Macroeconomic Theory

In this first chapter, we present the two benchmark models that we will use throughout the book in their simplest versions. First, we present the model for the determination of employment and income by companies and workers in a market setting, comparing the market outcomes obtained with unfettered competition and with various distortions, including market power by companies, price rigidity, and taxation. Then, we present the model for the determination of the saving behavior through the accumulation of a durable commodity that represents physical capital.

Over the last century, per capita income has grown at a fairly high average rate in several countries. Long-term income growth is a relatively new phenomenon in human history. In this chapter, we identify the main driving forces of income growth. We examine both exogenous and endogenous theories of economic growth.

Over the last century, risky equity has commanded a large premium over risk-less government debt in several countries. In this chapter, we show the reason why there should be such a premium but also point out that the standard model has a hard time replicating the size of the premium. We also discuss asset price bubbles, namely asset prices with a non-fundamental component.

In the short run, credit fluctuates together with income and employment, acting as an amplifier of exogenous shocks to the economy and sometimes as an independent source of fluctuations. In this chapter, we show that the competitive model with credit market imperfections that lead to collateral constraints can provide a theoretical explanation for these phenomena, which generate credit cycles. We examine both exogenous and endogenous credit cycle theories.

With unlimited access to market instruments, consumption variability, if any, can be driven by aggregate income shocks, but temporary idiosyncratic income variability would be smoothed out. Liquidity is useless in such circumstances, since all personal wealth is already fully liquid. Real-world consumption smoothing appears to be less than perfect. In addition, both companies and households routinely hold liquid instruments with little or no fundamental value. In this chapter, we examine a departure from the standard model in which heterogeneous traders cannot borrow without limit against their future income. The profile of personal consumption fluctuates over time independently of the variability of aggregate income and consumption. Liquid instruments help improve resource allocation. The price of such liquid instruments diverges from the fundamental value, including a liquidity premium. The creation of liquidity by monetary authorities can be socially beneficial by helping people relax their liquidity restriction when it is needed most, at the cost of creating inflation that erodes the value of currency.

In this chapter, we examine models in which the limitations to risk-sharing and consumption smoothing emerge endogenously. We will examine three classes of models, with credit contracts offered by intermediaries arising as optimal responses to private information about income realizations, with endogenous incomplete markets arising from the possibility that traders may hide their income from the risk-sharing arrangement, and with endogenous incomplete contracts arising from contractual enforcement limitations.

The financial and economic crisis that broke out in the late 2000s in the United States known as the Great Recession can be interpreted as a bank run gone awry with long-lasting negative spillover effects within and outside the country. In this chapter, we examine both a self-fulfilling and a fundamental-based theory of bank runs, in an environment in which deposit contracts help people insure against liquidity shocks that are their private information.

Unemployment is an anti-cyclical phenomenon that spikes after recessions. For a long time, unemployment has been considered a phenomenon incompatible with equilibrium that requires the absence of market clearing in the labor market. The models examined so far had well-functioning competitive markets or contracts offered by financial intermediaries. In this chapter, we examine situations in which markets and contracts are not available and trade happens in a bilateral and random manner, making the interaction genuinely strategic. Strategic interaction generates externalities among traders that make resource allocation inefficient. Moreover, coordination failures can emerge, giving rise to multiple Pareto-ordered equilibria with different levels of economic activity. Unemployment emerges due to the frictional nature of the labor market in which companies and workers negotiate the wage to divide the gains from trade.

In this chapter, we provide an introduction to dynamic programming, that is, the recursive methods widely used in advanced treatments of modern macroeconomics.

The aim of this book was to introduce the reader to modern macroeconomic theory. The common thread has been the general equilibrium model with competitive markets originally developed by Arrow and Debreu and extended in several directions by subsequent generations of economic theorists. The key aspect of this approach to macroeconomic theorizing is the identification of individual preferences and production possibilities as exogenous data and the prices and allocations as endogenous outcomes of the market interaction. We have shown that the attractive, but sometimes counterfactual, properties of the standard market model can be progressively weakened as different imperfections are added to the model, ranging from borrowing limits to incomplete markets, private information, and strategic interaction. In particular, the efficiency of equilibrium allocation disappears as the trade interaction becomes ridden with imperfections, opening up some room for policy intervention that is otherwise unnecessary. The typical role of policy is to compensate for market imperfection, providing a substitute for missing risk-sharing or consumption smoothing options when everything else fails.