Lecture 1.

Introduction to Third-year
Macroeconomics

ECON30009 Macroeconomics
Shuyun May Li
Department of Economics
The University of Melbourne
Semester 2, 2014

Outline
1. What is Macroeconomics?
2. Evolution of Macroeconomic thought
3. How does this subject fit in the big picture?
Reading: Prologue of AK, Kocherlakotas speech

1. What is Macroeconomics?
Macroeconomics is the study of the economys performance as
a whole and the governments role in altering that performance.
It departs from microeconomics in focusing on the whole
economy rather than its constituent parts.
Some important questions of Macroeconomics
Why do economies grow at different rates?
How do peoples saving and invest behaviour affect growth
and income?
How do foreign trade and investment affect the domestic
economy?

 What causes recessions and their attendant high

unemployment?
What is money and its economic function?
How do monetary and fiscal policies affect the economy in
the short and long runs?
What causes inflation? How does it relate to
unemployment?
What role banks play in the economy?
How do credit and insurance markets operate and alter
macroeconomic outcomes?

 Macroeconomics is a controversial discipline. Economists often

have different views regarding the important macro questions
listed above.
In particular, they can differ sharply about the causes, severity,
and cure for economic downturns, as well as the governments
role in the economy.
Different views form different schools of macroeconomic
thought. Macroeconomics is an ever-evolving area of research.
There have been many different schools formed in the evolution.
Next, we briefly review this evolution and introduce several
major schools of macroeconomic thought.

2. Evolution of Macroeconomic thought

Classical Economics
The first modern school of economic thought, developed in
the 18th and 19th centuries, by economists such as Smith
(The Wealth of Nations, 1776), and Ricardo.
A theory of price was developed to investigate economic
dynamics
Main idea: Adjustments in prices would automatically
equate demand to supply - invisible hand.
Keynesian economics
Until the 1930s most economic analysis did not separate out
individual economics behaviour from aggregate behaviour.
With the Great Depression, the field of macroeconomics
began to expand.
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 Particularly influential was the ideas of John Maynard

Keynes, as summarised in The General Theory of
Employment, Interest and Money, 1936.
Keynes emphasised the importance of aggregate demand
management by government, a departure from classical
economics.
In 1950-60s, Keyness ideas were widely accepted, and the
use of active fiscal and monetary counter-cyclical policies,
instructed by the IS-LM model and Phillips curve, had
been quite successful.
However, the stagflation experienced by many economies
in 1970s called for both expansionary and contractionary
policies.
This dilemma led to the collapse of the Keynesian
consensus.
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 Monetarism
Began in the late 1940s with the work of Friedman.
Regards the supply of and demand for money as the
primary means by which economic activity is regulated.
Views inflation as determined by variations in money supply
rather than aggregate demand.
Rejects fiscal policy because it leads to crowding out of
the private sector.
Advocats a central bank policy aimed at keeping the supply
and demand for money at equilibrium so as to maintain
price stability.
Ideas of monetarism have been generally accepted in central
banking practice since late 1970s (e.g., Greenspan).
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 Neoclassical Economics (methodology)

Refers to a general approach to economics, not a school of
economic thought.
Neoclassical economics is originated from classical
economics, further developed by Marshall, Walras, Hicks,
Arrow, Debreu, etc.
Emphasises an equilibrium analysisprices, outputs, and
incomes are determined through supply and demand, where
supply and demand are the collective outcome of the
individual optimising behaviour of households and firms.
There have been many critiques of neoclassical economics,
often incorporated into newer versions of neoclassical theory
and further strengthen its dominance status.
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 Growth Theory and New Growth Theory

Concurrent with the emergence of Keynesian
macroeconomics was the research agenda of growth theory
initiated by Harrod and Domar in 1940s.
Fast development in 1950s and 60s, with several versions of
neoclassical growth models (Solow, Diamond, Ramsey).
Surprisingly, for a very long time the development in growth
theory and the corresponding developments in Keynesian
economics (focus on economic fluctuations) are divorced.
Growth theory faded in late 60s through 80s, but made a
strong comeback in late 80s, marked by the development of
New/Endogenous Growth Theory.

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 New Classical Economics

Emerged in 1970s as a response to the failure of Keynesian
economics, motivated by Lucass work on Rational
Expectation and Lucas critique.
Lucas critique: It is naive to try to predict the effects of a
change in economic policy entirely on the basis of
relationships observed in historical data as such estimated
relationship could change as policy regime changes.
Lucas critique casted doubt on standard Keynesian models
built on reduced form equations as tools for macro policy
analysis.
How can macroeconomists get around the Lucas critique?

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The key is to build macro models based on more

fundamental features of the economy that are beyond the
control of the government, such as the technology of firms
and peoples preferences.
So the Lucas critique called for building microfoundations
for macro models, i.e., the macroeconomy must reflect the
sum of its partsthe rational behaviour of individual
housholds and firms.
A seminal development of this school is marked by the real
business cycle (RBC) theory in 1980s, first developed by
Kydland and Prescott.
The basic model of RBC theory incorporates stochastic
productivity shocks into a neoclassical growth model
(connects the studies of long-run growth and short-run
fluctuations for the first-time).
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 A striking finding of early RBC economists is that a large

fraction of aggregate fluctuations could be understood as an
efficient response to productivity (supply-side) shocks that
affected the entire economy, implying that there was little
role for government stabilization policy.
Though its finding was quite controversial, the RBC theory
has pioneered the use of dynamic stochastic general
equilibrium (DSGE) models and a set of analytical and
computational tools in modern macro research.
New Classical economics builds its analysis on an entirely
neoclassical framework. Two key assumptions: rational
expectations and perfect flexibility of prices and wages.
Other new classical economists: Sargent, Wallace, Barro.

