Topic 9.1: A Brief and Partial History of
Macroeconomics and Quantitative Macroeconomic
Models
ECOS3007 International Macroeconomics
Semester 1 2023
Lecture Slides
Week 11
The birth of macroeconomics I
Macroeconomics born as a …eld during and because of the Great Depression
idea that government could/should regulate the periodic ups and downs of the
economy rose to prominence
John Maynard Keynes, The General Theory of Employment, Interest, and
Money (1936)
basic tenets:
various rigidities/imperfections in many markets lead to disequilibria that can
last a long time
…scal policy and (later) monetary policy could induce large shifts in supply and
demand conditions
a basis for policy activism to mitigate recessions/depressions
Burns and Mitchell, Measuring Business Cycles (1946)
…rst systematic accounting of the co-movement of various aggregates
i.e., GDP, consumption, employment, in‡ation, unemployment rate, etc
2 / 14
The birth of macroeconomics II
prior to this, macro models are very basic
(qualitative/non-quantitative)— and hence, useless for guiding policy— and
micro-based, partial equilibrium
enabling the study of short-term/medium-term ‡uctuations
3 / 14
The rise of Keynesian
Keynes’book gave rise to a whole industry of interpreting and modeling it —
Keynesian macroeconomics was born
Prominent example: large-scale “Keynesian macroeconometric”models
(KMA) in 1960’s, led by
Kennedy’s Council of Economic Advisers (Solow, Tobin, Samuelson)
MIT/Penn/Federal Reserve Board
ISLM and AS/AD model (Hicks, 1937) the conceptual core
Statistical relationships between various macro variables were formulated
estimate α’s coe¢ cients using data; this is how macroeconomy “works”
For example, a "stable" Phillips curve relationship is a key ingredient and
becomes a centerpiece for policy formulation
The fall of Keynesian
Large-scale “Keynesian macroeconometric”models became widely used for
policy-making. . .
. . . until they stopped “working” in the 1970’s, amidst a high-in‡ation
environment (U.S. in‡ation between 15-20% in second half of 1970’s), sparked
by OPEC oil embargoes (an adverse supply shock)
the Phillips curve relationship broke down, i.e. it becomes "unstable"
policies based on existing PC relationship failed to stabilize the economy and
bring down in‡ation (until Volcker’s disin‡ation)
the whole existing macroeconomic theory were thrown into disarray
One main reason behind the breakdown: Price setters changed the way they
adjust prices, highlighting the role of expectations
The …nal death blow: Lucas’Critique (1976)
5 / 14
The fall of Keynesian (KMA and the Lucas’Critique)
Lucas’main insights:
humans are not robots – they response to incentives and their behavior may
change if policies change
the role of (rational) expectations is crucial, suggesting the need to explicitly
model agents’behavior (microfoundations)
the α’s themselves should be modeled as functions of government policy and
structural parameters
policymakers cannot rely on past reduced-form relationship (KMA) to persist
once a policy aiming to exploit the relationship is adopted
structural, instead of reduced-form estimations
Conclusion: KM models are not economic models
merely a statistical description of historical events
a damning criticism of the entire macroeconomics profession
6 / 14
The rebirth of macroeconomics, Phase I: RBC and DSGE
Following Lucas, real business cycles (RBC) theory/model was born
Features of RBC models (Kydland and Prescott, 1982, Long and Plosser
1983, King, Plosser, and Rebelo, 1988):
building blocks: (frictionless) neoclassical growth models and stochastic "real"
shocks (mainly TFP)
business cycles are e¢ cient and “natural”— policy has no stabilization role
explicit modeling of individual agents, e.g. households’preferences
("microfoundations"), and the use of rational expectations
dynamic general equilibrium framework
"calibration" instead of estimation
In essence, RBC theory incorporated all Lucas’criticisms — the resulting
models are essentially the …rst quantitative Dynamic Stochastic General
Equilibrium (DSGE) models.
7 / 14
The rebirth of macroeconomics, Phase II: The "New"
Keynesian (NK) (1990s)
Though RBC theory was shown to be quite a success in matching salient
features of (US) business cycles it lacks two important realisms: nominal
rigidities (market imperfections) and the role of (monetary) policy
Econometric evidence (e.g. Yun, 1996) show otherwise
In response to this (and to its past failure), the Keynesian faction (Mankiw,
Blanchard, Gali, etc.) extended RBC and "old" Keynesian models
This gives rise to New Keynesian (NK) models — features:
explicit microfoundations and rational expectations as in RBC
market imperfections are added, in particular nominal (price or/and wage)
rigidities
monetary policy has a stabilization role
relative importance of demand shocks, instead of supply (TFP) shocks
open-economy aspects
8 / 14
Post 2008-2009 Great Recession/GFC?
