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Roger E. A. Farmer1 November 2005 This draft: May 16, 2008

1 To

Roxanne.

Contents

Preface 1 What this Book is About 1.1 The Nature of the Enquiry . . . . . . . . 1.2 The Theory Summarized . . . . . . . . . 1.3 The Theory of Aggregate Supply . . . . 1.4 The Theory of Aggregate Demand . . . . 1.5 Additional Features of my Interpretation 2 The 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 2.10 Labor Market Components of the General Theory . Households . . . . . . . . . . . . . . Firms . . . . . . . . . . . . . . . . . Search . . . . . . . . . . . . . . . . . The Social Planner . . . . . . . . . . Aggregate Demand and Supply . . . Eﬀective Demand and the Multiplier A Deﬁnition of Equilibrium . . . . . Remarks on Ricardian Fiscal Policies Concluding Comments . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix 1 3 4 5 7 8 11 12 13 14 16 17 19 22 24 26 27 29 30 32 33 34 36 40

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3 Aggregate Demand and Supply 3.1 Households . . . . . . . . . . . 3.2 Firms . . . . . . . . . . . . . . 3.3 Search . . . . . . . . . . . . . . 3.4 The Social Planner . . . . . . . 3.5 Aggregate Supply and Demand 3.6 Keynesian Equilibrium . . . . . v

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vi 3.7 3.8

CONTENTS Keynes and the Social Planner . . . . . . . . . . . . . . . . . . 42 Concluding Comments . . . . . . . . . . . . . . . . . . . . . . 44 47 47 48 49 49 51 51 52 53 54 55 57 59 59 60 60 61 61 63 65 66 69 70 71 73 76 77 78 80 81 83 84 85

4 Saving and Investment 4.1 The Model Structure . . . . . . . . . . . . . . . . . 4.2 Households . . . . . . . . . . . . . . . . . . . . . . 4.2.1 The Initial Old . . . . . . . . . . . . . . . . 4.2.2 The Initial Young . . . . . . . . . . . . . . . 4.2.3 The Third Generation . . . . . . . . . . . . 4.3 Firms . . . . . . . . . . . . . . . . . . . . . . . . . 4.4 Search . . . . . . . . . . . . . . . . . . . . . . . . . 4.5 The Social Planner . . . . . . . . . . . . . . . . . . 4.6 Investment and the Keynesian Equilibrium . . . . . 4.7 The Deﬁnition of Equilibrium . . . . . . . . . . . . 4.8 Aggregate Demand and Supply . . . . . . . . . . . 4.9 Finding Values for the other Variables . . . . . . . 4.9.1 First Period Price and Output . . . . . . . . 4.9.2 Second Period Capital and Output . . . . . 4.9.3 Rental Rates and Consumption Allocations . 4.9.4 Second Period Prices . . . . . . . . . . . . . 4.10 Fiscal Policy in a Keynesian Model . . . . . . . . . 4.11 Concluding Comments . . . . . . . . . . . . . . . . 5 Presenting Business Cycle Facts 5.1 What’s Wrong with the HP Filter? 5.2 Measuring Data in Wage Units . . 5.3 Choosing a Per-Capita Measure . . 5.4 Interpreting Wage Units . . . . . . 5.5 The Components of GDP . . . . . 5.6 Concluding Comments . . . . . . . 6 The 6.1 6.2 6.3 6.4 6.5 6.6 Great Depression Preferences . . . . . . . . . . The Consumption Function . Technology . . . . . . . . . . Aggregate Supply . . . . . . . Search and the Labor Market Expectations Shocks . . . . . . . . . . . . . . . . . . . . . . .

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. . . . 120 . . . . . . . . . . . . . . . . . . Appendix . . .13 6. .6 The Theory Summarized . . . . . . . . . . . . . . . . 105 . . . . . . . . Concluding Comments . . . . . . . . . . . . . . . . . . . . . . The Household Problem . . . . . . . . . . . . . . . . . . . . Steady State Equilibria . . . . . . . . . . . . . . . .8 The Social Planning Problem . . . .4 7. . .3 7. . . . . . . . . . . . . . . . . . 123 123 124 125 132 132 135 8 Post War Experience 8. . . . . . vii 85 87 90 92 94 96 100 102 War-Time Recovery Household Structure . . . . . 8. . . . .1 The Household Problem . . . . .12 6. . . Dynamic Eﬃciency . Demand Constrained Equilibrium Keynes and the Great Depression Eﬃciency of Equilibrium . . . . . .8 6. . . . . . . . . . . . . . . . . . . . . . . . . .5 The Equity Premium . . . . . . . .7 7. 8. . . . . 112 . . . . . . . . . . . . . . . . . . . . . . . . . . .2 7. . . . . . . . . . . . . . . 7. . 120 . . . . . . . . . . . The Aggregate Consumption Function Aggregate Equations of Motion . . . . . . .6 7. . . . . . . . . . . . . 108 .3 Real Economic History . 119 . . . Concluding Comments . . .1 7. . . . . . . . . . . . . . . . . . . . . . 138 . . . . 110 . . . . . . . . . . . . . Appendix . . . . . . 113 . . . .14 7 The 7. . Crowding Out .7 6. . . . . . . . . . . . . . . . .11 6. .10 6. . . 110 . . . .CONTENTS 6. . . . . . . . . . .1 Adding Money to the Model . . . . . .2 The Consumption Function . . . . . . . . . . . . . . . . . . . . . . . . . . . Household and Government . . . . . . . . . . . . . . . . . . . . .2 The Impact of the Fed-Treasury Accord 8. . .5 7. . . . . . 7. 8. . . . . . . 8. . . . . . . . . . . . . . . . 105 . . . . . . . 121 . . . .9 6. . .1 Introduction . . . . . . . . . . .4 Monetary Economic History . .8. . . . . . . . . . . . . . . . . 9 Explaining Stagﬂation 137 9. . . . . . . . . . . . . . . . . .8. . . . . . . . . . . . . . . .

Preface My preface will appear here. ix .

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and Mexico have all experienced great depressions since 1980. What is new in this book is a theory of individual behavior that explains why these policies are appropriate and how they work. Timothy Kehoe and Edward Prescott (2007) deﬁne a great depression to be a period of diminished economic output with at least one year where output is 20% below the trend. Brazil. during the Great Depression of the 1930’s the unemployment rate exceeded 20% for a protracted period of time. The remedies I will suggest are standard and are part of the current arsenal of policies employed by the governments of all market economies. By this deﬁnition Argentina. A by-product of my analysis is an explanation of how inﬂation and unemployment can occur together and a theory of what it means to maintain full employment. and similar episodes have been a recurrent feature of capitalist economies since the beginning of the industrial revolution. Chile. This book is about the business cycle and how to control it. I will provide a theory of economic ﬂuctuations that explains why major recessions occur and I will explain how ﬁscal and monetary policy can be used to maintain high and stable employment. The Great Depression is not unique.Chapter 1 What this Book is About Those who cannot remember the past are condemned to repeat it. The Life of Reason (1905). The reasoning I will provide is Keynesian and is based on ideas from the General Theory of Employment Interest and Money (1936). Although economic ﬂuctuations in the U.S. have been relatively mild in recent decades. What causes big ﬂuctuations in economic activity? For several decades after the publication of the General Theory economists thought they had 1 . George Santayana.

Although there has been a recent resurgence of Keynesian ideas under the rubric of “new-Keynesian economics”. a number that is consistent with that cited by Lucas (1987. he meant the interpretations of Keynes that became incorporated into the IS/LM model and ultimately. those described in this book display Galí. In successive chapters I construct a series of models that build on a single idea. has been called into question. Axel Leijonhufvud made the distinction between Keynesian economics and the economics of Keynes. the key premise of the General Theory. But with the resurgence of classical ideas in the 1970’s. the models studied by the new-Keynesians are hybrids that incorporate a classical core. I assume that the planning optimum cannot be decentralized as a competitive equilibrium because moral hazard prevents the creation of markets for the search inputs.1 In his 1966 book. and Salido (2007. the welfare costs of business cycles are also small and arise from second order consequences of deviating from the social planning optimum. in which the level of economic activity is determined by investor conﬁdence or ‘animal spirits’. Gertler. page 56) ﬁnd that the average welfare costs of business ﬂuctuations in a New-keynesian model are less than . As an alternative. the Great Depression was thought to be a failure of an unregulated capitalist economy to eﬃciently utilize available resources. 1 . Leijonhufvud pointed out that the assumption that the General Theory is about sticky prices is central to Keynesian economics but it is not a central argument of the text of the General Theory. Chapter IV) in the context of the real business cycle model. I refer to the resulting model as ‘old-Keynesian’ to diﬀerentiate it from new-Keynesian economics that incorporates the natural rate hypothesis of Edmund Phelps (1970) and Milton Friedman (1968).2 CHAPTER 1 WHAT THIS BOOK IS ABOUT an answer. New-Keynesian models allow for temporary deviations of unemployment from its ‘natural rate’ as a consequence of sticky prices but they contain a stabilizing mechanism that causes a return to the natural rate over time. This book provides an alternative microfoundation to Keynesian economics that does not rely on sticky-prices.01% of steady state consumption. Although this technology is convex. In contrast to new-Keynesian models. into the new-Keynesian paradigm.0. Each of them is constructed around a conventional dynamic general equilibrium model in which real resources must be used to move unemployed workers into jobs using a ‘search technology’. Since the return to the steady state is typically rapid in these models. I introduce an equilibrium concept called demand constrained equilibrium. By Keynesian economics. that market economies are not inherently self-stabilizing.

1929.. This view is more extreme than that which Keynes ascribed to the ‘classical economists’ of whom he considered Pigou a prime example.industrial ﬂuctuations produced in the ways described [above] are certainly social evils”. Lavington (1922) and Haberler (1937) all recognized a role for total factor productivity.. nevertheless “. This is a remarkable turn of intellectual thought from the prevailing mood in the early post-war period when President Richard Nixon is famously quoted as saying “We are all Keynesians now”. point to post-war U.1 THE NATURE OF THE ENQUIRY 3 multiple stationary perfect foresight equilibria. According to this view. to a ﬁrst approximation. Economists who take this view. Chapter 22). “harvest variations” and “autonomous monetary movements” (Pigou. In “Industrial Fluctuations” Pigou concludes that although “. An early example is the book by Milton Friedman and Anna Schwartz (1963) who argued that the Depression was caused by incompetent monetary policy in the 1920’s. 1. The General Theory makes a break from 1920’s business cycle theory by ..the popular opinion that industrial ﬂuctuations as such must be social evils is invalid”. The Depression is seen as an unusual episode that requires explanation but it is thought that the place to look for such an explanation is in the actions of the regulatory authorities..S. but they also recognized alternative sources of aggregate ﬂuctuation including “errors of optimism and pessimism”. for each possible level of beliefs. Pigou (1929).1 The Nature of the Enquiry I began this chapter by posing a question: Why do capitalist economies sometimes go very wrong? One answer that has become fashionable is to argue that episodes like the Great Depression of the 1930’s are an aberration. More recently Cole and Ohanian (2004) have argued that Herbert Hoover’s regulatory policies deepened the depression in the early 1930’s. The view of business cycles that currently dominates the economics profession is that of real business cycles according to which most economic ﬂuctuations are caused by unforeseen shocks to total factor productivity.1. and there is a diﬀerent stationary unemployment rate. experience in which unemployment has been relatively low and business cycles relatively mild for long periods of time. a reﬂection of the allocation that would be made by a benevolent social planner whose goal is to maximize social welfare. the market system is eﬃcient and the allocation of resources in a laissez-faire economy is.

