Macroeconomics

See Wikipedia for a useful overview of the history of macroeconomic thought

## Basic terms, concepts and theories

### Conceptualizing the economy

* With the economy as a whole as the subject of macroeconomics, several considerations:
	+ How to disaggregate the aggregate economy? What are its constituent parts? In other words, what is the structure of the economy? Think of the 'structure' of a given model in terms of how it disaggregates the economy into different sectors
	+ Which spheres/activities to focus on (e.g. exchange/ production/ distribution)?
	+ What links are conceptualised between the different spheres? How markets are linked and rendered consistent with one another (general equilibrium considerations)?
	+ What presumptions are adopted regarding functioning of mechanisms?
	+ How is the macroeconomy aggregated back up to form a totality?
* Considering these different schools of thought/research paradigms, with distinct ideological origins and policy implications. They determine:
	+ Distinctions between
	+ Micro and macro spheres
	+ Short-run and long-run spheres
	+ Real and monetary spheres
	+ Role of the state and government policies
	+ Questions that will be asked, the conclusions that will be drawn and through which processes (with which methods) will these conclusions be reached
* Three definitions of SR-LR distinctions
	+ Empirical time definition: simply time span where there is no objective cutoff
	+ Time-to-adjust definition were capital stock is fixed and is the only input variable
	+ By definition: LR as where expectations are fulfilled & there are no shocks

### Basic terms

* Utility functions have to be continuous and differentiable, otherwise I can't maximize utility. Hence, maximizing U(C,L) both consumption and leisure have to be differentiable
* Marginal productivity of labor = w/p when maximization is assumed
* Equilibrium: Market clearing (in neoclassical) or state of rest (in Keynes)
* Capital-output ratio: the productivity of capital, i.e. how much capital do I need in order to produce X of output. A capital-ouptu ratio of 3 says that I need €30 in order to produce €10 per year.
* Homogeneity of degree 0: if you multiply your function by a constant to the power of 0 (i.e. it stays the same), nothing changes. Homogeneity of degree 1: a firm's production function is homogeneous of degree 1 (if all inputs are multiplied by t then output is multiplied by t). A production function with this property is said to have “constant returns to scale”
* A well-behaved production function: 1st deriveative is positive, 2nd derivative = negative (diminishing returns to scale)
* The basics of mainstream economcis:
	+ (Atomised/a-social/a-historical) Individual/agent as the main focus
	+ Who act rational
	+ Which means optimizing
		- Houshold/individual: utility
		- Firm: profit
	+ The economy = the sum of agents' actions with social order arising spontaneously
* Marginal productivity of labor: output rises as employment is increased, but at a diminishing rate
* Deadweight loss: fall in total surplus that results from a market distortion, such as a tax. In economics, a deadweight loss (also known as excess burden or allocative inefficiency) is a loss of economic efficiency that can occur when equilibrium for a good or service is not achieved or is not achievable
* Positive net investment: investment over and above that necessary to offset depreciation of the capital stock
* The 'short run': the period of time in which employment levels can change, but in which the size of capital stock, state of technology and labour force skills. and size may be assumed to be fixed
* Elasticity as the responsiveness of an economic variable to the change in another variable
	+ If prices of K and L change, the firm will substitute a cheaper input for a more expensive one. This profit-maximising behaviour will result in a change of the K/L ratio, and, hence, to a change in the relative shares of the factors. The size of this effect depends on the responsiveness of the change of the K/L ratio to the factor price changes. A measure of this responsiveness is the elasticity of substitution.
	+ Price elasticity: Price elasticity of demand = a measure of the responsiveness of the quantity demanded of a good or service to a change in its price, ceteris paribus
	+ Income elasticity: the responsiveness of the quantity demanded for a good or service to a change in the income of the people demanding the good, ceteris paribus. For example, the income elasticity of demand is higher for industrial goods (like electronics) than for primary goods (like food)
	+ Supply inelasticity = requiring a large price change to bring about even small changes in the quantities of goods
* Real aggregate demand: Real aggregate demand represents the sum of the demands for output of all the individuals in the economy
* Quantity theory of money: assumes that money is used exclusively as a means of exchange and as such is passed from individual to individual at a constant income velocity of circulation, V. The income velocity of circulation is a measure of the average number of times the money stock is exchanged in income-generating transactions during the period of analysis, so that, when V is multiplied by the nominal stock of money M, it must yield the nominal value of income, Py. An increase in the money supply does nothing to alter the values of real variables, but merely increases the money wage and price level
* As M rises so must Py, and this is the fundamental equation of the quantity theory of money but the rise comes from the rise in prices (nominal variables)
* Real wage, w, is defined as the money wage W divided by the price level, P.
* Output: is independent of the price level in the Classical model, since changes in the price level will be matched by corresponding changes in the money wage to maintain the labour market-clearing level of employment, N, and output, y.

d
y

d
N

{\displaystyle \tfrac{dy}{dN}}

 represents the marginal product of labour, that is, the amount by which output rises as a marginal extra labourer is employed; when the marginal product of labor is increasing, this is called increasing marginal returns; marginal cost is simply the wage rate w divided by the marginal product of labor - thus if the marginal product of labor is rising then marginal costs will be falling and if the marginal product of labor is falling marginal costs will be rising (assuming a constant wage rate).

d
2

y

d
2

N

{\displaystyle \tfrac{d^2y}{d^2N}}

 states that successive additions to employment generate smaller and smaller increases in output
* The average product of labor is the total product of labor divided by the number of units of labor employed, or Q/L; commonly used as a measure of labor productivity and usually shaped as an inverted u-curve where at the maximum of the curve average productivity=marginal productivity
* Interest rate: The interest rate, r, is expressed as a percentage per period, and depends upon the interaction of the savings and investment functions. It is assumed that the amount of investment undertaken per period, I, depends inversely on the rate of interest, r. Reason: the higher the rate of interest, the greater is the cost of borrowing to finance investment (or the more attractive is the alternative use of funds), and hence, the lower the profitability of investment, and therefore the lower the amount of investment.
* Savings rate: the amount of saving undertaken per period, S, depends positively on the rate of interest, such that more will be saved the higher the rate of interest. The Classical model assumes that the rate of interest adjusts to equate the supply of loanable funds created by the act of saving to the demand for such funds generated by investment
* Flow variables: are those which must be measured in terms of so many units per period. Investment is, therefore, an example of a ftow variable.
* Stock variables, on the other hand, are those which must be measured in terms of so many units at a point in time. say the beginning of the period (e.g. capital stock)
* Stocks and flows may be related; for example, the capital stock at the end of period I is equal to the capital stock at the beginning of the period t, plus the amount of investment which was carried out during period t, minus the amount of depreciation, or wearing out of capital, which took place during period t
* Comparative-static exercises are carried out by considering changes in variables previously taken as given in the model
* The Classical model in its purest form assumes that the labour market clears via real-wage adjustment, and that the demand for labour depends only on the properties of the production function. Implicit in the Classical model is the view that the price system works, so that price adjustment ensures that all markets clear, including, of course, the labour market, where the real wage may be viewed as the price of labour.
* 'Exogenous' or 'autonomous' variables are variables whose values are not determined within a given model. Examples from the Classical model are the money stock, M, and the income velocity of circulation. V, whose values are said to be exogenous to the model.
* An 'exogenous shock' is a change in the value of an exogenous variable or parameter, and comparative-static analysis examines the effects of such a shock on the values of the endogenous variables.
* The 'parameters' of a model are the constants which, along with the values of the exogenous variables, would need to be known precisely in order to solve the model numerica11y, or to draw accurately the curves in the geometric representation.
* Ricardian equivalence theorem: consumers take into account the future tax liabilities created by current spending; the Ricardian equivalence theorem postulates that even government bonds cannot be regarded as outside money. That is, government debt cannot be viewed as net wealth creation since there will be a corresponding tax liability down the line - The theory of Ricardian Equivalence can only be true in an economy in which the monetary sector is external to the system of production and distribution.
* Cobb-Douglas production function: Y = ALβKα where Y=total production, L=labor input, K=capital input, A=total factor productivity, α & β=output elasticities of capital and labor (where output elasticity measures the responsiveness of output to a change in levels of either labor or capital used in production, ceteris paribus)

### Introduction

* New classical synthesis: can we find a price system that brings equilibrium; little scope for money; classical dichotomy: separation between real and money sphere, where the real equilibrium - i.e. employment, output, I, S, relative prices - is determined in the real economy while the money equilibrium brings about absolute prices/nominal magnitudes; money as a veil that doesn't determine the real
	+ The ‘credit-as-saving’ view is rehabilitated in the Neoclassical Synthesis, where ‘real’ saving is brought into equilibrium with ‘real’ investment by the ‘real’ rate of interest, and a ‘real’ (that is, credit-free, because investment is financed elsewhere from ‘saving’) money supply is also brought into equilibrium by that same ‘real’ rate of interest.
	+ Classical system + money: Patinkin shows the inconsistency of the classical system + money and solves it with the real balance effect (in micro-terms 'money in utility function approach'); classical dichotomy is rejected in the short-run because money is not neutral in the short-run but only in the long run → voilà the division of SR/LR and the tension between micro/macro as well as between real/monetary
* Keynesians: effective demand, money (liquidity preferences), involuntary unemployment, interest rate as a monetary phenomenon
* New Keynesian = New consensus = DSGE = New Neoclassical synthesis
* Macroeconomics as the study of short-run fluctuations (business cycles) by means of math deductive modelling (DSGE)
* Macro emerges around the 1930s because of the Great Depression + Keynes' attack on the Neoclassical school (i.e. marginalists from the 1870s); then the formalist revolution around the 1950s
* Studying the economy (i.e. disaggregating it): whhat is the structure; what are the spheres of focus (production, distribution, exchange); links among the parts
* Schools of thought differ on the distinctions (answers on how these relate): micro/macro; short-run/long-run; monetary/real. These distinctions determine what the perspective on the role of the state is, what questions will be asked and what conclusions must be reached
* Neoclassicals: methodological individualism, methodological instrumentalism (marginalist principle), methodological equilibration
* General equilibrium aims at the consistency of different markets and the individual agents going about their maximization
* Conceptualizing the short- and long-run distinction as:
	+ A mere passage of time
	+ Speed of adjustment of various variables
	+ Axiomatically defined: long-run as the equilibrium end-point
* s = savings rate
* 1
s

{\displaystyle \frac{1}{s}}

 = Keynesian multiplier - multiplier of impact of autonomous or exogenous expenditure (i.e. by how much output changes in response to a change in government borrowing); conventional wisdom had it that government borrowing raises interest rates and uses resources which might otherwise have been spent by private firms or households (crowding out)

# * y

1
s

∗
I

{\displaystyle y = \frac{1}{s}\*I}

## Equilibrium

### Arrow-Debreu model

* Markets are complete. As Kenneth Arrow put it: “The view that only real magnitudes matter can be defended only if it is assumed that the labor market (and all other markets) always clear, that is, that all unemployment is essentially voluntarily.”
* In the Arrow–Debreu model, time, space and uncertainty become dimensions of the system, and cannot therefore be characteristics of the decision-making process
* Equilibrium over all locations, dates and contingencies is determined at a point outside time and cannot be challenged within the model specification
* Markets allow a Pareto-efficient allocation of resources
* Firms maximize their value and individuals maximize their utility
* Assumption of perfect certainty
* Decision-making: Every agent knows the future values of the relevant prices and interest rates, so maximizing the value of the firm is a purely technical exercise
* Debt finance and equity finance are equivalent
* The main informational role of financial markets is to provide the term structure of interest rates
* Stock markets are informationally redundant since the value of the firm can easily be calculated from the prices of inputs, outputs, and interest rates

### General equilibrium

* In the general equilibrium framework favored by the mainstream, within which everything happens simultaneously. That is, prices are set, contracts are struck, wages are earned, inputs are purchased, capital is built, incomes are spent, and output is produced all at the same instant allowing for as much re-contracting as necessary, without cost, before the final agreements are struck).
* Assume n commodities; pure exchange
* At the individual level, demand is determined by the maximization of utility whereas the supply is determined by the maximization of profit
* Walrasian
	+ GE
	+ Consistence across all markets
	+ Microfoundation principles
* Marshallian:
	+ Partial equilibrium
* Walrasian equilibrium (Walras's law = Say's law + money incorporated)
* In this Walrasian equilibrium, prices adjust to equate supply and demand in every market simultaneously. The general equilibrium system determines the quantities of all goods and services sold and their relative prices. Employment, production, and relative prices are determined without any mention of the existence of money, the medium of exchange. The simplest way to append money to the model is to specify a money demand function and an exogenous money supply. Money demand depends on the level of output and the price level. The level of output is already determined in the Walrasian system. The price level, however, can adjust to equate supply and demand in the money market.
	+ Is a set of prices such that the excess demand and supply are zero (i.e. the market clears)
	+ Suggests that the existence of excess supply in one market must be matched by excess demand in another market so that it balances out. It attempts to explain the functioning of economic markets as a whole, rather than as individual phenomena (i.e.≠ partial equilibrium theory, or Marshellian partial equilibrium of specific markets)
	+ General equilibrium theory tried to show how and why all free markets tended toward equilibrium in the long run → the process/mechanism through which this is achieved is the Walrasian auctioneer (tâtonnement) who matches supply and demand in a market of perfect competition → i.e. markets are linked through prices. The problem is that we need the fiction, as so-called perfect competition depends upon everyone being a price-taker so there is no one to make the prices.
	+ The auctioneer provides for the features of perfect competition (adjustment): perfect information and no transaction costs
	+ The important fact was that markets didn't necessarily reach equilibrium, only that they tended toward it
	+ As is well known, as a consequence of developments within general equilibrium theory itself, it cannot be assumed except under stringent conditions that Walrasian adjustment will lead to equilibrium (let alone that it exists, and is unique and efficient)
	+ There is also the issue of whether production and trading take place before or after prices have had a chance to adjust to their equilibrium values (raising what is known as Hicksian false trading).
* Formalist revolution (Arrow & Debreu) during the 1950s
* Propositions of the classical system
	+ Homogeneity postulate: the demand functions in the real sectors are assumed to be insensitive to the changes in the absolute level of money prices (i.e., with changes in the quantity of money there will be equi-proportional changes in all money prices); excess demands in the real economy are homogeneous of degree in the price vector (i.e. only relative prices matter for D & S of goods because if all prices simply double - e.g. a constant lambda muli, nothing changes) → the price mechanism equalizes such that there is no excess
* The excess function is defined in n-1 price ratios (I don't need all the prices)
	+ Say's law: at the aggregate level, the sum of aggregate demand Pi\*Di (in money terms) = the sum of Pi\*Si → P\*E (P1, P2...) = 0
		- So even if we have some excess supply in some market, at the aggregate there will then have to be an excess demand in another
	+ Quantity theory of money: supply of money Ms is assumed to be exogenously determined and demand Md

