Core Macroeconomics, Hilary Term 2017

Week 7: Intertemporal macroeconomics, consumption, "real business cycles"

An intertemporal approach to macroeconomics means careful modeling of forward-looking, optimising decisions by agents who trade off costs and benefits in different time periods. So it is a method rather than a topic. We will discuss (you will write about) consumption in some detail. You are already familiar with most of the issues from your work last year in intro macro, so now you are looking to deepen that understanding. We will also discuss models in which all decisions are made in an optimal, intertemporal way: households choosing not just consumption but also labour supply, firms choosing investment and labour demand. The real interest rate is the variable that ensures equilibrium in these frictionless, market-clearing, real business cycle models, which trace the evolution of the economy over time in response to shocks. Any fluctuations in such models are optimal. It may be unfortunate that a negative "technology shock" has occurred, but given this unfortunate exogenous shock, a reduction in employment is an optimal response by households to lower real wages; the Great Depression was a great vacation. As you study RBC models, notice what is not there: there is no money, no "nominal frictions", no inflation, no central bank. It is important to keep in mind that New Keynesian models are built on an RBC foundation. Recall (or re-read) Farmer's critique of New Keynesianism in this regard from Week 2 and please read the working paper by Paul Romer cited below.

Readings

The primary readings for real business cycles are the lecture notes and Ch. 11 "A real intertemporal model with investment" in Stephen Williamson, Macroeconomics, 5th ed. (Pearson, 2014). There are two copies in the Pembroke Library. Earlier editions (in which the relevant chapter will have the same title but may be numbered differently) are at the Social Sciences Library and the Bodleian. You may find this text useful on other topics as well.

A pdf of the old Ch. 7, 1st ed. is available here.

You will also find RBC models covered in C&S Ch. 16 and Romer, Ch. 4.

Please read Paul Romer's recent working paper "The Trouble with Macroeconomics", which you can download here.

A simple, first-year text with a consistent intertemporal perspective is Burda & Wyplosz, Macroeconomics: a European Text , (5th ed.).

On consumption, you will find C&S 1st ed. ch. 7 useful.

Romer, Advanced Macroeconomics, (3rd ed.) Ch. 7 is also good.

Muellbauer, J. "The Assessment: Consumer Expenditure," Oxford Review of Economic Policy , vol. 10 no. 2 (1994) pp. 1-41. (Also reprinted in Readings in Macroeconomics, Tim Jenkinson ed., OUP, 2nd ed. 2000.)

Muellbauer, J., "Housing, Credit, and Consumer Expenditure," Proceedings of a Federal Reserve Bank of Kansas City symposium, 2007. Also now a 2008 CEPR working paper. You should be able to download one of these versions.

There are three good short articles in a Journal of Economic Perspectives symposium on consumption, Spring 2001 issue (vol. 15, no. 2).

Assignment

This week's assignment has two parts.

1. Use the RBC model of the Williamson book to analyse the effects of an increase in government purchases, and contrast this analysis with the predictions of a Keynesian model. Prepare and submit notes and diagrams (not a formal essay) for your answer.

2. Write a short essay of about 1000 words on the following topic: Empirical evidence has shown that consumer spending in the UK rises by a lot more after a 1% fall in interest rates than does consumer spending in Japan. What explains this difference?"