4 CHAPTER 1 WHAT THIS BOOK IS ABOUT separating the theory of distribution from the theory of aggregate economic activity. These are exactly the policies that Keynes argued for in the 1930’s and it is ironic that the success of these very policies should be seen by some as evidence against the theories that spawned them. policy makers had little conception of how to run a successful monetary policy and for most of the 1930’s the short term interest rate was too low to be used as an eﬀective instrument of control. economy. the size of government has been large enough to create an automatic stabilizing mechanism that generates budget deﬁcits in recessions and potential surpluses in expansions. His arguments had an important inﬂuence on political economy and resulted in the current state-capitalist system in which the monetary and ﬁscal authorities in most Western democracies are charged with the objective of maintaining a high and stable level of employment. Seventy years of history since the publication of the General Theory have produced data that invalidates at least some of its key themes. Although Keynes believed that the market system is probably an eﬃcient way of deciding which kinds of goods are produced for a given volume of employment. it represents prima facie evidence for the success of Keynesian economics. the Fed actively pursues a countercyclical monetary policy by lowering the interest rate during recessions and raising it during expansions. In 1929 federal and state taxes together accounted for 11% of gdp but by 1999 that ﬁgure had risen to 36%. Rather. When the Fed was created in 1913. A good example is provided by the U.S. There are two key ideas in the General Theory that set it apart from pre- . Since 1945 however. Most notable amongst these is the experience of stagﬂation in the 1970’s that is inconsistent with the ‘reverse L’ theory of aggregate supply outlined in Chapter 21 of the General Theory on the theory of prices.2 The Theory Summarized Although the current volume is heavily inﬂuenced by the General Theory. Further. 1. it is not a simple translation of that book into the language of modern economics. he argued that unregulated capitalist systems do not produce an eﬃcient allocation of labor. The ﬁscal and monetary policy environment since 1940 has been very diﬀerent from that of the 1920’s and 1930’s as a direct consequence of ideas that arose from the publication of the General Theory and hence it is invalid to use the post-war period as an example of the success of the market system.

. time and experience and the collaboration of a number of minds will discover the best way of expressing them. modiﬁed in a way that respects recent developments in dynamic stochastic general equilibrium theory.3 The Theory of Aggregate Supply Chapter 2 presents a reformulation of the theory of aggregate supply. and have no desire that the latter should be crystallized at the present stage of the debate. The ideas that I have identiﬁed as central to Keynesian economics can be separated into theories of aggregate supply and aggregate demand.1. Keynes (1937. The following two Sections outline brieﬂy my main arguments and explain how they are related to the ‘fundamental ideas’ of the General Theory. 1. The integration of stochastic dynamics into modern economic theory provides a set of mathematical tools that enable me to integrate dynamic ideas into macroeconomics in a way that was not possible in the 1930’s. Pages 211-212). This book will preserve both of these ideas. Keynes’ theory has been widely criticized for its lack of microfoundations and it is often asserted that if the marginal disutility of labor is not equal to the real wage. who expressed the following sentiment in a 1937 article in response to his critics: I am more attached to the comparatively simple fundamental ideas that underlie my theory than to the particular forms in which I have embodied them. The second is that aggregate economic activity is determined by the ‘animal spirits’ of investors. Although the form with which I will state these ideas is diﬀerent from existing interpretations of the General Theory. the intellectual predecessors are those formulated by Keynes in 1936. then unemployed workers would be expected to oﬀer to work for a lower wage. If the simplest basic ideas can become familiar and acceptable.3 THE THEORY OF AGGREGATE SUPPLY 5 Keynesian economics: The ﬁrst is that there is something distinctive about the labor market that makes the marginal disutility of labor diﬀerent in general from the real wage. This argument is based on the implicit assumption that the labor market is an auction in which unemployed workers can eﬀectively signal their willingness to work to proﬁt maximizing ﬁrms. as Keynes assumed in Chapter 2 of the General Theory.

In this tradition it is assumed that the process by which an unemployed worker ﬁnds a job requires the input of resources on the part of the ﬁrm and time on the part of the worker. Pissarides (2000) provides an excellent summary. exempliﬁed by Barro and Grossman (1971). and Malinvaud (1977). In this book I pick up on recent literature due to Shimer (2005) and Hall (2005) that follows earlier work in search theory. To select an equilibrium and close the model I introduce the idea that households form beliefs about the future value of productive capital and I show that for any sequence of self-fulﬁlling beliefs. I develop a series of models in which the labor market is cleared by search but instead of closing it with an explicit bargaining assumption.6 CHAPTER 1 WHAT THIS BOOK IS ABOUT Following arguments by Patinkin (1989) and Clower (1965). they determine the wage to be paid through a Nash bargain. Benassy (1975). In this book I take an alternative approach. When a worker and a ﬁrm meet. the disequilibrium literature of the 70’s. Although there were contemporary writers. This argument rested on the fact that it contains what Lucas called ‘free parameters’ and comes down to the claim that. the theory is untestable. I assume only that all ﬁrms must oﬀer the same wage. as a consequence. This leads to a theory in which there are many wages all of which are consistent with a zero proﬁt equilibrium and it provides a microfounded analog of Keynes’ idea that there are many levels of economic activity at which the macroeconomy may be in equilibrium. there exists a Key- . Shimer’s criticism is commonly referred to as the ‘Shimer puzzle’ and it has generated a considerable amount of recent work amongst economists and graduate students who are exploring alternative wage determination mechanisms in an attempt to reconcile the volatility of vacancies and unemployment with a model in which economic ﬂuctuations are driven by productivity shocks. Shimer pointed out that this assumption does not provide a good quantitative explanation of employment ﬂuctuations and Hall proposed to replace it with an alternative wage determination mechanism. This literature was ultimately judged to be unsuccessful by a generation of economists who followed the equilibrium approach of Lucas and Rapping (1969) and Lucas (1972). (Axel Leijonhufvud (1966) is a leading example) who claimed that Keynesian economics was never about ‘sticky prices’. less than a given bound. he assumed that the real wage is determined one period in advance. Leijonhufvud and his followers never managed to formulate an alternative theory that was capable of answering the new-Classical criticism that disequilibrium theory is empty. tried to address this point by constructing an explicit theory of transactions at disequilibrium prices.

it is a departure worth making since it allows me directly to compare the implications of the theory with modern neoclassical alternatives. Keynes believed that some forms of uncertainty cannot be quantiﬁed and . Hence. perfectly ‘crowd out’ one dollar of private consumption expenditure and aggregate demand would be unaltered. Although this is a departure from Keynes’ theory of expectations. Problems with this theory were already apparent in the 1950’s when it was realized that estimates of the marginal propensity to consume were typically much lower in cross-section than time-series data.4 THE THEORY OF AGGREGATE DEMAND 7 nesian equilibrium. I am able to articulate the Keynesian story of the Great Depression in a model with well deﬁned microfoundations in which no individual agent has an incentive to deviate from his chosen action. 1. argued that one dollar of expenditure by government might. under some circumstances. In this book I will have cause to breathe new life into many of the old debates. Keynes contributed a theory of eﬀective demand based on the multiplier. I will construct a microfoundation to the theory of aggregate demand based on the assumption that agents are forward looking with rational expectations of future prices. on purely theoretical grounds. But this was not the only important debate that characterized the macroeconomics of the immediate post-war period. ‘A Theory of the Consumption Function’. The exercise of providing a dynamic foundation to Keynesian economics led to an attack on the intellectual foundations of the multiplier and a debate over the eﬀectiveness of ﬁscal policy. became irrelevant when Keynesian economics was replaced by the real business cycle paradigm. This led to Friedman’s (1957) book.1.4 The Theory of Aggregate Demand In addition to his theory of aggregate supply. Blinder and Solow (1973). in which he proposed the concept of permanent income as a way of resolving the disparity between diﬀerent estimates. and other preoccupations of the post-war Keynesian economists. This equilibrium will in general be ineﬃcient in the sense that a benevolent social planner would prefer a diﬀerent employment level that may be higher or lower. The debate was ultimately resolved by recognizing that crowding out would occur only if government bonds are not perceived as net-wealth by the community as a whole although this debate.

there may be overemployment just as there may be underemployment. In contrast to the previous formulations of this idea that I described in my book on the Macroeconomics of Self-Fulﬁlling Prophecies (1993). According to this theory. endowments and technology. as a consequence. Overemployment occurs if ﬁrms devote too many resources to the activity of searching for new workers and. in addition. Although these sources of uncertainty will be present in the models I describe in this book. Although the agents in my model will be able to form probability distributions over future events . agents in the models I will describe in the following chapters may form self-fulﬁlling beliefs that lead to an increase in the unemployment rate in the steady state. fewer workers are available to produce commodities. beyond which. 1.8 CHAPTER 1 WHAT THIS BOOK IS ABOUT that agents must act on the basis of partial information. Keynes argued that there exists a critical level of employment. outlined in Chapter 2. This theory is at odds with the observation of the 1970’s in which we saw the simultaneous occurrence of high levels of unemployment and inﬂation and hence the Keynesian theory must be revised. to provide a dynamic theory of wages and prices must ultimately be judged a failure. a necessary requirement for the emergence of inﬂation is the overemployment of existing resources. increases in aggregate demand would lead to inﬂation. It is here that I capture the Keynesian idea of the importance of ‘animal spirits’. Although he argued that his main ideas did not depend on these assumptions. In this book I will amend the Keynesian theory by developing a microfounded theory of aggregate supply that avoids this problem.5 Additional Features of my Interpretation Keynes built a static theory of aggregate supply based on the assumption that the money wage and the existing stocks of capital equipment could be taken as given. . agents will be required to form expectations of the future actions of others. the attempt that he made in Chapter 21.not all of these events will be fundamental in the sense in which that word is now used in general equilibrium theory to describe uncertainty due to changes in preferences. If investors today believe that all future investors will be pessimistic then this belief will be self-fulﬁlling. does not lead to a ‘reverse L’ theory of aggregate supply and in my version of the theory of aggregate supply. This theory.

This level of generalization was possible because Keynes was concerned with determining the level of economic activity at a point in time and for this purpose it is legitimate to take the stocks of all existing capital goods as ﬁxed. The chapter provides an elaboration of the Keynesian idea that investment and savings are equated not by changes in the rate of interest. But how does this argument extend to a fully dynamic economy? The labor market model of chapters 2-4 are set into simple one or two period economies in which income provides the scale variable to determine consumer behavior. measured in currency units. but also from a theoretical point of view. This was the lesson of Friedman’s work on the permanent income expounded in his 1957 book on the consumption function and it makes sense not only from an empirical point of view (it helps explain a discrepancy between cross-section and time series estimates of the consumption function). But the experience of post-war macroeconomics taught us that Keynesian relationships like the consumption function or the demandfor-money function would need to include not income but wealth as an explanatory variable. This extends the models of the previous chapters by allowing for the distinction between saving and investment that Keynes thought to be central to the determination of the level of aggregate economic activity. the Keynesian theory of aggregate demand does not extend easily to dynamic models. It is possible to put this theory together with Keynes’ theory of aggregate demand and to derive familiar Keynesian propositions.5 ADDITIONAL FEATURES OF MY INTERPRETATION 9 The General Theory. money-value. used only two units of measurement. and multiple capital goods. in Chapter 3. By restricting himself to the description of purely aggregate relationships between nominal gdp and employment Keynes was able to describe the forces that he believed determine the level of aggregate economic activity without making special assumptions about industrial structure. in contrast to much of the economics of Keynes’ followers. Chapter 4 continues the exposition of the Keynesian model by embedding a search theory of the labor market into a two-period model with overlapping generations. This exercise is instructive since it illustrates the power of the search-based version Keynes’ theory of aggregate supply. But although the static theory can be well expounded using the simple apparatus of the multiplier. I will show. and ordinary-labor measured in hours. that a theory of aggregate supply based on search theory can be expressed at this same level of abstraction and it is relatively simple to construct a static theory that allows for intermediate goods.1. A long-lived agent . multiple produced goods. but by changes in gdp.