	=

	1
	v

	P
	Y

	{\displaystyle = \frac{1}{v}PY}

		- Mv = PY or M = vPY
		- Walras' Law: The QTM can also be expressed in excess demand form: EDM = kPY - M
		- So even if we have an excess supply of goods, that should correspond to an excess of money
* Inconsistency between all the conditions
	+ Assume all prices double: Excess demand/supply of goods doesn't change (from the Homogeneity posulate); Md doubles → nothing has changed on the real side of commodities (i.e. real equilibrium remains) but disequilibrium in the money market
	+ Shortage of money leads to a decrease of transactions (because we lack money) and hence affects the real economy
	+ Hence, the need for an endogenous credit money creation
* Now, demand for money is usually proportionate to the amount of (nominal) output to be circulated and the degree of money circulation
* Resolution of all this: real balances effect
	+ What matters is not money (M) but money in relation to prices (M/P): people's demand will be determined by their **real** balances. If prices fall (and hence their real balance is increasing), they consume more/demand goes up which drives prices up again. Thus, th presence of real balances as an influence on demands ensures the stability of the price level
	+ Thus, the introduction of the real balance effect disposed of classical dichotomy, that is, it makes it impossible to talk about relative prices without introducing money; but it nevertheless preserve the classical proposition that the real equilibrium of the system will not be affected by the amount of money, all that will be affected will be the level of prices.
	+ Dispense with the classical dichotomoy, Say's law, retain Walras law and reformulate the homogeneity postulate: homogeneous of degree zero not only in the price sector but also in the money balance
* In the adjustment period (when money supply was doubled), money plays a role (because prices adapt) while in the long-run equilibrium money is neutral again and the classical dichotomy holds (i.e. the real economy determines the long-run position)
* The nature of general equilibrium analysis is barter; money only enters temporarily
* So how much does the Real Balance effect (M/P) matter in the short-run?
	+ Well, the definition of the RBE and its possible impact are interconnected
* Real Wealth Effect: if house prices rises, the real wealth effect will be 0 (at the aggregate level) because house owners are gaining while buyers will have to pay more - i.e. only distributional changes
* Real Balance Effect: if money is considered inside (i.e. there is a corresponding liability to money), the RBE goes to 0; if it is considered exogenous (no corresponding liability, thus this is not a zero-sum game) or outside (e.g. cash or government debt where the liability is the increase in future taxation) it is greater than 0
* Whenever S > I and recession looms, interest rates automatically fall to reinvigorate spending in the form of rising consumption and investment. Thus, in a world where the future is known, the fi nancial sector responds directly to the needs of the real sector and there is never an obstacle to reaching full employment.

## Classics

* Unemployment: Labor market and good market in simultatneous equilibrium, hence no room for (unvoluntary, non-temporary) unemployment
* Equilibrium as market clearing
* Removing rigidity of wages: crush bargaining/trade unions, curb minimum wage

## Keynes's General Theory

* The General Theory can be characterized as an investment theory of income and a financial theory of investment.
* An under-employment equilibrium created by the financial system: there is no reason to expect an accommodating adjustment in the interest rate (which might in fact face upward pressure in light of the deteriorating conditions in the economy). Instead, the fall in investment induces recession. Workers are laid off, incomes fall, and, therefore, so does saving. Eventually, S = I once again, but at a lower level of Y and with less-than-full employment.
* Keynes held that wages were “sticky” in terms of money: e.g. workers and unions tended to fight tooth-and-nail against any attempts by employers to reduce money wages (as opposed to the real purchasing power of these wages, taking account of changes in the cost of living) in a way they did not fight for increases in wages every time there was a small rise in the cost of living eroding their real wages. However, he was against the idea that the stickiness of money wages was the cause of unemployment, or that full flexibility of money wages (in particular, a decline in money wages) was likely to be a cure for depressions.
* Main gist: involuntary unemployment results from a deficiency in aggregate demand, itself the result of insufficient investment
* The rate of interest as being the inducement not to hoard
* Expectations based on the notion of fundamental uncertainty rather than (probabilistically) calculable risk.
* When, as happens in a crisis, liquidity-preferences are sharply raised, this shows itself not so much in increased hoards - for there is little, if any, more cash which is hoardable than there was before - as in a sharp rise in the rate of interest, i.e. securities fall in price until those, who would now like to get liquid if they could do so at the previous price, are persuaded to give up the idea as being no longer practicable on reasonable terms → A rise in the rate of interest is a means alternative to an increase of hoards for satisfying an increased liquidity-preference
* Keynes had highlighted that there could be a general glut of commodities if such excess supply was mirrored by an equal and opposite excess demand for money.
* Money is not a device to facilitate trade but rather money is an instrument that arises in the financing of investment and positions in capital and financial assets
	+ Keynes identified three motives for holding money, the transactions, precautionary and speculative demands for money. Of these, the speculative demand formed Keynes's theoretical innovation.
* Ricardian analysis was concerned with what we now call long-period equilibrium. Marshall's contribution mainly consisted in grafting on to this the marginal principle and the principle of substitution, together with some discussion of the passage from one position of long-period equilibrium to another
* Fluctuations in the degree of confidence are capable of having quite a different effect, namely, in modifying not the amount that is actually hoarded, but the amount of the premium which has to be offered to induce people not to hoard
* And changes in the propensity to hoard (i.e. the state of liquidity-preference) primarily affect, not prices, but the rate of interest; any effect on prices being produced by repercussion as an ultimate consequence of a change in the rate of interest → If propensity to hoard (savings rate) goes up, the interest offered to part with your money has to increase to compensate you for the risk
* The rate of interest is the factor which adjusts (at the margin) the demand for hoards to the supply of hoards.
* The first effect of the rate of interest (which is fixed by the quantity of money & the propensity to hoard): on the prices of capital-asset
* Secondly, opinions on the prospective yields of these capital assets also affect their prices
* Volume of investment depends on the propensity to hoard and on opinions of the future yield of capital-assets
* Aggregate output depends on the propensity to hoard, on the policy of the monetary authority as it affects the quantity of money, on the state of confidence concerning the prospective yield of capital-assets, on the propensity to spend and on the social factors which influence the level of the money-wage. But of these several factors it is those which determine the rate of investment which are most unreliable
* The necessity of equalizing the advantages of the choice between owning loans and assets (i.e. should I hoard money or invest in securities?) requires that the rate of interest should be equal to the marginal efficiency of capital. But this does not tell us at what level the equality will be effective
* The marginal efficiency of capital was defined by Keynes in subjective terms as ‘the expectation of yield’ in relation to ‘the current supply price of the capital asset’.
* Whereas in mainstream theory, S→I (because Say's law), in PK I→S (via the share in income of labor/profit)
* Interest rate = price of liquidity for Keynes (in GT)
* Keynes had put forward a liquidity preference theory of interest, according to which the liquidity preference of financial investors, or rentiers, determines the rate of interest that they will demand in order to part with immediate purchasing power when they lend money.
* For Keynes, I is determined by r and the Marginal Efficiency of Capital: I(r, MEC). Investment is limited by liquidity preference/uncertainty (of prospects of profit-making) and interest rate; investment decision is done by calculating the net present value of future cash flows (from the investment) and comparing this to the current rate of interst - however, Keynes now brings in fundamental uncertainty about the future (for Keynes, time is historical and not logical - you can't simply go back to before you made the investment decision)
# * Y

I

1
−
c

{\displaystyle Y = \tfrac{I}{1-c}}

where c is the marginal propensity to consume
* Aggregate demand is determined by C(Y) + I
* Demand management in the Keynesian sense is achieved through fiscal (government spending) or monetary policy (increasing money supply)
* Keynes made argued that declining money wages were not the cure for unemployment (and depressions) that classical economists thought
	+ Workers do not decide their level of real wages, and so cannot reduce these to a level that will ensure full employment.
	+ Reductions in workers’ money wages may result in decreased consumption, and therefore can result in lower incomes and output
	+ A decline in the price level creates increased real burdens for debtors (the # of money on the IOU is fixed, but if prices decline, this amount now can purchase more, i.e. is more of a loss to the debtor)
* Keynes’s analysis of the depression was one of defective demand due to under-investment caused by excessive long-term interest rates, rather than too much debt

## Interpretations of Keynes

### Timeline

* Radical critique of orthodox Keynesianism
* 1930s-1950s: Cambridge circle, focus on def output, employment, effective demand, distributional issues
* 60s-70s: extending effective demandd (in LR), capital controversies, endogenous money (Kalder vs. Friedman)
* 70s-80s: synthesis + institutionalisation
* 90s: methodology and History of econ though
* 2000s: applied work, econometrics, financial instability, financialization
* Different strands:
	+ Fundamentalists (Davidson, Chick, Shackle): fundamental uncertainty, money & liquidity preferences
	+ Kaleckians (Kalecki, Steindl): business cycle, growth, class conflict, effective demand, pricing
	+ Kaldonians (Kaldor, Goodwin, Grodley): growth, productivity growth, real economy financial system
	+ Sraffians (Gargriani): reative prices in multi-sector system, capital, capacity
	+ Institutionalists (Veblen, Galbraith): firm

### Neoclassical synthesis/orthodox Keynesianism

* Make Keynes a special case of GE with wage/price rigidities, dividing economics into (Keynesian) macro and (neoclassical) micro
* The disequilibrium interpretation of Keynes holds that unemployment results from a combination of market functions and constraints that lead to a rationing of jobs among workers. Fixed-price sellers, innexible money wages, and a floor to interest rates are some of the forms disequilibrium-inducing constraints can take.
* Sticky prices lie at the very heart of Keynesian Macroeconomics, and it explains quantity fluctuations in goods and labour markets as equilibrating movements arising because prices do not immediately change when aggregate demand shifts. A system (Monetarism-modified Keynesianism) in which prices are sticky (though not rigid), in which quantities change to absorb demand side shocks in the short run and in which inflation expectations though mainly backward looking, are endogenous, can account for the 1970s experience at least as well as any New-Classical system based on price flexibility, clearing markets and rational expectations.

1. IS/LM/orthodox Keynesianism (+ Philips curve) became the Neoclassical synthesis, which prevailed until 1970.
2. Disequilibrium theory which as of the 1990 became New Keynesians/New Synthesis: Reject the Walrasian adjustment mechanism because there is some blockage (price rigidity); rejecting the information-dissemination role of price; reject the Walrasion auctioneer
3. Post-Keynesian

* NAIRU (non-accelerating inflation rate of unemployment) was first defined by these Keynesians. Below FE because of non-economic factors or market powers (monopolies, trade unions etc)
* Involuntary unemployment (IU) is the result of a deficient AD (AD=C + I)
	+ Where AD = result of inssufficient I and of liquidity preferences under uncertainty
* Say's Law is rejected and reversed.
* IS curve: equilibrium in the goods market; represents equilibrium in the goods market in the y-i geometrical space; investment as a function of interest: I(r) and savings a function of output: S(y); the slope of the IS-curve is determined by the multiplier/i.e. by how much investment responds to r
	+ Where government spend can shift the curve, i.e. G influences the IS curve
* LM curve: Equilibrium in the money market where money supply is exogenously given and the demand for money is determined by income/output (y) and intereste rate: Md = pL (y,r)
	+ Money is also conceived as a store of value here
	+ Influence the LM curve with monetary policy
* (Physical) Marginal efficiency of capital (MEC) = the expected return; (MEC, r) - if there is no gain over r, why invest? Now since products aren't always be completely sold, let the MEC in ideal circumstances be called the physical MEC, or PMEC, and the one contingent on realising sales etc. be the monetary MEC, or MMEC. Necessarily, PMEC ≥ MMEC, as the latter materialises as the former only if all constraints are overcome
	+ In other words, the problem is not that the rate of interest is too high, since it could be below the full employment rate (think the minimal rates of interest in the global recession, see below); and the investment possibilities, at least in principle, are profitable since PMEC > r. But the investments are not made, and it is not because the cost of capital is too high. Rather, it is lack of confidence in the ability to sell the output - The reason for liquidity preference is not expectations about the rate of interest but expectations about future levels of effective demand.
	+ Marginal efficiency of capital to denote the anticipated return to an investment-In terms of the IS/LM approach, investments can be listed in descending order of rate of return, and all will be undertaken until MEC = r. Put differently, investments will be made (rather than hoard in anticipation of higher r) if the expected rate of return on the investment exceeds the current interest rate, if MEC ≥ r.
* Whereas Monetary Marginal efficiency of capital concerns our expectations about r
* What Joan Robinson called 'bastard Keynesianism': the so- called ‘grand synthesis’ in the postwar period between Keynesian macroeconomics and neoclassical microeconomics

