ADVANCED MACKOECONOMICSThis book was set in Lucida Bright by Publication Services, Inc. The editor was Lucille Sutton; the production supervisor was Friederich W. Schulte. The cover was designed by Delgado Des the cover illustration was drawn by Shane Kelley Project supervision was done by Publication Services. inc R. R. Donnelley & Sons Company was printer and binder. McGraw-Hill A Division of The McGraw-Hill Compames ADVANCED MACROECONOMICS Copyright © 1996 by The McGraw-Hill Companies, Inc. All rights reserved. Printed in the United States of America. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a data base or retrieval system, without the prior written permission of the publisher. This book is printed on acid-free paper. 7890DOC DOC 90987 ISBN 0-07-053667-8 Library of Congress Cataloginj Romer, David. Advanced macroeconomics / David Romer. p. cm. — (McGraw-Hill advanced series in economics) Includes bibliographical references and index. ISBN 0-07-053667-8 1. Macroeconomics. 1. Title. Il. Series. HBI72.5.R66 1996 339—de20 95-3728ABOUT THE AUTHOR David Romer is professor of economics at the University of California, Berkeley. He received his A.B. from Princeton University, where he was vale- dictorian, and his Ph.D, from M.LT. He has been on the faculty at Princeton and has been a visiting faculty member at M.LT. and Stanford. He is also a Research Associate of the National Bureau of Economic Research and serves on the editorial boards of several economics journals. His main research in- terests are monetary policy, the foundations of price stickiness, empirical evidence on economic growth, and asset-price volatility. He is married to Christina Romer, who is also an economist, and has two children, Katherine and Paul.CONTENTS Acknowledgments Introduction Chapter 1 THE SOLOW GROWTH MODEL Theories of Economic Growth Assumptions The Dynamics of the Model The Impact of a Change in the Saving Rate Quantitative Implications ‘The Solow Model and the Central Questions of Growth Theory Empirical Applications Problems Chapter 2 BEHIND THE SOLOW MODEL: INFINITE-HORIZON AND OVERLAPPING-GENERATIONS MODELS Part A THE RAMSEY-CASS-KOOPMANS MODEL ea) — eS 24 = 2.6 = = = Assumptions The Behavior of Households and Firms The Dynamics of the Economy Welfare ‘The Balanced Growth Path The Effects of a Fall in the Discount Rate The Effects of Government Purchases Bond and Tax Finance ‘The Ricardian Equivalence Debate xix uw w 12 15 18 23 26 34 38 39 se 40 46 aE ape = 64 66xii ~=CONTENTS Part B_ THE DIAMOND MODEL 72 2.10 Assumptions 72 2.11 Household Behavior 73 2.12 The Dynamucs of the Economy 75 2.13 The Possibility of Dynamic Inefficiency 81 2.14 Government in the Diamond Model 85 Problems 88 Chapter 3 BEYOND THE SOLOW MODEL: NEW GROWTH THEORY 95 Part A RESEARCH AND DEVELOPMENT MODELS 96 3.1 Framework and Assumptions 96 3.2 The Model without Capital 98 3.3. The General Case 104 3.4. The Nature of Knowledge and the Determinants of the Allocation of Resources to R&D il 3.5 Endogenous Saving in Models of Knowledge Accumulation: An Example 118 3.6 Models of Knowledge Accumulation and the Central Questions of Growth Theory 121 3.7 Empirical Application: Population Growth and Technological Change since 1 Million a. 122 Part B_ HUMAN CAPITAL 126 3.8 Introduction 126 3.9 A Model of Human Capital and Growth 128 3.10 Implications 132 3.11 Empirical Application: Physical and Human Capital Accumulation and Cross-Country Differences in Incomes 137, Problems 140 Chapter 4 REAL-BUSINESS-CYCLE THEORY 146 4.1 Introduction: Some Facts about Economic Fluctuations 146 4.2 Theories of Fluctuations 150 4.3. A Baseline Real-Business-Cycle Model 152 4.4 Household Behavior 154 4.5 A Special Case of the Model 158 4.6 — Solving the Model in the General Case 16447 48 aes 4.10 CONTENTS Implications Empirical Application: The Persistence of Output Fluctuations Additional Empirical Applications Extensions and Limitations Problems Chapter 5 TRADITIONAL KEYNESIAN THEORIES 5.1 a El 5.4 = 5.6 OF FLUCTUATIONS Introduction Review of the Textbook