Chapter 6 takes up the task of articulating the Keynesian explanation of the Great Depression in a multi-commodity dynamic model with an inﬁnitely lived representative household and a search-theoretic model of the labor market. (I also refer to this as Keynesian equilibrium) and I contrast its properties with the social planning solution. investment and labor hours as the salient facts of the business cycle. a good model is one that can generate artiﬁcial data with statistical properties that replicates those of the detrended data where detrending is achieved by removing a separate low frequency component from each time series in both the original and the artiﬁcial data. (RBC) agenda. each associated with a diﬀerent historical episode. In a Keynesian equilibrium the level of economic activity is indexed by the animal spirits of investors. In the chapter I deﬁne a notion of demand constrained equilibrium. Incorporating a search-theoretic model of the labor market into an inﬁnite horizon maximizing model in a consistent way provides a new set of challenges that go beyond the economics of the General Theory that I take up in chapters 6-8.10 CHAPTER 1 WHAT THIS BOOK IS ABOUT making plans for the inﬁnite future should be concerned about his wealth. Chapters 6. Chapter 5 argues that this approach misses important business cycle facts and it suggests an alternative approach inspired by Chapter 4 of the General Theory . According to this agenda. For every such sequence there is a Keynesian equilibrium. Unlike the ineﬃciencies arising from new-Keynesian models the deviations from ﬁrst-best are ﬁrst order and can be large.the measurement of data in wage units. motivated by the Real Business Cycle. But how should these facts be presented? Most recent work on business cycles. Using data presented in the way described in Chapter 5. Since this is a representative agent economy the social welfare function can be unambiguously deﬁned. has used the ﬁrst and second moments of detrended gdp. 7 and 8 deal with simple explanations of stylized facts. all but one of which is socially ineﬃcient. consumption. . deﬁned as a bounded self-fulﬁlling sequence of stock-market prices. not just his current income.

Why is this decentralization implausible? First. from an unemployed worker. the agency would purchase the right to match that vacancy with an unemployed worker. Each agency would operate a match technology and would purchase search inputs from ﬁrms and workers. back to the worker-ﬁrm pair. Most existing search models do not assume that these inputs are traded in competitive markets. If searching workers and vacancy posting ﬁrms take the real wage as given. the resulting general equilibrium model has fewer equations than unknowns.Chapter 2 The Labor Market Each chapter of this book is based on a model of the labor market where the search inputs of workers and ﬁrms are combined to produce matches. The agency would operate a matching process and resell the joint product. 1) the time spent searching by workers and 2) the resources needed to post vacancies by ﬁrms. they assume that vacancies and unemployed workers are matched randomly. But what might this decentralization look like? The natural decentralization would posit the existence of a large number of competitive employment agencies. From a ﬁrm with a vacant job. These assumptions allow one to prove versions of the ﬁrst and second welfare theorems in a general equilibrium model with search. a worker-ﬁrm match. every competitive equilibrium is Pareto optimal and every Pareto optimal allocation can be decentralized as a competitive equilibrium. it involves transactions 11 . diﬀerentiability and constant returns-to-scale. Instead. the exclusive right to match that worker with a vacancy. A match is an employed worker in place at a ﬁrm. Search requires two inputs. The agency would purchase. In search models it is typical to assume that the match technology satisﬁes standard neoclassical properties of monotonicity.

To capture this idea one requires a dynamic model since investment involves plans that span at least two periods. that the real wage is not equated to the marginal disutility of labor. Animal spirits are a key component of autonomous investment expenditure that. Nor do we ﬁnd private employment agencies that pay ﬁrms for the privilege of acting as their recruiting agents.12 CHAPTER 2 THE LABOR MARKET that we do not observe in the real world. 2. However. If such markets existed it would be diﬃcult or impossible to prevent an unemployed worker from selling the exclusive right to be matched to multiple agencies and to turn down job oﬀers when presented on spurious but hard-to-monitor grounds. Since there may be legitimate reasons to refuse a job. but more complicated in others. a one period model that abstracts from capital in which output and employment are driven by ﬁscal policy. A moments reﬂection suggests that these markets do not exist because of the moral hazard associated with monitoring the motives of the participants. in chapter 3. Eﬃcient operation of these markets requires exclusivity of contracts. eﬀective demand is driven primarily by the ‘animal spirits’ of investors. is the prime cause of ﬂuctuations in eﬀective demand. It is simpler since I abstract from capital and assume that . This chapter is an attempt to make sense of these ideas using a theory of labor market search.1 Components of the General Theory What are the key ideas of the General Theory and how might one construct a microfounded model that embodies these ideas? First. Casual observation of state run employment agencies suggests that this problem is present in practice and is a signiﬁcant impediment to the eﬃcient operation of a matching market. autonomous expenditure is also determined by government spending and by recognizing this I will be able to explain how a search model of the labor market can be embedded into general equilibrium in a relatively simple environment. in turn. Second. In the General Theory. The one period model I will describe is simpler in some directions. There are no private institutions that pay money to unemployed workers for the right to ﬁnd them jobs. than the ﬁrst dynamic model that I introduce in chapter 4. there is the principle of eﬀective demand based on the multiplier and taught to several generations of undergraduate students in the form of the Keynesian cross. the requirement that all potential matches must be accepted is not a feasible solution to this problem. there is the assertion in Chapter 2.

I will simplify the environment by studying a model in which there is a single period. they are unnecessary simpliﬁcations if one is interested in a comparative static view of macroeconomic activity. a single commodity.2 and 2. Since all families are identical I will refer to the consumption of an individual family and to aggregate consumption with the same symbol. and a large number of identical households and ﬁrms. Initially. the family self-insures its unfortunate members. 2.1) where J represents the utility of the family’s consumption. that of Ricardian equivalence. Sections 2. I want to link the periods in a dynamic general equilibrium model where the people in my model form rational expectations of future events. Although the single agent. In this model.3 are about the microeconomic behaviors of households and ﬁrms. The questions I will study are not ones that occupied Keynes who was concerned solely with relationships between aggregates.2 Households The model consists of a unit mass of families each of which has a unit mass of members. The utility of the family is represented by an increasing concave function j J = j (C) (2. it considerably simpliﬁes the nature of aggregate dynamics. These assumptions allow me to abstract from the fact that unemployed workers are typically worse oﬀ than employed workers. My goals are more comprehensive. to show how the principle of eﬀective demand can be consistent with individual behavior at a point in time. But they are questions that I will need to address in an enquiry that seeks to provide microfoundations to Keynes’ concepts of aggregate demand and supply. It is more complicated since I introduce a government sector and discuss an issue that was important in the 1970’s but has become less actively debated in recent decades. single good ﬁction is unnecessary to explain eﬀective demand in a comparative static model. I want ﬁrst. These are not simpliﬁcations found in the General Theory and.2 HOUSEHOLDS 13 all output is produced from labor.2. as I will show in Chapter 3. . C. Keynes took the existing stocks of capital and existing nominal wages as historically determined and he showed how eﬀective demand would determine economic activity. But beyond that.

7) (2. ˜ (2.L.X} max pY − wL (2.14 CHAPTER 2 THE LABOR MARKET Each family has a measure 1 of workers all of whom begin the period unemployed. measured in dollars. w is the money wage. where q ˜ ˜ is taken as given by the household in a search market equilibrium.2) such that pC ≤ wL (1 − τ ) + T. all income is consumed.4) constrains this to be no greater than 1.10) . Equation (2. H represents the measure of household members that search for employment and Equation (2. ˜ U = H − L. p is the money price. The measure of household members that successfully ﬁnd jobs is represented by q H. Equation (2.3) is a budget constraint.Y. Finally. L = qH. There is free entry and each ﬁrm solves the problem {V.8) (2. Leisure has no utility and each household solves the problem {C.3 Firms Firms produce output using a constant-returns-to-scale technology in which labor is the sole input. U. H ≤ 1.5) (2. Each family’s consumption is constrained by its after tax employment income. to be those searching workers who do not ﬁnd jobs. L is the measure of employed workers. τ is the tax rate and T is a lump-sum transfer. L = q.5) is the relationship between employment and search. pC = wL (1 − τ ) + T.H} max j (C) (2. the household size.4) (2.6) deﬁnes the measure of unemployed.6) Equation (2. 2. (2.9) Since there is no utility to leisure all workers look for a job and since there is no motive to save. This problem has the trivial solution H = 1.3) (2.

In a model of that kind there is no need for a recruiting department and one would require the real wage. this assumption should be seen as a convenient way of representing the equilibrium of a dynamic process. Y ≤ AX.14) V = [0. w A= (2. This innovation is not important and is made for expositional simplicity and to allow me. it might be argued that the ﬁrm can never successfully hire a worker. Given the exogenous hiring elasticity. ⎪ q ⎪ ⎨ ´ ´ ³ ³ (2. 15 (2. rather than output. I have assumed that labor.12) (2. to equal the marginal product of labor. L. Solving the ﬁrm’s problem leads to the correspondence. Y is output. A ﬁrm that employs L workers may allocate them to produce commodities (this is the measure X) or to the recruiting department (this is the measure V ). If a ﬁrm begins the period with no workers. to write down models that can easily be compared with more familiar real business cycle economies. X}. and if workers are an essential input to recruiting.13) Equation (2. L = qV. ´ ´ ³ ³ ⎧ ⎪ ∞ if pA 1 − 1 − w > 0. is used to post vacancies in contrast to most search models. The ﬁrm puts forward a plan that consists of a feasible 4−tuple {V. q This expression is closely related to the condition that would arise in a model where labor is hired in a spot market.3 FIRMS such that X + V = L. later in the book. The timing of the employment decision deserves some discussion since it allows the ﬁrm to use workers to recruit themselves. Since I will be thinking of the time period of the model as a quarter or a year.15) p . ∞] if pA 1 − 1 − w = 0.11) is the production function. A > 0 is a productivity parameter and X is the measure of workers employed by the ﬁrm in direct production. Y. A ﬁrm that devotes V workers to recruiting will hire qV workers where q is taken as given by the ﬁrm. a plan to use V workers in recruiting results in qV workers employed of whom X are used to produce commodities. w/p. q.2. q ⎪ ³ ³ ´ ´ ⎪ ⎪ ⎩ 0 if pA 1 − 1 − w < 0.11) (2.

2. 1 . the ﬁrm would shut down. (2. A.4 Search I have described how individual households and ﬁrms respond to the aggregate variables w. The correspondence represented in (2.16 CHAPTER 2 THE LABOR MARKET in order for the ﬁrm to produce positive output. as q approaches 1. p. ¯ ¯ m = H 1/2 V 1/2 . the entire workforce is engaged in recruiting and there is no-one left to produce commodities. which Mortensen-Pissarides deﬁne to be the ratio of vacancies to unemployment. which represents the number of workers that can be hired by a single recruiter. the ﬁrm would be willing to expand without limit. I have used bars over variables to distinguish aggregate from individual values. The technology of the spot-market model delivers a restriction on the real wage in equilibrium in the form of Equation (2. q and q. ¯ (2.16) q p Equation (2. Since leisure does not yield ¯ disutility and hence H = 1. This section describes how aggregate matches ˜ and aggregate employment are related to the aggregate measure of vacancies. and in the limit the production function of the search model converges to that of the spot-market model.17) ¯ where m is the measure of workers that ﬁnd jobs when H unemployed workers ¯ ¯ search and V vacancies are posted by ﬁrms. ¯ q is closely related to labor market tightness.15). this equation simpliﬁes as follows.16) is consistent with a range of equilibrium real wages since the hiring eﬀectiveness parameter. If q is large. This requires a description of the match technology which takes the form. The search-market equivalent is the equation µ ¶ 1 w A 1− = .14) is similar to the spot-market case but productivity is weighted by the hiring eﬀectiveness parameter q. If q is small. Existence of a solution with non-zero output requires q > 1.18) m = V 1/2. is an endogenous variable. q. the relative size of the recruiting department shrinks.1 As this parameter gets large. If A were less than the real wage. If productivity. ¯ (2. a small recruiting department can support a large workforce and productivity and the real wage will be high in a zero proﬁt equilibrium. the reverse is true and in the limit. were greater than w/p.

2.5 THE SOCIAL PLANNER

17

A further simpliﬁcation follows from the fact that, since all workers are initially unemployed, employment and matches are the same thing and hence,2 ¯ ¯ L = V 1/2 . (2.19)

2.5

The Social Planner

In Section 2.6 I will deﬁne an equilibrium concept that captures the idea of eﬀective demand. Before taking this step, it is helpful to have a benchmark against which to measure the properties of equilibrium. Consider a benevolent social planner who maximizes the welfare of the representative family. The planner solves the problem

{C,V,L,H}

max J = j (C) C ≤ AX, L = X + V,

(2.20) (2.21) (2.22) (2.23) (2.24) (2.25)

L = H 1/2 V 1/2, H ≤ 1, H = L + U.

