MACROECONOMICS
BY
Roger E. A. Farmer
Department of Economics UCLA
405 Hilgard Avenue
Los Angeles CA 90024
September, 97
Roger E. A. Farmer 1997. This is an incomplete and preliminary draft. You may
reproduce the material for personal use for a limited time only. Instructors may circulate
the material for classroom use after obtaining the written permission of the author.
, Macroeconomics
by
Roger E. A. Farmer
Part 1: Introduction And Measurement
1. What this Book is About
2. Measuring the Economy
3. Macroeconomic Facts
Part 2: The Classical Approach to Aggregate Demand and Supply
4. The Theory of Aggregate Supply
5. Inflation and Aggregate Demand
6. Saving and Investment
Part 3: The Modern Approach to Aggregate Demand and Supply
7. Unemployment and Labor Market Frictions
8. The Demand for Money
9. The Supply of Money
10. The IS-LM Model and Aggregate Demand
11. The Open Economy
Part 4: Dynamic Macroeconomics
12. Debt, Deficits and Economic Dynamics
13. The Neoclassical Theory of Growth
14. The Endogenous Theory of Growth
15. Unemployment, Inflation and Growth
16. Expectations and Macroeconomics
Part 5: Conclusion
17. What we Know and what we Don’t Know
,Roger E. A. Farmer Macroeconomics, December, 97
What’s in Each Part?
Part 1: Introduction and Measurement
Part 1 consists of 3 chapters. Chapter 1 introduces three major questions that we will study in
the rest of the book. 1) Why has GDP per person grown at an average rate of 1.6% per year
since 1890? 2) Why does GDP per person fluctuate around its trend growth rate? and 3) What
causes inflation? Chapter2 explains how we measure GDP and its component parts and it relates
the measurement of GDP to the measurement of wealth. In this chapter you will learn to attach
numbers to the US and the world economies. How big is GDP? How wealthy is the average
American? How large is the US economy relative to the rest of the world? Finally, chapter 3
explains how economists measure economic time series. What are the regularities that
characterize business cycles and how can these regularities be quantified?
Part 2: The Classical Approach to Aggregate Demand and Supply
In Chapters 4, 5 and 6 we move from a description of data to an explanation of it. We will study
a model of the complete economy, the classical model, that was developed over the course of a
hundred and fifty years, beginning in the late eighteenth century and ending in the early part of
the twentieth century. This model makes some strong simplifications that make it easy to
understand. Although these simplifications are too simplistic for the classical model to capture
all of the features of a modern industrial economy, the model is still useful to help us understand
certain features of the economy that are present in the more complete model that we will take up
later in the book.
Chapter 4 deals with the labor market and the theory of aggregate supply. It is a
complete description of all of the features that determine output and employment in an economy
operating at full employment. Chapter 5 deals with the classical theory of inflation and in
Chapter 6 we will study the classical model of the capital markets. At the end of Part 2 you will
have gained an insight into the equilibrium method – the idea that demand equals supply in each
of several markets in the economy simultaneously. You will also learn how this method can be
applied to real world economic problems: the causes of business cycles, the cause of inflation in
countries where inflation is very high, and the determination of savings and investment with
applications to current issues such as the aging of the population and the funding of social
security.
Part 3: The Modern Approach to Aggregate Demand and Supply
Part 3 contains five chapters that go beyond the classical model to develop a more modern
understanding of the theory of aggregate demand and supply. We begin, in Chapter 7, with two
alternative ways of understanding unemployment. We begin the chapter with a classical
perspective that views unemployment as the natural result of the fact that it is costly for firms to
search for workers. The main idea here is that there is a natural rate of unemployment that
occurs when no firm could profitably reduce unemployment by offering a lower wage or by
searching more intensively for the right employee. We proceed to model the Keynesian idea
that, for much of the time, unemployment may be either above or below this natural rate. The
idea that employment may differ from the natural rate is an important component of the
Keynesian theory of aggregate supply.
In Chapters 8, 9 and 10 you will study a modern approach to the theory of aggregate
demand. This approach is based on ideas from Keynes’ book The General Theory of
Employment Interest and Money in which Keynes combined a theory of the demand for money
2
, Roger E. A. Farmer Macroeconomics, December, 97
with a theory of equilibrium in the capital market. Keynes’ theory is more general than the
classical model of aggregate demand because it recognizes that the propensity to hold money is
not independent of the interest rate. This leads to a theory that explains why the position of the
aggregate demand curve depends on factors other than the quantity of money supplied.
Chapter 8 begins by generalizing the quantity theory of money to allow for the fact that
the propensity to hold money depends on the interest rate. Chapter 9 deals with the theory of
how the Fed. controls the money supply. Finally, Chapter 10 shows that equilibrium in the
capital market and equality between the quantity of money demanded and supplied can be put
together to generate an aggregate demand curve similar to the aggregate demand curve from the
classical model. The payoff to this generalization is a rich theory of business cycles in which
recessions may be caused by shifts of both the aggregate demand curve and the aggregate supply
curve. Since there are many variables that can shift aggregate demand, including changes in the
beliefs of investors and changes in fiscal policy, the complete Keynesian model can potentially
account for both the pre WWII experience as well as with recessions in the post war period. It
also provides policy makers with an understanding of how government behavior can influence
output and employment over the business cycle.
