Economics 311

Intermediate Macroeconomics

Mark Witte

Northwestern University

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Models

What do economists try to do?

• We make little stories about how individual agents make decisions, behave
• Rationality, utility maximization, profit
• Then we aggregate these individual events up to explain broader observed behavior
• Consumers have utility and budget constraints
• Firms seek profit and compete, at least to some degree
• Aggregate up to get supply and demand, Monopoly, Oligopoly, Prisoner's Dilemma, Externalities, Public goods
• The real world gives us data.
• We want to understand what are causes (exogenous factors) and what are effects (endogenous factors)
• To do this, we need to build models
• The real world is extremely complicated, so we must simplify
• We hope we leave out distracting parts and focus on what’s really driving the interesting questions

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Models are supposed to be useful

Models and maps leave a lot out, and that’s good. We need to make something big and complicated small enough that we can understand it to some useful degree.

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“To see a world in a grain of sand

And a heaven in a wild flower,

Hold infinity in the palm of your hand,

And eternity in an hour.”

• Auguries of Innocence, William Blake

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“In time, those Unconscionable Maps no longer satisfied, and the Cartographers Guild drew a Map of the Empire whose size was that of the Empire, coinciding point for point with it. The following Generations, who were not so fond of the Study of Cartography saw the vast Map to be Useless and permitted it to decay and fray under the Sun and winters.”

- On Exactitude in Science, Jorge Luis Borges

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Models are supposed

to be useful

Need the right model for the right question

• We hope that models can give us useful insight into some specific question
• Use the right model for the right question, the right degree of abstraction
• Don’t use a model with infinitely aged agents to try to explain savings for retirement
• Don’t try to use a model of perfect competition to explain oligopoly behavior

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Physicists dream of finding a TOE

“Theory Of Everything”

Want a macro model that explains everything

Finn Kydland & Ed Prescott

Nobel Prize 2004

Dynamic Stochastic General Equilibrium Models (DSGE)

• Goal: We would like to our models to have all choices that people in the model make be endogenously determined as functions of the exogenous (outside) factors
• General equilibrium, Econ 310-2 style, Arrow-Debreu model that determines
• Quantities, Prices, Employment, Interest rates
• “Endogenous,” determined in the system
• Given technology, preferences, resources
• “Exogenous” shocks from outside the system to technology, preferences, taxes
• The present depends upon what we expect about the future
• Expectations about the distribution of random (stochastic) future shocks to the economy
• “Microfoundations” for macro

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Problems with DSGEs

• Hard to solve general equilibrium models where all possible choices need to be found optimally
• Requires some simplification to be solvable
• Hard for these models to explain persistent periods of low output or high unemployment
• Little role for money

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Problems with DSGEs

• The world is full of complications, “frictions”
• Sticky prices and wages, contracts
• Labor search to find new jobs
• Maybe people are dumb, myopic?
• Habit persistence?
• Credit constraints?
• Very hard to have a model that includes all reasonable frictions that probably affect the actual economy and still be able to solve the model
• Result: We leave out some plausible frictions, but then to fit the data from the actual world we see, we need to pretend that the few frictions we do put in are amazingly powerful

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Alternatives

• Partial equilibrium - Take more stuff as given, things that we would prefer would be determined within the model
• “Ad hoc” models - Latin, means “for this”
• Give up on “one model to rule them all”
• Instead of a general model of everything:
• Many specific models for different aspects of the economy
• Not as intellectually satisfying
• This is what we do in the Ph.D. level Macro 411-1,2
• But Econ 411-3 Macro is something else….

Tradeoffs in Modeling

• Dynamic models are hard to solve
• Expectations about the future have huge effects on the choices made today
• Instead: John Maynard Keynes (1883-1946)
• The General Theory of Employment, Interest and Money (1936)
• Really a static model
• Explains recessions in a world without inflation (Gold Standard)
• “Hydraulic Keynesianism”
• This action causes that action which causes yet another action
• Like turning on the water into a system of pipes
• Caricature
• Simplifying assumption by Keynes: The present is all there is
• Expectations and their formation are not explicitly modeled

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This class will be about multiple equilibria

• There are many competing models to explain various aspects of the world
• It would be great to have one model that explained everything, but….
• Sometimes we just need a model that explains the situation at hand
• Most of what we will do will be looking at multiple equilibrium stories
• But there will be some unique equilibrium, growth models too

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Next up!

Models of equilibrium