Accessible, comprehensive, and wide-ranging, Macroeconomic Theory is the standard book on the subject for students and economists. The most up-to-date graduate macroeconomics textbook available today General equilibrium macroeconomics and the latest advances covered fully and completely Two new chapters investigate banking and monetary policy, and unemployment Addresses questions raised by the recent financial crisis Web-based exercises with answers Extensive mathematical appendix for at-a-glance easy reference This book has been adopted as a textbook at the following universities: American University Bentley College Brandeis University Brigham Young University California Lutheran University California State University - Sacramento Cardiff University Carleton University Colorado College Fordham University London Metropolitan University New York University Northeastern University Ohio University - Main Campus San Diego State University St.

He is the coeditor of Handbook of Applied Econometrics and was managing editor of the Economic Journal from to He is specialist adviser to the House of Lords on macroeconomics and a member of the Shadow Monetary Policy Committee. Many of our ebooks are available through library electronic resources including these platforms:. Teaching Professors : To request a print examination copy for course consideration, please visit: Ingram Academic. Inspection copies are only available to verified university faculty.

## MACROECONOMIC THEORY: A DYNAMIC GENERAL EQUILIBRIUM APPROACH, 2ND EDITION by Michael Wickens

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Add to Cart. More about this book. Adopted at these universities. Table of Contents [PDF]. Chapter 1 [PDF]. He asserts that we are living through the dark age of macroeconomics in which the hard-won wisdom of the ancients has been lost. In his view:. The economics profession has gone astray because economists, as a group, mistook beauty clad in impressive-looking mathematics, for truth. Skidelski , a biographer of Keynes, expresses a similar view that is worth describing in more detail.

How justified are these criticisms? While it is undoubtedly true that the future is uncertain, we still have to take decisions involving the long term, such as those concerning pensions, durable goods like houses and cars, and, for businesses, investment in buildings and machinery. These force us to take a view about the future and hence to make intertemporal decisions under uncertainty—a key feature of modern DSGE macroeconomics that seeks the best way to do this.

Although some events may be unpredictable—even catastrophic, such as earthquakes particularly if they are followed by tsunamis — most shocks to the macroeconomy are open to being modeled as stochastic processes and hence becoming calculable risks. It is not clear, however, that the financial crisis was due to fundamental uncertainty. As argued in chapter 15, it was caused by human error, resulting from a failure to interpret and apply existing theories of economics and finance correctly. And the reason for using mathematics is to ensure that the analysis is carried out logically and hence accurately.

In this book I have taken the view that, although there may be uncertainty about the stochastic processes affecting the economy, DSGE macroeconomics, in combination with modern financial theory, provides the best means we possess of trying to understand the macroeconomy. Various other complaints are sometimes made about DSGE models.

First, the models are far too simple to capture the full complexity of the economy, and as a result are of dubious value. Second, a comment made by some who are familiar with engineering, is that in general macroeconomic models are far too complex to be useful. The first opinion is easier for most people to sympathize with than the second. However, engineering has found that it is necessary to find a way of simplifying matters in order to make progress.

There may be a lesson in this for macroeconomics. It may provide a justification for the use of models that are designed to capture key features of the economy while retaining their simplicity by abstracting from unnecessary detail. The simplicity of macroeconomic models, commonly seen as a major weakness, may therefore be a potential strength. It is true that virtually all macroeconomic policy is based on a simplified model of the economy, and there is an obvious danger in applying the conclusions obtained from such models to situations where the simplifying assumptions are too distorting.

This makes it advisable to take care to establish the robustness of the conclusions to departures from the model assumptions. Nonetheless, as in engineering, the simple models of macroeconomics can often be remarkably robust and, therefore, useful. DSGE macroeconomic models tend to be more complex than Keynesian models, but they are still essentially highly stylized. Given the complexity of the economy and the high level of abstraction of theory, perhaps the best that one can hope for from theory is something quite modest: that it provides the intuition necessary to understand why the economy behaves as it does and what consequences policy might have.

In interpreting our analysis we should, therefore, bear in mind its limitations: that we are only using models of the economy and that these models are necessarily simplifying because to do otherwise would almost certainly mean making the analysis intractable. For another view of the relationship between macroeconomics and engineering, see Mankiw An assumption often objected to is that of a representative-agent economy.

