Macroeconomic Theory: A Dynamic General Equilibrium Approach - Second Edition

by Michael Wickens

Overview

The definitive graduate textbook on modern macroeconomics

Macroeconomic Theory is the most up-to-date graduate-level macroeconomics textbook available today. This revised second edition emphasizes the general equilibrium character of macroeconomics to explain effects across the whole economy while taking into account recent research in the field. It is the perfect resource for students and researchers seeking coverage of the most current developments in macroeconomics.

Michael Wickens lays out the core ideas of modern macroeconomics and its links with finance. He presents the simplest general equilibrium macroeconomic model for a closed economy, and then gradually develops a comprehensive model of the open economy. Every important topic is covered, including growth, business cycles, fiscal policy, taxation and debt finance, current account sustainability, and exchange-rate determination. There is also an up-to-date account of monetary policy through inflation targeting. Wickens addresses the interrelationships between macroeconomics and modern finance and shows how they affect stock, bond, and foreign-exchange markets. In this edition, he also examines issues raised by the most recent financial crisis, and two new chapters explore banks, financial intermediation, and unconventional monetary policy, as well as modern theories of unemployment. There is new material in most other chapters, including macrofinance models and inflation targeting when there are supply shocks. While the mathematics in the book is rigorous, the fundamental concepts presented make the text self-contained and easy to use. Accessible, comprehensive, and wide-ranging, Macroeconomic Theory is the standard book on the subject for students and economists.

• The most up-to-date graduate macroeconomics textbook available today
• General equilibrium macroeconomics and the latest advances covered fully and completely
• Two new chapters investigate banking and monetary policy, and unemployment
• Addresses questions raised by the recent financial crisis
• Web-based exercises with answers
• Extensive mathematical appendix for at-a-glance easy reference

This book has been adopted as a textbook at the following universities:

• American University
• Bentley College
• Brandeis University
• Brigham Young University
• California Lutheran University
• California State University - Sacramento
• Cardiff University
• Carleton University
• Colorado College
• Fordham University
• London Metropolitan University
• New York University
• Northeastern University
• Ohio University - Main Campus
• San Diego State University
• St. Cloud State University
• State University Of New York - Amherst Campus
• State University Of New York - Buffalo North Campus
• Temple University - Main
• Texas Tech University
• University of Alberta
• University Of Notre Dame
• University Of Ottawa
• University Of Pittsburgh
• University Of South Florida - Tampa
• University Of Tennessee
• University Of Texas At Dallas
• University Of Washington
• University of Western Ontario
• Wesleyan University
• Western Nevada Community College

Product Details

ISBN-13:	9780691152868
Publisher:	Princeton University Press
Publication date:	03/12/2012
Edition description:	Second Edition
Pages:	616
Product dimensions:	7.10(w) x 10.00(h) x 1.60(d)

About the Author

Michael Wickens is professor of economics at the University of York and at Cardiff Business School. He is the coeditor of Handbook of Applied Econometrics and was managing editor of the Economic Journal from 1996 to 2004. He is specialist adviser to the House of Lords on macroeconomics and a member of the Shadow Monetary Policy Committee.

