TI Macro I

Fall 2013
Notes, Chapter 1
Bjorn Br
ugemann
Last revision of this document: October 29, 2014

Chapter 1
Introduction
In this chapter I give a brief introduction to Macro I, and discuss its place in the Tinbergen
macro sequence.

1.1

Introduction to Macro I

This course introduces you to stochastic neoclassical growth models. These are basic models of the macroeconomy which build on general equilibrium theory. Standard consumer
and producer theory is used to model the behavior of households and firms. Markets are
perfectly competitive and complete in these models, and typically bring about an efficient
allocation of resources. In this sense there are no frictions or market failures. This class
of models has been used to study a large variety of issues in macroeconomics, including
business cycles, growth, and asset pricing. These models are useful for several reasons.
First, they are useful in understanding the efficient allocation of resources. Second, if in
the context of a particular application the relevant empirical evidence appears inconsistent with an efficient allocation of resources, then the precise nature of the discrepancy
can indicate what type of frictions ought to be included in the model. Third, elements of
the neoclassical growth model are important building blocks of macroeconomic models
with frictions. For example, so-called Dynamic Stochastic General Equilibrium (DSGE)
models are a class of models that is widely used to study monetary and fiscal policy, and
they are constructed by introducing a variety of frictions into basic stochastic neoclassical growth models. We will start by studying elements of general equilibrium theory
needed for macroeconomics, with a focus on modeling dynamics and uncertainty. Having
covered these basics, we will study different versions of the neoclassical growth model,
specifically a version with infinitely-lived households and a version with overlapping generations of finitely-lived households. We will use these models to take a first pass at some
applications. Applications vary from year to year as I teach the course, and may include
business cycles, growth, asset pricing, inequality and fiscal policy. To study quantitative
implications we need to solve the models numerically. You will practice basic techniques
for doing so in problem sets, specifically dynamic programming and linearization.

1.2

Place of Macro I in Macro Sequence

The defining characteristic of mainstream macroeconomics is that it builds on microeconomic theory to develop models of the macroeconomy, in particular consumer and
producer theory, as well as general equilibrium theory. Thus a typical model will consist
of a specification of the set of commodities produced and consumed, the preferences of
households over these commodities, commodity endowments, and the technologies available. These are all elements of the physical environment of the model. Furthermore, a
model needs to specify the mechanism through which resources are allocated, that is, how
it is decided what is being produced and who consumes what. A common assumption in
mainstream macroeconomics is that resources are allocated through perfectly competitive and complete markets. This assumption is common but not universal. The standard
toolbox of mainstream macroeconomics includes various departures from perfectly competitive and complete markets. This includes ways of modeling market incompleteness,
as well as departures from perfect competition such as monopolistic competition and
search frictions. Much current research in macroeconomics relies on these departures.
A common situation is that a given model uses search frictions in some markets while
maintaining perfect competition for other markets. Furthermore, the allocation that
would be generated with perfectly competitive and complete markets constitutes a useful benchmark for understanding the impact of frictions. Thus being able to work with
macroeconomic models with perfectly competitive and complete markets is necessary first
step in order to be able to read or participate in current research in mainstream macroeconomics. For this reason, the primary objective of this course is to get you to a point
at which you are comfortable working with macroeconomic models that have perfectly
competitive and complete markets.
The basic core models of mainstream macroeconomics, the neoclassical growth models
with infinitely-lived households and with overlapping generations, are essentially special
cases of the general equilibrium models you have studied in Micro I. Importantly, macroeconomics is primarily concerned with the dynamic behavior of the economy, both in the
short run (business cycles) or the long run (growth). Thus in our models agents face
dynamic decision problems. Additionally, agents face uncertainty when making their decisions. The resulting dynamic decision problems have a special structure which enables
us to solve them using methods such as dynamic programming and optimal control. You
already encountered these methods in Math II. We will review them and apply them to
the basic core models of macroeconomics.
Macro I is focused on models with perfectly competitive and complete markets. We
will see that markets work very well in these models in the following sense: the allocation
of resources achieved through markets is socially efficient. This is not to say that nothing
bad can happen in these models. The models allow for the possibility that an economy
is very poor due to a lack of resources or due to poor technology. But for given resources
and technology, markets insure an optimal allocation of resources. Similarly, an economy
can experience a recession due to shocks to technology, resources, or preferences, but
the response of the economy to these shocks is socially efficient. In particular, financial
markets work perfectly in these models. Thus these models are not designed to think
2

about market failures in financial markets.