An interesting argument against this simplification is that it commits the fallacy of composition. This asserts that if each individual attempts to do something, they end up achieving the reverse due to the aggregate consequences. The problem with this particular example is that it illustrates the dangers of using a partial rather than a general equilibrium analysis. One might ask what caused this sudden desire to save more, and whether the aim is a temporary or a permanent increase in individual savings.

If temporary, then, in a general equilibrium analysis, the additional supply of savings would be expected to reduce the cost of borrowing temporarily, thereby stimulating borrowing and consumption, and deterring an increase in savings. If permanent, then the fall in the cost of borrowing would make the cost of capital lower and so stimulate additional investment, raising the optimal level of the capital stock and hence output and income.

A temporary shock would not be expected to affect the optimal level of the capital stock, and therefore investment. Alternatively, if the cause of the additional saving was the assumption that in the future a temporary negative shock would affect output in the economy, this would induce forward-looking households to save more today in order to smooth consumption.

A general equilibrium analysis, therefore, rather dispels the contradiction contained in the fallacy. This does not, however, alter the fact that the assumption of a representative-agent economy is made to make the analysis more tractable. More advanced treatments of macroeconomic problems often allow for heterogeneity. This book is organized as a sequence of steps that extend the basic model in order to produce, by the end, a general picture of the economy that can be used to analyze its main features.

The sequence starts with the basic closed-economy model and is followed by the introduction of growth, markets, government, the real open economy, money, price stickiness, asset price determination, financial markets, the international monetary system, nominal exchange rates, and monetary policy.

The book concludes with a discussion of some empirical evidence on DSGE models. In view of the above strictures on the advantages of using simple models, rather than retaining each added feature for each subsequent step, thereby finishing up with a complex general model of the economy, we aim to return to the original model as closely as we can and add each new feature to that. In this way we aim to provide a toolbox that is suitable for understanding how the economy works and that is useful for macroeconomic analysis, rather than a fully specified macroeconomic model so complex that it can only be studied using numerical methods.

Our starting point, in chapter 2, is the basic dynamic general equilibrium centralized model for a closed economy expressed in real terms. Its purpose is to introduce the methodology of DSGE macroeconomics. Although the setting is simple and we assume perfect foresight, it provides a remarkably powerful representation of an economy that has been used to study a wide variety of problems in macroeconomics, including real business cycles.

It captures the key problem of DSGE macroeconomics, namely, the intertemporal decision to either consume today or invest in order to accumulate capital and produce more for extra consumption in the future. This simple model illustrates the important distinction between stock equilibrium and the sequence of flow equilibria that bring this about subject to suitable stability conditions. The steady-state solution of the basic model of chapter 2 is a static equilibrium. In chapter 3 we show how the basic model can be modified so that in steady state the economy may achieve balanced economic growth.

As a result, we are able to reinterpret the basic static solution as a description of the behavior of the economy about its steady-state growth path. As it is simpler to analyze a model with a static equilibrium, in later chapters we ignore growth, where possible, in the knowledge that we can focus on the deviations of the economy from its growth path.

If we require the full solution, we can add the growth path to the deviations from it. We decentralize decision making in chapter 4 and include markets to coordinate these decisions. In this way we are able to study the joint decisions of households and firms and their interactions in goods, labor, and capital markets. We show that various prices—notably wages and the rate of return on capital—although not included explicitly in the basic model, are nonetheless present implicitly. We introduce government into the model in chapter 5. We discuss the basis of government expenditures and how best to finance them with debt and taxes.

In the process we consider optimal debt and taxation policy and the sustainability of the fiscal stance.

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This discussion is extended in chapter 6 to cover the problem of time inconsistency in fiscal policy, and to introduce the overlapping-generations model. This is particularly useful for fiscal and other decisions involving time periods that are very long, such as that of a generation. We use this to study the increasingly important issue of how to finance pensions. In chapter 7 we introduce the foreign sector.