Table of Contents

Preface xiii

Chapter 1: Introduction 1

1.1 Dynamic General Equilibrium versus Traditional Macroeconomics 1

1.2 Traditional Macroeconomics 3

1.3 Dynamic General Equilibrium Macroeconomics 4

1.4 The Structure of This Book 7

Chapter 2: The Centralized Economy 12

2.1 Introduction 12

2.2 The Basic Dynamic General Equilibrium Closed Economy 12

2.3 Golden Rule Solution 14

2.3.1 The Steady State 14

2.3.2 The Dynamics of the Golden Rule 17

2.4 Optimal Solution 17

2.4.1 Derivation of the Fundamental Euler Equation 17

2.4.2 Interpretation of the Euler Equation 19

2.4.3 Intertemporal Production Possibility Frontier 20

2.4.4 Graphical Representation of the Solution 21

2.4.5 Static Equilibrium Solution 21

2.4.6 Dynamics of the Optimal Solution 23

2.4.7 Algebraic Analysis of the Saddlepath Dynamics 25

2.5 Real-Business-Cycle Dynamics 27

2.5.1 The Business Cycle 27

2.5.2 Permanent Technology Shocks 28

2.5.3 Temporary Technology Shocks 29

2.5.4 The Stability and Dynamics of the Golden Rule Revisited 29

2.6 Labor in the Basic Model 30

2.7 Investment 32

2.7.1 q-Theory 33

2.7.2 Time to Build 36

2.8 Conclusions 37

Chapter 3: Economic Growth 39

3.1 Introduction 39

3.2 Modeling Economic Growth 40

3.3 The Solow-Swan Model of Growth 42

3.3.1 Theory 42

3.3.2 Growth and Economic Development 44

3.3.3 Balanced Growth 44

3.4 The Theory of Optimal Growth 45

3.4.1 Theory 45

3.4.2 Additional Remarks on Optimal Growth 49

3.5 Endogenous Growth 50

3.5.1 The AK Model of Endogenous Growth 51

3.5.2 The Human Capital Model of Endogenous Growth 51

3.6 Conclusions 53

Chapter 4: The Decentralized Economy 54

4.1 Introduction 54

4.2 Consumption 55

4.2.1 The Consumption Decision 55

4.2.2 The Intertemporal Budget Constraint 56

4.2.3 Interpreting the Euler Equation 57

4.2.4 The Consumption Function 59

4.2.5 Permanent and Temporary Shocks 61

4.3 Savings 64

4.4 Life-Cycle Theory 65

4.4.1 Implications of Life-Cycle Theory 65

4.4.2 Model of Perpetual Youth 67

4.5 Nondurable and Durable Consumption 68

4.6 Labor Supply 70

4.7 Firms 73

4.7.1 Labor Demand without Adjustment Costs 73

4.7.2 Labor Demand with Adjustment Costs 75

4.8 General Equilibrium in a Decentralized Economy 77

4.8.1 Consolidating the Household and Firm Budget Constraints 77

4.8.2 The Labor Market 79

4.8.3 The Goods Market 80

4.9 Comparison with the Centralized Model 81

4.10 Conclusions 83

Chapter 5: Government: Expenditures and Public Finances 84

5.1 Introduction 84

5.2 The Government Budget Constraint 86

5.2.1 The Nominal Government Budget Constraint 86

5.2.2 The Real Government Budget Constraint 88

5.2.3 An Alternative Representation of the GBC 88

5.3 Financing Government Expenditures 89

5.3.1 Tax Finance 89

5.3.2 Bond Finance 91

5.3.3 Intertemporal Fiscal Policy 93

5.3.4 The Ricardian Equivalence Theorem 93

5.4 The Sustainability of the Fiscal Stance 96

5.4.1 Case 1 (Stable Case) 98

5.4.2 Implications 99

5.4.3 Case 2: (Unstable Case) 100

5.4.4 Implications 101

5.4.5 The Optimal Level of Debt 102

5.5 The Stability and Growth Pact 103

5.6 The Fiscal Theory of the Price Level 104

5.7 Optimizing Public Finances 105

5.7.1 Optimal Government Expenditures 106

5.7.2 Optimal Tax Rates 109

5.8 Conclusions 119

Chapter 6: Fiscal Policy: Further Issues 121

6.1 Introduction 121

6.2 Time-Consistent and Time-Inconsistent Fiscal Policy 121

6.2.1 Lump-Sum Taxation 123

6.2.2 Taxes on Labor and Capital 126

6.2.3 Conclusions 131

6.3 The Overlapping-Generations Model 131

6.3.1 Introduction 131

6.3.2 The Basic Overlapping-Generations Model 132

6.3.3 Short-Run Dynamics and Long-Run Equilibrium 135