The neoclassical growth models are the most basic members of a class of models often
referred to as Dynamic Stochastic General Equilibrium models (DSGE). Other members
of this class depart from the neoclassical growth models by introducing so-called frictions
that, loosely speaking, make the economy function less well. You will encounter DSGE
models with frictions in the other courses of the macro sequence. Macro II will at first
continue to work with the frictionless neoclassical growth model, using it to study fiscal
and monetary policy. But it will also introduce a first type of friction, so-called nominal
rigidities. These are frictions that interfere with changing nominal prices (the prices of
goods in terms of money). As you will see, these frictions have important implications for
monetary and fiscal policy. Macro III will introduce further frictions in labor, capital, and
product markets, including informational asymmetries and search frictions, and examine
how they affect the allocation of resources. Macro IV focusses on financial frictions, which
are also based on informational asymmetries.
A very common approach to a research question in mainstream macroeconomics is
to start with a neoclassical growth model and to add the frictions that are relevant for
the research question at hand. For example, suppose your research question is: What
monetary policy is socially optimal? In this case you may want to consider a model with
nominal rigidities. If you want to understand fluctuations in unemployment, you may
want to include search frictions. In the latter case you may decide to leave out nominal
rigidities, unless you believe that they are of first-order importance for the results. The
reason is that including too many unneeded frictions can make the model difficult to work
with. However, there is also an area of research on DSGE models which simultaneously
introduces a large number of frictions and then estimates the resulting model. Some
large-scale DSGE models have become popular with central banks as one way to think
about monetary policy. Sometimes the term DSGE is interpreted narrowly to refer to
this type of model.
The DSGE approach has been used to study a large variety of research questions. Before the financial crisis that started in 2008, most research in macroeconomics focused on
problems other than frictions in financial markets. Thus many DSGE models developed
during this period did not include financial frictions. In the course of the financial crises,
macroeconomics was criticized by many observers, and this criticism frequently included
claims that DSGE models are useless. When thinking about this criticism, it is important
to keep in mind that macroeconomics does not aim to develop a single all-encompassing
model of the macroeconomy that can then be used to answer all macroeconomic research
questions. Instead, typically macroeconomists develop a customized model for each specific research question. Most DSGE models were never intended to think about potential
problems in the financial sector. Hence it should not come as a surprise that they are
not useful for this purpose. Macroeconomists have developed a variety of models with
financial frictions , and you will encounter many of them in Macro IV. Usually these
models also build on microeconomic theory, but drawing more on contract theory. While
a lot of recent work on other research questions has explored quantitative implications
of the models used, much of the research on financial frictions has remained qualitative.

Whether one would still refer to these models as DSGE depends on how narrowly or
widely one defines DSGE. In any case, it is probably not very useful to criticize specific
models for not addressing questions they were not intended to address. A potentially
more useful and valid criticism would be that before the crisis macroeconomics as a field
did not allocate enough research effort to improving models of financial frictions and understanding potentially problematic developments in financial markets. The allocation
of research effort has certainly changed in recent years, and recent efforts to better understand financial crises has taken a variety of forms. Some work has focused on models
that are specifically focused on financial crisis. Other work has attempted to capture
financial frictions in a sufficiently simple way such that they can be incorporated in the
large-scale DSGE models mentioned above, which may be useful for understanding the
role of monetary and fiscal policy in a financial crisis.