Essentials of Advanced Macroeconomic Theory

Ola Olsson

• Publisher: Routledge
• Year: 2013
• eBook ISBN: 9781136494604
• Edition: 1
• Topic: Economics
• Subtopic: Corporate Finance
• Index: Economics

Trying to summarize the essentials of macroeconomic theory in the wake of the financial crisis that has shaken not only Western economies but also the macroeconomic profession is no easy task. In particular, the notion that markets are self-correcting and always in equilibrium appears to have taken a heavy blow. However, the jury is still out on which areas should be considered as failures and what which constitute the future of research.

The overall aim of this text is to provide a compact overview of the contributions that are currently regarded as the most important for macroeconomic analysis and to equip the reader with the essential theoretical knowledge that all advanced students in macroeconomics should be acquainted with.

The result is a compact text that should act as the perfect complement to further study of macroeconomics: an introduction to the key concepts discussed in the journal literature and suitable for students from upper undergraduate level through to PhD courses.

1  Introduction

1.1  The Issues

Macroeconomics is the study of the aggregate economy of a country. It seeks to understand how the economic decisions of individual persons and firms are translated through markets into aggregate economic outcomes. Variables of interest in macroeconomic analysis are, for instance, the level and change of gross domestic product, the aggregate level of investment, government debt, inflation, and unemployment.

The macro economy affects individuals both directly and indirectly. More or less all individuals in modern economies are, for instance, subject to income taxation, are affected by bank interest rates, receive some kind of government subsidy, and control household budgets whose real value depends on the aggregate price level.

Macroeconomics is distinguished from microeconomics primarily in the sense that the ultimate dependent variables are different. Microeconomics studies the behavior of individuals or firms in order to understand individual choices. Macroeconomics also increasingly starts off with the modeling of a “representative” individual or firm that maximizes utility or profits, but the dependent variable is aggregate outcomes on a national level.

Macroeconomic outcomes are central to politics within countries. Questions like those below are discussed at more or less every general election (as well as in between elections) in the Western world:

• What policies are most effective against unemployment, and how should the government or the central bank fight inflation?
• How can economic growth be increased?
• How should governments stabilize short-run fluctuations and business cycles?
• What is a sustainable level of government debt?

In an international economy with interwoven markets, macroeconomics is also a central theme in international politics. A recurrent issue in international economic policy-making has been the determination of exchange rates between currencies. Another topic which has an important impact on international relations is current account levels and deficits or surpluses in the balance of trade. In summary, macroeconomics is a central field for anyone with an interest in economic policy or economic development.

1.2  The National Accounts Identity

The main building block of macroeconomic theory is the national accounts identity, which shows the gross domestic product (GDP) of a country. Total GDP, denoted by Y_t, measures the total value of all final goods and services that have been produced in a country during one year.¹ GDP is an example of a flow variable, one that is measured per unit of time. The other major type of variables are stock variables, such as the level of the capital stock or of accumulated public debt, which measure the level at a given point in time. We will return to this latter type of variables later.

Total GDP can be calculated in three ways, which all should yield the same result. The most common characterization of GDP is to study it from the user side, i.e. what total GDP is spent on. This is the expenditure approach to measuring total GDP and can be described by the equation

In this key equation of macroeconomics, Y_t is total GDP as before at time t, C_t is aggregate private consumption, I_t is aggregate investment, G_t is government spending on goods and services, X_t is total exports from the country, and M_t is total imports. All these variables are flow variables.

Let us briefly take a closer look at these components of GDP. Aggregate private consumption C_t is typically the biggest item on the expenditure side and usually amounts to about half of total GDP. It includes personal spending on durable and nondurable goods and services during a year.² I_t is more specifically “gross domestic private investment” during one year. Investment is the acquisition of durable goods (with an expected life of more than one year) to be used as factors of production in the future, typically including machines and factories. Aggregate investment can in turn be split up into nonresidential investment, residential investment, and change in business inventories.

Government spending on goods and services G_t includes both government consumption (such as on salaries for teachers and judges) and investment (for instance, in government buildings). It also includes spending at all levels of government: state, regional, and local. Exports X_t is the value of goods and services produced within the country that are sold to people in foreign countries. Likewise, total imports M_t shows the value of goods and services produced outside the country that are bought by people inside the country.

This expenditure accounting of total GDP must be matched by the total income that all factors of production in the country earn during a given year. The income side of GDP is therefore

These incomes are eventually controlled by households in one way or another and are used for the expenditures above.

Furthermore, the total value of expenditures and incomes must be matched by the value added of aggregate production during a year. This is shown in the production side of the national accounts:

where the total values of production from all sectors of society are added.

The equation for the user side of GDP in (1.1) is the backbone of macroeconomic theory from which the subsequent analysis is derived and extended in numerous ways. It also serves as a introduction to an outline of the exposition below.

1.3  Outline

The following chapters are organized as follows. We start off by analyzing the long-run determinants of total GDP, i.e. growth theory. Chapter 2 is devoted to the Malthusian model of growth, Chapter 3 presents the neoclassical (or Solow) growth model and its extensions, and Chapter 4 deals with endogenous growth models where technological progress plays a prominent role. In Chapter 5, we develop the overlapping generations model, which is long-run in nature and which is used also in the chapters ahead.

After the long run, we take a look at macroeconomic theory in the short and medium run. In Chapter 6, we study models on the behavior of total GDP and its components over the business cycle, i.e. a period of roughly five years. Chapter 7 discusses a recurrent phenomenon in capitalist economies: financial crises and bank runs. We then move on to analyze specifically the constituent parts of the expenditure side: consumption (and saving) in Chapter 8, investment and asset markets in Chapter 9, and one of the key markets for understanding the macro economy, the labor market, in Chapter 10.

In the third main section of the book, we analyze a broad range of topics related to macroeconomic policy. We begin by presenting the traditional IS–MP, aggregate supply and aggregate demand frameworks and the refinements suggested by the rational expectations view and the new Keynesian view in Chapter 11. We then go on to public finance and fiscal policy (Chapter 12), and inflation and monetary policy (Chapter 13). Lastly, we discuss international aspects of economic policy in Chapter 14.

Some basic mathematical results that are used throughout the text are provided in an appendix.

Part I

The Long Run

2 The Malthusian World

2.1 Introduction

In this chapter, we will describe a model of long-run economic growth that was applicable to all countries in the world up until the industrial revolution and which still is a highly relevant model for some developing countries. In this “Malthusian world” there is a strong link between income per capita and population growth, so that anything that increases aggregate income in a society will soon be neutralized by an increase in the size of the population. Hence, even despite periods of rapid technological progress, income per capita will remain at a fairly constant level. Recent empirical work on historical data has shown that standards of living indeed appear to have been roughly similar in Assyria around 1500 BC, in Egypt during Roman times, and in late eighteenth-century England (Clark 2007). This section is motivated by this stylized fact from economic histor...

Table of contents

• Cover Page
• Half Title Page
• Title Page
• Copyright Page
• Contents
• List of figures
• Preface
• 1 Introduction
• Part I The Long Run
• Part II The Short and Medium Run
• Part III Macroeconomic Policy
• Notes
• Bibliography
• Index