Advanced Topics in

Macroeconomics
Dr. Soma Patra
Indian Institute of Foreign Trade, Kolkata
Introduction
• Macroeconomics : How is Macroeconomics different from Microeconomics?
• Dynamics & Aggregate Behavior
1. Dynamics (multiple period model, reallocation across periods, sometimes
simplified into two period settings, past & present)
2. Aggregate Behavior (generally a study of aggregate variables, simplification:
Assumption of CRS allows study of per capita variables and scale up to size of
the economy, this is why most macro models study the average
consumer/producer). Issues of heterogeneity remain (not a critique of
aggregate models but cannot capture differential affects across consumers or
firms by construction. Recent macro models have tried to address this
(computational issues remain the main challenge). Question: Under what
conditions can aggregate behavior be represented by a single consumer?
Introduction
• Evolution of Macroeconomic Thought
Macroeconomics as a field was born after Keynes famous book “The
General Theory of Employment, Interest, and Money” (1936).
This was the time of the Great Depression with big decline in GDP and
soaring unemployment rates, which led to incredible developments in
economic theory on how to address the problems.
First Period: From time of Great Depression to late 60s
Second Period: Lucas Critique (1976 till early 80s)
Third Period: Modern Macroeconomics Mid 1980 onwards
Introduction
First Period: Keynes approach was for an active role of the policy maker
(govt) in stabilizing the economy through use of fiscal & monetary
policy while economists before him mostly emphasized the self-
correcting role of the economy which meant long painful recessions.
Application of Keynes theory required precise estimates of how the
economic variables were related (Klein & Goldberger, 1955, rich model
structure with lots of interdependent equations), forecasts of how the
economy would respond to shocks, predict the dynamic path (ex:
suppose oil prices increase, how would income, consumption and
investment change? Once we knew the path, policy makers could
intervene in the appropriate way).
Introduction
• Phillips curve: Phillips (1958) negative relationship between inflation
and unemployment rate. Policy makers could utilize this relationship
which implied unemployment could be lowered (by increasing
demand through fiscal or monetary policy) but only at the cost of
higher inflation.
• Milton Friedman (1968), no permanent trade-off between
unemployment and inflation in the long run. Phillips curve is vertical
in the long run (unemployment will be back to the natural rate or the
long term rate).
Introduction
• Modern Macroeconomics: Most of the decisions rules regarding
consumption/ investment were assumed rather than derived from optimal
behavior of households and firms. Ex: Consumption was assumed to be a
function of current disposable income.
• Some of this was later rectified but analysis was still done in partial
equilibrium, econometric techniques still utilized “ad hoc” models.
• Lucas Critique (1976): Ad hoc models fit the data well but cannot be used
to determine the effect of policy. Agents will change their behavior in
response to policy but that might not align with the estimates from “ad
hoc” models: Ex: If ad hoc models predict people save 10% of their income,
policy makers might think a raise in G leading to a 100rs increase in income
will imply people save 10, consume 90. However, if people guess this to be
temporary or financed through higher taxes in future, they might save
more. Thus, macroeconomic relationships are not policy invariant.
Introduction
• Lucas emphasized agents take decisions based on all available information
“rational expectations”
• This implied expected changes in monetary policy may fail to stimulate
demand.
• People expect prices to rise simultaneously (wages and prices rise in
proportion, no change in firm or consumer behavior).
• Time inconsistency problem: any policy that relies on myopic/ lack of
foresight in people is doomed to fail. (Ex: Govt may think a policy is optimal
today but may deviate from this policy in future if its suboptimal under the
prevailing conditions in future). This leads to people believing policymakers
lack commitment and hence leads to ineffectiveness of the policy.
Introduction
• Time Inconsistency Example (Yves Merch Speech)
Suppose there is a flood plain where people should not build houses as then
it leads to high expenditure on building dams to protect the houses.
• People know if they build houses there govt. is going to build dams to
protect the houses so they will build houses and the expenditure will have
to be incurred.
• So, what is the solution? Commitment to not build dams irrespective of the
situation (do not use discretion but commit to sticking to a rule). Govt.
could pass a law that it will not build dams on the flood plain.
• Think about applications to fiscal (ex: taxation of capital)& monetary policy
(setting monetary policy by rule etc).
Introduction
• Modern Macroeconomic Models tried to address two different problems:
Lack of microfoundations & inconsistency between long run and short run
models.
Kydland & Prescott (1982): introduced labor/leisure choice and random
fluctuations in technology.
Large fractions of economic fluctuations can be explained by fluctuations in
TFP alone.
Utility maximizing households, profit maximizing firms, rational expectations
and no market failure. No active role of monetary or fiscal policy in stabilizing
fluctuations.
