Macroeconomic Theory and Policy

Macroeconomic Theory and Policy David Andolfatto Department of Economics Simon Fraser University 20061 1 c This text is not for sale, but may be distributed freely. ° 1 Contents Preface Part 1: Basic Theory Chapter 1: The Gross Domestic Product Chapter 2: Output and Employment Chapter 3: Government Spending and Taxation Chapter 4: Consumption and Saving Chapter 5: Government Deficits Chapter 6: Capital and Investment Chapter 7: Unemployment Part 2: Monetary Theory Chapter 8: Money Chapter 9: Inflation Chapter 10: Money and Capital Chapter 11: International Monetary Systems Part 3: Growth and Development Theory Chapter 12: Early Economic Development Chapter 13: Modern Economic Development 2 Preface The field of macroeconomic theory has evolved rapidly over the last quarter century. This evolution has manifested itself primarily in terms of methodological developments, rather than in the set of questions that interest macroecono- mists. These methodological developments entail the use of language and tools that are based on microeconomic theory (including game theory). Modern co- horts of PhD students are taught how to interpret macroeconomic phenomena in terms of model economies consisting of economic actors with explicit goals facing explicit constraints. Aggregate outcomes (model predictions) must sat- isfy a specified consistency (equilibrium) requirement. This methodology is in stark contrast to earlier methods that rely primarily on aggregate reduced-form equations to describe how an economy functions. Unfortunately (from my per- spective), most introductory and intermediate macroeconomic textbooks today continue to employ these earlier (and outdated) methods. It is time to move on. This text is designed to help. The main challenge in teaching macroeconomics to undergraduates using the modern methodology has to be the added technical (primarily mathematical) requirements that the approach demands. The frontier of the discipline uti- lizes models that are so complicated, they can only be solved using numerical methods. But while one cannot really do justice to the richness of the modern approach, I believe that one can convey many basic lessons and insights by employing a sequence of simplified models that build on each other. Much, if not all, of this basic intuition can be exposited by way of simple diagrams (and high-school algebra). This is what I try to do. You can judge for yourself whether you think I am successful in this endeavor. I would like to comment on a criticism that one often hears regarding the modern approach; in particular, its apparent reliance on the ‘representative agent’ hypothesis. As it turns out, I do make extensive (but not exclusive) use of this simplifying assumption. One should be aware, however, that the modern approach in no way depends on the representative agent formulation (there is nothing that prevents one from introducing as much heterogeneity that is desired). The representative agent hypothesis is used nowadays primarily as a pedagogical device. While some conclusions are no doubt sensitive to the assumption, there are many that are not (and it is these latter conclusions that deserve emphasis). In any case, I find it ironic that the criticism is most often leveled by those who prefer the older methodology; which, by its very nature, is typically cast in terms of a representative agent (e.g., in the form of an aggregate consumption function that makes no reference to individual differences). I like the modern approach for two reasons. First, it highlights the interac- tion between incentives and constraints that govern decision-making. Economics is about decision-making and macroeconomics is concerned with explaining how 3 individual decisions interact to generate aggregate outcomes. This decision- making process is almost entirely neglected in the older approach, which simply describes (rather than explains) why people behave the way they do. Second, because the modern approach insists on modeling preferences explicitly, there is a straightforward and entirely natural way to evaluate the welfare implica- tions of government policy interventions. In contrast, the older approach must rely exclusively on the modeler’s own ad hoc welfare function to make similar statements. For example, it is often simply assumed that higher income, or lower unemployment, or a stabilized business cycle must be welfare improving. As it turns out, these assumptions have little or no theoretical foundation. A qualified professional may understand the circumstances under which such an assumptions are justified; but a student trained solely in older methods is not likely to appreciate such subtleties (which possibly accounts for why we see so many crazy policies implemented). Alright then, enough blathering. Either you like the text or you don’t. Keep in mind that this is still work in progress (I have been revising these notes yearly). At least you can’t complain about the price! The manuscript can be downloaded for free at: www.sfu.ca/~dandolfa/macro2006.pdf At this stage, I would like to thank all my past students who had to suf- fer through preliminary versions of these notes. Their sharp comments (and in some cases, biting criticisms) have contributed to a much improved text. I would especially like to thank Sultan Orazbayez and Dana Delorme, both of whom have spent hours documenting and correcting the typographical errors in an earlier draft. Thoughtful comments were also received from Bob Delorme and Janet Jiang. I remain open to further comments and suggestions for im- provement. If you are so inclined, please send them to me via my email address: [email protected] 4 CHAPTER 1 The Gross Domestic Product 1. Introduction The Gross Domestic Product (GDP) is an economic statistic that one hears quoted frequently in the news and elsewhere. But what exactly is this GDP thing supposed to measure? And why should anyone care about whether it is measured at all? Most people have at least a vague idea that the GDP represents some measure of ‘economic performance.’ One often hears, for example, that a country with a higher GDP is performing better than one with a lower GDP; or that a rapidly growing GDP is better than a stable, or declining GDP. This idea of the GDP as a measure of economic performance is held so widely and (at times) accepted so uncritically, that on these grounds alone, it probably deserves closer scrutiny. Before we can talk sensibly about GDP and why it might matter, we should have a clear understanding of how the term is defined and measured. Most countries in the world have a government agency (or agencies) responsible for collecting and aggregating measures of economic activity. You can find a list of these agencies at the following website (the United Nations Statistics Division): http://unstats.un.org/unsd/methods/inter-natlinks/sd_natstat.htm In Canada, our national statistical agency is called Statistics Canada.2 Among other things, Statistics Canada maintains a system of national Income and Expenditure Accounts (IEA). The following quote, taken from the Statistics Canada webpage, sums up their own naive view of the world: The Income and Expenditure Accounts are the centre of macroeconomic analysis and policy-making in Canada. They are a means by which Cana- dians can view and assess the performance of the national economy. The accounts provide both a planning framework for governments and a report card on the results of the plans that governments carry out. At the core of the Income and Expenditure Accounts (IEA) is the concept of Gross domestic product (GDP) and its components. 2 See: http://www.statcan.ca/ 5 The statement above makes clear that GDP is considered a core concept. So let’s take some time to investigate its measurement and potential usefulness. 2. Definition of GDP Here is a standard definition of GDP: GDP: The total value of final goods and services produced in the domestic economy over some given period of time. From this definition, we gather that the GDP represents some measure of the level of production in an economy. For this reason, the GDP is commonly referred to as output. Keep in mind that output constitutes a flow of goods and services. That is, it represents the value of what is produced over some given interval of time (e.g., a month, a quarter, or a year). Food, clothing, and shelter services produced over the course of a year all contribute to an economy’s annual GDP. Let us now examine the definition of GDP more carefully. Note first of all that the GDP measures the ‘value’ of output. We will discuss the concept of ‘value’ in some detail later on; but for now, assume that value is measured in units of ‘dollars’ (feel free to substitute your favorite currency). When output is measured in units of money, it is referred to as the nominal GDP (at current prices). Output takes the form of goods and services. What is the difference between a good and a service? A good is an object that can be held as inventory; while a service is an object that cannot be stored. Think of the difference between an orange and a haircut. Note that any good is likely valued only to the extent that it yields (or is expected to yield) a service flow; as when I consume that orange, for example. Next, note that the definition above makes reference to final goods and services. A final good is to be distinguished from an intermediate good. An intermediate good is an object that is produced and utilized as a input toward the production of some other good or service within the time period of consid- eration. An example may help clarify. Imagine that last year, an economy produced $200 of vegetables, $150 of fertilizer, $100 of bread, and $50 of flour.

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