6.3.4 Comparison with the Representative-Agent Model 137

6.3.5 Fiscal Policy in the OLG Model: Pensions 138

6.3.6 Conclusions 143

Chapter 7: The Open Economy 144

7.1 Introduction 144

7.2 The Optimal Solution for the Open Economy 145

7.2.1 The Open Economy's Resource Constraint 145

7.2.2 The Optimal Solution 148

7.2.3 Interpretation of the Solution 149

7.2.4 Long-Run Equilibrium 150

7.2.5 Shocks to the Current Account 152

7.3 Traded and Nontraded Goods 154

7.3.1 The Long-Run Solution 158

7.4 The Terms of Trade and the Real Exchange Rate 159

7.4.1 The Law of One Price 160

7.4.2 Purchasing Power Parity 160

7.4.3 Some Stylized Facts about the Terms of Trade and the Real Exchange Rate 161

7.5 Imperfect Substitutability of Tradeables 163

7.5.1 Pricing-to-Market, Local-Currency Pricing, and
Producer-Currency Pricing 163

7.5.2 Imperfect Substitutability of Tradeables and Nontradeables 163

7.6 Current-Account Sustainability 167

7.6.1 Balance of Payments Sustainability 167

7.6.2 The Intertemporal Approach to the Current Account 173

7.7 Conclusions 174

Chapter 8: The Monetary Economy 176

8.1 Introduction 176

8.2 A Brief History of Money and Its Role 176

8.3 Nominal Household Budget Constraint 179

8.4 The Cash-in-Advance Model of Money Demand 181

8.5 Money in the Utility Function 183

8.6 Money as an Intermediate Good or the Shopping-Time Model 185

8.7 Transactions Costs 188

8.8 Some Empirical Evidence 190

8.9 Hyperinflation and Cagan's Money-Demand Model 192

8.10 The Optimal Rate of Inflation 194

8.10.1 The Friedman Rule 194

8.10.2 General Equilibrium Solution 195

8.11 The Super-Neutrality of Money 199

8.12 Conclusions 201

Chapter 9: Imperfectly Flexible Prices 203

9.1 Introduction 203

9.2 Some Stylized "Facts" about Prices and Wages 204

9.3 Price Setting under Imperfect Competition 206

9.3.1 Theory of Pricing in Imperfect Competition 207

9.3.2 Price Determination in the Macroeconomy with
Imperfect Competition 209

9.3.3 Pricing with Intermediate Goods 213

9.3.4 Pricing in the Open Economy: Local and
Producer-Currency Pricing 216

9.4 Price Stickiness 217

9.4.1 Taylor Model of Overlapping Contracts 218

9.4.2 The Calvo Model of Staggered Price Adjustment 219

9.4.3 Optimal Dynamic Adjustment 221

9.4.4 Price Level Dynamics 222

9.5 The New Keynesian Phillips Curve 224

9.5.1 The New Keynesian Phillips Curve in an Open Economy 227

9.6 Conclusions 228

Chapter 10: Asset Pricing and Macroeconomics 230

10.1 Introduction 230

10.2 Expected Utility and Risk 231

10.2.1 Risk Aversion 231

10.2.2 Risk Premium 232

10.3 No-Arbitrage and Market Efficiency 233

10.3.1 Arbitrage and No-Arbitrage 233

10.3.2 Market Efficiency 233

10.4 Asset Pricing and Contingent Claims 234

10.4.1 A Contingent Claim 234

10.4.2 The Price of an Asset 235

10.4.3 The Stochastic Discount-Factor Approach to Asset Pricing 235

10.4.4 Asset Returns 235

10.4.5 Risk-Free Return 236

10.4.6 The No-Arbitrage Relation 236

10.4.7 Risk-Neutral Valuation 237

10.5 General Equilibrium Asset Pricing 238

10.5.1 Using Contingent-Claims Analysis 238

10.5.2 Asset Pricing Using the Consumption-Based Capital
Asset-Pricing Model (C-CAPM) 240

10.6 Asset Allocation 247

10.6.1 The Capital Asset-Pricing Model (CAPM) 250

10.7 Consumption under Uncertainty 251

10.8 Complete Markets 252

10.8.1 Risk Sharing and Complete Markets 253

10.8.2 Market Incompleteness 256

10.9 Conclusions 256

Chapter 11: Financial Markets 258

11.1 Introduction 258

11.2 The Stock Market 259

11.2.1 The Present-Value Model 259

11.2.2 The General Equilibrium Model of Stock Prices 262

11.2.3 Comment 265

11.3 The Bond Market 265

