Core Macroeconomics, Hilary Term 2012

Week 4: A Keynesian closed-economy model

This week's focus is on the closed economy model that Carlin & Soskice present in Chapter 3, which is built up from three components: an IS-LM demand side; a supply side derived from the imperfectly competitive labour market model; and a monetary policy rule for the central bank. We will use the model to discuss the economy's response to various shocks, and the implementation of monetary policy. We will also look in a bit more detail at how monetary policy works.

A relevant topic that we will not discuss this week is the New Keynesian effort to build models featuring rational expectations and optimising decisions by households and firms ("microfoundations"), in which aggregate demand still has a persistent impact on the economy. Related issues you will encounter in lecture include menu costs and the New Keynesian Phillips curve. And you are already familiar with the sort of consumption theories embedded in New Keynesian models. There is a lack of readings that are both sufficiently accessible and sufficiently detailed for our purposes. Some non-technical overviews are suggested in the readings below.


The primary reading for this week is Carlin & Soskice, Chapters 2 (AS/AD), 3 (the 3-eqn model), and 5 (monetary policy).

On the transmission mechanism for monetary policy, see the Autumn 1995 (vol. 9, no. 4) special issue of the Journal of Economic Perspectives as a starting point, especially the article by Ben Bernanke and Mark Gertler, "Inside the Black Box: The Credit Channel of Monetary Policy Transmission" (pp. 27-48).

Also useful is Krugman, P., K. Dominguez, and K. Rogoff, "It's Baaack: Japan's Slump and the Return of the Liqudity Trap", Brookings Papers on Economic Activity, vol. 1998 no. 2, pp. 137-205.

We are looking for an article on the credit crunch and quantitative easing in the current recession. For now consider this webpage .

On central bank responses to inflation, see:
Ball, L. "What Determines the Sacrifce Ratio?" available in working paper version on line or published in Monetary Policy N.G. Mankiw, ed. (U. of Chicago Press, 1994).
Temple, J. "Openness, Inflation, and the Phillips Curve: A Puzzle," Journal of Money, Credit and Banking vol. 34, no. 2 (May 2002), pp. 450-68.
Caporale, B. and T. Caporale, "Political Regimes and the Cost of Disinflation" JMCB, vol. 40 no. 7 (Oct. 2008), pp. 1541-54.

On New Keynesian microfoundations, three non-technical overviews of this research programme are the following:
Mankiw, N.G. "The Macroeconomist as Scientist and Engineer" NBER working paper and unpublished manuscript, 2006.
Woodford, M. "Revolution and Evolution in Twentieth-Century Macroeconomics," Princeton University working paper, 1999.
Wren-Lewis, S. "Internal Consistency, Nominal Intertia and the Microfoundations of Macroeconomics," Oxford University Department of Economics Discussion Paper 450, September 2009.

For actual evidence on nominal rigidty see Blinder, Alan, "Why are Prices Sticky? Preliminary Results from an Interview Study," American Economic Review, vol. 81 no. 2 (May 1991), pp. 89-96.


The first student by alphabetical order in a tutorial group should pick either of the following essay topics; the second should do Essay 1; the third Essay 2.

1. What determines the degree to which the monetary authorities should respond to a rise in inflation above the target rate? Think about the slope and position of the Phillips Curve. Incorporate relevant data or cases in your answer.

2. How important is the "credit channel" in transmitting changes in monetary policy to the economy? You will want to explain the different possible transmission mechanisms as well as provide some evidence or a case study.

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