Since the objective function is increasing in C, the inequalities (2.21) and (2.24) will hold with equality. Using this fact and combining equations (2.22)—(2.24) leads to the expression C = AL (1 − L) , which is maximized at 1 1 A V ∗ = , L∗ = , C ∗ = . 4 2 4

2

(2.26)

(2.27)

In a dynamic model, employment will appear as a state variable in a programming problem since it takes time to recruit new workers. In this chapter, I abstract from this aspect of labor market dynamics.

18

CHAPTER 2 THE LABOR MARKET

C

C = AL (1 − L )

A 4

L*

1

L

Figure 2.1: The Social Planning Solution Figure 2.1 illustrates the nature of this solution on a graph.3 Since there is a representative family in this economy the only eﬀective decision of the social planner is how many workers to allocate to recruiting. Given the search technology, the optimum is achieved at V ∗ = 1/4. Any additional allocation of workers to recruiting would be counter-productive. Although the social planner could increase employment, the additional employed workers would not produce additional output - they would simply be recruiting additional recruiters and the resulting allocation would leave less, not more, output available for consumption. The social planning solution provides a clear candidate deﬁnition of full employment - it is the level of employment L∗ that maximizes per-capita output. In the General Theory, Keynes argued that a laissez-faire economic system would not necessarily achieve full employment and he claimed the

I have drawn this graph for the case B = 1 and in this case full employment occurs when 50% of the labor force is employed. 100% emplyment would result in zero output. Diﬀerent values of B will modify these values but the message remains the same. For example, if B = 3/4, full employment occurs at 33% unemployme

3

2.6 AGGREGATE DEMAND AND SUPPLY

19

possibility of equilibria at less than full employment as a consequence of what he called a failure of eﬀective demand. Section 2.6 makes this notion precise in a micro-founded model based on labor market search.

2.6

Aggregate Demand and Supply

Before giving a formal deﬁnition of equilibrium I will outline Keynes’ principle of eﬀective demand in the context of a one-good general equilibrium model where the spot-market model of the labor market is replaced by an appropriate deﬁnition of search market equilibrium. Keynes deﬁned the aggregate supply price of a given volume of employment to be the ‘expectation of proceeds which will just make it worth the while of the entrepreneurs to give that employment’ (Keynes, 1936, Page 24). I will return to this deﬁnition in Chapter 3 where I provide a multi-sector version of the model. In the one-sector representative agent version the following simpliﬁcations are possible. First, if one assumes rational expectations and no uncertainty then ‘expectations of proceeds’ may be replaced by ‘proceeds’. Second, proceeds are deﬁned as factor cost plus proﬁts and, in the representative agent environment, this is equivalent to the value of nominal gdp. Third, since I will be concerned with a real model, nominal and real gdp can be set equal to each other by choosing an appropriate numeraire. It is tempting to notice that, in the one good model, it is possible to choose a price normalization rule by setting p = 1. I will resist this normalization since it does not generalize to the multiple good world and instead I will choose the normalization w = 1. This implies that p is the inverse of the real wage. This fact is important in interpreting the aggregate supply and demand diagram of the General Theory. The Keynesian aggregate supply function may be represented by a diagram that measures the aggregate supply price in units of money on the vertical axis, Keynes called this Z, and ordinary units of labor on the horizontal axis, Keynes called this N. I have replaced the N of the General Theory with the symbol L to be consistent with the notation introduced earlier in the chapter. Using this notational change one can write Keynes’

. for a given value of employment.30) To complete the description of his equilibrium concept Keynes deﬁned D to be the proceeds which entrepreneurs expect to receive from the employment of L men. aggregate demand D is greater than aggregate supply Z. the relationship between D and L being written D = f (L) which can be called the Aggregate Demand Function. Z would be deﬁned by the expression Z≡ n X i=1 pi Yi . (2. (2.20 Aggregate Supply Function as. CHAPTER 2 THE LABOR MARKET Z = φ (L) . To elucidate the properties of aggregate supply Keynes asked us to consider what would happen if. to raise costs by competing with one another for the factors of production. More generally. Page 25.. (Keynes. 1936. In that case. N replaced by L and italics added).28) Bear in mind that in the General Theory. Like Z. there will be an incentive to entrepreneurs to increase employment beyond L and.. D is measured in monetary units. 1936. (2.29) where Y is the number of physical units of the produced good. (Keynes. if necessary. up to the value of L for which Z has become equal to D. Keynes’ principle of eﬀective demand amounts to the propositions that 1) employment is determined by the intersection of the aggregate demand and supply schedules and 2) equilibrium may occur at a point less than L∗ . Page 25. Z is the value of a set of heterogenous commodities and it is only in the one commodity model that it can be reduced to the expression Z ≡ pY. the full employment level that I have deﬁned as the solution to the social planning problem. ‘L’ is substituted for ‘N’ from the original).

13) and (2.34) which. (2.36) One can also combine Equations (2.35) and (2. (2. w = A (1 − L) .31) It follows. implies p= 1 .2. L = qV. q= 1 .11).12).33) to yield the expression. The following algebra establishes that for values of D in a given interval. L (2.16). Equation (2. in a symmetric equilibrium. that the following expressions characterize the relationships between q. A (1 − L) (2. Consider the implications of assuming that the economy is in a symmetric equilibrium in which ﬁrms take the hiring eﬀectiveness parameter q as given. ¯ ¯ Symmetry implies that the variables V and V . it follows that there exists a zero proﬁt equilibrium for any value of L ∈ [0. p (2.35) The aggregate supply function φ is found by combining (2.6 AGGREGATE DEMAND AND SUPPLY 21 In the one-good representative agent model the principle of eﬀective demand implies that competition between proﬁt maximizing ﬁrms will cause the real wage to adjust to the point where proﬁt is equal to zero. (2. (2. 1] with a real wage given by the expression. L and L are equal and the assumption that ﬁrms take q parametrically implies. there will exist a real wage that has this property.33) Combining the ﬁrst of these expressions with the zero proﬁt condition.32) (2. given the normalization w = 1. V = L2 . From the properties of the aggregate technology ¯ ¯ L = V 1/2 .37) .36) to yield the following expression for the physical quantity of output produced in this economy Y = AL (1 − L) ≡ ψ (L) . (2.V and L. Z = pY = L.

22 CHAPTER 2 THE LABOR MARKET Z A 4 Y= φ (L ) p (L ) ≡ ψ (L ) φ (L ) = L 45º L* 1 L Figure 2.2: The Aggregate Supply Fucntion The aggregate supply function.2 as the solid line and the dashed curve. Although it is tempting to refer to ψ (L) as the aggregate supply function this would be a mistake since. Moving along the aggregate supply function from zero to L∗ . as Keynes made clear in the General Theory. Moving beyond L∗ . this measure cannot easily be generalized beyond the one-good case. aggregate supply as deﬁned by Keynes continues to increase as the price level rises but the physical quantity of the produced good falls. output is increasing. But in models with multiple equilibria there is no reason to impose a government budget . 2. φ (L) and the output function Y = ψ (L) are graphed on Figure 2. Models that incorporate a constraint of this kind were dubbed Ricardian by Robert Barro (1974).7 Eﬀective Demand and the Multiplier In modern DSGE models the government is assumed to choose expenditure and taxes subject to a constraint.

41) into (2. the . Recall. the Keynesian equilibrium. set equal to 1. Y . (2. one can close the model in the way advocated by Leeper. Z K is given by T ZK = . is less than L∗ . Aggregate demand is related to employment by the expression D = (1 − τ ) wL + T. from Equation (2. Substituting (2. and the aggregate demand function.2.36) that aggregate supply is given by the expression. are depicted in Figure 2.7 EFFECTIVE DEMAND AND THE MULTIPLIER 23 constraint and Eric Leeper (1991). (2.43) τ where the superscript K is for Keynesian.3 together with the physical quantity of output. (2. He calls a policy in which the government choose both taxes and expenditure. Equation (2. discussing models of monetary and ﬁscal policy. it follows that aggregate demand is equal to D = (1 − τ ) L + T.3) is one where there is positive unemployment since at LK .42) (2.40). Z = L. To derive the aggregate demand function for the one-good representative agent economy one need only recognize that materials balance requires D = pC.’ The modiﬁed-search model of the labor market is one with multiple equilibria and hence.39) where recall that τ is the tax rate and T represents lump-sum transfers measured in dollars. Equation (2. Since we have chosen w as the numeraire. the equilibrium value of income.40) it follows that D = (1 − τ ) Z + T. has argued that one should allow government to choose both taxes and expenditure and that this choice selects an equilibrium. The aggregate supply function.36). (2.41) and that in equilibrium when D = Z. an ‘active ﬁscal regime. The equilibrium depicted in Figure(2.40) where all terms of this equation are in monetary units.38) This is the GDP accounting identity in a model with no government expenditure and no investment. (2.

less output than at L∗ . Instead I will use the term to refer to a . that has was used by Jean Pascal Benassy (1975). T .3: Aggregate Demand and Supply social planning optimum. and over employment since the Keynesian equilibrium would be associated with too many workers employed.24 CHAPTER 2 THE LABOR MARKET D. If government were to increase transfers. it would be possible to increase the Keynesian equilibrium to a point to the right of L∗ . that is not what I mean here. Jacques Dreze (1975) and Edmond Malinvaud (1977) in a literature on ﬁx-price economics that was developed in the 1970’s. Z A 4 1 Y = ψ (L ) Aggregate Supply Z =L T 45º D = (1 − τ ) L + T Aggregate Demand LK L* 1 L Figure 2. demand constrained equilibrium. 2. A policy of this kind would result in a higher price level (a lower real wage).8 A Deﬁnition of Equilibrium This section provides a formal deﬁnition of equilibrium based on the ideas sketched out above. I will appropriate a term. Although ﬁxed-price models with rationing of the kind studied by these authors are sometimes called demand constrained equilibria.

V 3) Search market equilibrium: (2.1 (Demand Constrained Equilibrium) For any given τ and T a symmetric demand constrained equilibrium (DCE) is a real wage w/p. ∞] if A 1 − 1 − w = 0. the modiﬁed-search model of the labor market provides a micro-foundation to the Keynesian cross that characterized textbook descriptions of Keynesian economics in the 1960’s. p T ≤ (1 − τ ) AX. aggregate expenditure is determined as a multiple of transfer payments where the multiplier is the inverse of the tax rate.51) (2. 1) Feasibility: Y ≤ AX. . (2. w 2) Consistency with optimal choices by ﬁrms and households: ³ ³ ´ ´ ⎧ ⎪ ∞ if A 1 − 1 − w > 0. ⎪ q ⎪ ⎨ ³ ³ ´ p´ V = [0.49) (2.50) (2.46) (2.44) L≤V C ≤ Y.8 A DEFINITION OF EQUILIBRIUM 25 competitive search model that is closed with a materials balance condition. q ⎪ ´ p´ ³ ³ ⎪ ⎪ ⎩ 0 if A 1 − 1 − w < 0.45) (2. equal to output. is demand determined and is equal to a multiple of exogenous expenditure. Income. with the following ˜ properties.52) To summarize. Deﬁnition 2. C. w w q=L ˜ L q= . Since I have abstracted from saving and investment. The common heritage of both usages of demand constrained equilibrium is the idea of eﬀective demand from Keynes’ General Theory.2.48) 1/2 . X + V = L. L. an allocation {Y. V.47) (2. (2. q p p T C = L (1 − τ ) + . X} and a pair of numbers q and q.

