Macro Theory and Policy

‘Modern Macroeconomics’
 Endogenous Money
Nowadays it is generally accepted that by setting
the Repo/base rate/MPC Policy Rate the Bank of
England can largely determine the level of
prevailing interest rates, but the ‘supply’ of
money then responds more or less ‘passively’ to
the demand for credit at these interest rates:
 Bank of England sets price of
credit but volume is demand
Interest Rate determined: Endogenous

Volume demand determined

Prevailing Interest rates(s)

Commercial Bank’s Mark-up

B of E MPC Policy Rate

Volume of
Money/Credit
 GPT Chat Response to:
What are the monetary transmission mechanisms from Quantitative Easing to the real economy?

• Lower Interest Rates: One of the primary goals of QE is to lower long-term interest rates. Central banks achieve this by purchasing government
bonds and other securities from the market, thereby increasing the demand for these assets and pushing their prices up. As bond prices rise, their
yields (interest rates) fall. Lower long-term interest rates encourage borrowing and investment by both businesses and consumers, stimulating
economic activity.

• Boosting Asset Prices: QE tends to increase the prices of financial assets, such as stocks and real estate. This wealth effect can lead to increased
consumer spending and business investment. Higher stock prices can also improve business and consumer confidence, leading to further spending
and investment.

• Portfolio Rebalancing: When central banks purchase large quantities of government bonds and other assets, they inject liquidity into the financial
system. Investors who sell these assets to central banks may seek higher-yielding or riskier investments, such as corporate bonds, stocks, or real
estate. This portfolio rebalancing effect can lower borrowing costs for corporations, making it cheaper for them to invest and expand their operations.

• Weakening the Currency: QE can lead to a depreciation of the currency as investors seek higher returns elsewhere due to lower interest rates. A
weaker currency makes exports more competitive and imports more expensive, boosting export-oriented industries and supporting economic growth.

• Credit Channel: By reducing interest rates and increasing liquidity in the financial system, QE can encourage banks to lend more freely. Lower
borrowing costs for businesses and households can stimulate spending and investment, further supporting economic activity.

• Expectations Effect: QE can influence future inflation expectations and economic outlook. By signaling a commitment to supporting economic
growth and avoiding deflation, central banks can influence consumer and business behavior, encouraging spending and investment.

OK, so far as it goes, but this is more than just switching one asset for another,
so can be ‘pushing on a string’, what was in effect happened was that QE has been
central bank funding the Treasury: Fiscal policy ‘masquerading’ as monetary policy.
 Why the Central Bank sets Interest Rates
Central Banks are charged to be concerned with two things:

1. The inflation gap (actual Inflation minus target inflation)

2. The output gap (and hence unemployment or the risks of accelerating/decelerating inflation)

This is called a ‘Taylor Rule’:

MPC’s r= The ‘natural’ interest rate* + a. Inflation Gap + b. Output Gap

The natural (often called ‘neutral’) interest rate is the rate that the central bank would choose if inflation and output
were both on target.

Different central banks may have different a and b coefficients, that is, place different weights on inflation and
output/unemployment, and the same central bank may also adjust a and b through time.

* Sometimes called the ‘Wicksellian Interest rate’ after the Swedish economist Knut Wicksell, who in 1898 defined it as the interest rate that is compatible with a stable
price level.
Bank of England Loses Control of Interest
Rates!
Interest rate

Commercial lending rates

Uncertainty and fear widens ‘spread’

Normal mark-up

MPC’s rate

Loans
 The TR Curve
The central bank ‘leans against the wind’ to push the economy back on course

Interest Rate (r)

TR (Taylor Rule Curve)

If output above trend raise r

Neutral/Natural
Rate of Interest

If output below trend lower r

NAIRU/
Output
Natural Rate of Output
(Long-term rate of growth)
 EQUILIBRIUM WITH TAYLOR RULE AT R*

r
AS

TR

R*

IS

NAIRU
Q
Interest
Rate

3D ‘Taylor Curve’

‘Natural & Target Rates’ TR

r star (r*)

_ + GDP/employment
Gap

+ TR

Inflation Gap
Burda & Wyplosz MACROECONOMICS 7/e Figure 11.1

Cyclical Fluctuations

© Michael Burda and Charles Wyplosz, 2017. All rights reserved.