### IS/LM + IU

* Horizontal axis: national income/real gross domestic product
* Vertical axis: the real interest rate, r
* If the IS cureve is vertical, reductions in r (the cost of capital) do not lead to more saving and investment.
* The neoclassical synthesis may misrepresent Keynes by focusing on Walrasian price adjustment rather than quantity adjustment
* Since this is a non-dynamic model, there is a fixed relationship between the nominal interest rate and the real interest rate (the former equals the latter plus the expected inflation rate which is exogenous in the short run);
* Each point on the IS curve represents the equilibrium between the Savings and Investment (S=I)
* Given expectations about returns on fixed investment, every level of the real interest rate (i) will generate a certain level of planned fixed investment and other interest-sensitive spending → lower interest rates encourage higher fixed investmen
* Income is at the equilibrium level (for a given interest rate) when saving (out of this income) = investment
* In summary, this line represents the causation from falling interest rates to rising planned fixed investment (etc.) to rising national income and output
* The IS curve is defined by the equation:
* Y = C(Y-T(Y)) + I(r) + G + NX(Y)
	+ Where Y = income
	+ C(Y-T(Y)) = consumer spending (as an increasing function of the disposable defined as "income-taxes")
	+ I(r) = investment (as a decreasing function of the real interest rate)
	+ G = government spending
	+ NX(Y) = net exports (exports minus imports) as a decreasing function of income (decreasing because imports are an increasing function of income).
* Analysis of fiscal (IS) and monetary (LM) policies
* IS negatively slopped and the magnitude of the slope depends on the interest-elasticity of Investment and the size of the multiplier. (Its position depends on any autonomous demand factor, including fiscal policy).
* LM derives from the equality between supply of money (assumed exogenous) and demand for money (or equilibrium in the Money Market). Transactions demand for money depends positively on income such that more income will lead to more money demanded, and less money will be held the more expensive it is to do so in interest foregone (opportunity cost of holding money). Its size depends on the income elasticity of money demand for transactions and the interest elasticity of money demand for speculation; position depends on monetary policy/MS and any change in money demand not due to changes in the rate of interest or income
* IS/LM explains the relationship between investment and money, intersection of IS and LM will give overall (general!) equilibrium.
* IU can come from (i.e. where the ISLM is in equilibrium but such that the labor market doesn't clear)
	+ Wage/price rigidity because nominal wages are rigid
	+ Investment trap (investment is r-inelastic/doesn't respond to r)
	+ Interest rate rigidity: real balances (more money is not spent but hoarded) doesn't lead to a fall in r (horizontal LM in the r-y space); where r is higher than to allow full employment (I is inelastic to r)
	+ Liquidity trap: monetary policy loses its ability to stimulate the economy, either because it is unable to increase broad monetary aggregates (which lead the business cycle) when banks will not lend, or because it is unable to lower nominal interest rates when the zero lower bound is reached; changes in the money supply that fail to translate into changes in the price level; if interest rates are sufficiently low and investors expect them to rise in the future, then they do not invest into assets like bonds whose value is expected to fall.
		- Pessism over future demand brings about insufficient I, hence demand, hence IU
* These 3 can be conceived as failures in Walrasian price adjustment mechanism
* If there is a shock in IS, this translates into a shift in AD, (which has an effect on employment) which makes prices fall. The LM shifts to the right. Keynes effect occurs: Assume below-full employment (Y<YFE). Excess supply of goods leads to increase in real balances, M/P increases → (we have more money in real terms, but what to do with it) rate of interest falls -or doesn't in case of the liquidity trap -. Low interest rates in turn increases I - or not in case of the investment trap -. Effective demand rises and output grows
* Pigout effect is a similar but shortened story: lower P → higher M/P → "we are wealthier" → higher consumption of goods (higher AD)
* Pigou argued that were wages and prices sufficiently flexible, then unemployment would result in falling wages and prices. The resulting increase in the real value of wealth, especially money holdings, in relation to current production would cause an increase in expenditure, which would bring the economy back to a full employment equilibrium. This is known today as the ‘real balance effect’.
* ISLM + Real balance effect: IU only explainedd as wage rigidity; the IS curve (fiscal policy controlling the IS) and the LM (Monetary policy controlling the LM) are not independent here
* Money supply as a stabilization tool to boost AD in times of need, i.e. to restore full employment

### Disequilibrium/Keynesian Reapprraisal

* Disequilibrium/Reappraisal as an alternative view of Keynesianism was put forth in the 1960s, as a critique of the IS/LM framework
* Rejection of Walrasian price adj. mechanism/re-contractiong process (Walrasianian auctioneer) → i.e. rejection of prices as information dissemination; moves focus away from price adjustment and towards quantity adjustment (fixed price models)
* Walrasian adjustment mechanism (re-contracting process) assumes away any informational or coordination problems
* Expand the concept of equilibrium to non-Walrasian one (as point of rest)
	+ i.e. economy stays away from general market-clearing equilibrium - disequilibrium state may persist irrespective of the level (or ratio) of prices/ wages/ interest rates
* Decentralized economy; coordination and information problems
* Trade and exchange take place sequentially
* Neoclassical decision-making process - notional D vs. effective (constrained) decision-making process as effective D & effective S
* Neoclassical: max U(c, l) where l=leisure, s.t. the budget constraint pc+wl <= wH; leisure l + N (work) = H
* Clower's Dual decision hypothesis:
	+ Bringing in microfoundations on why the aggregate consumption function is a function of income (C = C(Y)) - as opposed to conceiving consumption as a function of relative prices (neoclassicals)
	+ Traditional theory assumes that a household chose its labor supply and consumption to maximize utility subject to the constraint that income > cost of consumption goods purchased
	+ HH are, however, also constrained by the labor they can sell so that demand for consumption goods will depend on realized sales of labor → undermines Walras law (where demand is notional) because now excess demand is ≠ 0. The ESL is not meet by an EDG since HH don’t have cash to buy → “you cannot put income into your demand functions if you suppose that individuals earn income from inside the system – for then income is not an independent variable.”
	+ In the absence of an auctioneer prices will fail to clear markets, trade will take place at disequilibrium prices, commodity demands will diverge from Walrasian demands, and as a result, activities may fail to be coordinated.
	+ The main question investigated by Clower was which excess demands drive prices – notional or effective excess demands. If prices respond to effective excess demands instead of notional demands the dynamic behavior of the economy will differ from that predicted by the Walrasian tâtonnement
	+ Trade takes place sequentially and/or at disequilibrium prices; price mechanism may fail to fulfil its information-disseminating role (as opposed to price rigidities, etc)
	+ Contrasts the neoclassical notional decision-making process (continuous competitive exchange equilibrium; actual prices = market-clearing prices) with Keynesian effective or dual decision making (workers optimisation problem limited by quantity/credit/labor/goods availability constraints; utility maximization under these constraints are the actual/effective demand + supply)
	+ Quantity constraints introduce nonlinearities that complicate dynamic stability of the economic system as to FE equilibrium and require a distinction between notional and effective demand
* Leijonhufvud
	+ For quantity constraints to come into effect it is not necessary to introduce institutional price rigidities, merely the assumption that prices (including wages) do not adjust as fast as quantities. He conceptualized this by talking in terms of the ranking of adjustment speeds (Classicals: prices are quicker than quantities; Keynes: quantities are quicker than prices)
	+ For Leijonhufvud the heart of the General Theory lay in an inter-temporal coordination failure. The rate of interest is the relative price of current and future consumption and Leijonhufvud claimed that Keynes’s theory of liquidity preference amounted to a theory of why the rate of interest would fail to coordinate economic activities.
	+ Both Clower & Leijonhufvud believed that the Walrasian tâtonnement model could not explain real-world markets: to understand how markets worked it was necessary to understand how prices changed. In Clower’s case, this meant the dynamics of price changes, and in Leijonhufvud’s, paying attention to the ranking of adjustment speeds.
* For HHs:
	+ Unavailability of goods: work less! (why work if you can’t buy?) – labor supply ↓
	+ Unavailability of jobs: I can demand less
* For firms:
	+ Unable to sell output: reduce labor employed (effective decision on how much labor to demand is taken)
	+ Unavailability of labor:
* 4 possible market ‘equilibrium’ regimes in a simple microeconomic disequilibrium model:
	+ Classical unemployment: ESL + EDG →HH want consume more but is constrained
	+ Underconsumption: EDL + ESG →firms want to sell more than HH want to buy and employ more than workers want to supply
	+ Repressed inflation: EDL + EDG → supply-constrained economy so HH want to buy more goods that are not there and firms want to produce more but no workers in sight
	+ Keynesian unemployment: ESL + ESG →demand-constrained economy so that HH want to consumer more but don’t have work and firms want to hire more but are restricted by insufficient sales →lack of coordination instead of price problem since both HHs firms would like to see more employment and output at the prevailing prices.
* There is an effective supply of labour curve (that is constrained by the availability of consumption goods), and an effective demand for goods curve (that is constrained by the availability of jobs).
* In the absence of sufficient interest and price elasticity, the adjustment process to an autonomous investment shock (i.e. ES of goods) may become a long one, and firms will not continue producing at an unchanged level once they’ve filled up their inventories with ES
* Planned labor reflects the firms' assumptions that they will be able to sell all of their resulting output at the prevailing market price. Hence any development in the commodity market which invalidates this crucial assumption must also invalidate these plans  The firm is constrained by its realised sales (i.e. by the limited demand for its goods), and that constrains the labour demanded
* Main point of Disequilibrium theories: not whether prices are fixed (or moving slowly), but that the market adjustment mechanism may fail
* Problems with Disequilibrium accounts: the role of money is neglected, especially into the context of microeconomic GE analysis (exchange could be barter); role of expectations downplayed; importance of I in generating (effective) demand is also downplayed; emphasis on microfoundations & methodological individualism

## Harrod-Domar Model

* The Harrod-Domer growth model postulates economic growth to be determined by an incremental capital-output-ratio (ICOR) and a fixed domestic savings rate
* Explain an economy's growth rate in terms of the level of saving and productivity of capital
* Steady growth in a model of a fixed capital-output ratio C and a fixed savings-output ratio is noted. A unit of capital will produce l/C unit of output, which in its turn will generate s/C units of net savings (i.e. addition to capital stock), so that the rate of growth of the capital stock will equal s/C → The rate of growth =

s
a
v
i
n
g
s
−
r
a
t
i
o
S

C
a
p
i
t
a
l
−
o
u
t
p
u
t
−
r
a
t
i
o
C

{\displaystyle \tfrac {savings-ratio S}{Capital-output-ratio C}}
* 3 kinds of growth
	+ Warranted growth: growth rate at which all saving is absorbed into investment; rate of growth at which the economy does not expand indefinitely or go into recession
	+ Actual growth: real rate increase in a country's GDP per year
	+ Natural rate of growth: growth an economy requires to maintain full employment
		- The so-called natural rate of economic growth is defined as exogenously given and being the sum of the growth of the labor force and the growth of labor productivity
		- If actual rate < natural rate = unemployment rises; if actual rate > natural rate = unemployment falls; hence, the natural rate of growth must be the rate of growth that keeps the rate of unemployment constant.
		- The natural rate sets the ceiling to the divergence between the actual growth rate and warranted growth rate
* Steady-state balanced growth is achieved if

s
v

=
n

{\displaystyle \frac{s}{v} = n}

 (v = capital output ratio, K/Y) - if warranted growth rate = natural growth rate. Steady-state meaning that K, L, Y are all growing at the same rate
	+ If gw > gn → shortage of labor
	+ If gn > gw → Full unemployment
* Hence, if companies adjust investment according to what they expected about future demand, and the anticipated demand is forthcoming, warranted growth equals actual growth
* Harrod's 'natural' rate of growth is the maximum sustainable rate of growth in the long run given by the rate of growth of the labour force n and the rate of labour-saving technical progress m. If the warranted and the natural rate are meant to be equal, then:

s
C

=
n
m

{\displaystyle \tfrac{s}{C} = n + m }

* For the two rates to be equal, all four variables can be adjusted to bring about correspondence
	+ Adjustment through savings: the savings coefficient depends essentially on the distribution of income between workers and capitalists, since capitalists have a higher propensity to save than the workers have.
* What is the dynamic relationship between output and investment?
* Dual role of investment: multiplier & accelerator
* Multiplier:
	+ (autonomous) investment boosting output (aggregate demand)
	+ boosting output by expanding capacity (i.e. supply side)
	+ Neoclassical: S → generate I (which is essentially Say's law); S & I are determined by thrift (postponing consumption)
	+ Keynes: I → generates S; savings are a leakage in the system that might or might not translate into investments
* Investment is a function of the difference between expected output Y\* and Y (yesterday's output)
* v=capital output ratio (productivity of capital)
* I
t

=
(

X
t

−

Y

t
−
1

)
v

{\displaystyle I\_t = (X\_t - Y\_{t-1})v }

Y
t

=

1
s

I
t

{\displaystyle Y\_t = \frac{1}{s}I\_t}

* The ratio of actual demand over expected demand for output (Xt) is therefore:

Y
t

X
t

=

C
s

(

X
t

−

Y

t
−
1

X
t

)

{\displaystyle \frac{Y\_t}{X\_t} = \frac{C}{s} (\frac{X\_t-Y\_{t-1}}{X\_t})}
* Where

(

X
t

−

Y

t
−
1

X
t

)

{\displaystyle (\frac{X\_t-Y\_{t-1}}{X\_t})}

 is simply the rate of growth
* Accelerator: I = vY\*-Y
	+ Expectation of additional effective demand determines the level of investment in the Harrod model and that investment, throught the 'multiplier', generates a certain level of effective demand in a Keynesian manner
* Knife-edge problem: if actual growth is slower than the warranted rate, then effectively we are claiming that excess capacity is being generated, i.e., the growth of an economy's productive capacity it outstripping aggregate demand growth. This excess capacity will itself induce firms to invest less—but, then, that decline in investment will itself reduce demand growth further—and thus, in the next period, even greater excess capacity is generated
* Similarly, if actual growth is faster than the warranted growth rate, then demand growth is outstripping the economy's productive capacity. Insufficient capacity implies that entrepreneurs will try to increase capacity through investment—but that that itself is a demand increase, making the shortage even more acute. With demand always one step ahead of supply, the Harrod-Domar model guarantees that unless we have demand growth and output growth at exactly the same rate, i.e., demand is growing at the warranted rate, then the economy will either grow or collapse indefinitely.