Sims (1994) and Woodford (1995) in which it has been argued that. In the context of this literature Leeper (1991) characterizes monetary and ﬁscal regimes as active and passive. But the model I have formulated is not a simple restatement of the new-Keynesian models studied by Cochrane.26 CHAPTER 2 THE LABOR MARKET 2. An active ﬁscal regime is characterized by the fact that the government budget equation holds as an equilibrium condition for only one price system as opposed to a passive ﬁscal policy in which it holds for all feasible price systems. Old Keynesian economics diﬀers from these models because in an old Keynesian model there is a multiplicity of steady states. that the ﬁscal theory is a selection device in a model in which there would otherwise be multiple equilibria. the price level can. Kocherlakota and Phelan (1999) have argued. be determined by ﬁscal policy. In simple representative agent economies. It is precisely the possibility that ﬁscal policy may be active that determines the equilibrium values of output and employment in the model that I have constructed in this chapter. In an incisive survey of this literature. I think correctly. contrary to the monetarist view. An active regime is one where the response to inﬂation is more aggressive and a one per cent increase in inﬂation is met with a greater than one percent increase in the interest rate. the papers by Cochrane (1999). A passive monetary regime is one in which the nominal interest rate is set by the Fed to respond weakly to a nominal anchor. If the Fed perceives an increase in inﬂation it raises the interest rate less than one-for-one. These results lead naturally to the question: What determines the price level if the monetary regime is passive? The ﬁscal theory of the price level answers this question by arguing that the government is a large agent that does not act as a price taker. A policy of this kind is called non-Ricardian or ‘active’.9 Remarks on Ricardian Fiscal Policies A large literature has developed recently on Ricardian and non-Ricardian ﬁscal policies. . under some circumstances. in the ﬁscal theory the government chooses a plan that would violate its budget constraint for all but a single price system. Sims and Woodford. Whereas a typical agent in a general equilibrium model chooses an allocation taking prices as given. an active policy can be shown to lead to a unique equilibrium whereas a passive policy is associated with the existence of multiple equilibria that take the form of many paths leading back to a unique steady state. (see for example.

The resulting model lacks one equilibrium condition which makes it a perfect partner for the Keynesian theory of demand determination.10 Concluding Comments The model I have described has many features in common with the ‘Keynesian cross’ that was taught to several generations of undergraduates.2. agents do not trade the inputs to the search technology in competitive markets. It for precisely this reason that Keynes called his book the General Theory. Although this route was intellectually coherent.4 A major criticism of Keynesian theory is that. unemployed workers and vacancies and a single price. The combination of a complete set of Walrasian markets and a demand-determined level of economic activity is inconsistent: it results in a system with one more equation than unknown. That model was criticized by Patinkin (1989) amongst others since it lacked a coherent theory of the labor market. it castrated the main message of the General Theory: that the level of economic activity is demand determined in equilibrium. The search-based model of the labor market described in this chapter provides a microfoundation to Keynesian economics that is not Walrasian since by assumption. it gives unemployed workers an incentive to oﬀer to work for a lower wage. when augmented by a classical model of the labor market. The resulting synthesis leads to a coherent theory of output and relative prices that does not suﬀer from the classical criticism that unemployed workers have an incentive to oﬀer to work for a lower wage. He viewed the Walrasian equilibrium as on of many possible rest points of the system.10 CONCLUDING COMMENTS 27 2. 4 . The search technology has two inputs. the real wage. Patinkin put together Keynesian economics with general equilibrium theory by including the real value of money balances in utility and production functions.

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The theory of index numbers as we understand it today was not available at the time and Keynes’ use of these units to describe relationships between the components of aggregate economic activity was clever and new. Page 41] The other unit that Keynes uses in the general theory is that of monetary 29 . Here Keynes is clear that he will use only two units of measurement. Aggregate demand and supply are typically explained in the context of a one commodity model in which real gdp is unambiguously measured in units of commodities per unit of time. Chapter 4 of the General Theory is devoted to the choice of units. a monetary unit (I will call this a dollar) and a unit of ordinary labor.. i.the quantity of employment can be suﬃciently deﬁned for our purpose by taking an hour’s employment of ordinary labour as our unit and weighting an hour’s employment of special labor in proportion to its remuneration. [General Theory.. Keynes chose ‘an hour’s unit of ordinary labor’ to represent the level of economic activity because it is a relatively homogeneous unit. To get around the fact that diﬀerent workers have diﬀerent skills he proposed to measure labor of diﬀerent eﬃciencies by relative wages. Thus .Chapter 3 Aggregate Demand and Supply The concepts of aggregate demand and supply are widely used by contemporary economists. an hour of special labour remunerated at double ordinary rates will count as two units. My purpose in this chapter is to explain the meaning that Keynes gave to them.. In the General Theory there is no assumption that the world can be described by a single commodity model.e..

I will assume that utility takes the form j (C) = n X i=1 gi log (Ci ) . A household that allocates H members to search will receive a measure qH of jobs where the employment rate q is taken ˜ ˜ parametrically by households.1 and 3. they will have the interpretation of diﬀerent types of capital goods. The factors may be thought of as diﬀerent types of land although in later chapters.2 extend the model of Chapter 2 by adding multiple goods. Each household has a measure 1 of members.6) . when I introduce investment. I will maintain the convention throughout the book that boldface letters are vectors and x·y is a vector product. (3. L = qH. ˜ U = H − L. p is a vector of n money prices. This is not the same as the relationship between a price index and a quantity index that is used to explain aggregate demand and supply in most modern textbooks. Since I am going to concentrate on the theory of aggregate supply. C is a vector of n commodities. T is the lump-sum household transfer (measured in dollars) and τ the income-tax rate. 3.3) (3. His aggregate demand and supply curves are relationships between the value of aggregate gdp measured in dollars and the volume of aggregate employment measured in units of ordinary labor.1 Households Sections 3. (3.H} max J = j (C) .5) ¡ ¢ ¯ p · C ≤ (1 − τ ) Lw + r · K + T.1) (3. I will begin by describing the problem of the households.4) (3. H ≤ 1. I use the symbol rj to 0 refer to the j th rental rate. The household decides on the measure H of members that will search for jobs. I will continue to assume the existence of identical households. each of which solves the problem {C.2) (3. w is the money wage.30 CHAPTER 3 AGGREGATE DEMAND AND SUPPLY value. and on the amounts of its income to allocate to each of the n commodities. r is a vector of money ¯ rental rates and K is a vector of m factor endowments.

and technologies to be CES.9) where gi is the budget share allocated to the i0 th good.7) Later.11) Since all income is derived from the production of commodities it follows from the aggregate budget constraints of households.3. For more general homothetic preferences these shares would be functions of the price vector p. Although the analysis could be generalized to allow utility to be homothetic.12) The equivalence of income and the value of output is a restatement of the familiar Keynesian accounting identity.9) represents disposable income and is deﬁned by the equation Z D = (1 − τ ) Z + T. The term Z D in Equation (3. (3. My intent is to ﬁnd a compromise model that allows for multiple commodities but is still tractable and for this purpose. (3. I will also assume that each good is produced by a Cobb-Douglas production function and I will refer to the resulting model as a logarithmicCobb-Douglas.8) (3. this extension would considerably complicate the algebra. (3. pi Ci = gi Z D . (3. Household income. ﬁrms and government that Z is also equal to the value of the produced commodities in the economy. immortalized in the textbook concept of the ‘circular ﬂow of income’. or LCD. (3.10) and is measured in dollars.1 HOUSEHOLDS where the utility weights sum to 1. Z≡ n X i=1 pi Yi . n X i=1 31 gi = 1. the log utility model is familiar and suitable. economy. The solution to the problem has the form H = 1. . Z is deﬁned as ¯ Z ≡ Lw + r · K.

Li } a (3. The function Ψi is assumed to be Cobb-Douglas. Xi ) . The j 0 th element of Ki . .16) j=1 Since the assumption of constant returns-to-scale implies that the number of ﬁrms in each industry is indeterminate I will refer interchangeably to Yi as the output of a ﬁrm or of an industry. Ki. Each ﬁrm recruits workers in a search market by allocating a measure Vi of workers to recruiting. (3.1 Ki.13) where Ki is a vector of m capital goods used in the i0 th industry and Xi is labor used in production in industry i. Xi ) ≡ Ai Ki. is (3. and is produced by a constant returns-to-scale production function Yi = Ψi (Ki . i.j + bi = 1. Ki.m Xibi . . (3. Each ﬁrm takes parametrically the measure of workers that can be hired.m Xibi .1 i. . m X ai.14) a a a (3.m ) .1 i.j . Ki. Ki ≡ (Ki. Li = qVi .17) Li = Xi + Vi .2 .Vi . The ﬁrm solves the problem {Ki .2 i.2 . . . denoted Ki.j and bi sum to 1.m Ψi (Ki . Ki. Output of the i0 th commodity is denoted Yi .2 . The total measure of workers Li .Xi .2 Firms There are n ≥ m commodities.18) max pi Yi − wLi − r · Ki a a (3.15) where the constant returns-to-scale assumption implies that the weights ai. employed in industry i. (3.1 .32 CHAPTER 3 AGGREGATE DEMAND AND SUPPLY 3. denoted q. . is the measure of the j 0 th capital good used as an input to the i0 th industry and Ki is deﬁned as. .m Yi ≤ Ai Ki.2 i.19) (3.20) i.1 Ki. and employment at ﬁrm i is related to Vi by the equation. .

of employment at the ﬁrm.Li } (3.r . Q. where Q is deﬁned as µ ¶ 1 Q= 1− . q max pi Yi − wLi − r · Ki .25) (3.3.28) bi pi Yi = wLi . . q and q. w. a a a (3.1 Ki. as a multiple. 3.j as functions of w. m.2 . j = 1.21) and (3.2 i.1 i.22) we can write labor used in production.22) Using equations (3. 33 (3.27) (3. µ ¶ w .Xi .23) (3. and pi and substituting these expressions into the production function leads to an expression for pi in terms of factor prices. Xi . i The solution to this problem is characterized by the ﬁrst-order conditions ai.Vi . r.j rj .3 SEARCH Li = Xi + Vi . . Using these ﬁrst-order conditions to write Li and Ki. p.29) pi = pi Q The function pi : Rm+1 → R+ is known as the factor price frontier and is homogenous of degree 1 in the vector of m money rental rates r and in the productivity adjusted money wage.24) We may then write the problem in reduced form.m .26) i. r. {Ki . Li = qVi . . Ki.21) (3. Li Xi = Li Q. . (3. .m Yi ≤ Ai Lbi Qbi Ki.j pi Yi = Ki. (3. .3 Search I have described how individual households and ﬁrms respond to the aggregate variables w. This section describes the process by which ˜ .

30) ¯ where m is the measure of workers that ﬁnd jobs when H unemployed work¯ ¯ workers are allocated to recruiting in aggregate by all ﬁrms. Since leisure does not yield disutility and hence H = 1. n.j ≤ Kj .1 i. . . (3. . ¯ (3. ers search and V I have used bars over variables to distinguish aggregate from individual val¯ ues. . ¯ ¯ L = V 1/2 .2 i.36) b i. that is. Ki.m Ci ≤ Ai Ki. .32) Jobs are allocated to the i0 th ﬁrm in proportion to the fraction of aggregate recruiters attached to ﬁrm i.4 The Social Planner n X i=1 In the multi-good economy.L. V where Vi is the number of recruiters at ﬁrm i. (3. ¯ (3.V. . ¯ m = V 1/2.38) H ≤ 1.34 CHAPTER 3 AGGREGATE DEMAND AND SUPPLY searching workers are allocated to jobs.31) Further. . ¯ Vi Li ≡ V 1/2 ¯ . this equation simpliﬁes as follows. since all workers are initially unemployed.35) (3. . ¯ ¯ m = H 1/2 V 1/2 . I assume that there is an aggregate match technology of the form.m (Li − Vi ) i . the planner solves the problem max j (C) = a a {C.37) (3.33) 3. (3. m Li = µ H V ¶1/2 Vi .2 .H } a gi log (Ci ) (3.34) (3.1 Ki. employment and matches are equal. . n X i=1 ¯ Ki. i = 1. j = 1.