The economy is no longer constrained to consume only what it can produce itself. All of this should result in a welfare improvement for the economy. Making the economy open introduces many new issues and variables, and so greatly complicates the basic model. For example, there is the allocation problem between domestic and foreign goods and services and the determination of their associated relative price the terms of trade , the relative costs of living of different countries the real exchange rate , and the sustainability of current-account deficits.

So far all variables have been defined in real terms. This is partly to show that money plays a minor role in most of the real decisions of the economy. In chapter 8 we study nominal magnitudes—including the general price level and the optimal rate of inflation—by introducing money into the closed economy. Our focus here is on what determines the demand for money and why this might be affected by interest rates.

We also discuss the use of credit instead of money. Although in a partial-equilibrium view of the economy money appears to impose a real cost, we show that in general equilibrium money is far more likely to be neutral in its effect on real variables. This chapter paves the way for the later discussion of monetary policy as it covers a key channel in the monetary transmission mechanism, namely, how money and interest rates affect other variables via the money market.

Later we consider whether money has real effects in the short run. Up to this point it has been assumed that prices are perfectly flexible and adjust so that markets clear each period. This is often regarded as a major weakness of DSGE models compared with Keynesian models, which tend to stress the imperfect flexibility of prices, arguing that this causes a consequent lack of market clearing. In chapter 9 we show how to introduce imperfect price flexibility into the DSGE model. We show how monopolistic competition in goods and labor markets may cause imperfect price flexibility and result in a cost to the economy in terms of lost output.

In this way we are able to incorporate price stickiness yet retain the benefits and insights of the DSGE model. Such models are sometimes known as New Keynesian models. The principal remaining difference between Keynesian and DSGE macroeconomics is that in the DSGE framework we continue to assume that the economy is always in equilibrium— albeit a temporary, and not necessarily a long-run, equilibrium.

Thus economic agents always expect to be in their preferred positions subject to the constraints they face, one of which is the information they possess. In this sense, even prices are chosen optimally.

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Having introduced price stickiness, we then consider how this affects the determination of the aggregate supply function, a key equation in the determination of inflation. As a result of viewing the economy as always being in equilibrium ex ante but not ex post , it becomes more difficult to explain unemployment that is involuntary. The obvious implication of being in equilibrium is that unemployment must be voluntary. In chapter 9—a new chapter for the second edition—we examine whether two well-known theories of unemployment—search theory and efficiency-wage theory—provide a satisfactory explanation of unemployment.

We contrast these theories with an alternative explanation: that the persistence of unemployment is due to price and wage stickiness. Once the preserve of finance, these issues are now increasingly recognized as essential components of economics and, in particular, of DSGE theory. After adding uncertainty due to stochastic features of the economy, the same basic model that we have used to analyze consumption, savings, and capital accumulation can be used to determine financial assets and asset prices. This provides an explanation of asset prices based on economic fundamentals as opposed to the usual approach in finance, namely, relative asset pricing.

Consequently, asset prices are determined in conjunction with macroeconomic variables instead of in relation to other asset prices. The general equilibrium theory of asset pricing is set out in chapter 11 and it is specialized to apply to the bond, equity, and foreign exchange FOREX markets in chapter Before reaching chapter 11, we have, for the most part, ignored the fact that intertemporal decisions involve uncertainty about the future and are based on forecasts of the future formed from current information.

Our analysis has therefore been conducted using nonstochastic, rather than stochastic, intertemporal optimization. This has allowed us to use Lagrange multiplier analysis instead of the more complicated stochastic dynamic programming. In general equilibrium asset pricing, uncertainty about future payoffs is a central feature of the analysis.

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The degree of uncertainty about each asset can be different. It ranges from certain to highly uncertain payoffs. Assets with certain payoffs have risk-free returns; those with uncertain payoffs have risky returns that incorporate risk premia in order to provide compensation for bearing the risk. A key issue in asset pricing is the problem of determining the size of the risk premium that is required in order for risk-averse investors to hold a risky asset, i.

In our previous discussion of the economy, in effect we treated savings as being invested in a risk-free asset. It may seem, therefore, that we must rework many of our previous results in order to allow for investing in risky assets. This would, of course, greatly complicate the analysis as it would necessitate the inclusion of risk effects throughout.