### Cambridge controversy

* The question of whether the natural growth rate is exogenous, or endogenous to demand (and whether it is input growth that causes output growth, or vice versa), lies at the heart of the debate between neoclassical economists and Keynesian/post-Keynesian economists; the two theories of income distribution that were being debated were the marginal-productivity theory and the “Cambridge” theory according to which the distribution of income between proi ts and wages was determined by the the growth rate and the savings behavior of capitalists and workers
* Both camps generally treated the natural rate of growth as given. Virtually all the focus of the debate centered on the potential mechanisms by which the warranted growth rate might be made to converge on the natural rate, giving a long-run, equilibrium growth-path.
* Keynesians/Post-Keynesians in Cambridge, UK (Nicholas Kaldor, Joan Robinson, Luigi Pasinetti, Piero Sraffa, and Richard Kahn): concentrated on adjustments to the savings ratio through changes in the distribution of income between wages and profits, on the assumption that the propensity to save out of profits is higher than out of wages; growth is primarily demand-driven because growth in the labor force as well as in labor productivity both respond to the pressure of demand, both domestic and foreign; in many countries, demand constraints (related to excessive inflation and balance of payments difficulties) tend to arise long before supply constraints are ever reached.
* Neoclassical/New-Keynesians in Cambridge, US (Paul Samuelson, Robert Solow, and Franco Modigliani): focused on adjustments to the capital/output ratio through capital-labour substitution if capital and labour were growing at different rates
* Neoclassical argue that capital is explained by marginalist revenues whhile surplus-based theories say that profits etc. are derived from surplus
* R. Lucs Jr. (Marhall Lecture): capital is a non-measurable entity and consists of heterogenous goods

## Methodology, microfoundations & the CD

### Neoclassical methodology

* Methodological individualism:
	+ Understanding social phenomena by understanding actions of individual action
	+ Imposes axiomatically a strict separation of structure from agency - socio-economic explanation, at any point in time, must move from agency to structure, with the latter being understood as the crystallisation of agents’ past acts
	+ Unidirectional explanation from individual to social structure
* Methodological instrumentalism:
	+ All behaviour is preference-driven: it is to be understood as a means for maximising preference-satisfaction (not to be confused with actual, psychological satisfaction - homo economicus may maximise his preference satisfaction while feeling suicidal). Preference is given, current, fully determining, and strictly separate from both belief and from the means employed. Everything we do and say is instrumental to preference-satisfaction
	+ Early on, preferences as fixed & exogenous, then this changed in neoclassical econ → game theory brought reconsideration of the standard assumption that agents’ current preferences are separate from the structure of the interaction in which they are involved. Suddenly, what one wants hinged on what she thought others ex-pected she would do.
	+ The person is defined as a bundle of preferences, her beliefs reduce to a set of subjective prob-ability density functions, which help convert her preferences into expected utilities, and, lastly, her Reason is the cold-hearted optimiser whose authority does not extend beyond maximising these uilities
	+ People could, and ‘should’, be modelled as if they possessed consistent preferences which guide their behaviour automatically
	+ Ordinal utilitarianism: rationality is reduced to the consistency of one’s preference ordering which, by definition, determines that which agents will do
	+ Homo economicus is still exclusively motivated by a fierce means-ends instrumentalism
* Methodological equilibration
	+ What behaviour should we expect in equilibrium?
	+ Neoclassicism cannot demonstrate that equilibrium would emerge as a natural consequence of agents’ instrumentally rational choices.
	+ Assumes (axiomatically) that agents (or their behaviour) will find themselves at that equilibrium and ask: If rational agents are behaving according to the theory’s equilibrium prediction, will they have cause to stop doing so?

### Microfoundations

* Hayek denied significance of economic aggregates - only individuals' experience of production and exchange is meaningful economic data
* Revived by Lucas critique of the macroeconomics of the 60s (Neo-classical synthesis Keynesianism): aggregation is done without consideraton of the decision by agents. In Lucas, agents are representative and have rational expectations (i.e. utility-maximizers)
* Neo-classical synthesis Keynesianism (especially Hicks' IS/LM or Patinkin's GE): exogenous aggregate variables (investment, fiscal deficit, interest rates) determine endogenous aggregates (national income, employment)
* Mean the grounding of macroeconomic models on models of individual optimizing behavior, with macroeconomic phenomena being, for the most part, a reflection of relationships that could be found at the level of the individual agent and in which the dominant framework was the theory of general competitive equilibrium
* Relationship between macro & micro as the relationship between individuals (usually optimising) and the economy; depends upon how the economy is disaggregated and how the individual components fit together
* Whilst money is shown to affect the short run, it has no impact upon the long run even though the long run is the outcome of the disturbed short run.

### Classical dichotomy

* Idea that there is a division within the economy between the so-called real economy (comprised of inputs and outputs, supply and demand, production and consumption; determined by fundamentals; relative prices & relative magnitudes) and the money (or financial) economy (absolute prices); money is simply a counting unit, a veil, an add-on to the pre-determined real equilibrium
* All of the below follows naturally from the QTM (MV=Py) and from the assumption that V is fixed, in which case, if M increases, so must P

* Background story of the Classicals:
	+ The Classical model in its purest form assumes that the labour market clears via real-wage adjustment, and that the demand for labour depends only on the properties of the production function. This gives rise to the Classical dichotomy, or the property of the values of the real variables in the model being determined independently of the value of the nominal money stock.
	+ Assume perfect competition in both the labor and product markets. Under such circumstances profit-maximizing employers will be willing pay workers a real wage equal to their marginal product.
	+ Given diminishing returns to labour in the production function, employers will need a lower real wage to induce them to demand more labour (i.e. downward sloping DN curve that is solely determined by the production function and not expected demand)
	+ Since real wages are perfectly flexible and adjust instantly (market clearing), the supply and demand for labour will be equated at the real wage level
	+ The Classical aggregate demand curve, AD, is derived from the QTM, which assumes that money is used exclusively as a means of exchange and as such is passed from individual to individual at a constant income velocity of circulation v

* Real aggregate demand represents the sum of the demands for output of all the individuals in the economy
* Output is independent of the price level in the Classical model, since changes in the price level will be matched by corresponding changes in the money wage to maintain the labour market-clearing level of employment and output
* Classical dichotomy: the values of the real variables in the model being determined independently of the value of the nominal money stock;CD postulated to not hold in SR but very well in the LR because real balances

m
o
n
e
y

p
r
i
c
e
−
l
e
v
e
l
s

{\displaystyle \tfrac {money} {price-levels}}

 can be out of equilibrium in the short run with impact upon demand whereas prices can adjust in the long run to restore the economy, and real balances, to equilibrium → The most money can do is to affect the adjustment process and not the equilibrium outcome
* Price flexibility (which is assumed by CD) allows a separation of real and nominal variables: while in the short run price stickiness or asset market disturbances deviate prices (or real exchange rates) from their real ‘fundamental’ values, these influences will evaporate in the long run and trade/current account adjustments will determine prices (or exchange rate) movements anew.
* Short-run deviations will have no lasting effect on real variables, as long-run money neutrality is maintained (in the long-run fundamentals matter)
* In equilibrium, inflation is zero and hence the nominal and real rate of interests are one and the same. Investment, in the CD, is determined (inversely) by the rate of interest (conceived of as the cost of borrowing to finance investment). Similarly, savings increase as the IR does → The Classical model assumes that the rate of interest adjusts to equate the supply of loanable funds created by the act of saving to the demand for such funds generated by investment.
* The introduction of the real balance effect disposed of classical dichotomy, making it impossible to talk about relative prices without introducing money; but it nevertheless preserve the classical proposition that the real equilibrium of the system will not be affected by the amount of money, all that will be affected will be the level of prices → In the adjustment period (when money supply was doubled), money plays a role (because prices adapt) while in the long-run equilibrium money is neutral again and the classical dichotomy holds (i.e. the real economy determines the long-run position)

* Any microeconomic basis for failure of the classical dichotomy requires some kind of nominal imperfection
* Patinkin tried to reconcile micro GE principles and Keynesian macro by introducing a transacting role for money. First, he demonstrated the invalidity of the CD (see below) and second he introduced the real balances effect or the incorporation of real money balances into the utility function, and hence into the excess demands for commodities. The resolution was achieved came at two expenses: (1) money was shown to not be neutral in the SR, but (2) CD remains valid in the LR,
* The dichotomy is comprised of CD, HP, SL and WL. On this basis, in the 1950s, Patinkin demonstrated the simple but devastating result that the classical dichotomy is invalid, as the four properties cannot all hold simultaneously
	+ From HP it follows that doubling prices doesn't change real economy/relative prices (there is no system-wide money illusion); demands, and excess demands, in the n goods markets will not change in response to a change in the absolute price level on its own
	+ However, Money demand increases (which, however, is fixed in the QTM here) → This means that, contrary to WL, the sum of excess demands across all markets cannot always be zero since it cannot hold both before and after the hypothetical shift in prices
* Now, with the hypothetical doubling of prices, the real economy remains the same because of HP but there is a need for more money to facilitate buying and selling at these higher prices. With such a shortage of money for making transactions, there is liable to be a reduction in those transactions. This means there can be a shortage of money with an impact on the real economy
* The CD is rejected since the money supply appears in the real economy (the system of excess demands, E). So HP is rejected; doubling all prices does not leave E unchanged unless M is doubled as well. SL is rejected, as any overall excess demands in goods market can be equal and opposite to those in the money market. But at least WL is retained!

* Implications for policy
	+ If UE is due to real-wage rigidity, the government can do nothing to reduce it by adjusting its spending, taxing or monetary policies, but, according to the Classical view, can only urge wage-bargainers to settle for lower real wages via money-wage cuts, or forcibly curb union powers or change minimum wage legislation to the same end → Classical model can be made to account for UE by introducing rigiditities in the way of market clearing. If unemployment is due to moneywage rigidity, then the Classical view may still be said to support money-wage cuts as a remedy for curing unemployment, but it could also recommend adjustment of the money supply
	+ In the face of (and only then!) money wage rigidity the Classical economists could not only recommend policies to induce money-wage cuts, but could also recommend increases in the money supply to move the aggregate demand curve, increase the pnce level, reduce the real wage and, hence, increase employment

## Solow–Swan model

* Solow and Swan proposed an economic model of long-run economic growth set within the framework of neoclassical economics.
* Explain long-run economic growth by looking at capital accumulation (assuming FE focuses on the link between factor accumulation and output); labor growth or population growth; and increases in productivity/technological progress
* At its core, the model offers a neoclassical (aggregate) production function, often specified to be of Cobb–Douglas type, which enables the model "to make contact with microeconomics"
* Endogenize v (capital-output ratio); Post-Keynesians endogenize the savigs rate while Malthusians endogenize labor supply
* Introduce aggregate production function (substitutability of capital and labor)
* Constant returns to scale (homogenous of degree one): if we increase x by 1, y increases by 1
* Extended the Harrod–Domar model by adding labor as a factor of production and capital-output ratios that are not fixed as they are in the Harrod–Domar model. These refinements allow increasing capital intensity to be distinguished from technological progress
* Takes up the problematic balance between warranted and natural growth in Harrod
* Attempts to explain long-run economic growth by looking at
	+ Capital accumulation
	+ Labor or population growth
	+ Increases in productivity/technological progress
* In the short run, growth is determined by moving to the new steady state which is created only from the change in the capital investment, labor force growth and depreciation rate. The change in the capital investment is from the change in the savings rate
* In the long run, growth is achievable only through technological progress
	+ Y = F(K, AL) where AL is a labor-augmenting technology (Harrod-neutral), increasing labor productivity
	+ Y = AF (K, L) (Hicks neutral)
* Assume constant constant savings ratio s and that S = I - then we're always at FE (given perfect flexibility of prices)
* SSBG: sf(k) = nk → in order to be at equilibrium (warranted = natural growth rate) : the amount of savings/worker should be sufficient such that it brings about new investment (given S = I) such as to equip every new-born worker with the same capital as the previous workers
	+ Thus, choose the mix of K and L appropriately (since they are substitutible)
* Increase in the savings rate will not change the growth rate of the balanced path/remains constant - it only changes the level (level effect)
* In the part of the curve to the left of the straight line, capital is more productive:

* Call

d
Y

Y

{\displaystyle \tfrac{dY}{Y} }

 the growth rate of output
* Call

∂
Y

∂
K

{\displaystyle \tfrac{\partial Y}{\partial K}}

 the marginal productivity of capital
* Solow residual:

g
A

=

g
Y

−
a

g
K

−
(
1
−
a
)

g
L

{\displaystyle g\_A = g\_Y - ag\_K - (1-a)g\_L }

	+ Where gA is the accounting growth rate, a = income going to capital, (1-a) the income going to capital, and where if we subtract the two from the growth rate, the rest will be accounted for by productivity growth

### New growth theories

* Harrod-Domar only addresses LR instability (gw</sub ≠ gn)
* Neoclassical exogenous growth theory is essentially a theory of the contribution that increases in factor inputs make to output in a perfectly functioning economy.
* Endogenous growth theories
	+ Endogenize the source of productivity growth
		- Externatlities (as by-production of capital accumulation); learning by doing (adapting, adopting, watching, exporting)
	+ Strong micro basis
		- Individual optimization
		- Reliance on production differentiation, economics of scale, human capital formation
	+ Market imperfactions (increasing return to scale)

## Post-Keynesianism

* Radical critique of mainstream Keynesianism (esp. IS/LM representation and the Neoclassical Synthesis) and as an alternative approach to the macroeconomy, retaining Keynesian aspects (e.g. emphasis on the determining role of aggregate effective demand, money etc), but also bringing influences from others (like Kalecki or Marx).
* In short: With the rejection of Say's Law (and the non-automatic translation of savings into investment), the investment decision, and its role in business cycles (or deficient demand) takes central stage, together with the role of systemic expectations and money, within a setting of radical uncertainty
* 1960s - early 1970s: Capital Controversies; Mid 1970s-1980s: Syntheses and Institutionalisation of PK; after 2008, renewed focus on financial instability
* Strands of PK:
	+ Fundamentalist Keynesians (American, Marshallian): money, liquidity preference, uncertainty, methodology (e.g. Davidson, Kregel, Chick, Dow, Weintraub, Shackle)
	+ Kaleckians: Pricing, growth, cycles, employment, profits, effective demand, class conflict (e.g. Kalecki, Steindl, Asimakopulos, Eichner, Bhaduri, (young) Robinson)
	+ Kaldorians: Growth, money, international, productivity regimes (Goodwin, Harrod, Godley, Thirlwall, McCombie)
	+ Sraffians or neo-Ricardians: Relative prices in multi-sectoral production, capital theory, capacity, normal profit rate (Kurz, Garegnani, Nell, Pasinetti)
	+ Institutionalists: Institutions firms, banks, labour (Veblen, JK Galbraith, Fred Lee, P. Earl, Arestis)
* PK sees outcomes in terms of systemic factors (distribution and monopolisation), rather than as the consequence of individual optimisation in the context of imperfect markets (which became the basis of New Keynesianism) with otherwise given endowments, preferences and technologies.
* PK influenced mainstream: mainstream drew from the PK monopolisation structure and process, to move away from perfect competition, albeit through an individualistic and rational framework