40) to eliminate Vi from the production function we can rewrite (3. this is the term (1 − L).41) Equation (3. . m. denoted H ∗ . Ki. i a a a (3. (3. i = 1.35) in terms of Ki and Li . . employment at ﬁrm i.34) and exploit the logarithmic structure to write utility as a weighted sum of the logs of capital and labor used in each industry. this is because of congestion eﬀects in the matching process.41) makes clear that the match technology leads to a production externality across ﬁrms. . The externality is internalized by the social planner but may cause diﬃculties that private markets cannot eﬀectively overcome.1 i. . I will show below that this externality is the source of Keynesian unemployment. (3.m Lbi (1 − L)bi .42) = i=1 Li (1 − L) gi ai.39) Combining this expression with Equation (3. . n. . . . and aggregate employment.1 Ki.j = Kj . j = 1. . To ﬁnd a solution to the social planning solution.37) and (3.43) (3. .40) Equation (3. i = 1. . j = 1. Ki. i. Vi = Li L.38) can be rearranged to give the following expression for aggregate employment as a function of aggregate labor devoted to recruiting. we may substitute Equation (3. .2 . .44) . i=1 (3. Using Equation (3. and of the externality terms that depend on the log of (1 − L). . . in ﬁrm i0 s production function. Equations (3.j = λj .40) implies that it takes more eﬀort on the part of the recruiting department of ﬁrm i to hire a new worker when aggregate employment is high. . .4 THE SOCIAL PLANNER 35 Since the optimal value of H. The ﬁrst-order conditions for the problem can then be written as Pn gi bi gi bi .37) leads to the following relationship between labor used in recruiting at ﬁrm i. (3.m Ci = Ai Ki.j n X ¯ Ki. When all other ﬁrms have high levels of employment it becomes harder for the individual ﬁrm to recruit workers and this shows up as an external productivity eﬀect. will equal 1.2 i. L≡ n X i=1 Li = V 1/2 .41) into the objective function (3. m. n. .3.

the social planner sets employment at 1/2 and allocates factors across industries using weights that depend on a combination of factor shares and preference weights.45) The ﬁrst-order conditions can also be used to derive the following expression for the labor L∗ used in industry i. L∗ = Pn i gi bi i=1 (3. (3. This intuition is incorrect: A more appropriate analogy would be to compare the aggregate supply function to the ﬁrst order condition for labor in a one good model. it follows from some i=1 simple algebra. is produced from labor L and capital K using the function ¡ ¢ ¯ Y = A L K α L1−α . that the social planner will make the same allocation of labor in the LCD economy as in the simple one-good model studied in Chapter 2.48) The fact that L∗ is equal to 1/2 follows from the assumption that the elasticity of the matching function is 0.j ∗ ¯ Ki. (3. When I began this project I thought of aggregate supply as a relationship between employment and output. L∗ = 1/2.5 Aggregate Supply and Demand This section derives the properties of the Keynesian aggregate supply curve for the LCD economy.43) and (3.44) to yield the optimal allocation of capital good j to industry i.47) i=1 gi ai.5.42) and the fact that L = n Li . the social planner solves Equations (3. I will maintain this assumption in the current chapter but I will need to relax it later in the book when I calibrate a model of this kind to match U. (3. i gi bi L∗ .S.1 3. Intuition that was carried over from my own undergraduate training led me to think of this function as analogous to a movement along a production function in a onegood economy. data.46) To derive the capital allocation across ﬁrms for capital good j. Consider a one-good economy in which output. 1 . gi ai.j = Pn Kj. Y. Using Equation (3.36 CHAPTER 3 AGGREGATE DEMAND AND SUPPLY the The variable λj is a Lagrange multiplier on P j 0 th resource constraint.j For the LCD economy.

49) ¯ where L is replaced by L. the price chosen by Keynes . (3. Page 25. the proceeds which entrepreneurs expect to receive from the employment of L men. I will restate some passages that I cited in Chapter 2 relating to Keynes’ deﬁnitions of aggregate supply and demand. 1936.5 AGGREGATE SUPPLY AND DEMAND 37 where A may be a function of aggregate employment because of the search externalities discussed above. the relationship between D and L being written D = f (L) which can be called the Aggregate Demand Function. (Keynes. In a general equilibrium environment Walras law implies that one price can be chosen as numeraire. Keynes deﬁned the aggregate supply price Z to be the ‘expectation of proceeds which will just make it worth the while of the entrepreneurs to give that employment’ (Keynes. to raise costs by competing with one another for the factors of production.3. At the risk of boring the reader through repetition. Keynes then asked us to consider what would happen if. The points that I want to make are worth repeating because the original intent of the General Theory has been obfuscated by decades of misinterpretation.. if necessary. 1936. the Keynesian aggregate supply function. Page 25. up to the value of L for which Z has become equal to D. It is not possible to understand this deﬁnition without allowing relative prices to change since the notion of competing for factors requires an adjustment of factor prices. 1936. ‘L’ is substituted for ‘N’ from the original).. aggregate demand D is greater than aggregate supply Z. In that case. By aggregate demand he meant. for a given value of employment. N replaced by L and italics added). (Keynes. It would be a mistake to call the function. there will be an incentive to entrepreneurs to increase employment beyond L and. Page 24). A (L) K α L1−α .

The ﬁrst order condition for the use of labor at ﬁrm i has the form Li = bi Yi pi . By ﬁxing the money wage Keynes was not assuming disequilibrium in factor markets.38 CHAPTER 3 AGGREGATE DEMAND AND SUPPLY was the money wage. To determine relative prices we must turn to preferences and here the assumption of logarithmic utility allows a simpliﬁcation since the representative agent allocates ﬁxed budget shares to each commodity Yi pi = gi Z D .50) can be rearranged to yield the expression. A movement along the aggregate supply curve is associated with an increase in the price level that reduces the real wage and brings it into equality with a falling marginal product of labor.51) which is the Keynesian aggregate supply function. the equation that triggers competition for workers is the ﬁrst-order condition w (1 − α) Y = . Using this deﬁnition.52) i=1 For the LCD economy the aggregate supply function has a particularly simple form since the logarithmic and Cobb-Douglas functional forms allow individual demands and supplies to be aggregated. Z ≡ pY = wL . Given a value of w. Z. the Keynesian aggregate supply curve takes on a diﬀerent interpretation from that which is given in introductory textbooks. Once this is recognized. In an economy with many goods the aggregate supply price. w (3. competition for factors requires adjustment of the money price p and the rental rate r to equate aggregate demand and supply.53) To aggregate labor across industries we need to know how relative prices adjust as the economy expands. (3. Equation (3. In the one-good economy. he was choosing a numeraire. is price times quantity. (3. is deﬁned by the expression n X Z≡ pi Yi .50) Aggregate demand Z. (1 − α) (3.54) . L p (3.

59) (3.53) with (3.5 AGGREGATE SUPPLY AND DEMAND 39 where Z D is disposable income.57) Since the government budget must also balance T = τ Z. on factor supplies.56) gi bi .60) is the Keynesian aggregate supply curve for the multi-good logarithmic-Cobb-Douglas economy. (3. (3. Can this expression be generalized beyond the LCD case? The answer is yes.56) can be written as. . in general. .55) Li = w Summing Equation (3. and Eq. Km .60) (3. The following paragraph demonstrates that. these stocks serve only to inﬂuence rental rates. (3. it is the ﬁrst-order condition for labor. the aggregate supply curve in a one-good economy is not a production function. Z D = Z (1 − τ ) + T = Z.3.55) over all i industries and choosing w = 1 as the numeraire leads to the expression ZD = where χ≡ 1 L ≡ φ (L) . it follows that income and disposable income must be equal. but the resulting expression for aggregate supply depends. Z= 1 L ≡ φ (L) . given our special assumptions about preferences and technologies. bi gi Z D . Combining Equation (3. In the LCD economy it is an aggregate of the ﬁrst order conditions across industries with a coeﬃcient that is a weighted sum of preference and technology parameters for the diﬀerent industries. . χ (3. . that is. χ n X i=1 (3. that is.58) Equation (3.54) yields the expression. To reiterate. Z will be a function not only of L but also of ¯ ¯ K1 .

j Yi pi rj (3. rj (3. ψj Z rj = ¯ . and the aggregate supply price Z. Equation (3.63) determines the nominal rental rate for factor j as a function ¯ of the aggregate supply price Z and the factor supply Kj . n X D= pi Ci .63) ai.j Yi pi .j = Pn i=1 ai.j gi . determined? As in the one-good model aggregate demand follows from the gdp accounting identity.54).65) i=1 In an economy with government purchases and investment expenditure this equation would have two extra terms as in the textbook Keynesian accounting identity that generation of students have written as Y = C + I + G.62) Exploiting the allocation of budget shares by consumers. L. one can derive the following expression.6 Keynesian Equilibrium What determines relative outputs in the Keynesian model and how are aggregate employment.66) . (3.j = ai. Kj where ψj ≡ n X i=1 (3. 3.64) Equation (3.61) Combining the ﬁrst order conditions for factor j and summing over all i industries leads to the expression ¯ Kj = n X i=1 Ki. (3. (3.40 CHAPTER 3 AGGREGATE DEMAND AND SUPPLY The ﬁrst order condition for the j 0 th factor used in ﬁrm i can be written as Ki.

when D = Z. Z K is given The Aggregate Supply Function The Aggregate Demand Z = 1 L Function χ Z. the aggregate demand function for the LCD economy is given by the equation.69) .6 KEYNESIAN EQUILIBRIUM 41 P In our notation C is replaced by n pi Ci .68) In a Keynesian equilibrium.67) and since D = i=1 pi Ci and χZ = L. that is. the value of income. χ Pn i=1 (3.1: Aggregate Demand and Supply by the equality of aggregate demand and supply. from Equation (3.3. Y is replaced by D.56). and G and I i=1 are absent from the model. D D = (1 − τ ) ZK L χ +T T 1 χ LK 1 L Figure 3. ZK = T . D = (1 − τ ) L + T. (3. τ (3. The Keynesian consumption function is simply the budget equation n X pi Ci = (1 − τ ) Z + T.

1]. To make the argument for ﬁscal intervention one need only compare aggregate employment in the social planning solution with aggregate employment in a Keynesian equilibrium.1. LK = χZ K . for a given volume of employment. The formalization of Keynesian economics based on search contains the additional implication that there also may be overemployment since LK may . The social planner would choose 1 L∗ = . 2 The Keynesian equilibrium at LK = χT . But he was not a proponent of socialist planning. is the same allocation that would be achieved by a social planner. the model displays an ineﬃcient level of employment and in this sense there is an argument for a well designed ﬁscal policy. The Keynesian aggregate demand and supply functions for the LCD economy are graphed in Figure 3.7 Keynes and the Social Planner How well do markets work and do we require government micro-management of individual industries to correct ineﬃcient allocations of resources that are inherent in capitalist economies? Keynes gave a two part answer to this question. He argued that the level of aggregate economic activity may be too low as a consequence of the failure of eﬀective demand and here he was a strong proponent of government intervention. 3.71) (3. If eﬀective demand is too low. In this section I will show that the model outlined in this chapter provides a formalization of Keynes’ arguments.42 CHAPTER 3 AGGREGATE DEMAND AND SUPPLY and equilibrium employment is given by the expression. But the allocation of factors across industries. For any value of LK < L∗ we may say that the economy is experiencing Keynesian unemployment and in this case there is a possible Pareto improvement that would make everyone better oﬀ by increasing the number of people employed.70) may result in any level of employment in the interval [0. τ (3.

as employment tends to 1. Ki. Contrast these equations with their counterparts for the competitive equilibrium.j = Pn Kj. there is too much production on average and by lowering L back towards L∗ the social planner will be able to increase the quantity of consumption goods available in every industry.75) . L∗ . gi ai.j i=1 (3.j = n X i=1 gi ai.73) implies that these resources will be allocated across industries in proportion to weights that depend on the preference parameters gi and the production elasticities ai.73) ai. and the resource constraints (3. Equations (3. that determine factor allocations in the social planning solution.. In the limit. m. Equation (3.3. rj (3. In an overemployment equilibrium the additional workers spend more time recruiting their fellows than in productive activity.. rj Pn i=1 (3. 1/χ. Every employed worker is so busy recruiting additional workers that he has no time to produce commodities.72) ¯ Given the resources Kj for j = 1.j ∗ ¯ Ki. be increased by employing fewer workers across the board. The factor demand equations (3.46) and (3. Here the capitalist system fares much better.j = ai. .61). What about the allocation of factors across industries.62) are reproduced below. nominal gdp tends to its upper bound. in this case. Overemployment is also Pareto ineﬃcient and welfare would.j Yi pi . will be allocated across industries in a similar manner. are reproduced below gi bi L∗ = Pn L∗ . Although a value of LK greater than L∗ is associated with a higher value of nominal gdp (Z K > Z ∗ ). for very high values of employment the physical quantity of output produced in each industry is very low and in the limit at L = 1.74) Kj = Ki..47).72) implies that the volume of resources employed.j . i gi bi i=1 (3.j Yi pi . Equation (3. Yi is equal to zero in each industry and pi is inﬁnite.7 KEYNES AND THE SOCIAL PLANNER 43 be greater than L∗ . But although gdp measured in wage units always increases as employment increases.