Burda & Wyplosz MACROECONOMICS 7/e Figure 11.1 (a)

Cyclical Fluctuations:
Changes we see, and how we decompose them.
Long-term growth
(+) cyclical deviation trend
Actual real GDP
Real GDP

(-) cyclical deviation

0 Time
© Michael Burda and Charles Wyplosz, 2017. All rights reserved.
Burda & Wyplosz MACROECONOMICS 7/e Figure 11.12 (b)

Macroeconomic Shocks: Real (IS) Shocks

TR Exogenous increase in demand:

IS curve shifts to the right.
Nominal interest rate

B In response to output expansion,

i‘ the central bank raises the interest
A rate.
i Exogenous decrease
C
i‘‘ in demand: IS curve
IS‘ shifts to the left.
In response to output
IS contraction, the central
IS‘‘ bank lowers the interest
rate.
Y‘‘ Y‘ Y‘ Output

© Michael Burda and Charles Wyplosz, 2017. All rights reserved.

Burda & Wyplosz MACROECONOMICS 7/e Figure 11.12 (c)

Macroeconomic Shocks: TR Shocks

© Michael Burda and Charles Wyplosz, 2017. All rights reserved.

Burda & Wyplosz MACROECONOMICS 7/e Figure 11.12 (d)

TR Adjustments to Macroeconomic Supply Shocks

AS’
AS
TR‘‘
AS” Central bank lowers its
TR target interest rate:
TR‘
i‘‘ TR curve shifts to the
Interest rate

right
i
i‘
Central bank raises its
target interest rate:
IS
TR curve shifts
to the left
Y‘‘ Y‘ Y‘ Output

© Michael Burda and Charles Wyplosz, 2017. All rights reserved.

Burda & Wyplosz MACROECONOMICS 7/e Fig. x.xx

© Michael Burda and Charles Wyplosz, 2017. All rights reserved.

Zero Lower Bound (ZLB) and the Great
Recession

IS1
TR
Interest
Rate
IS2

ZLB

Output

Before Recession

After Recession
 New Keynesian micro-foundations
Developed since the 80’s
Keynesian: markets do not work perfectly
(imperfect markets) and there is scope for
government intervention, in particular, aggregate
demand management.

Micro-foundations: Uses individual optimisation to

produce equilibria in which agents do not wish to
change their behaviour.
 Imperfect Labour Market
Efficiency wages and the ‘Wage-Setting Curve’

Assumes employers wish to pay their workers

more than the bare amount it takes to attract
them.

The notion of efficiency wage theory is that

firms are pursuing a wage policy so as to recruit,
motivate and retain their workers.
 The wage setting curve is above the
supply curve of labour

Wage Setting Curve

Real
Wage

Supply Curve
of Labour

Labour
 Explaining efficiency wages
The notion of efficiency wage theory is thus that
firms are pursuing a wage policy so as to recruit,
discipline/motivate and retain their workers.

Or you could use a trade-union pressure

argument….
Turnover cost explanation for efficiency wages
 3 reasons why the WS curve slopes
upwards
1. Higher wages are needed to induce more
people to enter the labour market overall, and for
any particular firm to recruit workers.
2. Workers’ fear of losing jobs decreases with more
buoyant labour market, so a larger premium i.e.
efficiency wage, is required to increase the
opportunity cost of losing a job.
3. Turnover costs increase as more jobs become
available elsewhere, so a higher efficiency wage is
needed to keep these costs down.
a) Show the amount of involuntary unemployment in the diagram
 WS Curve
Real Wage
Supply of Labour

Demand for Labour

Labour
Involuntary Unemployment
 Involuntary unemployment even in
equilibrium!
At E ws the WS curve shows the amount of
labour that profit maximising firms wish to
employ to maintain the wage they have set,
even though there are workers who would
willingly work for less than the wage on the WS
curve.
It is this unemployment that provides a fear of
losing a job and reduces the availability of
alternative employment
New Keynesian foundations often assume
imperfect competition in product markets

MC

D
MR
Monopoly PC
Q
 Imperfect competition can cause price
stickiness
• Menu costs?
• Surveys indicate that the main sources of price
stickiness are strategic interactions between
competing firms and implicit or explicit
contracts with their customers, with menu
costs being judged less important.
For example: A rudimentary
oligopoly model
Firm’s ‘Rule of Thumb’ Mark-up, Sticky Prices
and Quantity Adjustments

Sticky
Price
Mark-up
Unit Cost (MC)

Demand Curves

Quantity Adjustment Output Q

 Carlin & Soskice
“We shall assume that firms are monopolistically
competitive. They respond to shifts in aggregate
demand by increasing or decreasing output.
They do not change their price immediately… At
the next annual wage round, firms reassess their
price and adjust it taking into account any
change in costs”

(Adaptive expectations)
We can think of the real wage dividing output into shares of labour and profit*
*minus other costs