### AD & AS

* A central concern in PKE is the distribution of the income that is generated → In the SR: effective AD can be affected by changes in the distribution of income, e.g. in favour of capital or labour and via distributional struggle, while in the LR (i.e. growth questions) it is also asked whether labor's bad position in neoliberalism fuelled generation of unbalanced and unequal growth → is the regime wage-led, profit-led, debt-led, profit-without-investment led
	+ With capitalists having a higher propensity to save, the average saving rate of the economy increases if profit share rises (at the expense of wages) and vice-versa → the amount of profits and the rate of profit are totally independent of the workers savings rate. Whilst workers can get a bigger share of profits by saving more, they cannot they cannot save their way to socialism and eliminate the influence of capitalists by a gradual erosion of their share in the capital stock
	+ PK distribution theory ≠ neoclassical distribution theory(i.e. assumes constant shares of factors of production in output and factor prices determined by their relative scarcities, as reflected through marginal products)
	+ i.e. also a kind of Keynesian multiplier in PK, but with a consideration of distribution of income
* Whether rising wage-shares bolster demand and increases the rate of capacity utilization, which, in turn, induces capitalists to invest, or that rises in the profit share serve as the primary stimulus to economic growth
	+ Rejection of Say's Law, and the reversal of causality from investment to savings; I is determined independently from S → To break the automatic translation of S into I (i.e. Say's Law), needs to move away from barter economy (where money is simply a veil) and establish a monetary production economy.
* Accumulation is not controlled by household saving but by the investments of prot-seeking firms: In slum, investment is low because prospects of profit are weak and uncertain. Because investment is low, employment is low and incomes are low. Because incomes are low, expenditure is low. Therefore business is working below capacity and there is little demand for new investment goods (capital equipments and stocks)
* The effective demand determination via distributional issues and the impact of monopoly on output, pricing and the profit share → degree of monopoly also increase prices, suppress wages and decrease both supply and demand
* Keynes: Investment determines Savings via income (S adjusts to I via changes in Y): ΔI → ΔY → ΔS
* Kalecki: Investment determines Savings via profits: ΔI → ΔΠ → ΔS
* Wage-led growth models, inspired by the contributions of Nicholas Kaldor, estimate the degree to which capitalist investment is attuned to the growth of autonomous demand. In contrast, profit-led models, influenced by the work of Joan Robinson, gauge to determine the extent to which capitalist investment is an independent function subordinate to the rate of profit
* A fall in consumption today does not signal an automatic increase in consumption tomorrow (i.e. the inter-temporal substitution effect that is assumed to be automatically met in mainstream macroeconomics).
* Extension of the principle of effective demand to the long run.

### Money & investment

* Money supply is endogenous, demand-led and the role of the central bank is not to control it, but to act as a lender of last resort + CB controls short-term IR and not MS
* Reversed causality between money and inflation (and hence invalidation of the QTM)
* Money supply is determined via credit money creation and financial innovation - FIs as active creators of deposits (i.e. causality reversed): Loans create deposits or banks extend credit by creating money
* While neoclassical econ or the MM postulate that the type of financing (out of earnings, savings, sales of equity or debt) is not important, PK theory stresses that capital purchased today will only be validated by future income flows. Present income flows validate past investment decisions, and if current flows are below expectations, then past decisions will not be validated. Financial commitments made in the past may not be met, and this will in turn affect expectations about the future
* Firms are free, within wide limits, to accumulate as they please, and the rate of saving of the economy as a whole accommodates itself to the rate of investment that they decree

### 5 fundamental features

* Economy understood as systemic structures (≠methodological individualism), with the first 2 being the most important in PK
	+ Class structure → effect on AD of this structure
	+ Monopoly → how it restricts output, keeps price level up and aggregate demand lower (Kalecki: in slump, firms combine to protect prices)
	+ Global division between core/developed & periphery/D-ing → distinct characteristics (e.g. what they can produce, import/export); core tending to be advantaged by this structure → structuralist macroeconomics
* Systemic processes
	+ Monopolization → Wages are held down by monopolies both favouring profits but also reducing growth through deficient demand
	+ Globalization → terms of trade: Lucas paradox/surplus transfer to core which undermines their development and reproduces the global structure
	+ Financialization: role of money in distributional outcomes; more speculative vs. real investment, at expense of effective demand and working class incomes; broadened view of finance: from industrial finance to other forms of financing, esp. housing, private finance, state finance
* Theoretically distinct from mainstream
	+ Effective demand (role of monopolized structure and functional distribution of income on AD)
	+ Money as endogenous (credit/bank money) → responding to facilitate supply in meeting whatever degree of effective demand is generated
	+ Financial instability
	+ Time: historical & irreversible
	+ Uncertainty: fundamental and ≠ probabilistic risk → implications on the conceptualisation of agents' rationality (`Reasonable rationality' as opposed to `Hyperrationality' and the probabilistic expectation formation of the mainstream)
* Methodologically dinstictive
	+ Inductive in methodology: drawing upon institutional analysis and empirical regularities in constructing its theory (≠ deductive methodology) → models can, at best, clarify exposition
	+ Ontological holism (≠methodological individualism)
	+ Dynamic historical time and its irreversibility (≠ logical time): implications for the short run/ long run divide, which can no longer be sustained
* Anti-capitalist: raising the real and social wage/expand employment and living standards through higher AD

### Kalecki

* Capitalists earn what they spend and workers spend what they earn; The more capitalists invest (higher I) or the more they consume (lower sπ), the more profits they get.
* Expenditure (for I or C) of capitalists creates markets for other capitalists and determines their profits (as a class)
* Effective demand (≠Say's law: AS→AD and S→I): AD→AS and I→S
* Multiplier: change in I → change in change in Y → change in S
* Kalecki: effective demand works through the functional distribution of income (distinguish income to C and L). Changes in I → changes in profits → in S
* Y = Π + W = C + I = CW + CΠ + I
* So while in Keynes: S(Y) = sY, in Kalecki we have

S
Y

=

s
Π

Π

Y

{\displaystyle \tfrac{S}{Y} = \tfrac{s\_\Pi \Pi}{Y}}
* Sc = I-SW
* Profits = Investment + fiscal deficit + trade surplus + (Cc - Sw): P = I + (G-T) + (X-M) + (Cc - Sw)
* Equilibrium is achieved when
* In Neoclassical distribution theory: the share in income is determined by the marginal productivity of capital and labor - Marginal propensity of capital is = r and the marginal propensity of labor is = w/p
* Capitalist Π is determined by what they spend
* What determines I?
	+ Kalecki: national income is disaggregated by its distribution into profits and wages, prior to its disaggregation into savings and consumption - the level of saving will depend upon the (functional) distribution of income between capital and labour. So s is a weighted average of the higher sp and the lower sw , and therefore lies somewhere between sw < s < sp
	+ Kalecki answer #1: Degree of monopoly: firms in order to survive have mark-up pricing (charging a price above the perfectly competitive, i.e. = to marginal cost, one) or, in order to prop up Π they restrain output and investment; monopoly depends on market share, inelasticity of demand etc., collusion (degree of monopoly at the firm level depends on market share, degree of collusion and inelasticity of industry's demand) → if ratio of profits to wages increases (because higher monopoly), real profits remain the same, but the real wage bill falls (both due to lower real wage and due to a reduction in demand for wage-goods, and hence output and employment in wage-goods industries; Π per unit of output increase, but total output falls, and a shift in the distribution against labour results).
	+ Kalecki answer #2: Principle of increasing risk
* The level of profits in consumption-goods production is detennined by the condition that profits in the production of consumer goods equal the wage bill in the production of investment goods
* Internal own capital (retained earnings)
* Kaldor: If capitalists save everything (sp=1), and workers consume everything (sw=0), then S = spP = I, which rearranged is P=I/sp. Hence, the higher the sp gets, the smaller the investments.
	+ The expenditure of capitalists creates markets for other capitalists and boosts their profits. As Kaldor puts it, capitalists (as a class) earn what they spend, whilst workers are deemed to spend what they earn in passive response to whatever employment and wages come their way.
* Keynes, Kalecki, Minsky: emphasis on investment decisions and on systemic expectations of fundamental uncertainty as well as money/finance
* For Kalecki, developed capitalism is \irrational" because it is systematically unable to make full use of all the resources it creates for either consumption or investment.

### Steindl

* Based on Kalecki's principle of increasing risk, Steindl developed a liquidity preference theory of investment: companies are constrained in their investment in fixed capital by the need to keep sufficient liquid reserves and assets to be able to meet future cash commitments (which they can accomplish by borrowing/raising new capital - expanding future liabilities - or by varying investment commitment

## Monetarism

* Theoretical schizophrenia: At the micro level economic agents are optimising (profit or utility) in a world of perfect competition, perfect information, complete markets etc (orthodox microeconomics/ neoclassical); at the macro level however unemployment persisted as the money wage (or interest rate) were rigid
* Difference with Keynsianism a matter of degree: differences in the size and nature of the multipliers
* Friedman's positivist methodology: models are valuable to the extent that they are instrumental for predictions and unrealistic assumptions don't matter as long as the model does its job
* Expectations enter macro, but expectations without uncertainty (defined as your guess about price level as opposed to notions of confidence in the future of the economy); expectations are formed by individuals rather than systems (e.g. financial)
* Laissez-faire policy: i.e. deflationary management and spending-cuts

### Friedman's QTM or MD&MS

* Retains the QTM assumed association between money supply increase and a equivalent increase in prices - Friedman developed QTM as a theory of the demand for money very much as alternative to Keynesian liquidity preference theory
* MD is assumed to be autonomous & stable (erratic changes are blamed on governm)
* MS is either exogenously set by government policy/CB or determined by variables outside the money demand function
	+ MS is independent of MD
	+ MS determines prices/nominal income
* Demand: QTM reinterpreted as real demand for money; demand (determined by price of good, price of other related goods, preference, income) for money is similar to demand of other goods. MD/P as a function of real income Q, inverse of money velocity k, rates of return on equity/bond, expected inflation, ratio of non-human to human wealth, and given tastes and prefs.
* Monetary expansion will ultimately be reflected in price increases and the long-run effect on output is nil.
* Money demand was now an active constituent in the determination of income
* No distinction of different motives for holding money, and confidence regarding future demand conditions disappears.
* During post-war period, orthodox (hydraulic/ISLM/Phillips curve) Keynesianism was predominant; AD-management via fiscal and monetary policy
* Friedman was not Walrasian but a Marshallian - he did not derive the NRU from equilibrium but did attach it to it. NRU is determined by supply/real side, corresponding to frictional or temporal or institutional impediments
* What distinguished Keynesianism from monetarism was the relative emphasis on the output as opposed to the price inducing effect of reflationary policy.
* Consumption function: no longer the Keynesian C=cY; Consumption dependent on current & future income: C = f(permanent income, r); consumption smoothing (a Keynesian multiplier reduced in role and size & stretched over time)
	+ The marginal propensity to consume out of temporary income, which is crucial for the Keynesian multiplier, was likely to be much smaller than Keynesians assumed
	+ Any deviation of actual spending from its LR level will be due to effects of transitory components of income
	+ Greater role of IR (higher interest rates make current consumption more costly)
* Key elements in monetary doctrine
	+ The presumed line of causality running from money stock to the level of nominal income
	+ Private sector is inherently stable at FE; disturbances in private sector activity primarily the result of "erratic" changes in the pattern growth of the money supply, i.e. source of instability is located in the discretionary power of monetary authority ≠ Keynesianism, that posits that discretionary monetary policy is stabilising (or fine-tuning) an unstable economy.
	+ Vertical Philips curve (in the long-run, a steady rate of inflation cannot be used as a policy variable to reduce the level of unemployment)