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 New Keynesian Economics

Developed partly in response to the critique of Keynesian
economics by new classicals.
Strives to provide microeconomic foundations to Keynesian
economics by showing how imperfect markets can justify the
demand management by government or its central bank.
The main assumption that distinguishes it from new
classical economics is that wages and prices do not adjust
instantly to allow the economy to attain full employment,
thus non-clearing markets can exist and persist, even when
rational expectations apply.

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 New Keynesians attempt to explain the nominal stickiness

with microeconomic analysis of price adjustment.
At the same time, New Keynesian economists also adopt the
same modeling framework (DSGE) as new classical
economists and emphasise microfoundations.
In recent years, a lot of central banks, including the RBA
and RBNZ, start to apply New Keynesian models for
monetary policy analysis.
Economists: Samuelson, Tobin, Modigliani, Mankiw,
Christiano, Woodford, etc.

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 Modern Macro researchtowards an integration

The New Classicals and New Keynesians often had
disagreements in 1980s-1990s.
By 2000, a synthesis was developing, building on the
neoclassical approach adopted by RBC and new growth
theory, but also allowing for the imperfections emphasised
by New Keynesians.
The basic modeling framework: DSGE
Emphasise a quantitative anlaysis: assign values to model
parameters to match certain dimensions of the data and
conduct simulations to yield quantitative predictions of the
model
Hinge on heavy use of computers to compute, simulate and
estimate the model
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3. How does this subject fit in the big picture?

Structure of Macroeconomics subjects at Uni. Melbourne
First year and second year Macro
Focus on definitions, data facts, and relationships among
aggregate variables
The relationships among aggregate variables are presented
using reduced-form models of Keynesian economics
Aiming at fostering economic intuitions
Third year and Honours (first-year Masters) Macro
Introduction to advanced study in macroeconomics
Using simplified versions of neoclassical macro models to
address macro questions
Aiming at deepening understanding and improving
analytical skills
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 Ph.D. Macro:
Focus on a comprehensive set of analytical, computational
and estimation skills to work with modern macro models
Presenting seminal articles in the literature (new classical,
New Keynesian)
Aiming at fostering professional researchers in the field of
macroeconomics.
The goal of the development of macroeconomics as a discipline
is to be able to answer the important macro questions in a
more complete and more precise way.
This is why verbal intuitions are not enough and why we need
a mathematical formalisation of the economymodels.
Economists build models to simplify reality to understand it.
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 A classification of Macro models

Macroeconometric or observational models: directly specify
concrete functional forms describing a reduced form
relationship among variables for estimation.
A traditional approach, often take the form of system of
equations or regressions.
IS-LM, AS-AD, and Phillips curve all fall in this category.
Policy analysis based on this approach is subject to the
Lucas critique.
Theoretical or structural models
Toy model: simple, highly-stylised models, illustrate
intuitions and yield qualitative insights
Quantitative model: relatively realistic, estimated with
data, draw quantitative implications
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 A good model captures key relationships, that is, economists

focus on the most important factors that are relevant for the
question to be addressed, while ignoring what they believe to
be minor details.
The focus of 3rd and Honours year macro is to use simple but
formal theoretical macro models to analyse the central macro
questions.
The central macro questions listed earlier are closely linked:
The ability to borrow through credit market influences how
much a society saves;
The amount of saving in turn governs how much it invests
and how fast it grows;

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 Economic growth alters the publics demand for money and

the rate of price inflation;
And the inflation rate influences the choice of monetary and
fiscal policies;
The policies have their own independent effects on the
economys saving, investment and growth.
The connection of the macro questions requires a theoretical
framework capable of linking the answers to each question to
those of the others.
Such an integrated approach is the hallmark of AK. It uses a
single framework, the life-cycle model, to explore and connect
the major issues of macroeconomics.
Well start with the basic form, then gradually add more
elements to enrich the model to address further topics.
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 Despite its simplicity, the life-cycle model fits in the

neoclassical approach and DSGE framework for modern
macro models
micro-founded: aggregate supply and demand are collective
outcomes of decisions of households and firms
dynamic: it describes the evolution of the economy over
time (recall that IS-LM and AS-AD are both static)
individual rationality: firms and households both optimise
forward looking or rational expectation: households predict
future rate of return to capital when they make
consumption and saving decisions
heterogeneous agents: young households work and save
while old households spend
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 In other words, the simple model is dynamic and general

equilibrium, but not stochastic.
The life-cycle model well work with sits between a toy mode
and a fully quantitative model.
Besides the main focus, a lot of time will also be devoted to
Definitions, data facts (updated with more recent and
Australia-relevant data), and economic intuitions
Literature review
Applications of the theories and policy discussions around
the models

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Review Questions
Understand what Macroeconomics is about, and what kind of
questions it aims to address
Have a general understanding of the evolution of macroeconomics
and several major schools of macroeconomic thought
Understand the difference of the neoclassical approach from the
Keynesian models in Intermediate Macroeconomics (the general
equilibrium analysis in third year micro is neoclassical)
Have some idea of current state of macro research, and think for
yourself what you will need to learn to get there.
Understand the classifications of macro models
Have a general understanding of how the macro subjects at
Melbourne are structured and where this subject stands.
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