Real Wage
w/p

Profit share

Set real wage

Marginal
Labour share Product of
Labour

Labour
 Deriving the New Keynesian ‘Price-setting
curve’ (C&S ‘simple’ approach)
• Assume labour is the only cost
• The firm sets a price that is a mark-up over its unit labour costs
• The firm’s unit labour costs are the wage costs per unit of
output
• Given the nominal wage, the price set by the firm implies a real
wage and this is called the price-setting real wage since it is the
outcome of the firm’s pricing behaviour
• For a given nominal wage and with constant output per worker,
the price setting real wage curve is flat
• Intuitively, think of the firm’s price setting decision as dividing
output per worker into two chunks: profit per worker and the
real wage.
Carling and Soskice
 Think of it as
The WS curve being set by The PS curve being set by
the HR department the marketing department

W W
P P
WS

PS

L L
 Think of it in the Long-run as
Real Wage

Output Wage setting curve

Supply of Labour

Marginal Product

Price setting curve

New-Keynesian Neo-classical
NAIRU NAIRU Employment
What happens if the degree of monopoly
increases?

?
Where the price-setting (PS) curve intersects the
(WS) curve determines equilibrium employment

Real Wage
W
P WS

PS

Equilibrium L
 C&S
“This is an equilibrium because there is no
incentive for either wage- or price-setters to
change respectively, the nominal wage or the price
they set. The real wage will therefore be constant
and there will be no upward or downward pressure
on wage or price inflation. We also know from the
discussion of the wage-setting curve that at the
equilibrium real wage and employment level, there
will be involuntary unemployment.”
New Keynesian equilibrium employment and
unemployment: when equilibrium is disturbed
 C&S
It is important to notice at this point that
although workers care about the real wage,
what gets set by wage setters is the nominal
wage. The real wage workers end up with will
depend on what happens to prices in their
consumption basket. In effect, the marketing
departments set the real wage.
A demand shock: Raised Business Expectations
leads to I↑

r LM

IS1 IS2

Q
𝑾 WS
𝑷 HR/Union attempts to raise real wage but
Marketing pushes it down again
PS

NAIRU L
Accelerating Inflation and Deflation
P

Accelerating Inflation Accelerating deflation

Voluntary UE Involuntary UE

NAIRU Unemployment
 3 equation New Consensus Model
The basic equations (in a closed economy) are:
1. An IS curve with forward looking expectations
(inter-temporal)- shows the interest rate that will
deliver the central bank’s chosen output gap to set the
inflation target (rational expectations)
2. A Phillips Curve with backward looking inflation
expectations (Adaptive expectations)
3. A monetary rule for setting the interest rate to
steer the economy on a ‘best’ path between inflation
and unemployment/output.
 Loss = Loss (Inflation Gap, Output Gap)

A Graphical Representation of
Inflation a Central Bank Loss Function with
equal weighting on inflation and output
Hi
gh
er
Lo Bliss Point
ss

Target ss Hig
r Lo h er
ig he Lo
ss
H

Output
NAIRU
The IS & Phillips curve
Carling and Soskice Fig. 4.3
 Adjustment Path and Policy:
If policy can affect output, even if only for the short-
run, then it can be set to minimise a loss-function

1
Inflation

S/R Expected Inflation

= Target

A
From 1 inflation
could be brought
quickly to target at
A, but A slower reduction Output
is less costly in output/unemployment
Dynamic Stochastic
Equilibrium Modelling
DSGE models capture elements of the New Keynesian
Paradigm and the New Classical school giving rise to the

‘New Neoclassical Synthesis’

 Dynamic
These models incorporate time and hence expectations, they
are repeatedly hit by unexpected shocks to which they adjust.
PS The continual impacts of unanticipated ‘shocks’ means the
economy may never actually settle down to a stationary state,
as the economy in the real-world doesn’t move immediately
from one equilibrium to a new equilibrium (as in comparative
statics).

Examples of ‘Impulse-Propagation Mechanisms’: Shocks may

persist, agents may take time to capture new information,
prices may be ‘sticky’, agents may ‘wait’ to see if changes are
permanent
 Stochastic
Subject to continual random demand and supply
shocks

Examples:
Demand shocks : changed expectations, payment
mechanisms, international shocks.

