Advanced Macroeconomics Minford for PRINT.indd 1 01/04/2019 15:07 Minford for PRINT.indd 2 01/04/2019 15:07 Advanced Macroeconomics A PRIMER Second Edition Patrick Minford Professor of Economics, Cardiff Business School, Cardiff University, UK David Peel Professor of Economics, Lancaster University Management School, University of Lancaster, UK Cheltenham, UK • Northampton, MA, USA Minford for PRINT.indd 3 01/04/2019 15:07 © Patrick Minford and David Peel 2019 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical or photocopying, recording, or otherwise without the prior permission of the publisher. Published by Edward Elgar Publishing Limited The Lypiatts 15 Lansdown Road Cheltenham Glos GL50 2JA UK Edward Elgar Publishing, Inc. William Pratt House 9 Dewey Court Northampton Massachusetts 01060 USA A catalogue record for this book is available from the British Library Library of Congress Control Number: 2018967813 ISBN 978 1 78897 097 6 (cased) ISBN 978 1 78897 099 0 (paperback) ISBN 978 1 78897 098 3 (eBook) Typeset by Servis Filmsetting Ltd, Stockport, Cheshire 2 0 Minford for PRINT.indd 4 01/04/2019 16:37 Contents in brief Preface xiii PARTI MODELSOFTHEECONOMY 1 Macroeconomics: asuccinctintroduction 3 2 Solvingrationalexpectationsmodels 37 3 Partialinformationandsignalextraction 78 PARTII EVALUATINGGOVERNMENTPOLICY 4 Stabilizationpolicy: canwe? 99 5 Stabilizationpolicy: shouldwe? 125 6 Practicalissuesofeffectivestabilization 152 7 Fiscalpolicyandthegovernmentbudgetconstraint 158 8 Unemployment,productivityandgrowth 185 9 Politicaleconomyinmacroeconomics 208 PARTIII EXTENDINGANDDEEPENINGTHE MODELS:THEOPENECONOMYAND MICRO-FOUNDATIONS 10 Themacroeconomicsofanopeneconomy 231 11 The Lucas critique and representative agent models in cashless economies 246 12 Moneyinrepresentativeagentmodels 285 13 Openeconomyrepresentativeagentmodels 306 PARTIV CONFRONTINGMODELSWITHFACTS 14 Testing the rational expectations hypothesis in financial markets 321 Minford for PRINT.indd 5 01/04/2019 15:07 vi Advanced macroeconomics · 15 Howtotestmacroeconomicmodels 407 16 Theproblemofidentification 422 17 What do we know about the causes of macroeconomic behaviour? 433 Bibliography 445 Index 485 Minford for PRINT.indd 6 01/04/2019 15:07 Full contents Preface xiii PARTI MODELSOFTHEECONOMY 1 Macroeconomics: asuccinctintroduction 3 Theclassicalmodel 3 TheKeynesianmodel 10 ThePhillipsCurveandtheneo-Keynesiansynthesis 14 2 Solvingrationalexpectationsmodels 37 Thebasicmethod 39 TheMuthmethodofundeterminedcoefficients 43 RE models with expectations of future variables (REFV models) 45 Choosingauniquestablepath 51 OthermethodsofsolutionforREFVmodels 54 Thetechniquesinapplication: amorecomplicatedexample 57 AmoregeneralwayoflookingatanREFVmodel 64 Stabilityproblemsinrationalexpectationsmodels 67 Conclusions 71 Appendix2A.1: whenadaptiveexpectationsarerational 72 3 Partialinformationandsignalextraction 78 TheNewClassicalPhillipsCurve 80 Thesupplyside: integratingmacrowithmicro 85 Capitalmarketsandpartialmacroinformation 86 Recentapplications: informationlagsandnewsshocks 94 Conclusions 95 PARTII EVALUATINGGOVERNMENTPOLICY 4 Stabilizationpolicy: canwe? 