We show in chapter 11 that this is not, in fact, necessary as all we need do is risk-adjust all returns, i. This implies that we can continue to work with only a risk-free asset and to use nonstochastic optimization. Hence, most of the time we are able to ignore such uncertainty.

In chapter 7 we treat the nominal exchange rate as given and consider only the determination of the real exchange rate. In chapter 13 we analyze the determination of nominal exchange rates. As the exchange rate is an asset price the relative price of domestic and foreign currency , we must use the asset-pricing theory developed in chapters 11 and The no-arbitrage condition for FOREX is the uncovered interest parity condition, which relates the exchange rate to the interest differential between domestic and foreign bonds.

Macroeconomic theories of the exchange rate are based on how macroeconomic variables affect interest rates and, through these, the exchange rate. Before embarking on our analysis of exchange rates in chapter 13, we discuss the effect of different international monetary arrangements on the determination of exchange rates. Having covered the principal components of the DSGE model, in chapter 14 we study the use of the model in formulating monetary policy. Our analysis is based on the New Keynesian model of inflation. To bring out its new features we contrast this with the traditional Keynesian analysis of inflation.

We consider alternative ways of conducting monetary policy: via exchange rates, money-supply targets, and inflation targeting. In the process we extend our discussion of the determination of exchange rates in chapter 13 by developing a New Keynesian model of exchange rates. We then focus solely on inflation targeting. We examine the optimal way to conduct inflation targeting both in a closed economy and in an open economy with a floating exchange rate.

We conclude our discussion of monetary policy by proposing a simple model of monetary policy in the eurozone, where there are independent economies but a single currency, and hence a single interest rate for all economies. In chapter 15—another new chapter—we develop the interconnections between macroeconomics and finance further. We consider several issues: we discuss borrowing constraints and default, the role of the banking and financial systems in the financial crisis of —11; we examine alternative models of the banking sector, their ability to account for the financial crisis, and how best to incorporate a banking sector in a DSGE model; and we propose a DSGE model with default risk.

The final chapter, chapter 16, presents a brief account of how well simple DSGE models perform in explaining the main stylized facts of the economy, and tries to identify some of their shortcomings. We base our discussion on a small selection of studies of the real business cycle that is designed to illustrate the principal issues rather than to be fully comprehensive.

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The main focus in this literature is on the ability of these models, whether they are for a closed or an open economy, to explain the business cycle solely by productivity shocks. We then examine a DSGE model of the economy that claims to provide a better explanation of economic fluctuations by including various market imperfections and frictions that introduce different types of shocks, including monetary-policy shocks.

The attraction of this approach is that monetary shocks may then have persistent real effects. It has been suggested, however, that such models suffer from a lack of identification as these market imperfections are open to more than one interpretation.

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We discuss this issue together with the more general question of whether DSGE models are identified. Given the diversity of DSGE models considered in this book, we complete the chapter with some reflections on how one might decide which features to include when constructing a DSGE model. Finally, we provide a mathematical appendix in which we explain the main mathematical results and techniques we have used in this discussion of contemporary macroeconomic theory based on DSGE models. There are also exercises with solutions for students and these are available on the Princeton University Press web site at.

In this chapter we introduce the basic dynamic general equilibrium model for a closed economy. The aim is to explain how the optimal level of output is determined in the economy and how this is allocated between consumption and capital accumulation or, put another way, between consumption today and consumption in the future. We exclude government, money, and financial markets, and all variables are in real, not money, terms. Although apparently very restrictive, this model captures most of the essential features of the macroeconomy.

Subsequent chapters build on this basic model by adding further detail but without drastically altering the substantive conclusions derived from the basic model. Various different interpretations of this model have been made. It is sometimes referred to as the Ramsey model after Frank Ramsey , who introduced a very similar version to study taxation Ramsey The model can also be interpreted as a central or social planning model in which the decisions are taken centrally by the social planner in the light of individual preferences, which are assumed to be identical.

It is also called a representative-agent model when all economic agents are identical and act as both a household and a firm. Another interpretation of the model is that it can be regarded as referring to a single individual. Consequently, it is sometimes called a Robinson Crusoe economy. Any of these interpretations may prove helpful in understanding the analysis of the model. This model has also formed the basis of modern growth theory see Cass ; Koopmans Our interest in this model, however interpreted, is to identify and analyze certain key concepts in macroeconomics and key features of the macroeconomy.

