Principles of Macroeconomics

Eco-104

Dr. Adnan Haider

Professor of Business Economics and Analytics
[email protected]

Week-03: Spring 2024

School of Thoughts in
Macroeconomics
Roots of Western Philosophy
Roots of Western Philosophy

(My Personal Readings)

Catholic Church During Medieval Times
 Reformation Movement-I
• The Protestant Reformation was a
religious reform movement that
swept through Europe in the
Martin Luthe
1500s. (German priest)
• It resulted in the creation of a 1483-1546

branch of Christianity called

Protestantism, a name used
collectively to refer to the many
religious groups that separated
from the Roman Catholic Church
due to differences in doctrine.
 Reformation Movement-II
• Calvinism
– Reformed Tradition, Reformed
Protestantism, Reformed Christianity
• It is a major branch of Protestantism
that follows the theological tradition
and forms of Christian practice set
John Calvin, French Theologian
down by John Calvin and other 1509 - 1564
Reformation-era theologians. It
emphasizes the sovereignty of God
and the authority of the Bible.
• Calvin was the one who supported
that interest is legitimate except in
the case of lending to the poor,
– but (inconsistently) also said that a
person should not be a professional Statues of William Farel, John Calvin,
Theodore Beza, and John Knox at the
moneylender. International Monument to the Reformation in
Geneva, Switzerland.
 Calvinism and Modern Economic Thinking
• Some may be surprised to discover that Adam Smith, despite his image as the “Father
of the Free-market Capitalism” and his general advocacy of laissez-fair economics,
came out strongly in support of controlling usury (Jadlow, 1977; Levy, 1987).
• While he opposed a complete prohibition of interest, he was in favour of the
imposition of an interest rate ceiling.
• This, he felt, would ensure that low-risk borrowers who were likely to undertake
socially beneficial investments were not deprived of funds as a result of “the greater
part of the money which was to be lent [being] lent to prodigals and projectors
[investors in risky, speculative ventures], who alone would be willing to give [an
unregulated] high interest rate” (see, Smith, Wealth of Nations).

• The great twentieth century economist John Maynard Keynes held a similar position
believing that “the disquisitions of the schoolmen [on usury] were directed towards
elucidation of a formula which should allow the schedule of the marginal efficiency to
be high, whilst using rule and custom and the moral law to keep down the rate of
interest, so that a wise Government is concerned to curb it by statute and custom and
even by invoking the sanctions of the Moral Law”
(Keynes, General Theory,1936: 351-3).
Calvinism and Modern Economic Thinking
Origin of Modern Western Philosophy

(My Personal Readings)

 Modern Western Philosophy

(My Personal Readings)

Evolution of Various School of
Thoughts in Economics
 Classical
School

David Hume Adam Smith J. B. Say

(1711-1776) (1723-1790) (1767-1832)
 Classical
School

David Ricardo
Thomas Malthus James S. Mills Leon Walras
(1772-1823)
(1766-1834) (1806-1873) (1834-1910)
 Classical
School

Francis Edgeworth Irving Fisher Knut Wicksell Arthur Pigou Alfred Marshall
(1845-1926) (1867-1947) (1851-1926) (1877-1959) (1842-1924)
Industrial Revolution
Classical
economic theory
was developed
shortly after the
birth of western
capitalism.

Ideas were
formulated to
protect the
economic interest
of rich classes.
 Karl Marx and The origin of
Communism

Karl Marx
(1818-1883)

Friedrich Engels
(1820-1895)
Communism: Russia and China
Rise and Demise of Communism
Ronald Reagan and Margaret Thatcher
Communism, Socialism and Capitalism:
A Comparison
Death of Classical’s Mainstream Thinking
Great Depression of 1930’s
Death of Classical’s Mainstream Thinking

• Main ingredients:
– Say’s Law
• Supply create its own demand
– Fallacy of classical’s Invisible Hand
• Self Correction Mechanism
– Classical Dichotmy and notion of QTM “Balancing of
Real and Monetary side of the economy, M.V=P.Y”
 Keynesian
Revolution