Supply shocks: changed expectations, raw material

prices, technology, immigration.
 General Equilibrium
These models assume a potential simultaneous equilibrium of:

1) The intertemporal IS curve

2) Monetary Policy rule (eg Taylor rule)

3)Phillips curve

(If prices are fully flexible and expectations rational they get there
‘instantaneously’)
These three equations are the common ‘chassis’ of modern models-
except for even more dynamic, non-equilibrium approaches
 Used for policy analysis and forecasts
including by
• Bank of England (COMPASS)
https://www.bankofengland.co.uk/-/media/boe/files/working-paper/2013/the-boes-forecasting-platform-compass-maps-ease-an
d-the-suite-of-models.pdf

• US Federal Reserve
• Bank of Canada (ToTEM), Bank of England
(BEQM), European Central
• IMF
• European Commission

(Not the OBR or NIESR)

 Advantages of DSGE

• Provides many results of a textbook IS-LM model in a

dynamic coherent micro-founded context

• Escapes the Lucas (1976) critique, unlike traditional

structural equation models in which estimated parameters
are not invariant to policy shifts.

• With computational techniques is quite a flexible technique

• Provides insights on the linkages between monetary and

fiscal policy, inflation and the business cycle.
 But
DSGE has many shortcomings, inconsistencies and
ad hoc extreme assumptions: Basic DGSE neo-
classical models have an absence of frictions or
imperfections, perfect competition, instantaneous
price adjustments, rational expectations, Pareto-
efficiency, firms are all identical, as are consumers*!
* ‘Representative Agent assumption’ can be relaxed but with greater complexity and less certainty
But they may be seen as logical ‘ideal type’ models
rather than empirical exercises
 Following Neo-classical tradition:
‘Real Business Cycle’ Theory
The model is driven by the supply-side, that is, a production function with
stochastic shocks: Output is a function of (Capital, Labour and ‘technology’)

Consumers have rational expectations and so inter-temporal consumption

functions based on expected earnings/wealth, so maximise present discounted
value of expected utility subject to inter-temporal budget constraint
(consumption smoothing).

Changes in productivity, from shocks, require agents to make adjustments in

behaviour to keep maximising- in particular adjusting their leisure work trade-
off plans- this causes cycles in employment and output. (Also, for S & I, as S
goes straight to I, Says Law holds)

Government spending and borrowing are ultimately constrained by tax

revenues (so Ricardian Equivalence is Relevant)
The Baseline RBC Model
There is everywhere perfect competition, rational expectations and market clearing.

A production function: Q=Q(K,L)

Output (Q) depends on the volume of capital (K) and Labour (L) inputs. Changes in technology (T)

The technology changes that affect the production function, and hence productivity and marginal products, follows a trend but is also
disturbed by random shocks: T=T(Trend, Random Shocks)

The net addition to the

Capital stock = Investment = Q (Real Y) – Consumption = Savings.
This can be modified for net investment if a coefficient for depreciation is included.

From the production function, Labour and Capital are paid their Marginal Products: Real Wage (W/P) = MPL and Real Interest Rate r = MPK

The ‘Representative Household Agent’ maximises an intertemporal utility function consisting of consumption and leisure/non work) over
time:

U=U(Discounted flow of Consumption and Leisure)

And chooses consumption today, and consumption in the future through investing savings. Similarly, the household agent chooses leisure
today and for the future. Opportunity cost of leisure is forgone consumption now, and though potential savings and interest rate (MPK), also
future consumption.
Their budget constraint for consumption is their discounted budget constraint of expected income from wages from work and the return on
their savings from any assets and the money saved from wages:

Budget Constraint =Budget Constraint (Discounted income from Savings and Return on assets)
Subject to a discount rate, workers will choose to work most when their MPL, and hence wage, is higher, and take more leisure when it is
lower. This drives fluctuations in the level of employment. Hence, a positive technology shock that increases MPL will increase both
employment and output, so cycles are driven by real not monetary shocks.
 RBL Basics
Real Wage = w/p
Tech Shock

Q=Q(K,L) Intertemporal
Re-optimisation

MPL 1 MPL2
Employment Today
L &Q
L t=1

Real Business Cycles

 New Keynesian DSGE model
(often called ‘New Synthesis’)

• Essentially the RBC model-but with sticky prices because

of imperfect competition in product markets
• Not all firms can change prices at anyone time, only a
fraction each period: this produces a Phillips Curve ‘set’
almost identical to the Friedman-Phelps S/Run- L/Run set
But forward not backward looking:
∆P = ∆P (Exp ∆P, Output gap)
• By managing expectations through credible forward
commitments, authorities can influence economy’s
adjustment path to shocks and so improve welfare (hence
‘Keynesian’)
 Bank of England:
The MPC’s judgement is paramount
when agreeing their forecasts, but the process also relies on a range of economic models. Such as