Deviation from previous thought that fluctuations were due to changes in
consumer behaviour or misaligned decisions of policy makers.
Introduction
• Caveats:
TFP only source of fluctuations.
What is TFP? Output that cannot be accounted for by observable inputs (labor, capital, intermediate
good). Measurement issues arise depending on how many inputs are considered. Change in
utilization of capital is another example (suppose energy constraint)
Yet this model remains the starting point of all modern macroeconomics.
To address the issues, other shocks have been included, productive role of government expenditure,
market co-ordination (ex technology adoption), sticky wages (unions), sticky prices (menu costs),
imperfect information (asymmetric information: adverse selection, moral hazard).
RBC with nominal rigidities (New Keynesian Models)
Since financial crisis, introduce financial frictions, broad class of models called DSGE.
D: Dynamic S: Stochastic GE: General Equilibrium
All these models are microfounded and have a general equilibrium framework. Stochastic means
random, all these models study the how random shocks to exogenous variables cause economic
fluctuations.
Models
• What are models? Simplified representation of the economy
• How to judge models? Every model has its shortcomings, a model
should be judged on how well it answers the issue you want to study
and the insights it provides on the workings of the economy (which
are seen in the data). No one model can explain everything!
• Why do we design models to study the effect of variables? Why not
follow the approach of hard sciences (run experiments, random
selection, split into control & treatment group)?
• Difficult to implement in macroeconomic settings, also global
validation.
Macroeconomic Data
• Real vs. Nominal GDP
• Nominal: Valuation of current output at current prices
• Real GDP: Valuation of current output using base year prices (selection of
base year, chain weighted real GDP)
• GDP Deflator (nominal GDP/ real GDP)X100
• CPI (fix a basket of goods, estimate how the cost of this basket varies over
time relative to the base year)
• Problems with estimating the CPI
• CPI vs GDP deflator or other measures
• India uses many different measures (WPI, Private Final Consumption
Expenditure deflator etc.)
• Unemployment rate: (unemployed/employed +unemployed)X100
Data to Model
• Generally real GDP is taken to be representative of real output in
models.
• Sometimes depending on the question, industrial production is also
used.
• For aggregate price : CPI/ GDP deflator or any other measure can be
used (again depends on the research question)
• Measuring Business Cycles : Fluctuations around a trend, decompose
GDP data into trend and cycle (most commonly HP filter is used).
• These filters split the data into two, a trend and a cycle. We study the
cyclical component for business cycle analysis.
Data to Model
• Correlations between the cyclical components of the series are studied, standard
deviations too.
• If correlation with output is positive: pro cyclical (C, I)
• If correlation with output is negative: counter cyclical (unemployment rates)
• Acyclical: correlation is weak with the cycle (weak positive or negative).
• Remember aggregation sometimes leads to correlations that may be weaker (ex:
average real wage may not move much due to “composition bias”). Employment
variation during booms and recessions happens mostly in low skill, low wage
workers. Thus, low skill low wage works are over represented in booms and
underrepresented during recessions which depress the true procyclical behavior
as in average real wages do not rise a lot during booms and do not fall a lot
during recessions (Solon, Barsky and Parker, 1992).
• Standard deviation are a good measure of volatility (ex Investment more volatile
than output, output more volatile than consumption).
Facts about the Business Cycle
• Fluctuations of output are not regular (hence the thought that the
economy is hit by random disturbances which then propagate
through the economy, the major disagreement among
macroeconomists is about the source and propagation mechanisms).
• Fluctuations are distributed very unevenly within the components of
output (investment particularly inventory investment shows the
biggest change, within consumption consumer durables are hit
harder), net exports & G are relatively stable.
• Asymmetric output movements: long periods of expansion followed
by short periods of sharp dips.
Facts about the Business Cycle
• Magnitude of fluctuations vary over time: Fluctuations before Great
Depression & After Great depression were not that different. But post
1980s upto 2007 was an era of unprecedented macroeconomic
stability (“Great Moderation”) with only two mild recessions.
• Post 2007, financial crisis and COVID are the two major recessionary
periods.
• Okun’s Law: A 3% shortfall in GDP relative to normal growth causes a
1% increase in unemployment rate (since productivity and work hours
also decline during recessions unemployment rates changes less
relative to output), see table 5.3.
Real Business Cycle Data (Romer)
Real Business Cycle Data (Source: Romer 5.1)
Real Business Cycle Data (Romer)
Real Business Cycle Data (Romer)
Indian Data (Prepared by Kinnori & Team)
Indian Data
Indian Data
Quarterly GDP Cyclical Component