The last chapter in this section, Chapter 11, explains how the idea of demand
management must be modified in an open economy. The chapter concentrates on the difference
between different kinds of exchange rate regimes and it explains the constraints on monetary
policy that follow in world of fixed exchange rates.
Chapters 8 through 11 contains ideas that were extremely influential in macroeconomics
during the period from 1940 through the 1970’s. These ideas are important, but not essential, to
an understanding of what has been happening in macroeconomics since the 1970’s. Their main
contribution is to provide a theory of the interaction between the capital market and the demand
and supply of money that provides a complete theory of the factors that shift aggregate demand.
The ideas that have been most important to macroeconomics in the last couple of decades can be
understood using the simpler classical theory of aggregate demand based on the quantity theory
of money. For this reason, chapters 8 through 11 are optional and you may choose to omit them
and jump to the modern theory of expectations and dynamics covered in Part 4.
Part 4: Dynamic Macroeconomics
Part 4 contains 5 chapters that are united by their concern with economic dynamics; an explicit
theory of how the economy moves from one period to the next. The first of these, Chapter 12,
introduces the idea of a difference equation, the tool that we use to study the movement of
economies through time. This chapter is the easiest of the 5 and you may want to read Chapter
12 even if you choose not to study the material in the remainder of the section. Chapter 12 uses
difference equations to explain why policy makers are concerned with balancing the budget. It
explains why balancing the budget has emerged as a problem only in recent years and it offers
some perspective on how important the problem may be in the future.
Chapters 13 and 14 are two of the more difficult chapters in the book since they
explicitly use difference equations to understand economic growth. But although these chapters
are relatively hard, they are also two of the most rewarding. They will bring you to the frontier
of knowledge on the topic of economic growth and teach you why growth theory has absorbed
the time of some of the finest minds in economics over the past twenty years. Economists study
growth because it is possible that the right mix of economic policies in a country could increase
the growth rate and contribute enormously to the welfare of its citizens.
In Chapters 15 and 16 you will learn how to extend the neoclassical model to a dynamic
setting. At the end of chapter 10 we had covered a static version of this model in which we were
3
BY
Roger E. A. Farmer
Department of Economics UCLA
405 Hilgard Avenue
Los Angeles CA 90024
September, 97
Roger E. A. Farmer 1997. This is an incomplete and preliminary draft. You may
reproduce the material for personal use for a limited time only. Instructors may circulate
the material for classroom use after obtaining the written permission of the author.
, Macroeconomics
by
Roger E. A. Farmer
Part 1: Introduction And Measurement
1. What this Book is About
2. Measuring the Economy
3. Macroeconomic Facts
Part 2: The Classical Approach to Aggregate Demand and Supply
4. The Theory of Aggregate Supply
5. Inflation and Aggregate Demand
6. Saving and Investment
Part 3: The Modern Approach to Aggregate Demand and Supply
7. Unemployment and Labor Market Frictions
8. The Demand for Money
9. The Supply of Money
10. The IS-LM Model and Aggregate Demand
11. The Open Economy
Part 4: Dynamic Macroeconomics
12. Debt, Deficits and Economic Dynamics
13. The Neoclassical Theory of Growth
14. The Endogenous Theory of Growth
15. Unemployment, Inflation and Growth
16. Expectations and Macroeconomics
Part 5: Conclusion
17. What we Know and what we Don’t Know
,Roger E. A. Farmer Macroeconomics, December, 97
What’s in Each Part?
Part 1: Introduction and Measurement
Part 1 consists of 3 chapters. Chapter 1 introduces three major questions that we will study in
the rest of the book. 1) Why has GDP per person grown at an average rate of 1.6% per year
since 1890? 2) Why does GDP per person fluctuate around its trend growth rate? and 3) What
causes inflation? Chapter2 explains how we measure GDP and its component parts and it relates
the measurement of GDP to the measurement of wealth. In this chapter you will learn to attach
numbers to the US and the world economies. How big is GDP? How wealthy is the average
American? How large is the US economy relative to the rest of the world? Finally, chapter 3
explains how economists measure economic time series. What are the regularities that
characterize business cycles and how can these regularities be quantified?
Part 2: The Classical Approach to Aggregate Demand and Supply
In Chapters 4, 5 and 6 we move from a description of data to an explanation of it. We will study
a model of the complete economy, the classical model, that was developed over the course of a
hundred and fifty years, beginning in the late eighteenth century and ending in the early part of
the twentieth century. This model makes some strong simplifications that make it easy to
understand. Although these simplifications are too simplistic for the classical model to capture
all of the features of a modern industrial economy, the model is still useful to help us understand
certain features of the economy that are present in the more complete model that we will take up
later in the book.