The rest of the book builds on this first pass through this highly simplified preliminary account of the macroeconomy. The model may be described as follows. The problem to be addressed is how best to allocate output between consumption today and investment i. The national income identity also serves as the resource constraint for the whole economy. In this simple model total output is also total income and this is either spent on consumption or is saved.

This shows how kt , the capital stock at the beginning of period t , accumulates over time. The increase in the stock of capital net investment during period t equals new gross investment less depreciated capital. This equation provides the intrinsic dynamics of the model.

This gives the output produced during period t by the stock of capital at the beginning of the period using the available technology. We also assume that the marginal product of capital approaches zero as capital tends to infinity and that it approaches infinity as capital tends to zero, i. These are known as the Inada conditions. They imply that at the origin there are infinite output gains to increasing the capital stock, whereas, as the capital stock increases, the gains in output decline and eventually tend to zero. If we interpret the model as an economy in which the population is constant through time, then this is like measuring output, consumption, investment, and capital in per capita terms.

Output and investment can be eliminated from the subsequent analysis and the model reduced to just one equation involving two variables. Having established the constraints facing the economy, the next issue is its preferences. What is the economy trying to maximize subject to these constraints? Possible choices are output, consumption, and the utility derived from consumption. We could choose their values in the current period or over the long term. We are also interested in whether a particular choice for the current period is sustainable thereafter.

This is related to the existence and stability of equilibrium in the economy. We consider two solutions: the golden rule and the optimal solution. Both assume that the aim of the economy the representative economic agent or the central planner is to maximize consumption or the utility derived from consumption. The difference is in attitudes to the future. In the golden rule the future is not discounted, whereas in the optimal solution it is.

In other words, any given level of consumption is valued less highly if it is in the future than if it is in the present. We can show that, as a result, the golden rule is not sustainable following a negative shock to output but the optimal solution is. Consider first an attempt to maximize consumption in period t. This is perhaps the most obvious type of solution. It would be equivalent to maximizing utility U ct. From the resource constraint, equation 2. In the following period output would, of course, be zero as there would be no capital to produce it.

This solution is clearly unsustainable. It would only appeal to an economic agent who is myopic, or one who has no future. We therefore introduce the additional constraint that the level of consumption should be sustainable. In effect, we are assuming that the aim is to maximize consumption in each period. With no distinction being made between current and future consumption, the problem has been converted from one with a very short-term objective to one with a very long-term objective.

The solution can be obtained by considering just the long run and we therefore omit time subscripts. In the long run the capital stock will be constant and long-run consumption. This action might not be possible to undo. Are you sure you want to continue? Upload Sign In Join. Home Books Politics. Save For Later. Create a List. Summary Macroeconomic Theory is the most up-to-date graduate-level macroeconomics textbook available today. The most up-to-date graduate macroeconomics textbook available today General equilibrium macroeconomics and the latest advances covered fully and completely Two new chapters investigate banking and monetary policy, and unemployment Addresses questions raised by the recent financial crisis Web-based exercises with answers Extensive mathematical appendix for at-a-glance easy reference This book has been adopted as a textbook at the following universities: American University Bentley College Brandeis University Brigham Young University California Lutheran University California State University - Sacramento Cardiff University Carleton University Colorado College Fordham University London Metropolitan University New York University Northeastern University Ohio University - Main Campus San Diego State University St.

Read on the Scribd mobile app Download the free Scribd mobile app to read anytime, anywhere. Index Preface No subject with a foot in both the academic and public domains like macroeconomics remains unchanged for long. In his view: The economics profession has gone astray because economists, as a group, mistook beauty clad in impressive-looking mathematics, for truth. The model consists of three equations. The first is the national income identity: 2. The second equation is 2. The third equation is the production function: 2. This is a nonlinear dynamic constraint on the economy.

Figure 2. The marginal product of capital. Start your free 30 days. Page 1 of 1. Close Dialog Are you sure? Also remove everything in this list from your library. Are you sure you want to delete this list? Remove them from Saved? No Yes.