Most/typical RBC and NK models share one (not-so-good) assumption:
complete …nancial market (Modigliani-Miller)
Modigliani-Miller theorem:
value of the …rm is independent of …nancing considerations (debt versus
equity) — no role for …nancial intermediaries
perfect information, perfect credit markets, no possibility of bankruptcy
composition of …nancial intermediaries’balance sheet has no e¤ect on
aggregate economy
Post GFC:
we now know this is not true
incorporating …nancial frictions into DSGE models is now an active research
area, see e.g. Bernanke, Gertler, and Gilchrist (1999), Iacoviello (2005),
Gilchrist, Ortiz, and Zakrajsek (2009), Gerali, et al. (2010), Roger and Vlcek
(2011), Gambacorta and Signoretti (2014), Bianchi and Bigio (2021)
an argument for macroprudential policies (or central bank policy mix)
9 / 14
Where we are today?
Most modern macro models are DSGE, and most DSGE models are variants
of NK models
There is (was) a convergence among macroeconomists about what elements
must be present in a "good" DSGE model — Goodfriend and King (1998)
termed this as the "New Neoclassical Synthesis"
Use of DSGE in central banks (sample): the ECB, the Federal Reserve, Bank
of Canada, Norges Bank, Sveriges Riksbank, RBA
Post-GFC: incorporating …nancial frictions into modern NK/DSGE models
Post COVID-19 pandemic?
10 / 14
Summing up
DSGE models o¤er important advantages:
explicit microeconomic foundation
robust to Lucas’critique
welfare analysis is clear and straightforward (can compare di¤erent policies)
design of optimal policy
quantitative instead of qualitative
can be used for forecasting, conducting policy simulations, and to guide
policies
Some disadvantages, however:
more complicated (due to its rigorous micro foundations)
not so straightforward to solve and estimate (recent advance in solution
methodology and computer processors mitigate this concern)
can be hard to analyze sometimes (due to its general equilibrium nature)
But still, the advantages more than make up for the disadvantages
11 / 14
References I
Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon (1999). "The …nancial
accelerator in a quantitative business cycle framework". Handbook of
Macroeconomics, ed 1, vol 1.
Bianchi, Javier, and Saki Bigio. (2021). "Banks, liquidity management and
monetary policy". Forthcoming in Econometrica.
Burns, A. and W. Mitchell (1946). Measuring Business Cycles. National Bureau of
Economic Research.
Gambacorta, Leonardo, and Federico M. Signoretti. (2014). "Should monetary
policy lean against the wind?: An analysis based on a DSGE model with banking."
Journal of Economic Dynamics and Control 43: 146-174.
Gerali, A., S. Neri, L. Sessa, F. Signoretti (2010). "Credit and Banking in a DSGE
Model of Euro Area". Journal of Money, Credit, and Banking 42, September.
Gilchrist, Ortiz, and Zakrajsek (2009). "Credit Risk and the Macroeconomy:
Evidence from an Estimated DSGE Model". Paper presented at Reserve Bank of
Australia Research Workshop ‘Monetary Policy in Open Economies’, Sydney, 14–15
December.
12 / 14
References II
Goodfriend, M. and R. King (1997). "The new neoclassical synthesis and the role
of monetary policy". NBER Macroeconomics Annual.
Hicks, J. R. (1937). "Mr. Keynes and the ’Classics’: A Suggested Interpretation".
Econometrica 5 (2): 147–159.
Iacoviello, M. (2005). "House Prices, Borrowing Constraints, and Monetary Policy
in the Business Cycle". American Economic Review 95(3), 739-764, June.
Keynes, John Maynard (1936). The General Theory of Employment, Interest and
Money.
King, R., C. Plosser, and S. Rebello (1988). "Production, growth, and business
cycles: I. The basic neoclassical model". Journal of Monetary Economics, vol
21(2-3).
Kydland, Finn E. and Edward C. Prescott (1982). “Time to Build and Aggregate
Fluctuations“. Econometrica 50: 1345-1370.
Long, John B, Jr & Plosser, Charles I (1983). "Real Business Cycles". Journal of
Political Economy, University of Chicago Press, vol. 91(1), pages 39-69, February.
13 / 14
References III
Lucas, Robert (1976). "Econometric Policy Evaluation: A Critique". In Brunner,
K.; Meltzer, A. The Phillips Curve and Labor Markets. Carnegie-Rochester
Conference Series on Public Policy.
Modigliani, F.; Miller, M. (1958). "The Cost of Capital, Corporation Finance and
the Theory of Investment". American Economic Review 48 (3): 261–297.
Roger, Scott, and Jan Vlcek. (2011). "Macroeconomic costs of higher bank capital
and liquidity requirements". IMF Working Paper 11/103.
Yun, Tack (1996). "Nominal price rigidity, money supply endogeneity, and business
cycles". Journal of Monetary Economics 37(4).