Chapter 4 deals with the labor market and the theory of aggregate supply. It is a
complete description of all of the features that determine output and employment in an economy
operating at full employment. Chapter 5 deals with the classical theory of inflation and in
Chapter 6 we will study the classical model of the capital markets. At the end of Part 2 you will
have gained an insight into the equilibrium method – the idea that demand equals supply in each
of several markets in the economy simultaneously. You will also learn how this method can be
applied to real world economic problems: the causes of business cycles, the cause of inflation in
countries where inflation is very high, and the determination of savings and investment with
applications to current issues such as the aging of the population and the funding of social
security.
Part 3: The Modern Approach to Aggregate Demand and Supply
Part 3 contains five chapters that go beyond the classical model to develop a more modern
understanding of the theory of aggregate demand and supply. We begin, in Chapter 7, with two
alternative ways of understanding unemployment. We begin the chapter with a classical
perspective that views unemployment as the natural result of the fact that it is costly for firms to
search for workers. The main idea here is that there is a natural rate of unemployment that
occurs when no firm could profitably reduce unemployment by offering a lower wage or by
searching more intensively for the right employee. We proceed to model the Keynesian idea
that, for much of the time, unemployment may be either above or below this natural rate. The
idea that employment may differ from the natural rate is an important component of the
Keynesian theory of aggregate supply.
In Chapters 8, 9 and 10 you will study a modern approach to the theory of aggregate
demand. This approach is based on ideas from Keynes’ book The General Theory of
Employment Interest and Money in which Keynes combined a theory of the demand for money
2
, Roger E. A. Farmer Macroeconomics, December, 97
with a theory of equilibrium in the capital market. Keynes’ theory is more general than the
classical model of aggregate demand because it recognizes that the propensity to hold money is
not independent of the interest rate. This leads to a theory that explains why the position of the
aggregate demand curve depends on factors other than the quantity of money supplied.
Chapter 8 begins by generalizing the quantity theory of money to allow for the fact that
the propensity to hold money depends on the interest rate. Chapter 9 deals with the theory of
how the Fed. controls the money supply. Finally, Chapter 10 shows that equilibrium in the
capital market and equality between the quantity of money demanded and supplied can be put
together to generate an aggregate demand curve similar to the aggregate demand curve from the
classical model. The payoff to this generalization is a rich theory of business cycles in which
recessions may be caused by shifts of both the aggregate demand curve and the aggregate supply
curve. Since there are many variables that can shift aggregate demand, including changes in the
beliefs of investors and changes in fiscal policy, the complete Keynesian model can potentially
account for both the pre WWII experience as well as with recessions in the post war period. It
also provides policy makers with an understanding of how government behavior can influence
output and employment over the business cycle.
The last chapter in this section, Chapter 11, explains how the idea of demand
management must be modified in an open economy. The chapter concentrates on the difference
between different kinds of exchange rate regimes and it explains the constraints on monetary
policy that follow in world of fixed exchange rates.
Chapters 8 through 11 contains ideas that were extremely influential in macroeconomics
during the period from 1940 through the 1970’s. These ideas are important, but not essential, to
an understanding of what has been happening in macroeconomics since the 1970’s. Their main
contribution is to provide a theory of the interaction between the capital market and the demand
and supply of money that provides a complete theory of the factors that shift aggregate demand.
The ideas that have been most important to macroeconomics in the last couple of decades can be
understood using the simpler classical theory of aggregate demand based on the quantity theory
of money. For this reason, chapters 8 through 11 are optional and you may choose to omit them
and jump to the modern theory of expectations and dynamics covered in Part 4.
Part 4: Dynamic Macroeconomics
Part 4 contains 5 chapters that are united by their concern with economic dynamics; an explicit
theory of how the economy moves from one period to the next. The first of these, Chapter 12,
introduces the idea of a difference equation, the tool that we use to study the movement of
economies through time. This chapter is the easiest of the 5 and you may want to read Chapter
12 even if you choose not to study the material in the remainder of the section. Chapter 12 uses
difference equations to explain why policy makers are concerned with balancing the budget. It
explains why balancing the budget has emerged as a problem only in recent years and it offers
some perspective on how important the problem may be in the future.
Chapters 13 and 14 are two of the more difficult chapters in the book since they
explicitly use difference equations to understand economic growth. But although these chapters
are relatively hard, they are also two of the most rewarding. They will bring you to the frontier
of knowledge on the topic of economic growth and teach you why growth theory has absorbed
the time of some of the finest minds in economics over the past twenty years. Economists study
growth because it is possible that the right mix of economic policies in a country could increase
the growth rate and contribute enormously to the welfare of its citizens.
In Chapters 15 and 16 you will learn how to extend the neoclassical model to a dynamic
setting. At the end of chapter 10 we had covered a static version of this model in which we were
3