99 ModelswiththeSargent–Wallacesupplycurve 100 Modelswithlong-termnon-contingentcontracts: theNewKeynesianPhillipsCurve 109 Minford for PRINT.indd 7 01/04/2019 15:07 viii Advanced macroeconomics · NewClassicalmodelswithintertemporalsubstitution 115 Conclusions 119 Appendix4A.1: automaticstabilizers—anaside 121 5 Stabilizationpolicy: shouldwe? 125 Thewelfarecriterion 125 Optimaleconomicpoliciesandtimeinconsistency 128 Conclusions 150 6 Practicalissuesofeffectivestabilization 152 Evaluating policy in New Keynesian models with overlapping wage/price contracts 152 Conclusions 157 7 Fiscalpolicyandthegovernmentbudgetconstraint 158 Governmentsolvencyandthegovernmentbudgetconstraint 158 The‘fiscaltheoryofthepricelevel’ 162 Modelsoffiscaleffect 164 Theconnectionbetweenfiscalandmonetarypolicy: unpleasantmonetaristarithmeticinamodelof selfishoverlappinggenerations 172 Conclusions 177 Appendix 7A.1: fiscal-monetary links in a neo-Keynesian model with wealth effects 178 8 Unemployment, productivityandgrowth 185 Unemployment 186 Theoptimalroleofgovernment 188 Growth 190 Derivationofamodelforinnovation 196 Conclusions 207 9 Politicaleconomyinmacroeconomics 208 TheNordhausmodel 209 Rationalexpectationsandreputation 211 Arationalexpectationsmodelofvotersandparties 213 Explainingpartypolicy 217 Relatedissues 219 Thepoliticaleconomyofthesupplyside 221 Conclusions 224 Appendix9A.1: differencesineconomicpoliciesofpolitical partiesandcentralbankindependence 226 Minford for PRINT.indd 8 01/04/2019 15:07 4 AFdFuvulalllnCCcoeodnnttmeennattcssroeicixoxnomics · ·· PPAARRTTIIIIII EEXXTTEENNDDIINNGGAANNDDDDEEEEPPEENNIINNGGTTHHEEMMOODDEEQLLSS:: F Q TTHHEEOOPPEENNEECCOONNOOMMYYAANNDD MMIICCRROO--FFOOUUNNDDAATTIIOONNSS 1100 TThheemmaaccrrooeeccoonnoommiiccssooffaannooppeenneeccoonnoommyy 223311 TThheeccuurrrreennttaaccccoouunntt::ttwwoommooddeellss 223333 HHoommeepprriicceess::tthheessuuppppllyyssiiddee 223355 P TThheeccaappiittaallaaccccoouunnttaannddtthheerreessttoofftthheeooppeenneeccoonnoommyymmooddeell 223399 45° CCoonncclluussiioonnss 224422 L Q AAppppeennddiixx1100AA..11::lloonngg--rruunneeqquuiilliibbrriiuummiinntthheeooppeenneeccoonnoommyy 224433 W Long-Run P D S AS S 1111 TThheeLLuuccaassccrriittiiqquueeaannddrreepprreesseennttaattiivveeaaggeennttmmooddeellss Short- iinnccaasshhlleesssseeccoonnoommiieess 224466 P W * 0 Run TThheeLLuuccaassccrriittiiqquueeooffppoolliiccyyeevvaalluuaattiioonn 224466 AS P DDeeeeppssttrruuccttuurree 224488 TThheebbaassiiccssttrruuccttuurreeooffaarreepprreesseennttaattiivveeaaggeennttmmooddeell 225511 S GGeenneerraalleeqquuiilliibbrriiuumm 225555 D A TThheeggoovveerrnnmmeennttbbuuddggeettccoonnssttrraaiinntt 225566 TThheepprriicciinnggooffccoonnttiinnggeennttccllaaiimmss 225588 l* L Q* Q GGoovveerrnnmmeennttbboonnddssaassnneettwweeaalltthh::mmooddeellsswwiitthhiinntteerrtteemmppoorraall