77) This expression is identical to the social planning solution. The most egregious misrepresentation is the notion of aggregate demand and supply that we teach to undergraduates and that bears little or no relationship to what Keynes meant by these terms.61) and (3.75) leads to the following equation that determines the allocation of factor j to industry i in a Keynesian equilibrium. What about the allocation of labor across industries? The ﬁrst order conditions for ﬁrms imply bi pi Yi = wLi . Equation (3.79) that determines the allocation of labor across industries is identical to the social planning solution with one exception.j i=1 (3. gi bi Li = Pn LK . The representative textbook author has adopted the Humpty Dumpty approach .76) pi Yi = gi Z. It is in this sense that Keynes provided a General theory of employment. the eﬃcient level of aggregate employment L∗ is replaced by the Keynesian equilibrium level LK . Equation (3. (3.j = Pn Kj . gi ai. (3.73). Combining this expression with Equations (3.79) gi bi i=1 Pn where I have used the fact that χ ≡ i=1 gi bi . gi ai. and in general it is not one that he thought would be found by unassisted competitive markets.44 CHAPTER 3 AGGREGATE DEMAND AND SUPPLY Consumers with logarithmic preferences will set budget shares to utility weights (3.76) and using the fact that χZ K = LK gives.78) Combining this expression with Equation (3.8 Concluding Comments It is diﬃcult to read the General Theory without experiencing a disconnect between what is in the book and what one has learned about Keynesian economics as a student. as envisaged by Keynes. 3.j ¯ Ki. the classical value L∗ is just one possible rest point of the capitalist system.

The textbook aggregate demand curve plots a price against a quantity.neither more nor less. . textbook Keynesians have tried to ﬁt the round peg of the General Theory into the square hole of Walrasian general equilibrium theory.3..”2 The textbook aggregate demand curve slopes down. 2 The quote is from Alices’ Adventures in Wonderland. by Lewis Carroll. it means just what I choose it to mean . so does the Keynesian aggregate demand curve. but the “aggregate demand price” and the “aggregate supply price” of the general theory are very diﬀerent animals from the price indices of modern theory.when I use a word.8 CONCLUDING COMMENTS 45 that. at least in name.. “. The fact that the ﬁt is less than perfect has caused several generations of students to abandon the ideas of the General Theory and to follow the theoretically more coherent approach of real business cycle theory. the Keynesian aggregate demand curve slopes up. The time has come to reconsider this decision. Beginning with Patinkin (1989).

.

In earlier chapters I showed that there may be many equilibria. not its cause. In addition it 47 .Chapter 4 Saving and Investment The models I have discussed so far are missing a central component of the General Theory. In the General Theory. Section 4. save for the future and invest in capital to produce commodities in the second period. the young in the ﬁrst period. One of these generations. To explain this idea.1 The Model Structure The chapter builds a model economy that has all the same features as the one commodity environment that I introduced in Chapter 2.10 introduces ﬁscal policy into the two period model and shows how government may design a tax-transfer system to restore full-employment. indexed by the stance of ﬁscal policy. In Walrasian general equilibrium models saving and investment are brought into equality by changes in intertemporal prices. Chapter 4 introduces this idea by developing a model with saving and investment. That is not an entirely satisfactory account of Keynes’ message since Keynes saw ﬁscal policy as the remedy to mass unemployment. In the Keynesian model they are equated by changes in employment. 4. Keynes argued that the distinction between these concepts was central to his theory of eﬀective demand. Explaining the diﬀerence between these two mechanisms is the main purpose of this chapter. I will explain this distinction with a two-period model populated by three generations of households. the idea that investment is the driving force of business cycles.

labeled 1 and 2 and three generations labeled 0. At the end of period 1. I refer to them as generations 0 and 1. In later chapters I will adapt the same structure by adding more periods and more generations each of which behaves like generation 1. Generation 1 is young and owns an endowment of time. This latter model is the natural general equilibrium environment in which to discuss Keynesian economics since the representative agent environment places strong restrictions on the equilibrium interest rate that limit the possibility to discuss meaningful ﬁscal policies. generation 0 dies. In period 2 there are two generations alive. Whereas eﬀective demand in Chapter 2 was a function of ﬁscal policy. in this chapter it will also depend on the beliefs of investors. I will begin by describing the choices made by the old and the young in the ﬁrst period. I will then move on to the second period of the model and introduce the choices of a third generation that I refer to as generation 2. Generation 0 is old and owns the capital stock. The second is the overlapping generations model of Allais (1947) and Samuelson (1958). This richer structure allows me to discuss the idea that unemployment is produced by a lack of investment spending. At the beginning of period 2 generation 2 is born and is endowed with a production technology. the economic choices made by agents of each generation. The decisions of generations 0 and 2 are limited and most of the action in this model takes place with the choices made by generation 1. . thus xs is the date t value of the variable x associated with the generation born t in period s. Throughout the chapter a superscript will index the period in which a generation was born and a subscript will index calendar time. in turn.48 CHAPTER 4 SAVING AND INVESTMENT has an extra period and a produced factor of production. The ﬁrst assumes the existence of a representative family that makes decisions for the inﬁnite future. I will assume that there are two periods. and 2.2 Households This section describes. capital. Two competing dynamic general equilibrium models are widely used in macroeconomics. 1. 4.

This commodity has money price p1 in period 1. .4) where the preference weights g1 and g2 sum to 1.4.2) There is unique commodity in each period that may be consumed or accumulated to be used as capital in production in the subsequent period.3) which directs the household to consume all of its wealth. C2 = g1 log C1 + g2 log C2 .H1 } max ¡ 1 1¢ ¡ 1¢ ¡ 1¢ j 1 C1 . Generation 0.K2 .2 The Initial Young As in previous chapters I assume a unit measure of households with preferences over current consumption of household members. (4. 1 (4.2.C2 . K1 is an initial stock of capital owned by generation 0. (4. solves the problem ¡ 0¢ max j 0 C1 . g1 + g2 = 1.1 4. 0 δ is the depreciation rate and C1 is consumption of generation 0 in period 0 0 1. Adding bequests will not change the main message of the book provided bequests are given because the giver obtains direct utility from the size of the gift. r1 is the money rental rate for capital in period 1.1 The Initial Old subject to the constraint There are two coexistent generations in period 1. (4.2. The representative generation 1 household receives utility from consumption in periods 1 and 2 and solves the problem 1 1 {C1 . (4. Since I assume that the utility function j 0 (C1 ) is increasing in C1 .1) 0 {C1 } 0 p1C1 ≤ [(1 − δ) p1 + r1] K1. the household’s decision problem has the trivial solution 0 p1 C1 = [(1 − δ) p1 + r1 ] K1 .5) Throughout the book I will abstract from the bequest motive.2 HOUSEHOLDS 49 4.

(4. L1 + U1 = H1 = 1.9) p1C1 + p1 K2 ≤ w1 L1 . (4.10) where w1 is the money wage in period 1. µ ¶ r2 p2 1+i= +1−δ .8) where q is taken parametrically by the household. Households may borrow and lend with each other at money interest rate i and hence the intertemporal budget constraint is.7) The relationship between H1 and L1 is given by the expression L1 = qH1 .14) that deﬁnes the money interest rate i at which households have no desire to borrow or lend with each other.50 CHAPTER 4 SAVING AND INVESTMENT Each household member is endowed with a single unit of time in period 1 and a fraction H1 of all members search for a job where H1 ≤ 1. ˜ (4. Of the workers that search. 1+i 2 (4. ˜ Generation 1’s allocation problem is subject to the sequence of budget constraints 1 (4. K2 is capital carried into period 2. 1+i and the no-arbitrage condition. a fraction L1 ﬁnd a job and the remaining U1 are unemployed. H1 will be chosen to equal 1. 1 p1C1 + p2 1 C ≤ w1 L1 . 1 p2 C2 ≤ (r2 + p2 (1 − δ)) K2 . p2 p1 (4.12) 1 p2 C2 = g2 w1L1. (4. r2 is the money rental rate in period 2. . hence.11) The solution to this problem is characterized by the consumption allocation decisions 1 p1 C1 = g1 w1L1.13) (4.6) Since leisure does not yield utility. (4. and p2 is the money price in period 2.

(4.X 1 } subject to the constraints. There is no labor market in period 2. L1 = qV1.V1 .15) (4.16) In period 2 there is a third generation that solves the problem ¡ 2¢ max j 2 C2 . α 1−α Y1 ≤ AK1 X1 . Since the structure of this problem is a special case of the problem described in Chapter 3. There is a large number of competitive ﬁrms each of which solves the problem p1 Y1 − w1 L1 − r1 K1 . when I introduce an inﬁnite horizon model. in this chapter.22) L1 = X1 + V1 . I will be relatively brief in my description.K1 .C2 } 2 p2 C2 ≤ p2 Y2 − r2K2 . (4.2. This section describes the choices made by ﬁrms in period 1.20) (4. (4.19) max {Y1 . 4.17) The solution to this problem is given by the expression.4. where output Y2 is produced with the technology α Y2 ≤ K2 . p2 (4.17) and that members of this generation rent capital from generation 1 and produce output Y2 .18) In later chapters. each generation will be modeled like that of generation 1. .3 Firms I have described production in period 2.3 FIRMS 51 4. that generation 2 owns the technology described by Equation (4.3 The Third Generation (4. a 2 {K2 .L1 .21) (4. 2 C2 = Y2 − r2 K2 . To keep this two-period example as simple as possible I assume.

the ﬁrm must choose a feasible plan {Y1 .27) ¯ where L is employment. X1 } to maximize proﬁt taking the wage w1 . α (4. L1 p1 (4. (4. the price p1 and the recruiting eﬃciency q as given. There is a match technology of the form. (4. In a symmetric equilibrium.21).25) w1 Y1 = .24) Y1 r1 = .29) . q is taken as given by the individual ﬁrm. (4. equal to the measure of workers that ﬁnd jobs when ¯ ¯ H1 unemployed workers search and V1 workers are allocated to recruiting by ¯ = 1 and hence ﬁrms.28) (4. the rental rate r1.28) and (4. (4. L1 .26) imply ¡ ¢ ¯ Q = 1 − L1 . K1 p1 where the aggregate productivity variable µ ¶ 1 Q= 1− .26) 4.4 Search The search technology is identical to that described in Chapter 2. A ﬁrm that allocates V1 workers to recruiting will hire qV1 = L1 workers of which X1 will be allocated to productive activity.52 CHAPTER 4 SAVING AND INVESTMENT As in Chapters 2 and 3.23) (4. ¯ ¯ 1/2 ¯ L1 = H1 V11/2 . The solution to this problem is characterized by the ﬁrst-order conditions (1 − α) α and the factor price frontier p1 = µ w1 [1 − α] Q ¶1−α ³ r1 ´ α . Households choose H ¯ ¯ L1 = V11/2. (4. V1 . K1 .