11.3.1 The Term Structure of Interest Rates 266

11.3.2 The Term Premium 272

11.3.3 Estimating Future Inflation from the Yield Curve 277

11.3.4 Comment 279

11.4 The FOREX Market 279

11.4.1 Uncovered and Covered Interest Parity 280

11.4.2 The General Equilibrium Model of FOREX 289

11.4.3 Comment 292

11.5 Conclusions 293

Chapter 12: Nominal Exchange Rates 295

12.1 Introduction 295

12.2 International Monetary Arrangements 1873-2007 297

12.2.1 The Gold Standard System: 1873-1937 298

12.2.2 The Bretton Woods System: 1945-71 299

12.2.3 Floating Exchange Rates: 1973-2007 300

12.3 The Keynesian IS-LM-BP Model of the Exchange Rate 304

12.3.1 The IS-LM Model 305

12.3.2 The BP Equation 309

12.3.3 Fixed Exchange Rates: The Monetary Approach to the Balance of Payments 312

12.3.4 Exchange-Rate Determination with Imperfect Capital Substitutability 313

12.4 UIP and Exchange-Rate Determination 315

12.5 The Mundell-Fleming Model of the Exchange Rate 317

12.5.1 Theory 317

12.5.2 Monetary Policy 318

12.5.3 Fiscal Policy 319

12.6 The Monetary Model of the Exchange Rate 320

12.6.1 Theory 320

12.6.2 Monetary Policy 321

12.6.3 Fiscal Policy 325

12.7 The Dornbusch Model of the Exchange Rate 325

12.7.1 Theory 325

12.7.2 Monetary Policy 328

12.7.3 Fiscal Policy 330

12.7.4 Comparison of the Dornbusch and Monetary Models 330

12.8 The Monetary Model with Sticky Prices 332

12.9 The Obstfeld-Rogoff Redux Model 334

12.9.1 The Basic Redux Model with Flexible Prices 335

12.9.2 Log-Linear Approximation 341

12.9.3 The Small-Economy Version of the Redux Model with Sticky Prices 343

12.10 Conclusions 346

Chapter 13: Monetary Policy 348

13.1 Introduction 348

13.2 Inflation and the Fisher Equation 353

13.3 The Keynesian Model of Inflation 355

13.3.1 Theory 355

13.3.2 Empirical Evidence 358

13.4 The New Keynesian Model of Inflation 358

13.4.1 Theory 358

13.4.2 The Effectiveness of Inflation Targeting in the New Keynesian Model 365

13.4.3 Inflation Targeting with a Flexible Exchange Rate 369

13.5 Optimal Inflation Targeting 371

13.5.1 Social Welfare and the Inflation Objective Function 372

13.5.2 Optimal Inflation Policy under Discretion 374

13.5.3 Optimal Inflation Policy under Commitment to a Rule 378

13.5.4 Intertemporal Optimization and Time-Consistent Inflation Targeting 380

13.5.5 Central Bank versus Public Preferences 382

13.6 Optimal Monetary Policy using the New Keynesian Model 384

13.6.1 Using Discretion 384

13.6.2 Rules-Based Policy 386

13.7 Monetary Policy in the Euro Area 387

13.7.1 New Keynesian Model of the Euro Area 389

13.7.2 Model 389

13.7.3 Optimal Monetary Policy 390

13.7.4 Competitiveness and Absorbtion 392

13.7.5 Is There Another Solution? 393

13.8 Conclusions 393

Chapter 14: Real Business Cycles, DGE Models, and Economic Fluctuations 396

14.1 Introduction 396

14.2 The Methodology of RBC Analysis 397

14.2.1 Steady-State Solution 400

14.2.2 Short-Run Dynamics 401

14.3 Empirical Evidence on the RBC Model 405

14.3.1 The Basic RBC Model 406

14.3.2 Extensions to the Basic RBC Model 408

14.3.3 The Open-Economy RBC Model 410

14.4 DGE Models of the Monetary Economy 415

14.4.1 The Smets-Wouters Model 416

14.4.2 Empirical Results 420

14.5 Conclusions 422

Chapter 15: Mathematical Appendix 424

15.1 Introduction 424

15.2 Dynamic Optimization 424

15.3 The Method of Lagrange Multipliers 426

15.3.1 Equality Constraints 426

15.3.2 Inequality Constraints 431

15.4 Continuous-Time Optimization 432

15.4.1 Calculus of Variations 433

15.4.2 The Maximum Principle 434

15.5 Dynamic Programming 434

15.6 Stochastic Dynamic Optimization 438

15.7 Time Consistency and Time Inconsistency 440