### Philips curve & inflation

* For Friedman, monetary policy could have disastrous real effects in the SR (for him, 10 years)
* Structural crisis in the 1970s (stagflation): How could there be increasing unemployment and accelerating inflation, as this would indicate both deficient and excess demand at the same time?
* Friedman's supply side policies: removing restrictions, flexible labor market, privatise, liberalisation - until you get at max to the natural rate of unemployment, below that is only possible in the short run and at the expense of inflation
* Since one standard Keynesian policy instruments, exchange rate devaluation/depreciation, is shown to lead to nothing but inflation-it can have no real effects
* Effectively, Friedman was applying strict neoclassical theory to the Phillips Curve so that money illusion is eradicated; the equation, therefore, explains the relative price of labor rather than the absolute price
* Friedman argued that there is no long-run trade-off between inflation and unemployment - inflation is now a function of both unemployment and past in inflation expectations: if Ut<UN, then expInfl > pastExpInfl → Expectations and actual inflation must chase each other upward in an accelerating spiral
* Laidler: MS is determined by bank reserves and unexpected changes in MS
* Friedman blames contraction of MS for the Great Depression
* Both Friedman & Laidler believed in monetary business cycle (in contrast to Lucas, who thinks prices change immediately)
* Monetarists criticized that the Phillips curve was based on an implicit assumption that the private sector of the economy suffered from perpetual money illusion. They introduced the expectations augmented Phillips curve
* Vertical Phillips curve (natural rate of unemployment NRU): rejection of the trade-off between inflation and unemployment; real supply side → real equilibrium; reducing unemployment by whiggling the supply side variables (wage flexibility, trade union)
	+ Methodological shift: inductive to deductive
* New Classical Economics after monetarism: eliminate any Keynesian element; introduction of rational expectations and instantaneous market clearing
* Expectation-augmented Phillips curve by Friedman: agents adjust upward their expectation of inflation because they underestimated the price level (adaptive expectations; future expectations about inflation; equilibrium is attained when expectations are fulfilled/inflation is stable → reducing UE below the NRU is only possible with inflation. Moreover, lowering unemployment to some degree permanently below the natural rate leads to ever-accelerating, not constant, inflation such that in the long-run the Philips curve becomes vertical at the natural rate of unemployment, so inflation and unemployment are unrelated in the long run.
	+ Explanation: assume expansionary monetary policy, boosting aggregate demand, lowering UE. However, due to the higher inflation (we're moving to the left on the Philips curve, i.e. to a lower UE/higher inflation point), workers’ expectations of future inflation changes. That is, (rational & fully informed) workers will recognize their nominal wages have not kept pace with inflation increases so their real wages have been decreased. In the future, they will renegotiate their nominal wages to reflect the higher expected inflation rate, in order to keep their real wages the same. As nominal wages increase, production costs for the supplier increase, which diminishes profits. As profits decline, suppliers will decrease output and employ fewer workers. That is, the short-run Phillips curve shifts back to the right, we're back at the natural rate of unemployment - this time at a higher level of inflation though [1]
* In the LR, real output, and unemployment, are determined by Natural Level of Output and UN, themselves determined by the real (supply) side of the economy.
* The natural rate hypothesis (Friedman), or NAIRU (Modigliani & Papademos later) theory, predicts that inflation is stable only when unemployment is equal to the natural rate of unemployment.
* Expectations
	+ Under Keynes’ money illusion, changes in nominal variables (prices, wages, etc…) were accepted by agents as real despite overall purchasing power remaining stable.
	+ Friedman: adaptive expectations; natural rate of unemployment; changes in MS knock economy off equilibrium; economy adapts slowly (whereas in Lucas it adapts instantaneously)
	+ Adaptive expectations: Et-1(Pt = α Pt-1 + (1-α)Et-2 → Today's expectation (inflation) = yesterday's expectation + over/undershooting (it's a theoryless behavioral backward-looking law where you're simply using historical data); adaptive expectations process for price expectations, so that expectations are made up of a weighted average of previous price changes
	+ Agents might suffer from the money illusion, i.e. their price expectations have yet to catch with the current rate of inflation. If expectations actually catch up with the rate of inflation, then the economy can be said to be in a steady state equilibrium. At this steady state, a natural rate of unemployment is defined. With no money illusion, the Phillips Curve is vertical, so that any UE-inflation trade-off-can only be a temporary phenomenon.
	+ The problem of adaptive expectations from the point of view of NCE: if agents constantly underestimate inflation, surely they would revise the way in which they form expectations. Furthermore, it is precisely because agents with adaptive expectations do not work with a model of the economy that they are able to persist in underestimating inflation despite the evidence of what they are estimating to the contrary

### Critiques

* Kaldor's causality: it has yet to be shown that the money stock is the exogenous variable and the level of prices and wages the endogenous variables and not versa
* Kaldor: Credit expands merely in response to demand, and so changes in money supply are endogenous
* Fine: Monetarism fails to specify why inflation matters at all? Why not simply announce that you're disinflating (agents will adjust their expectations after all)
* It is assumed that monetary auhorities control inflation directly (and that there is only one inflation)

## New Classical (Macro)Economics

* Also: Freshwater economics (Chicago)
* Rational expectations: agents work with a model to form expectations (which they don't in adaptive); we're all aware of the perfect model because the "learning process is already done" - agents use new evidence not only to modify existing expectations/estimates but to choose the best model
* While new classicals shared with monetarists the view that the economy is inherently stable unless disturbed by erratic monetary growth and that when subjected to some disturbance will quickly return to its natural level of output and employment, they believed that it is unanticipated monetary shocks that are the dominant cause of business cycles
* 4 key features of NCE:
	+ GE based on choice-theoretic micro-foundations within the Walrasian GE (consistency across markets, Walras Law)
	+ RE: no systematic expectational error; expectations formed with a (theoretical) model
	+ No money illusion: can't fool agents; only real magnitudes matter
	+ Continuous market clearing: Complete & continuous price/wage flexibility and complete/perfect markets, ensure markets continuously clear.
* Monetarist explanation of business cycle: as an EQ phenomenon; economy, if left on its own, will always be in the supply-determined Walrasian equilibrium (both in SR and LR).
* Whereas in Keynes-and in Marshall-equilibrium concepts are used as points of departure in arguments which show that disequilibrating forces are at work that disrupt the various defined equilibrium, so that the economy transits among equilibria--the orthodox interpretation of Keynes, as well as the new classical economics, takes the equilibrium defined by model parameters as the "normal" state of the economy.
* The aggregate supply curve and the rational expectations hypothesis - Keynesian Macroeconomics (including its Monetarist variation) could accommodate rational expectations, but it cannot be reconciled with the universal existence of the continuously clearing flexible price competitive markets which are a sine qua non of the "aggregate supply curve" explanation of the Phillips curve.
* NCE : RE + instantaneous market clearing (i.e. fully flexible prices/excess demand functions set to 0)
* Credit and finance are assumed away and the ‘real’ rate of interest is merely the rate at which future ‘real’ incomes and expenditures are discounted to present values and resources set aside for consumption in retirement
* New-Classical competitive model differs from traditional treatments of perfectly competitive economies inasmuch as agents in it do not have full information about the structure of relative prices when they engage in trade - when a producer observes a change in the price of his product, he does not know whether it reflects a change in the good's relative price or a change in the aggregate price level (this confusion is the cause of recessions). A change in the relative price alters the optimal amount to produce → this is NCE's explanation for business cycle fluctuations (Price expectations may deviate from LR values if due to incomplete info agents cannot distinguish between specific and general price disturbances)
* Agents form expectations "as if" they were fully informed about tbe structure of the economy in which they operate
* Output and employment fluctuation such as we observe in the real world are, according to New-Classical Economics, voluntary responses to misperceived price signals, which occur because prices change (Keynesians + Monetarists explains quantity changes as occurring because prices do not change fast enough to keep markets cleared)
* Lucas misperception model:
	+ Difference between SR and LR comes from random monetary/nominal shocks emanating from monetary policy (lack of information on the part of the population so to speak; agents are confused/misperceive)
	+ Lucas surprise Aggregate Supply Hypothesis (the well known Surprise Supply equation, which is essentially a reformulation of the EA-PhC with RE embedded in it)
		- SR Lucas Supply: Real output deviates from its natural level only in response to deviations of actual price level from its rational expected value; i.e. due to unexpected (surprise) increases in MS (and hence the price level) while without these SR actual output is indepenent of systematic monetary policy (only SR price level depends on this) → That is why inflation is only a monetary phenomenon.
		- The Lucas AS curve can be expressed in inflation terms (**it's a RE-augmented PhC**): inflation surprise leads to a temporary reduction of U below the NRU (or a temporary increase of output from its natural level, QN); Lucas AS function describes the relation between output and inflation → only surprises are effective.
	+ Re-interpration of Phillips curve - as a random relationship
* Lucas: A short-run equilibrium relationship between inflation and unemployment (Phillips curve) will result if inflation is unanticipated due to incomplete information.
* Due to RE, agents understand the (government's) incentive and internaliize it while expectations are formed, expectations are higher than target:

π
t
e

>

π
T

{\displaystyle \pi\_t^e > \pi^T}
* Money supply has a random and a systemic part. Representative agents have rational expectations:
* M
t

=

M
t
′

u
t

{\displaystyle M\_t = M\_t' + u\_t}

	+ Where the first M term is the actual monetary policy, the second one the systematic one an the third an error/random term
	+ Systematic monetary policy does not affect Q in the SR or LR but only P in the SR and LR
	+ Remember, with Friedman expectations are adaptive (expectations will conform to inflation) and hence monetary policy can affect the SR (even though at the expense of inflation), essentially it has an effect until people have updated their expectations; here, with RE, this doesn't even work even in the SR since private agents shift their actions in equal and opposite amounts to government (it can only work in the SR if gov. changes MP *after* agents have formed expectations - see credibility problem), and short-run expectations are immediately and instantaneously in long-run equilibrium (just as they factor in future increased taxation if the government embarks on deficit spending #RicardianEquivalence)
* AS:

Q
t

=

Q
N

a
(

P
t

−

P
t
e

)

{\displaystyle Q\_t = Q\_N + a(P\_t-P\_t^e) }
* AD:

Q
t

=
b
c
(

M
t

−

P
t
e

)

{\displaystyle Q\_t = b + c(M\_t-P\_t^e)}
* LR equilibrium (i.e. where expectations are met); output will be at its natural level:

Q
t

=

Q
N

{\displaystyle Q\_t = Q\_N }

and

P
t

=

M
t
′

b
−

Q
N

c

{\displaystyle P\_t=M\_t' + \frac{b-Q\_N}{c}}

* SR expectation formation mechanism - Rational expectations:
	+ E(AS) = E(AD)
	+ E
	(

	Q
	N

	a
	(

	P
	t

	−

	P
	t
	e

	)
	)
	=
	E
	(
	b
	c
	(

	M
	t

	−

	P
	t
	e

	)
	)

	{\displaystyle E(Q\_N + a(P\_t-P\_t^e)) = E(b+c(M\_t-P\_t^e))}
	+ Q
	N

	a
	(
	E
	(

	P
	t

	)
	−
	E
	(

	P
	t
	e

	)
	)
	=
	b
	c
	(
	E
	(

	M
	t

	)
	−
	E
	(

	P
	t
	e

	)
	)

	{\displaystyle Q\_N + a(E(P\_t)-E(P\_t^e)) = b+c(E(M\_t)-E(P\_t^e))}
	+ E
	(

	P
	t

	)
	=
	E
	(

	P
	t
	e

	)
	=

	P
	t
	e

	{\displaystyle E(P\_t) = E(P\_t^e) = P\_t^e}

		- Where the first term = model expecation of what P will be; second term=model expectations of agents expectations to be; third term =agents expectation
* LR-equilibrium: Defined by expectations being fullfiled and no monetary shocks
* Equilibrium output is determined by the supply-side of the model (back to Say's Law), and the price level depends only on (systematic) money supply (back to CD & QTM)
* In the absence of unanticipated changes in the money supply, the economy will always be at its long run equilibrium (which is supply-determined by technology, endowments, and preferences while the QTM determines LR EQ price level)
* The Lucas model (and much of NCE) understand business cycles fluctuations (i.e. deviations of SR output from LR trend): These are due to monetary shocks, in the presence of imperfect information (extreme monetarist explanation of business cycles).
* Social welfare function:

# S
f
(
Q
,
π
# )

λ
1

(

π
t

−

π
T

)
2

λ
2

(

Q
t

−

Q
T

)
2

{\displaystyle S = f(Q,\pi) = \lambda\_1(\pi\_t-\pi^T)^2 + \lambda\_2(Q\_t-Q^T)^2}

	+ Note that the lambdas simply represent weightings. If you increase the first lambda, you increase inflation-aversion
* Why would governments target a level of output above the natural rate? - pareto-inefficiencies (unemployment benefits, power of trade unions)
* Government credibility/reputation building: incur unemployment/output costs

π
t

<

π
t
e

{\displaystyle \pi\_t < \pi\_t^e}

	+ Argument for independent CB. The short-sightedness of governments (grounded in their 4-year cycle) prevents them from following on a long-term strategy based on reputation
* In NCE, the analytical techniques can be used to derive macro-predictions witb empirical content from notbing but well specified micro-premises only on the assumptions of representative agents operating in competitive markets cleared by flexible prices.
* In a New-Classical world, quantities change because prices fluctuate. Output and employment should therefore vary at least simultaneously with (or perhaps lag behind) the price level; but it is a stylized fact of real world business cycles that quantity changes seem to precede associated price level changes.
* In those models the BoE has increasingly been accepted, in line with the new classical approach to macroeconomic dynamics, that changes in variables over time are responses to shocks or stochastic disturbances, i.e. random events with a known probability distribution, affecting a system that starts in general equilibrium, and then reverts to a different general equilibrium.
* Bottom line: unanticipated monetary policy does have a short-run effect, whereby a surprise increase in money supply can lead to a temporary boost in real activity, as a result of errors in expectations due to agents’ (or the representative agent’s) misperceptions of the money supply
* Policymaker is envisioned to minimize a loss-function

### (Monetary) Policy under NCE

* As to fiscal stimulus: Lucas argued that because of the Ricardian equivalence, rational agents would simply take the money from the government stimulus and save it since they know that the bill will later come due, i.e. no effect of fiscal policy - concentrate on monetary policy if at all
* Policy ineffectiveness proposition: Discretionary systematic monetary policy is totally ineffective, and only random/arbitrary monetary policy can have short-run real effects; money and monetary policy are neutral in both SR & LR so long as changes in money supply are anticipated (i.e. unanticipated shocks can have an effect although agents might learn to antipate suprises); money super neutrality: if money is neutral even in SR
	+ Policy ineffectiveness proposition: systematic monetary policy cannot change real output (only price levels) and its random part, if at all effective, is only destabilizing; although, as the New Keynesian (NCM) theories clearly demonstrate, it is the assumption of instantaneous market clearing (i.e. fully flex prices) that is fundamental for the policy ineffectiveness proposition. For NCM re-invents a role for policy, while retaining rational expectations
	+ 2 underlying assumptions: Prices and wages are perfectly flexible, and expectations are rational. If prices are sticky, anticipated changes in the money supply have an effect on real output, even if expectations are rational.
* Lucas critique: all prior models are flawed because not taking account of such countervailing action by economic agents
	+ Re-invention of the PhC as a random relation, as opposed to a systematic one; PhC not as a permanent trade-off/ policy menu between the two original PhC) nor because of slow adjustment of (adaptive) expectations (Friedman's PhC), but because of incomplete info in light of monetary surprises' (i.e. as a relation arise from random shocks).
	+ Argues that government policy cannot take empirical relations (e.g. PhC)) as the basis for policy, since agents will respond differently to known policy than to random shocks
* While the Lucas model allows for real effects of unexpected variations in monetary policy (modeled as stochastic variation in the growth rate of the money supply), it implies that any real effects of monetary policy must be purely transitory and that monetary disturbances should have no real effects to the extent that their influence on aggregate nominal expenditure can be forecast in advance
* Time inconsistency problem: the ‘best’ policy for the government to announce before the agents form expectations (ex ante) is different from the best policy that will be adopted after the agents have adopted those expectations (ex post) → Consequently, they are aware of the government’s time-inconsistent problem and take it into account whilst forming their expectations. This gives rise to so-called inflationary bias. If output is to be sustained at the level QN, M will have to be increased to a higher level than would otherwise be necessary because this is what agents will be expecting \*\*Inflationary bias: Qt = QN but at a higher in ation rate, due to higher in ation expectations. Note the asymmetry: While rational agents understand the goals & incentives of govnt (and anticipate them), the latter is never allowed to understand the futility of its actions.
	+ The problem is that the benevolent policymaker is facing a labor market player who is clever enough to fully understand the game that is being played. The other player discerns that the optimal zero inflation policy will be time-inconsistent (i.e. no longer optimal after wage contracts are settled). Rational agents expect the policymaker, if equipped with discretion, to renege on the optimal zero-inflation policy and to spring deliberate “inflation surprises” upon them. By contrast, if the policymaker foregoes the option to reoptimize by precommiting to a “rule,” the system, while still ending up at the (distorted) natural rate level, would not suffer the extra burden of an inflationary bias. This is the time-inconsistency case for “rules rather than discretion.”
* Governments can regain credibility only by adopting disinflationary policy (as the UK & US did in 1980s) for agents to believe this represents a change in policy (or objective function), thereby allowing them to lower their expectations without suspecting that a surprise increase in the money supply will result