• Counter ideas from classical economics

– Business Cycle literature vs. Growth Literature
– Reverse Say’s law: Demand creates its own supply
– Breaks Walras General equilibrium notion
– Notion of Market failure
• Nominal Rigidities
– Sticky prices, sticky wages…
• Stable empirical relationships:
– Consumption function of total income, C=f(Y)
– Phillips Curve:
• Relationship b/t inflation and unemployment, π=f(U)
– Unstable money demand + Liquidity trap
• Monetary policy ineffective – focus on fiscal policy
Hicks: Mr. Keynes and Classics:
A suggested interpretation
 Monetarist’s
Counter-revolution
• Early Chicago school critiques, led by Milton Friedman
– Failure of central planner, Government failure
– Stable relationship: money demand
– M.V=P.Y, Quantity of money M is exogenous
– Economic instability was caused by inept monetary policy-
• Friedmand and Schwatz (1963).
• “Inflation is always and everywhere a monetary phenomena”
– Consumption is a function of permanent income
• Fiscal intervention only provides temporary income
 Neo-Keynesianism
• First Neo-classical or “Classical and
Keynesian” synthesis
– Samuelson, Tobin, Modigilani, Solow, Patinkin
– Short vs. Long run
• Market Failure only in the short run, as current prices
are essentially pre-determined.
• Prices and wages are rigid only in short-run
• Large-scale equation by equation behavioral models
• No Financial Frictions
 Post-Keynesianism
• Neo-Keynesianism (AD/AS model) is a
misinterpretation of Keynes’ ideas
• Heterogeneous group
– Financial frictions, speculation
– Minsky, Moore, etc…
– Money endogeneity
– Irrational expectations, Animal Spirits
– Disequilibrium analysis
– Markups theories
 1970’s Stagflation

• Rational Expectation Theory

• Real Business Cycle Theory
• New-Keynesian Theory
Phillips-curve breakdown
 Rational Expectation Theory
• Rational Expectations- Idea by John Muth (1963)
– Initial attempt was purely methodological
– Alternative to Adaptive expectation philosophy
– Removal of the occurrence of systematic errors

• Theoretical underpinnings-
– Tom Sargent and Neil Wallace, show that in a micro-founded setting systematic monetary policy aimed at
stabilizing economy s doomed to fail
– Phillips Curve was empirically rejected

• Microfoundations are key for policy analysis (Phelps)

– Lucas Critique, (Robert Lucas)
– Structural rather reduced form analysis
– Lucas Supply Curve (Expectation augmented Phillips Curve)

• Fully dynamic models

– Policy ineffective proposition
– Dynamic inconsistency arguments, (Kydland and Prescott)
 What’s Exogenous
• Monetarist Regressions

– Showed that money stock was exogenous to income,

i.e., γk insignificant

• Money Demand Equations

– Mehra (1978) showed that income and interest rates

were also explaining money causally

**Mehra, Y. P. (1978), “Is Money Exogenous in Money Demand Equations?”, Journal of Political Economy, 211-228
 VAR- A solution

• Only explanation was a multiple-equation model

– Chris Sims (1980) found that money was predicted by
interest rates, which was predicted by past production
– Hard to argue that money was “erratic”
• SVAR can predict effects of policy interventions
– Critique on SVAR- it only allow conditioning of
future policy
– However, modern DSGE models allow for his type of
conditioning
 Real Business Cycle Theory
• Real shocks to technology cause economic
fluctuations
– Supply side focus- TFP shock only
– Quantitative Macro, Calibration, Moment Matching,
etc…
– Shocks induce substitution of consumption and leisure
– Fluctuations may not require policy response
– Instantaneous price adjustment
– No financial frictions
– Monetary Policy plays a secondary role
 New-Keynesian Theory

• Second New-Neo-Classical, Keynesian Synthesis

– Stanly Fischer, John B. Taylor, David Romer, G.
Mankiw, G. Calvo, Rottemberg, many more…
– Add Keynesian features in RBC type DSGE models
• Sticky prices
– Market Power and transection costs
– Resource allocation and expectations in the absense of market
clearing
• Model selection
– VAR-Impulse response of linearized DSGE models

Salt Water Fresh Water

Crisis of Thinking in 21st Century

• Global Financial Crisis

• Present Challenges
• Stability
• Way-forward
Global Financial Crisis
2008/09

Raguram Rajan

Nouriel Roubini
Challenges from 2006 to 2015
• DSGE models are “ripe for improvement”
– Forecast errors during recession were of a size that should
practically never occur
– Micro-foundations are typically weak

• Belief distortions

• Macroeconomics and financial frictions

– Interaction b/w price and financial stability
– Liquidity and systemic risk
– Hetrogeneity
– Interaction b/w interest rates and macro-prudential policies
Stability
Recovery from GFC and Tradeoffs
New Innovations in Macro
 New Innovations in
Macroeconomic thinking
Economics of COVID
Shock
Economics of COVID
Shock
Shapes of Economic Recovery
World Economics After the
COVID Shock
Q/A Session