15.8 The Linear Rational-Expectations Models 442

15.8.1 Rational Expectations 443

15.8.2 The First-Order Nonstochastic Equation 444

15.8.3 Whiteman's Solution Method for Linear Rational-Expectations Models 446

15.8.4 Systems of Rational-Expectations Equations 453

References 459

Index 471

What People are Saying About This

DeJong

Wickens's text provides a tremendous introduction to modern macroeconomics. The coverage of material is thorough. The writing is clear and lively. The mathematics is sufficiently detailed without being overly technical, and the mathematical appendix helps keep the text largely self-contained. Intuition behind key results is provided beautifully throughout. Having worked through the text, students will be well-equipped for a journey toward the macroeconomics frontier.
— David N. DeJong, University of Pittsburg

Philip Lane

This book provides an integrated, self-contained, and accessible exposition of modern macroeconomic theory. Particular strengths include coverage of macroeconomic approaches to asset pricing and the analysis of monetary and fiscal policies. It is an excellent textbook for students in masters and PhD courses and an excellent reference for professional economists.
— Philip Lane, Trinity College Dublin

Christopher Pissarides

This is an innovative graduate textbook that develops much of modern macroeconomics in the framework of stochastic general equilibrium models. The book is especially good for its integration of macro and finance.
— Christopher Pissarides, London School of Economics and Political Science

A. Farmer

There are very few good textbooks on the dynamic general equilibrium approach to macroeconomics; Macroeconomic Theory fills a big void and provides a comprehensive and integrated approach to the subject that covers both real and monetary models. Professor Wickens develops a series of topics, beginning with real models of the economy and proceeding through growth, fiscal policy, financial models, and the modern approach to monetary economies. Each topic begins with theoretical background and proceeds to practical applications. The level is appropriate for masters or advanced undergraduate students and is a welcome addition to the field that is likely to be widely adopted.
— Roger E. A. Farmer, University of California, Los Angeles

Andersen

A most welcome graduate (or advanced undergraduate) textbook in macroeconomics. The book is well-written and the text is effectively organized and progresses in a natural and easy-to-follow way. The text offers a mathematical approach that is easily accessible to the students. The technical level is sufficiently detailed to allow students to understand the role of the underlying assumptions and how the models work, and yet it avoids unnecessary technicalities and sidetracks. As an extra bonus, it offers a treatment of financial aspects which are often neglected in macro textbooks.
— Torben M. Andersen, University of Aarhus, Denmark

Andrew Scott

This is a first-rate book that definitely helps fill a surprising lacuna in graduate macro teaching.
— Andrew Scott, London Business School

Editorial Reviews

"Accessible, comprehensive, and wide-ranging, Macroeconomic Theory will become the standard text for students and is ideal for economists, particularly those in government, central and commercial banking, and financial investment."

World Book Industry

"Accessible, comprehensive, and wide-ranging, Macroeconomic Theory will become the standard text for students and is ideal for economists, particularly those in government, central and commercial banking, and financial investment."—World Book Industry

From the Publisher