy. Active Stabilisation. 71
o Topic 7.3 – Fiscal Policy and the PIH. 73
o Topic 7.4 – Government Debt – Sustainably Financing Spending. 79
Topic 8 – Finance and the Macroeconomy. Carlin and Soskice Chapters 5 and 6.
o Topic 8.1 – Interest Rates and Monetary Transmission. 90
o Topic 8.2 – Asset Price Bubbles and the Financial Accelerator. 93
Topic 9 – The Global Financial Crisis. Carlin and Soskice Chapter 7 and 13.
o Topic 9.1 – The Zero-Lower Bound (ZLB) on Nominal Interest Rates. 100
o Topic 9.2 – Market Mortgages: Short-term Borrowing, Securitisation and
Subprime Lending. 101
o Topic 9.3 – The Global Financial Crisis in the Three-equation Model. 107
Topic 10 – The Consequences of the Crisis and Course Overview. Carlin and
Soskice Chapter 7.
o Topic 10.1 – The Consequences of the Crisis. 111
o Topic 10.2 – Course Overview. 118
,Macroeconomic Theory and Policy – ECON0016 Rodrigo Antón García
ECON0016: MACROECONOMIC THEORY & POLICY SUMMARY – TERM 1
Topic 1 – Introduction and Demand Side. Carlin and Soskice Chapter 1.
o Topic 1.1 – Introduction.
Macroeconomics involves the study of aggregate variables; these include output,
inflation, unemployment, productivity, etc. An important part of it has to do with policy
and how it is used to stimulate the economy and respond to economic shocks.
• Notation.
Nominal values are expressed in upper case letters. Whereas Real values, adjusted to
prices and inflation levels, are expressed in lower case letters.
- For example, ! = "/# means the real wage is the nominal wage divided by the
price level.
- Nonetheless, interest rates are always written in lower cases. As such, $ (“iota”)
is the nominal interest rate, % the real interest rate.
Expected values are denoted by the superscript &. Other important superscripts and
subscripts will be defined when used.
- For example, dynamic models such as the Phillips Curve need time subscripts:
"
'! = '! + *(,! − ," ). Here, the inflation at time 0 ('! ) is equal to the expected inflation
at time 0 ('!" ), plus a constant parameter (*) times the difference between the output at
time 0 (,! ) and the equilibrium output (," ).
- Normally, we can omit time subscripts when they are all the same. E.g., , = 1 +
2 + 3 means ,! = 1! + 2! + 3! , ∀0.
• Demand and Supply Sides.
1
,Macroeconomic Theory and Policy – ECON0016 Rodrigo Antón García
• The Three-equation (IS-PC-MR) model.
IS (Planned Investment and Savings Decisions): The Demand Side. (Topics 1 & 2).
- It shows the relationship between the real interest rate, % , and the level of
output, , and the combinations at which aggregate spending in the economy is equal to
output. The downward sloping curve shows the demand side of the economy.
- The IS curve measures non-durable consumption of households and investment
by households and firms.
- An increase or decrease in such, is
thus represented by a movement along the
curve. The higher the interest rate, the less
you want to consume and to invest, and so
the lower output we would observe.
- Government spending here is
modelled as exogeneous. So, a change in
government spending is represented by a
shift in the IS curve. A change in
expectations is also represented by a shift.
- The larger the multiplier, the larger is the rightward shift of the IS curve associated
with any given amount of additional government spending and the flatter the IS curve is,
since with a larger multiplier, a given cut in the interest rate has a larger effect on output.
WS / PS: The Supply Side. (Topic 3)
- It shows the relationship between
the real wage, ! , and the output, , ,
presenting a wage-setting and a price-
setting issue in an imperfectly competitive
labour market.
- From this graph we can derive the Phillips Curve, which links the expected
inflation to real life inflation, affected by the supply, and thus summarising the supply side
with nominal stickiness.
MR: Monetary Rule. (Topic 4).