### CBI

* Friedman rejected CBI, rejecting the concentration of vast powers “in a body free from any kind of direct, effective political control; CBI means dispersal of responsibilities and lack of accountability, the rule of men rather than law, and susceptibility of CBers to particular interests
	+ CBI became seen as representing 'rule' in NCE when it was still a synonym for discretion to Friedman
* CB will supposedly develop a higher inflation aversion than government (which is subject to political business cycle), thereby ensuring an appropriate weight on the long-term benefits of the primacy of price stability
* Independence is presented as a device for insulating monetary policy from myopic political pressures - the aim of discretionary policies, however, is to stabilize an unstable economy, not to resort to deliberate surprise inflation in order to push employment beyond its equilibrium level.
* Depoliticization of monetary policy is coupled with legitimising the use of unemployment as the necessary cost of building government reputation in the fight against inflation → Monetary policy is merely a technical instrument in the control of inflation with no distributive and social implications
* Politics is the means by which the state can be made effective, and so the conclusion is drawn that it must be neutralised by transferring its means of being so to what is presumed to be an apolitical regulator.
* The absence of any correlation between CBI and real economic performance is actually a rather troubling finding, given that price stability as the primary or even sole goal for monetary policy is generally justified on the grounds that low inflation would somehow improve real economic performance

## RBCT

* Briefly: persistent real (supply-side) shocks, rather than unanticipated monetary (demand-side) shocks, to the economy. The focus of these real shocks involves large random fluctuations in the rate of technological progress that result in fluctuations in relative prices to which rational economic agents optimally respond by altering their supply of labour and consumption; observed fluctuations in output are viewed as fluctuations in the natural rate of output, not deviations of output from a smooth deterministic trend.
* Modern equilibrium business cycle theory starts with the view that ‘growth and fluctuations are not distinct phenomena to be studied with separate data and analytical tools’
* Economoy understood as a moving (dynamic, i.e. intertemporal) Walrasian GE system
	+ Continuous market clearing
	+ Rational expectations (but ≠ Lucas because for RBCT shocks are not nominal/monetary)
* Buffeted by **real** supply shocks, called 'impulse', and propagation mechanisms (i.e. ways by which shock is transmitted in the economy)
	+ How shocks to the economic system were propagated across time and across sectors in the economy were a central theme of students of the business cycle
	+ One prominent candidate for such mechanisms is the intertemporal substitution of labor
* What? Aim is to explain theoretically how induced fluctuations (due to shocks) in macro aggregates can be matched (quantitatively) to empirically observed comovements
* How? Construction of artificial models (DSGE) from solid micro-principles
* With regards to the three macro distinctions?
	+ Micro/macro: macro subsumed under micro because economy constructed as a micro-based GE system in which individuals rationally optimize intra and intertemporally not only consumption but also leisure (given preferences, technology, endowments)
		- Introuction of expected utility-discounting future utility
	+ Money/real: money disappears because only real variables matter
	+ SR/LR: unifying the two by collapsing/endogenizing SR onto LR; SR to be studied in the same framework as LR-growth (thus, dynamic trends have to be taken into account)
* Fluctuating line (GDP-time space) is called business cycle and fluctuations due to continuous technological shocks vs. LR-growth path/potential output/FE-output. What is conventionally conceived of as the recession is simply another GE point in RBCT theory (i.e. we're always as FE-output and hence only voluntary UE; there are no "deviations"; there is no gap between actual and potential)
* Recessions are just the optimal response at a different GE point, markets never fail - no need for stablization policy because there is nothing to stabilize
* If a negative technological shock occurs, individuals respond optimally by withdrawing work now/take more leisure (Great Depression = Great Vacation) → if you start from the assumption that people are perfectly rational and markets are perfectly efficient, you have to conclude that unemployment is voluntary and recessions are desirable
* Unlike Solow-growth model, which assumed (the trend of) technological progress to be smooth over time, in RBCT technology moves in stochastic and erratic way
* Building artificial models (derived from solid microfoundations); match stylised facts quantitatively; Friedman's positivist instrumentalism
* Doesn't matter whether the model matches reality (because only an instrument), only whether conlusion does
* The equilibrium level of output can easily be disturbed by real disturbances of many sorts—variations in the rate of technical progress, variations in government purchases, changes in tax rates, or different kinds of shifts in tastes.

### DSGE

* DSGE models share a structure built around three interrelated "blocks": a demand block, a supply block, and a monetary policy equation. Formally, the equations that define these blocks are built on microfoundations and make explicit assumptions about the behavior of the main economic agents in the economy:
	+ HH maximize a utility function over consumption and labor effort
	+ Firms maximize profits + have a production function specifying the amount of goods produced, depending on the amount of labor, capital and other inputs they employ
* In DSGE modeling, the central equation for consumption supposedly provides a way in which the consumer links decisions to consume now with decisions to consume later and thus achieves maximum utility in each period
* Economy made up of infinite # of atomistic households, producing single good and max(U). Since all individuals understand the same “Truth”, it suffices to model one “representative individual” to fully represent reality
* Dynamic: studying how the economy evolves over time; involves C-S decision ('Calvo pricing' to introduce dynamics into GE); a representative agent solves a dynamic optimisation problem over an infinite time horizon (this can be in discrete or continuous time); time only enters the problem through the discount function, which is used to reduce the weight of utility in future periods; when some ‘shock’ hits a model, the transition path is modelled between the steady state equilibria before and after the shock. In other words, what limited dynamics exist in DSGE models are omitted when discussing the main implications of the models, taking us back to the world of comparative statics.
* Stochastic: shocks are uncertain/economy is affected by random shocks; only deal with stochastic behaviour in a stylised sense: by imposing terms which are stochastic — usually normally distributed — into the rest of the model; take an existing parameter and makes it stochastic whereas it is the **change** in a variable which is stochastic
* General: entire economy is concerned, i.e. interactions between different parts of the economy can be modelled - however, interactions are seen through the price mechanism while non-price communication is ruled out
* Equilibrium: subscribing to the Walrasian, general equilibrium theory; the ‘equilibrium’ in a DSGE model refers to the entire time path of the economy, while the ‘steady-state equilibrium’ is the unchanging outcome most people would think of as an equilibrium; In the time-path equilibrium of a DSGE model what isn’t changing is the relationship between key variables
* GE: impose consistency on individual decisions
* Calibration allows to quantify and compare the model with the actual data
* Take a synthetic variable (synthesizing observations) and come up with assumptions that allow your model to mimic observations
* Steps for calibration

1. Construct a artificial economy
2. Derive optimization problems
3. Obtain FOLS
4. FOLS + constraints → solve system of (non-linear stochastic difference) equations by means of loglinearizing approximation (1st order Taylor expansion)
5. Give numerical values to parameters, i.e. the α in Y=F(K,L) = At Kα L1-α where α is usually .7 for labor and .3 for capital
6. Solve model - optimal decision rules
7. Simulation and compare with actual data

* When the forecasts of Keynesian economics were exposed by the stagflation of the 1970s, mainstream macroeconomics reversed back into what was called ‘microeconomic foundations’, or the so-called Lucas critique. Outside intervention into the market was no longer justified by theory. Uncertainty and irrational expectations, part of Keynesian thought, were replaced with ‘rational expectations’ in a myriad of Dynamic Stochastic General Equilibrium models. DSGE models had equilibrium because they started from the premise that supply would equal demand ideally; they were dynamic because the models incorporated changing behaviour by individuals or firms (agents); and they were stochastic as ‘shocks’ to the system (trade union wage push, government spending action) were considered as random with a range of outcomes, unless confirmed otherwise). [2] [3]
* In DSGE models, the credit crisis that erupted in august 2007 is the result of an exogenous increase in risk aversion, and not the result of previous periods of euphoria that led to bubbles in asset markets and unsustainable debt levels. In the DSGE-world the crisis is the result of an event that could not be foreseen, like a meteor hit.

## New Keynesianism

* Saltwater economics (MIT)
* New Keynesian models have incorporated the rational expectations hypothesis and representative individuals, market imperfectiosn such as due to wage and price stickiness (nominal rigidities), asymmetric information and monopoly power, and Friedman’s natural rate hypothesis; show that market non-clearing (and involuntary unemployment) can still emerge in the presence of RE
* Market failure due to asymmetric information (Akerlof), moral hazard or adverse selection

* Emphasis on information consolidates the role of expectations as crucial (as opposed to systemic functioning or variables such as class, power and conflict)
* Rationale for why markets might not clear or why prices might not adjust downwards, even in the presence of excess supply and freedom for prices to move.
* LM curve replaced by Taylor-rule (which was later adapted and introduced New Monetary Consensus)
* New Keynesians start with rational behavior and market equilibrium as a baseline, and try to get economic dysfunction by tweaking that baseline at the edges. Such tweaks enable New Keynesian models to generate temporary real effects from nominal shocks
* Keynes vs. micro GE in the 1930s
* Neoclassical synthesis in the 1940s (IS/LM + PhC, incorporate Keynesian into neoclassical GE)
* Efficient wage theory: credit rationing theories; wage will end up higher than market clearing because under asymmetric information this is optimal
	+ I pay higher wages to get higher productivity
* Information asymmetry can also lead to no markets to establish (like health insurance: when prices go up, the healthy leave)
* Douglas North: ha! Institutions exist because markets are imperfect
* Krugman: international trade explained by increasing returns to scale, not imperialism
* Imperfections: away from perfect competition (e.g. monopolistic competition)
* Macroeconomy is conceived in terms of SR deviations around a LR trend, with these deviations determined by a mix of random shocks and market imperfections or rigidities → LR values are determined by supply side but given sticky prices, the short-run equilibrium may be demand-determined.
* Policy: state might be somewhat effective

### New Consensus Macroeconomics

* New Consensus Macroeconomics (NCM) is the term used to summarise the three main reduced-form equations of a (basic) new Keynesian DSGE model. That is, a new IS (Euler equation, first-order condition, of intertemporal utility maximisation), a new Phillips curve (first-order condition of profit maximisation by monopolistic intermediate firms) and a Taylor rule (for monetary policy).
* NCM entailed an eclectic selection of new Keynesian sources of imperfections and rigidities, albeit succumbing to the general equilibrium and stochastic paradigm of the RBC theory, and fully embracing the DSGE analytical framework for the study of business cycles
* Accepts the DSGE fully but brings in a division between SR & LR due to speed of adjustment of prices - while in the LR all prices are fully flexible, in the SR there is slow adjustment → no market clearing (demand-determined), response of economy to exogenous shocks will not be optimal, role (justified and capable) for monetary policy
* RBC ≠ NCM because price stickiness leaves room for a distinction between SR and LR based on speed of adjustment (i.e. quantities also matter for market clearing and SR-EQ may be demand-determined)
* There exist two distinct and independent sources of distortion in the NCM model
	+ Monopolistic competition in the goods market that makes the long-run equilibrium level of output, y\*, Pareto suboptimal
	+ Sticky prices do not allow for both attaining the constrained natural level of output, y\* (in the short run), and for an efficient response to an exogenous disturbance.
	+ It is because of rigid prices that a role for monetary policy emerges. The block of three equations describes the scope and mechanism of monetary policy in stabilising the economy in the presence of exogenous shocks
* Assume exogenous shock leading to actual inflation and output deviate above their target and equilibrium levels, respectively
	+ Taylor rule: CB should react by increasing the nominal interest rate
	+ Due to sticky prices, this nominal increase will translate into a rise in the expected real rate of interest
	+ Through the IS curve this will depress consumption (and investment) and signal a commitment to control the inflation rate
	+ A reduction of inflation follows both through reducing excess demand and by reducing inflationary expectations (via the Phillips-like curve).
	+ Both output and actual inflation move downwards towards their targeted levels → Inflation and output stabilisation are coincident
* NCM has an RBC supply-side equilibrium as its basis and as its target
* First equation (This is like the old IS curve, as actual demand and output are below long-run equilibrium if the expected real interest rate is above its equilibrium, natural level (r\*t), as this tends to depress demand.):

(

y
t

−
y
∗

)
t

=

a
1

(
y
−
y
∗

)

t
−
1

a
2

E
(
y
−
y
∗

)

t
1

a
3

(

i
t

−
r

∗
t

−
E

Π

t
1

)

{\displaystyle (y\_t-y\*)\_t = a\_1(y-y\*)\_{t-1} + a\_2E(y-y\*)\_{t+1} + a\_3(i\_t -r\*\_t -E\Pi\_{t+1}) }

 where

(

y
t

−
y
∗

)
t

{\displaystyle (y\_t-y\*)\_t}

 = output gap

a
1

(
y
−
y
∗

)

t
−
1

{\displaystyle a\_1(y-y\*)\_{t-1}}

 = previous output gap

a
2

E
(
y
−
y
∗

)

t
1

{\displaystyle a\_2E(y-y\*)\_{t+1}}

 = expected future output gap

i
t

−
E
(

π

t
1

)

