Inequality

By whatever indicator it is assessed, inequality has been rising in recent years. This book considers it a macroeconomic issue and innovates by including it among its topics. The chapter begins by reviewing evidence and facts on inequality, measurement issues, and the relation with poverty. The macroeconomic models of income distribution reviewed next include vintage models, endogenous growth models, and whether inequality can be accommodated in ‘representative-agent’ models. Attention then turns to ‘factor’ (labour-capital) income shares, which have also been changing recently, reviewing both the relevant analytics and the possible processes that underlie this change. The chapter concludes with recent debates on determinants of inequality, the evolution of the labour share (the ‘r-g’ question), and the future of income distribution.

The Rational Expectations Hypothesis and the New Classicals

This chapter analyses the Rational Expectations Hypothesis (REH), a pillar of forward-looking macroeconomics that emphasizes expectations. It also develops its implications in terms of ‘market efficiency’ and related concepts. It then reviews New Classical Macroeconomics: its main tenets, the ‘Lucas supply function’ that is crucial for much subsequent theory, and the ‘Lucas island model’ that underpins it. The centrepiece ‘Policy Ineffectiveness Proposition’ (PIP) is developed both intuitively and more formally. Subsequently, the chapter reviews one major line of criticism of PIP, the fact that markets may not clear, based in particular on staggered wage setting. Broader criticisms of the REH, including ‘bounded rationality’, are also reviewed. The chapter concludes with yet another landmark contribution of Robert Lucas, namely the ‘Lucas critique’ of activist stabilization policy.

Fiscal Policy and Public Debt

This chapter looks at fiscal policy, broadly interpreted to include its implications on deficits, debt, and fiscal solvency. It is informally divided in two parts, starting from the latter set of issues. After introducing the budget deficit, debt and the government budget constraint, and related issues, it proceeds to analyse fiscal solvency, deriving formal conditions and discussing extensively indicators and required policy rules. The role of growth in ensuring fiscal solvency is put in sharp relief. Additionally, the ‘dilemma of austerity’ is critically discussed, i.e. whether ‘fiscal consolidations’ can in fact damage public finances by being recessionary. We then turn to the effects of fiscal policy on economic activity: A ‘toolkit’ of static fiscal multipliers is discussed, as is the intertemporal approach to fiscal policy (including Ricardian Equivalence), complemented by empirical evidence.

Monetary Policy

This chapter discusses monetary policy. It is informally divided in two parts: The former discusses the rationale for and the main features of the current institutional ‘architecture’ related to monetary policy. A formal analysis of time inconsistency of optimal discretionary policy and the concomitant inflationary bias is followed by analyses of commitment and reputation. Subsequently, the Chapter looks at possible resolutions of the difficulties associated with discretionary policy, including independent Central Banks and inflation targeting. It also discusses the new features and proposals that emerged post-2007–9. A ‘policy in practice’ section looks at Taylor rules. In the latter part, we review the recent analyses on financial structure and the ‘credit channel(s)’ of monetary policy transmission. The chapter concludes with a review of Quantitative Easing, macroprudential regulation, and the current thinking on monetary policy as part of a wider package of optimal stabilization policy.

Sectoral Analyses

This wide-ranging chapter reviews a number of models that underpin aggregate analyses (‘sectoral’ models). It begins with the profusion of work on consumption (Permanent Income Hypothesis, the Life-Cycle Model, and the modern analyses that sprang from the ‘random walk’ model). Saving, durable consumption, demographics, and behavioural elements are among the many topics reviewed. The chapter continues with investment, including issues such as: the accelerator, neoclassical model, user cost of capital, Tobin’s q, effects of financial imperfections, uncertainty, state-contingent (‘S-s’) models, vintages, technical progress, and inventories. Housing is reviewed next, another innovation of the book. Finally, the models of consumption are a stepping-stone towards the macroeconomics of finance. The topics reviewed here include the CCAPM and CAPM models, the equity premium puzzle, and the term structure of interest rates, as well as developments in stock markets and the growth of finance (‘financialization’).