Keynesian Model of Aggregate Demand The Open Economy Alternative Assumptions about Wage and Price Rigidity Output-Inflation Tradeoffs Empirical Application: Money and Output Problems: Chapter 6 MICROECONOMIC FOUNDATIONS Part A 6.1 6.2 63 64 Part B 6.5 66 67 68 69 Part C 6.10 6.11 6.12 6.13 OF INCOMPLETE NOMINAL ADJUSTMENT ‘THE LUCAS IMPERFECT-INFORMATION MODEL Overview The Case of Perfect Information The Case of Imperfect Information Implications and Limitations STAGGERED PRICE ADJUSTMENT Introduction A Model of Imperfect Competition and Price-Setting Predetermined Prices Fixed Prices The Caplin-Spulber Model NEW KEYNESIAN ECONOMICS, Overview Are Small Frictions Enough? The Need for Real Rigidity Empirical Applications xiii 168 175 180 183 190 195 195 197 205 214 222 232 236 241 242 242 243 246 250 256 256 caTE 262 265 7 276 276 278 ea eaxiv CONTENTS 6.14 Coordination-Failure Models and Real Non-Walrasian Theories 6.15 Limitations Problems Chapter 7 CONSUMPTION 71 = rae 7.4 rae 7.6 Consumption under Certainty: The Life-Cycle/ Permanent-Income Hypothe: Consumption under Uncertain Hypothesis Empirical Application: Two Tests of the Random-Walk Hypothesis The Interest Rate and Saving Consumption and Risky Assets Alternative Views of Consumption Problems : The Random-Walk Chapter 8 INVESTMENT 8.1 8.2 8.3 84 85 8.6 8.7 88 Investment and the Cost of Capital A Model of Investment with Adjustment Costs Tobin's q Analyzing the Model Implications ‘The Effects of Uncertainty: An Introduction Financial-Market Imperfections Empirical Applications Problems Chapter9 INFLATION AND MONETARY POLICY cal es 9.3 9.4 ce 96 9.7 9.8 Introduction Inflation, Money Growth, and Interest Rates Monetary Policy and the Term Structure of Interest Rates The Dynamic Inconsistency of Low-Inflation Monetary Policy Addressing the Dynamic-Inconsistency Problem Some Macroeconomic Policy Issues Seignorage and Inflation The Costs of Inflation Problems 294 300 302 309 310 316 a BP 328 332 341 345 345 348 353, 354 358 364 369 380 384 388 388 389 Be 398 403 412 420 429 433CONTENTS xv Chapter 10 UNEMPLOYMENT 439 10.1 Introduction: Theories of Unemployment 439 10.2 A Generic Efficiency-Wage Model 441 10.3 A More General Version 446 10.4 The Shapiro-Stiglitz Model 450 10.5. Implicit Contracts : 461 10.6 Insider-Outsider Models 465 10.7 Hysteresis 469 10.8 Search and Matching Models 473 10.9 Empirical Applications 481 Problems 486 References 494 Name Index 523 Subject Index 528Section 1.7 Section 2.7 Section 2.13 Section 3.7 Section 3.11 Section 4.8 Section 4.9 Section 5.6 Section 6.4 Section 6.13 Section 6.14 Section 7.1 Section 7.3 Section 7.5 Section 7.6 Section 8.8 Section 9.3 Section 9.5 Section 10,9 EMPIRICAL APPLICATIONS Growth Accounting Convergence Saving and Investment Investment, Population Growth, and Output Wars and Real Interest Rates Are Modern Economies Dynamically Ffficient? Population Growth and Technological Change Since 1 Million B.c Physical and Human Capital Accumulation and Cross-Country Differences in Incomes The Persistence of Output Fluctuations Calibrating a Real-Business-Cycle Model Productivity Movements in the Great Depression Money and Output International Evidence on Output-Inflation Tradeoffs The Average Inflation Rate and the Output-Inflation Tradeoff Supply Shocks Microeconomic Evidence on Price Adjustment Experimental Evidence on Coordination-Failure Games Understanding Estimated Consumption Functions Campbell and Mankiw's Test of the Random-Walk Hypothesis Using Aggregate Data Shea's Test of the Random-Walk Hypothesis Using Household Data The Equity-Premium Puzzle Liquidity Constraints and Aggregate Saving Buffer-Stock Saving The Investment Tax Credit and the Price of Capital Goods Cash Flow and Investment The Response of the Term Structure to Changes in the Federal Reserve's Federal-Funds-Rate Target Central-Bank Independence and Inflation Contracting Effects on Employment Interindustry Wage Differences XVii 26 27 31 32 61 84 122 137 175 180 182 232 253 289 291 293 297 312 319 322 330 338 339 380 381 396 409 481 484