aannddggeeooggrraapphhiiccccoonnssttrraaiinnttss 225599 Figure 1.1 Aggregate supply OOvveerrllaappppiinnggggeenneerraattiioonnssmmooddeellss 225599 GGeeooggrraapphhyy::tthheeBBeewwlleeyy––TToowwnnsseennddmmooddeell 226622 theaverageforcesaffectingtheeconomyratherthanontheirdistributionacross TThheerreeaallbbuussiinneessssccyycclleemmooddeell 226655 agents. Aggregatesupplyinthistheorydependsontechnology,preferencesand CCoonncclluussiioonnss 227722 relative prices. Demand depends on the quantity of money and on incomes. AAppppeennddiixx1111AA..11::tthheetteecchhnniiqquueeooffddyynnaammiiccpprrooggrraammmmiinngg 227744 AAppppeennddiixx1111AA..22::uussiinnggddyynnaammiiccpprrooggrraammmmiinnggttoocchhoooossee Supply tthheeooppttiimmaallmmoonneettaarryyppoolliiccyyuunnddeerroouuttppuuttppeerrssiisstteennccee 228800 Figure 1.1 shows four quadrants, bottom left is the labour market, top left the 1122 MMoonneeyyiinnrreepprreesseennttaattiivveeaaggeennttmmooddeellss production function2,28t85o5p right a 45 graph transferring output through to the ◦ IInnttrroodduucciinnggmmoonneeyyiinnttooBBeewwlleeyy––TToowwnnsseennddaanndbdoOOttLLoGmGmrmigoohddte,ellswshich22i8s877the supply curve between the price level and output. The production function, PF, which can be thought of as the optimal be- MMoonneeyyiinntthheeOOLLGGmmooddeell 229900 haviour of the average firm times the number of firms, takes capital as given TThheeccaasshh--iinn--aaddvvaanncceemmooddeell 229911 and hence shows diminishing returns of output (Q) to increasing labour input UUnnpplleeaassaannttmmoonneettaarriissttaarriitthhmmeettiiccrreevviissiitteedd 229955 (L). Fromitisderivedthedemandforlabour,DD,where(fortheaveragefirm) AAwwiiddeellyyuusseeddNNeewwKKeeyynneessiiaannmmooddeellaannddiittssssoolluuttiioonn 229955 therealwageequalsthemarginalproductoflabour,orequivalentlytheprice= PPoossssiibblleemmooddeerrnneevvoolluuttiioonnssooffmmoonneeyyaannddmmoonneettaarryy marginal cost, the first-order condition of a profit maximum. The supply of ppoolliiccyy::tthheerree--eemmeerrggeenncceeooffccoommmmooddiittyymmoonneleayyb??our,SS,isshown33w003i3thaflattishslope,indicatingthatthesubstitutioneffect CCoonncclluussiioonnss ofrisingrealwages,3W3004,4issubstantiallylargerthantheincomeeffect; thiscould P come about because either workers substitute effort across time or unemploy- 1133 OOppeenneeccoonnoommyyrreepprreesseennttaattiivveeaaggeennttmmooddmeeellsnstbenefitsarege3n30e0r66ousandlong-lasting(asdiscussedbelow,respectively,in TThheeooppeenneeccoonnoommyyiinntthheeccaasshhlleessssOOLLGGmmooddeellChapters 3 and 9). 330066 AAnnooppeennccaasshh--iinn--aaddvvaanncceemmooddeellwwiitthhddyynnaassttiicchhoouTussweehohooalglddgregatesu33p00p99ly,AS,curvesareshown. Oneisvertical,indicatingthat AAssmmaallll--ccoouunnttrryyvveerrssiioonn if all prices (P) rise3t31h11e1supply of and demand for labour will not change since Minford for PRINT.indd 9 01/04/2019 16:43