Business Cycles and Stabilization Policy

This chapter reviews the theory related to business cycles. After outlining early approaches (including the multiplier-accelerator interaction and Goodwin cycles), it proceeds to discuss the modern debates between New Classical/Real Business Cycle (RBC) theorists and New Keynesians. This discussion is structured at various levels: more intuitive and discursive, then more analytical with the development of a formal RBC model and of a Dynamic Stochastic General Equilibrium model that synthesizes the two approaches. The chapter continues with a review of Vector Autoregressions. Finally, a narrative of a number of episodes is offered: the Great Depression, post-World War II cycles, Japan, effects of oil on business cycles, and the Great Recession (2007–9) and the subsequent slow recovery. The overarching philosophy is that a suite of models, old and new, and approaches, modelling, econometric, and narrative, are useful in offering complementary perspectives.

From AD-AS to Advanced Macroeconomics

The chapter reviews basic building blocks of macroeconomic theory, such as the production function, labour supply and demand. It also reviews elementary models such the IS-LM, AD-AS, and the Phillips Curve. In doing so, it provides a bridge between standard elementary/intermediate material, that readers of this book will have typically been exposed to, and the more advanced macroeconomics that is its main subject. Alongside analytics, the chapter outlines the history of macroeconomics as a way of better appreciating the models and current theory. The policy implications of various theories and models are centrepieces. A brief detour into formal theory of policy-making offers additional policy perspectives. The chapter also summarizes six benchmark ‘policy ineffectiveness propositions’ developed in subsequent chapters, as a way of looking ahead.

The Theory of Growth

This chapter reviews the theory of growth. As motivation, it first discusses a range of related facts, including structural change and facts on the ‘new economy. It then launches into the Solow Growth Model (SMG) and related issues. The question of convergence, growth/development accounting, and the world income distribution are discussed next. The later part of the chapter discusses Endogenous Growth Theory(ies) (EGT). After offering an intuitive discussion of the limitations of SMG that EGT aims to rectify, the chapter reviews the AK model, including the processes that underpin it and its properties, and human capital, including its two-sector formulation. Newer EGT models are then reviewed, including models based on expanding product variety and those based on improving quality and product replacement (‘creative destruction’). The chapter concludes with evidence, the policy implications of EGT, and directions of current research.

Unemployment

This chapter offers a wide-ranging review of the macroeconomics of unemployment and related issues. Setting the scene with definitions, motivation, and facts, the discussion proceeds to a baseline wage and price setting model, which offers some first key insights. Formal models of trade unions and efficiency wages, and of the less standard, but topical, dual labour markets, are developed next. Dynamic issues, such as hysteresis and its underpinning factors, are also discussed. A major subsequent theme is the flows and search-based recent theory, emphasizing job creation and destruction, hiring and firing costs, and the Beveridge Curve. Additionally, the effects of technical progress on unemployment, wage inequality, and job polarization are discussed. The chapter concludes with a review of the high European unemployment of the 1980s and 1990s and the ‘shocks versus institutions’ debates on its causes.

Introduction to Dynamic Macroeconomics

This chapter offers an introduction to the methods and main models used in dynamic macroeconomics. After reviewing key concepts such as lifetime utility maximization and the period-by-period and intertemporal budget constraints, first-order conditions for intertemporal optimization (the Euler equation and the labour-leisure choice) are developed. These methods are applied in developing the workhorse Ramsey model, with discussion of related concepts such as dynamic efficiency and market equilibrium versus the command optimum. An extension of the Ramsey model incorporates adjustment costs in investment and develops the user cost of capital. Furthermore, the Sidrauski model, with its implications for monetary economies, is reviewed. Finally, the discussion turns to another workhorse dynamic model, the overlapping-generations model and its implications. As an application of this model, the properties of various methods of funding social insurance are discussed.