- Finally, we would derive the optimal
monetary rule curve. This is not an arbitrary
monetary policy; it is an optimal response
monetary policy rule.
• Models, Theory and Data.
The macroeconomy is exceedingly complex both in cross-section and time-series.
Nonetheless, the models we build are extremely simple; in fact, “three equations” are set
to describe millions of agents interacting in endless complicated ways in an institution
and technological environment that is constantly changing. As such, we have to keep in
mind that models are not the absolute truth: simply a way of structuring our thoughts.
2
,Macroeconomic Theory and Policy – ECON0016 Rodrigo Antón García
"The curious task of economics is to demonstrate to men how little they really know about
what they imagine they can design." Hayek.
Consumption is modelled as a function of some deeper parameters. 1# (Λ$ ) represents
some necessary level of expenditure, 1% (Λ$ ),! consumption from extra income and
1& (Λ$ )%! the impact of interest rates on consumption.
These are behavioural models, and as such you can research data and back up the
respective coefficients. The important detail we will see later, when we talk about
Permanent Income Hypothesis, is to relate these coefficients to deeper parameters.
Market Clearing.
For simplicity reasons, we assume Market Clearing; the level of output should be the
same as aggregate demand , = 67. If this is not the case, interest rates and/or other
variables can help us adjust factors so that the market eventually clears.
Approaches to select coefficients.
1. Empirical: Micro-level and macro-level data.
2. Theoretical:
- “Ad hoc” behavioural models. E.g., Standard Keynesian model of consumption:
1 = 1# + 1% ,; where, 1# is the autonomous consumption and 1% the Marginal Propensity
to Consume (MPC). Not as good as microfundations which take into account deeper
parameters, and so when policy and variables change it enjoys greater accuracy.
- Microfounded. Based on an aggregated description of the behaviour of
individuals, 1! = 1! (Λ$ ) = 1# (Λ$ ) + 1% (Λ$ ),! + 1& (Λ$ )%! where Λ$ is a list of variables
including preferences; habits; expectations; credit constraints, etc.
3
, Macroeconomic Theory and Policy – ECON0016 Rodrigo Antón García
• Modelling Households.
Household spending consists of non-durable consumption (cinema, food, restaurants
services), durable consumption (cars, fridges, PCs) and housing.
For our purpose, we will model consumption by households as non-durable consumption.
This is because when you think about durable consumption and housing, these provide
a stream of services that spans from the date of its purchase. Whereas, in non-durable
consumption you derive utility only at the precise moment, not at any future period.
For this reason, durable consumption and housing are very much treated like investment.
If we characterize investment by spending that provides a stream of utility and profits in
the future, durable-consumption and housing are not too different from firm investment.
This is reinforced by the historic behaviour of these
three when we come to analyse data.
As we can see in this graph from the Great Recession,
non-durable consumption was much affected in
contrast to durable consumption and housing.
• Modelling Consumption.
Each consumer consumes a different basket of goods; the macro aggregate is the sum
of each individual’s consumption. But, how are we going to deal with this aggregation?
Let 1(,! be the consumption of household ℎ at time 0. Then, if there are ? households in
the economy, aggregate consumption at time 0 is 1 = ∑* (+, 1(,! .
To obtain an individual disaggregated example we ignore heterogeneity and use a
representative agent; we assume that the decision of a single representative household
can be used to represent the aggregate behaviour of all households in the economy.
The effectiveness of this assumption is very relative; it can be seen as a reasonable
simplifying assumption but also reduce accuracy and representativeness.
• The Permanent Income Hypothesis (PIH).
The Permanent Income Hypothesis states that individuals optimally choose their
consumption profile in response to their income profile; they select how much they
consume by allocating their resources across their lifetimes (borrowing and saving).
- Individuals optimally choose how much to consume by allocating their resources
across their lifetimes, resources include assets, current and future income.
- This is a forward-looking decision and will depend on interest rates, asset values,
expectations of future income, expectations of future taxes, etc.
- The result is that optimal consumption is smooth compared to income.
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