‘COMPASS is a “New Keynesian” general equilibrium model and

shares many features with similar models in use at other central
banks and policy institutions. Prices and wages are assumed to
be sticky, so monetary policy affects output and employment in
the short to medium term. Expectations of future events,
including the actions of monetary policy makers, can also
affect current output and inflation’.
https://www.bankofengland.co.uk/-/media/boe/files/working-paper/2013/th
e-boes-forecasting-platform-compass-maps-ease-and-the-suite-of-models.pdf
 With imperfect product markets there is no involuntary
unemployment but there is ‘under employment’

Real
Wage
Supply of Labour
More employment
in neoclassical perfect
product markets

Equilibrium
Wage

MP

Price-setting curve

Imperfect Neo-classical
Product Markets Perfect Competition Employment
NAIRU NAIRU
 Calvo Pricing

TIME
Comparing adjustment paths to AD shock

Output Gap +
0
_

Time

Inflation Adaptive
Philips Curve

Time

Inflation
New Keynesian DSGE
Phillips Curve
Time
 RBC Intertemporal GE Model
Shake it all about!
Future

Slope Pareto-efficient
=M
RT,
Re
alc
on
str
a
int Slope =MRS, subjective choice
s(h
it by

Slope = I + Interest Rate

sho
cks)

Today
Purposes of DSGE v’s ‘Structural’/ (VARS)

DSGE models are often used for exploring theoretical analysis, policy
evaluation, and for forecasting. Particularly useful for studying implications
of variations (such as changing parameters) in economic theory and
conducting counterfactual policy experiments.

Structural (VAR) macro models are used for forecasting, policy analysis,
and exploring the empirical relationships among aggregate variables. They
focus on capturing the observed relationships in the economy rather than
micro economic theory.
 Forecasting is a ‘Mugs Game’

“Unfortunately, there is little evidence concerning the relative

merits of different approaches to evaluating macroeconomic
models. Researchers use various mixes and types of calibration
exercises, formal estimation, examination of the plausibility of the
ingredients, and consideration of the consistency with specific
facts. At this point, choices among these approaches seem to be
based more on researchers’ “tastes” than on a body of knowledge
about the strengths and weaknesses of the approaches.”

(Romer. D, Advanced Macroeconomics)

 Aggregate Demand and Supply
• Seem deceptively easy- but it all depends on
what lies beneath AD & AS
The options are:
Price, Inflation
or
Inflation gap

Output, output gap, or

in more complex presentations
Can you identify them? steady state growth
 Now Apply Negative Supply Shock to Neoclassical
synthesis and 3-equation Model with Efficiency Wages
 The neoclassical synthesis
Negative supply shock with AD unchanged

AS 2 AS 1
Real TR1=TR2
interest
rate

IS1 = IS2

AS 2 < AD = AS 1 Real Income (Y or Q)

P
 Negative Supply Shock in WS & PS Framework
Real Wage e.g. Energy price rise
W/P

Wage Setting (WS)

Price Setting (PS1)

Price Setting (PS2)

Employment (L)
 In RBC Frame
Price of energy
Negative ‘Technology’ shock*
Q=Q(L , K)
MPL
(If expected to be temporary ) L now & L future Q
now

Monetary Policy affects only inflation, Classical Dichotomy

Holds, Pareto-efficient at all times
*recall that technology is broadly defined in RBC
 Agent Based Models
ABMs have two distinguishing features: they are:

A) “Agent-based,” modelling individual agents—households, firms, banks, etc. by

assuming certain decision rules and/or optimisations.

B) They are simulation models. That is, the aggregate dynamic properties are derived
“bottom up,” that is, emerging from the micro-behaviour of the individual agents
and the structure of their interactions.

M) ‘Made-up’. That is, they allow a huge range of assumptions and so can potentially
produce almost any result!
 VAR Models – but subject to the Lucas Critique?

VAR models are suitable for situations where multiple time series variables are
interrelated. They generalise univariate models by allowing for multivariate time-series.
Each variable in the system is modelled as a linear combination of its own past values
and the past values of other variables in the system. The ‘lag order’ in a VAR model is
simply the number of past time periods considered for each variable .

So, for a VAR(1) model with just two variables this could look like:

X1t = X1t-1 + X2t-1

X2t = X1t-1 + X2t-2

Where, for example, X1t-1 is the value of the first variable one time period ago.
A VAR(2) of the model could therefore be:

X1t = X1t-1 + X1t-2 + X2t-1 + X2t-2

X2t = X1t-1 + X1t-2 + X2t-1 + X2t-2
 Postscript
In practice policy-makers tend to be eclectic, using a mix of these models as hybrids
according to the circumstances of the day, and often drawing on the ‘judgement and
experience’ of seasoned forecasters and data observers.

‘Main economic forecast choices have been judgment calls not

modelling’
Robert Chote