{\displaystyle i\_t -E(\pi\_{t+1})}

 = real interest rate

* Second equation is a New Keynesian Philips curve (max profits, monopol. comp., price maker, Calvo price stickiness). The anticipated inflation rate will be higher, the higher it has been in the past and the higher it is anticipated to be (as a weighted sum), since past inflation will have an inertia of its own and the future inflation will be factored into decision making:

Π
t

=

b
1

Π

t
−
1

b
2

E
(

Π

t
1

)

b
3

(

y
t

−

y
t

∗
)

{\displaystyle \Pi\_t = b\_1\Pi\_{t-1} + b\_2E(\Pi\_{t+1}) + b\_3(y\_t-y\_t\*)}

 where

Π
t

{\displaystyle \Pi\_t}

 is inflation

* Third equation, unlike the LM curve, arises out of the independent role played by the central bank in setting its policy instrument: the nominal rate of interest (money supply is supposedly endogenised by a replacement of the old LM curve with the TR).; Taylor rule for setting the rate of interest with the central bank raising the interest rate to deflate the economy to the extent that the inflation rate and the level of demand exceed target or equilibrium:

y
t

=

y
t

∗

Π
t

=

Π
T

# (
0
)

i
t

=

r
t

∗

Π
T

E
(

Π
t

# )

Π
T

{\displaystyle y\_t = y\_t\* \Pi\_t=\Pi^T (=0) i\_t=r\_t\* + \Pi^T E(\Pi\_t)=\Pi^T}

 where

Π
T

{\displaystyle \Pi^T}

 = bank’s targeted rate of inflation

y
∗

{\displaystyle y\*}

 = potential (natural) output

* Systematic policy (via the Taylor rule) has a stabilising role whilst, at the same time, unanticipated shifts in the central bank’s interest rate (an error term in the Taylor rule) are unambiguously destabilising → the model takes the simplest possible view of the monetary, i.e. financial, system. It is merely a source of demand through the leverage of the interest rate
* NCM vs. RBC:
	+ Monopolistic competition & mark-up pricing ≠ perfect markets
	+ Price stickiness/nominal rigidities ≠ flexible prices → a narrowed stabilisation role for monetary policy is allowed (though only through ICB with a clear interest-rate policy rule, i.e. Taylor rule)
	+ Allows for nominal or demand shocks
	+ SR S-shocks & D-shocks ≠ technological shock
	+ Endogenous money through a nominal interest rate (though distinct from PK)
	+ Re-introduction of the short/long run divide
* Fiscal policy vanished in the 1970 with (Friedman's) denial of the multiplier effect: Ricardian equivalence & crowding out effects are brought forward
* 'Divine coincidence': There is no trade-off between inflation stabiliation and output, based on presumption that output gap stabilisation is a by-product of inflation stabilisation (or that inflation stability implies economic stability).

#### NCM and the GFC

* NCM was at loss because:
	+ Absence of a meaningful financial sector
	+ Commitment to `divine coincidence' (stable inflation → stable output gap and financial stability)
	+ Downgrade or complete absence of fiscal policy
	+ Absence of a discussion around (involuntary) unemployment, which cannot be easily accommodated in the NCM toolkit
* Why did the signicant decline in house prices (why was there a bubble?) since 2007 or the substantial losses sustained by financial institutions affect aggregate real economic activity?
* Housing market: every asset has a corresponding liability; hence any change in housing prices would have only pure distributional effects and zero net wealth effects. In other words, distributional issues (say among creditors and debtors) have no impact at the aggregate macro level

## Global financial crisis

* In the neoclassical literature, the basis of economic activity is the exchange of ‘real’ resources, which finance merely passively facilitates.
* Instead of acknowledging endogenous money creation, money supply/demand was seen as unstable
* Immediate response to crisis was that the European interbank market freezes, hence ECB throws in undisclosed amounts of liquidity; after that a gradual reduction of the nominal rate of interst
* Economics in crisis: lack of meaninigful financial sector,except EMH since the 70s; duality of money (macro) and finance (micro); commitment to divine coincidence; lack of fiscal policy;
* Complete markets in contrast to EMH (full risk sharing/insurance): intertemporal utility maximizing - idiosyncratic shocks are backed by others such that on the aggregate level there are no shocks
* Given the representative agent paradigm, real wealth effect should net out (because distributional effects have no impact)
* Neoclassical growth model (of financial integration): emphasize allocative efficiency and risk sharing as the main sources of potential gains from financial integration - however, empirically, this is not the case
* Deregulation as a factor in the financial crisis: it may be a necessary condition of the crisis, but it is not a suffi cient one.

### Policy response

* Liquidity provision (lender of last resort)
* Reducing base (interst) rate - zero lower bound
* QE (large purchase of asset - usually short-term gov bonds - to increase money supply) but also expansion of the monetary base by large scale purchases of mainly longer-term govnt bonds, as well as other assets (e.g. MBS), by the Central Bank
	+ Fed: QE1 Nov/2008: Fed purchases up to $600bn in agency MBS and agency debt. (But with no impact on the balance sheet, as sterilised by Treasury). May/2009: A major expansion of $1.15trn { now unsterilised QE2: Nov/2010 - Jun/2011: Further purchase of $600 bn of longer dated treasuries, at a rate of $75 bn per month. Sept/2011: Operation Twist; QE3: Sep/2012 Dec/2013: $40bn per month on agency MBS until the labour mkt improved substantially.
* Negative IR policy
* Expansionary fiscal policy in 2008/2009, then austerity (expansionary fiscal contraction)
* CBs have attained new remits, especially around the financial stability domain (macro-prudential responsibilities)
* Theoretical conundrums for economics:
	+ Why was there a bubble in the housing market?
	+ Why would the collapse of asset market and financial market have impact on real economy?

## Macroeconomic accounting

* Government spending increases the net financial assets of non-government, whereas taxes do the reverse
* In the case of a government deficit, in which government spends more into the economy over the period than it taxes out, non-government will spend less than its income, with the flow of saving adding to its stock of net financial wealth. Net financial assets will increase. When, instead, government runs a surplus, taxing more out of the economy than it spends into it, non-government will spend more than its income, by either running down past savings or borrowing. Net financial assets will decrease.
* Think of government spending involves crediting bank accounts whereas taxes involve debiting bank accounts
* In general, the government’s financial balance is matched dollar for dollar by the non-government’s financial balance, but with the signs reversed. The sector that spends less than its income is said to have maintained a financial surplus over the period
* Usually, it is assumed that once government has set its fiscal policy (including tax rates and spending measures), it is the spending decisions of non-government that determine which sector runs a deficit, and which sector runs a surplus. The idea here is that non-government spending decisions, by affecting income, affect the amount of tax payments. This is because, for given tax rates, the amount taxed out of the economy rises and falls automatically with income
* GDP = C + I + G + X - M → think of the expenditures as coming from three sectors: government, which spends G; the domestic private sector, which spends C and I; and non-residents who spend X on domestic production and generate M by selling foreign output to residents.
* Also, because GDP includes only income generated by domestic production, it excludes income received by residents on the basis of foreign production while including income received by foreigners on the basis of domestic production.
* Some residents work overseas employee compensation, dividends or interest. These are all examples of primary income flows → Adding the primary income balance to GDP gives a measure called Gross National Income, denoted GNI. There can also be current transfers, with nothing of economic value provided in exchange, such as a pension paid to a domestic resident by a foreign government (or the reverse). These are referred to as secondary income flows. The primary income balance reflects net primary income flows (i.e. primary income derived by residents from foreign production minus primary income derived by foreigners from domestic production). The secondary income balance reflects net secondary income flows → Adding the secondary income balance to GNI gives a measure called Gross National Disposable Income (GNDI). It is a measure of the total income received by residents. If we denote the sum of net primary and secondary income flows F, we have:

GNDI = GDP + F = C + I + G + X – M + F
* Subtracting taxes (T) from the left and right-hand sides of this expression (which preserves the equality) gives: GNDI – T = C + I + G – T + X – M + F or rearranged

(GNDI – T – C – I) + (T – G) + (M – X – F) = 0
whereby
GNDI – T = disposable income
C & I = expenditures of domestic-private sector (its disposable income minus its expenditure, i.e. its financial balance)
T – G = government’s financial balance (difference between taxes & government spending, i.e. fiscal balance)
M – X – F = foreign sector’s financial balance (M=income foreigners receive from selling output to domestic economy, minus the amount they spend on domestic output (X), minus the net primary and secondary income F)
* Subtracting C from disposable income (GNDI – T) leaves that part of disposable income that is not consumed. **This is private saving (S = GNDI – T – C)**
* Rewritting this you get the sectoral balances identity:

(S – I) + (T – G) + (M – X – F) = 0
Domestic Private Balance + Government Balance + Foreign Balance = 0
* The result can be aggregated a bit more by combining the domestic-private and foreign sectors into the Non-Government Sector. The identity then becomes: Non-Government Balance + Government Balance = 0
* Whatever the non-government balance happens to be, the government’s balance must be its mirror image.

### International BoP

* Current account: "what have I earned through trade, services, lending & investing" minus "what have I PAID FOR trade or work or lending or investing" → The difference is the current account balance, thus: current account = saving minus domestic investment
* Capital account: "how have I attracted the money to pay for the current account balance?" and "how have I invested the money of the current account balance (if I have a surplus)?"
* Current account surplus (i.e. exported more than imported) ≡ capital account deficit (I have invested more money than I have received capital)
* Current account deficit ≡ capital account surplus (i.e. imports > exports)
* A current account deficit means that a country’s financial claims on the rest of the world (i.e. its assets) have decreased, or the rest of the worlds' claims on the country (its liabilities) have increased
* A capital account surplus is a (net) financial inflow which is used to finance a current account deficit, a financial outflow
* Note that foreign money does NOT flow into the country. Dollars ‘flow’ in from foreign investors and ‘flow’ out to US T bills seller. ( In the process, domestic money increases. ) In fact, the dollars never leave the US – remember, money is numbers in computers. Foreign money is useless in the domestic economy, which uses domestic money
* Government FX reserves are foreign financial assets → they are not a stash of dollars in the country. Foreign investment is an exchange of private domestic assets (e.g. equity) for official foreign assets (T bills)

## Exchange rate

* Moving from domestic finance to international finance means that you add to the fiscal & monetary policy the new areas of exchange rate policy & capital account policy → therefore you now have the international macroeconomic policy trilema
* The Exchange rate (X-rate) is determined by supply & demand of local currency LC relative to $ (LC/$ Xrate) → supply & demand are determined BOTH by trade and capital flows
* A low LC/$ X-rate (i.e. little LC vs. a lot of $) means that imports are cheap, but it's bad for the exports sector
* To increase the LC/$ rate, offer $ for LC
* To decrease the LC/$ rate, offer LC for $

## Inflation

* Inflation targeting is a monetary policy in which a central bank has an explicit target inflation rate for the medium term and announces this inflation target to the public. The assumption is that the best that monetary policy can do to support long-term growth of the economy is to maintain price stability. The central bank uses interest rates, its main short-term monetary instrument
* However, the unemployment rate generally only affects inflation in the short-term but not the long-term. In the long term, the velocity of money is far more predictive of inflation than low unemployment

## Critiques of Keynesian economics

* Keynesian says: "The lack of global aggregate demand is, in a sense, one of the fundamental problems underlying this crisis. Lack of aggregate demand was the problem with the Great Depression, just as lack of aggregate demand is the problem today"
	+ Reply to this from critics: to say the cause of the Great Recession was due to a lack of demand is bit like saying that that the cause of the streets being wet today is because it is raining today. That tells us nothing about why it is raining today and/or what causes rain to happen. Describing the Great Recession as a lack of demand is just that, a description, not an explanation.
* Marxist economics could have told the Keynesians that easy money or reversing austerity would not do the trick.
* Keynesian: "if governments had never adopted ‘neo-liberal’ policies of austerity, there would never be any recessions"
	+ Reply from critic: But what if the cause of the Great Recession and the subsequent Long Depression is not the product of a ‘lack of demand’ as such or ‘pro-cyclical’ government spending policies (austerity) but is caused by a collapse of the capitalist sector, in particular, capitalist investment. → Investment collapsed because profitability in the capitalist sector fell, then the mass of profits fell, leading to investment, employment and incomes to fall, in that order. Then it’s the change in profits that leads to changes in investment and demand (consumption), not vice versa, as the Keynesians argue.
* Data show that profits stop growing, stagnate, and then start falling a few quarters before the recession, when investment and wages start falling.” Tapia concludes that “The evidence is quite overwhelming that profits peak several quarters before the recession, while investment peaks almost immediately before the recession. Then profits recover before investment does, as illustrated by the investment trough that occurs around the end of the recession or the start of the expansion but following the profit trough for at least a few quarters
* Many mainstream economists argue that this is what matters in an economy because 70% of the economy is consumption. But in a capitalist economy, it is investment that decides, in particular business investment
* Keynesian: lower profits for capitalism will make capitalism work better because there will be more competition and less monopoly; and less profits means more wages and so more demand
	+ Reply from (Marxist) critic: It's thhe opposite, namely that lower profitability and profits will lead to lower investment and productivity growth and a prolongation of the depression. Only a large destruction of capital values in a slump that restores profitability will create eventual recovery in a capitalist economy.
* In effect, what the Keynesians want to see is an end to ‘neoliberal’ policies and their replacement by what used to be called ‘social democratic’ policies of government intervention to manage the capitalist economy and boost investment and demand. The brief period of capitalist success (confined to the advanced capitalist economies) was due to relatively high profitability of capital after the world war and the relative strengthening of the labour movement in conditions of relatively full employment that forced concessions from capital. The subsequent neo-liberal period was not the result of right-wing governments ‘changing the rules of the game’ but the crisis of falling profitability that necessitated new reactionary policies and governments to restore profits at the expense of labour.

## References

<references>

1. ↑  https://thenextrecession.wordpress.com/2016/05/02/explaining-the-last-ten-years-keynes-or-marx-who-is-right/