31) and (4. λ1 + λ2 + λ3 = 1. C2 + λ2j 2 C2 .32) 0 1 1 2 determine the six variables. C2 = μ1 .5 THE SOCIAL PLANNER 53 4. 1 1 2 α C2 + C2 ≤ K2 + (1 − δ) K2 . ¡ 1 1¢ 1 λ1 j2 C1 . ¡ 1 1¢ 1 λ1 j1 C1 .32).30) subject to the two feasibility constraints (4.35) (4. (4. C1 .39). µ ¶ 1 1 1−α α 1−α − = 0. C2 . The solution to this problem requires that the two inequalities (4.31) and (4.32) should hold with equality and.4. {C1 . ¡ 0¢ ¡ 1 1¢ ¡ 2¢ max (4. 0 1 1 {K2 . in addition. (1 − α) K1 L1 (1 − L1 ) L1 1 − L1 ¡ 0¢ 0 λ0 j1 C1 = μ1 .31) (4. C2 and C2 and the two Lagrange multipliers μ1 and μ2 associated with the inequality constraints (4.L1 . (4. K2 .37) (4.39) The six equations (4. C1 . and the two constraints (4.30) λ0 j 0 C1 + λ1j 1 C1 . .34) — (4. ¡ 2¢ 2 λ2 j1 C2 = μ2 .C1 .5 The Social Planner How would a benevolent social planner arrange production and consumption in this economy? This section addresses that question by studying the solution to the following constrained optimization problem.C1 . His problem is characterized as the maximization of (4.36) (4. the amount of capital to carry into period 2. (4. α−1 −μ1 + μ2 αK2 = 0. C2 }.32). employment in period 1. C1 .33) The social planner chooses K2 .L1 . C2 = μ2 . and a way of allocating commodities to indi0 1 1 2 viduals. L1 . the following six ﬁrst order conditions should be satisﬁed.31) and (4.38) (4.C2 } 0 1 α C1 + C1 + K2 ≤ K1 L1−α (1 − L1 )1−α + K1 (1 − δ) .31) and (4.34) (4.32) where the numbers λi are welfare weights that sum to 1.

6 Investment and the Keynesian Equilibrium We are used to thinking of general equilibrium in Walrasian terms.35) which implies that optimal employment in period 1. I will show below that the existence of this externality may make it diﬃcult or impossible for a market economy to make the right employment decision and I will formalize this idea in the concept of a demand constrained equilibrium. Since the Keynesian model is missing an equation. Agents take prices and endowments as given and form demands — an equilibrium is a set of prices and an allocation of commodities such all markets clear and no individual has an incentive to alter his allocation through trade at equilibrium prices. In all other ways. occurs when 1 1 L∗ = . I will use this extended concept to introduce the idea that investment determines economic activity and I will show that there is an interval such that.40) This problem diﬀers from a conventional social planning problem since there is an externality in the technology that is internalized by the social planner . This section extends the DCE equilibrium concept of Chapter 2 to the two-period model. there exists a demand constrained equilibrium. call this L∗ . there are not enough markets to determine equilibrium allocations. But if this problem can be corrected.this is the occurrence of the term 1 − L1 in the production function in period 1. this chapter closes the model with the assumption that investors form a set of beliefs about the future. for any value of investment expenditure in that interval. the existence of commodity and asset markets implies that a decentralized economy can produce a Pareto eﬃcient allocation. the planner chooses how to allocate commodities across individuals and across time. by construction. 1 2 (4. 4. Keynes called this ‘animal spirits’. the problem is conventional. For the Keynesian model we will require a diﬀerent equilibrium concept since. Following the General Theory. there are many equivalent candidates for an equation with which to close it. Given L1 . But this assumption has many representations all of which will be consistent .54 CHAPTER 4 SAVING AND INVESTMENT The most important of these conditions is Equation (4.

with a self-fulﬁlling equilibrium. con0 1 1 2 sumption allocations {C1 . C1 .42) 4. ¯ I1 = (1 − α) (1 − b) .1 (Demand Constrained Equilibrium) Let I1 be given by the equation. By assuming that ˜ entrepreneurs have ﬁxed beliefs about the appropriate value of I1. i} . employment is determined by matching the equilibrium numbers of searchers on each side of the market. In this chapter I have chosen to represent the assumption by assuming that the value of capital is determined by the beliefs of investors. I will be able to separate the equation that determines aggregate demand and employment from the equations that determine relative prices. These values are to be contrasted with the superscript ∗ that denotes the social planning optimum when the planner uses the welfare weights λi . Speciﬁcally. ˜ ˜ If I1 is large I will say that investors are optimistic and if I1 is small they ¯1 such that for any value of are pessimistic. lending and capital in the asset markets. characterized by values for prices {p1 . let ˜ (4. I have chosen this deﬁnition because it simpliﬁes the equilibrium concept. unemployment U1 . (4. w1 .7 The Deﬁnition of Equilibrium This section extends the deﬁnition of a demand constrained equilibrium from Chapter 2 to the two-period model with capital.43) . for Keynes. In the labor market. (4. ¯ Deﬁnition 4.41) I1 ≡ p1 K2 . I1 . Since this concept is based on ideas from the General Theory I will also refer to it as a Keynesian equilibrium and I will refer to equilibrium values of variables in the model with the superscript K.7 THE DEFINITION OF EQUILIBRIUM 55 there is an equilibrium. C2 } employment L1. p2 .4. ˜ I will refer to I1 as investment although this is a misnomer since it is in fact the money value of the next period’s capital stock. The resulting dichotomy allows me to provide an interpretation of textbook Keynesian models that has a ﬁrm microfoundation. C2 . I will show that there is value I £ ¤ ˜ ¯ I1 ∈ 0. productions Y1 and Y2 and capital K2 such that no individual has an incentive to change his behavior given the prices and the quantities demanded and supplied for commodities in each period and for borrowing.

44) (4.57) .52) (4.55) p1 = [1 − α] Q α 3) Consistency with optimal choices by households: 0 p1C1 = [(1 − δ) p1 + r1 ] K1 . i}.56 where CHAPTER 4 SAVING AND INVESTMENT ˜ ¯ For any given I1 ∈ 0. 0 1 C1 + C1 + K2 − K1 (1 − δ) ≤ Y1 .46) (4. (4.56) (4.53) (4. ˜ 1) Feasibility: α 1−α (4. w1 . p1 L1 r2 Y2 =α . X1 + V1 = L1 . (4. C2 } and (iv) a pair of numbers q and q: with the following properties. 1 2 C2 + C2 ≤ Y2 + K2 (1 − δ) α Y2 ≤ K2 . r1 . C1 .54) . X1}. V1. (ii) a production plan {Y1 . p1 2) Consistency with optimal choices by ﬁrms: r1 Y1 =α . C2 . £ ¤ b = α + g1 (1 − α) .47) (4. 0 1 1 2 (iii) a consumption allocation {C1 . ˜ I1 K2 = .45) Y1 ≤ AK1 X1 . p2 K2 µ ¶1−α ³ ´ w r α 1 1 (4. p2 . p1 K1 Y1 w1 = (1 − α) . (4. Y2. L1 .51) L1 ≤ V11/2 . r2 .49) (4.50) (4.48) (4. 1 p1 C1 = g1 w1L1. K2. I1 a symmetric demand constrained equilibrium (DCE) is (i) a six-tuple of prices {p1 .

63) 1−α As in the General Theory I refer to Z1 ≡ p1Y1 as the aggregate supply price of employment.58) (4.61) (4.23) and is given by the expression 1 Z1 = L1 ≡ φ (L1) . 57 (4.4. D1 is equal to i £ ¡ 0 ¢¤ h 1 ˜1 − (1 − δ) p1 K1 . (4. 1+i 2 p2C2 = p2Y2 − r2 K2.62) L1 = V11/2 . ˜ q= L1 . this section develops aggregate demand and supply equations and shows that the equality of aggregate demand and supply results in an equilibrium employment level LK that is 1 feasible and that satisﬁes the optimality conditions of households. V1 (4. In Section 4.8 I will show that a DCE exists and in Section 4. In Section 4.60) (4.9 I show that there exist prices that support this allocation as a demand constrained equilibrium. The function φ (L1 ) that has this property is found from the ﬁrst order condition for labor (4. Period 1 aggregate demand. 4. An important feature of a Keynesian equilibrium is that there is a diﬀerent demand constrained equilibrium for every value of £ ¤ ˜ ¯ I1 in the interval 0.8 Aggregate Demand and Supply To show existence of a Keynesian equilibrium.64) .59) 4) Search market equilibrium: q = L1 .8 AGGREGATE DEMAND AND SUPPLY 1 p2 C2 = g2 w1 L1 . D1 = p1 C1 + C1 + I (4. I1 : All of these equilibria have the property that no investor has an incentive to deviate from his plan.9 I show how to compute the prices and allocations associated with this equilibrium. As in previous chapters I will choose the money wage w1 as the numeraire and I deﬁne aggregate supply to be the money value of gdp at which employers are indiﬀerent to hiring L1 workers. L1 .

58 CHAPTER 4 SAVING AND INVESTMENT where the ﬁrst term in square brackets is the money value of aggregate consumption and the second is the money value of investment. K Z1 = b = α + g1 (1 − α) .67) K LK = (1 − α) Z1 . I ¯ I = (1 − α) (1 − b) .1. which. Imposing this condition and solving Equations (4. the money value of additions to capital. ˜ This is the point where the deﬁnition of investment as I1 . It follows from the linearity of the aggregate demand and supply ˜ equations that there exists a Keynesian equilibrium for any value of I1 ∈ £ ¤ ¯ where 0. 1] and aggregate supply is deﬁned by Equation (4.65) leads to the following expression for the equilibrium value of the aggregate supply price. (4. leads to a considerable simpliﬁcation of the equations that determine equilibrium. by using the ﬁrst-order conditions.66) Equilibrium employment.68) The Keynesian equilibrium is illustrated in Figure 4.3) and (4.63) it follows that the maximum value of aggregate supply is equal to 1/ (1 − α) . LK is equal to 1 1 ˜ I1 . the equation that determines equality of aggregate demand and aggregate supply would have contained the additional term − (1 − δ) K1 p1 . (4. (4. 1 (4. .69) The following section establishes this claim formally by showing how the other variables of the model are determined. K K The Keynesian equilibrium occurs when D1 = Z1 . Since employment must lie in the interval [0. Using Equations (4. rather than p1I1 . There is no conceptual diﬃculty in following this alternative deﬁnition but it would break the separation of the equations that determine equilibrium prices from those that determine aggregate demand and supply. 1−b (4. leads to the expression ˜ D1 = [(1 − δ) p1 + r1 ] K1 + g1w1 L1 + I1 − (1 − δ) p1 K1. where. If I had chosen p1I1 as the object of investors’ beliefs.63) and (4.12).65) D1 = bZ1 + I1 .23) and (4.24) can be simpliﬁed as follows ˜ (4. the money value of period 2 capital.

The equilibrium price in period 1.9. C2 and C2 .9 FINDING VALUES FOR THE OTHER VARIABLES 59 D1 .4.9 Finding Values for the other Variables I have shown how aggregate supply and employment are determined in period 1 in a Keynesian equilibrium. the 1 2 K capital stock K2 and the outputs Y1K and Y2K are determined in equilibrium. pK can 1 . This section applies some simple algebra by rearranging ﬁrst-order conditions and budget identities and may be skipped without loss of content if the reader is inclined. the consumption allocations C1 .1 First Period Price and Output I turn ﬁrst to the determination of prices and of the physical value of output. Z1 Aggregate Supply Z1 = 1 1−α 1 L1 1− α Aggregate Demand I1 1 1−α D1 = b L1 + I1 1−α L LK 1 Figure 4.1: Aggregate Demand and Supply 4. 1 + iK . 4. It remains to be shown how the prices ¡ ¢ 0K 1K 1K 2K pK . pK . Y1K in the Keynesian equilibrium. C1 .

pK is an increasing monotonic function 1 1 of LK . Generation 0 consumes the amount C1 which is found from the budget equation.75) The real rental rate r1 /p1 is found from the ﬁrst order condition for rental capital in period 1 K r1 YK =α 1 . (4. Y1K (4.2 Second Period Capital and Output K ˜ I now turn to the variables K2 and Y2K . pK 1 (4.76) pK K1 1 .73) p1 and hence ¡ K ¢α Y2 = K2 .60 CHAPTER 4 SAVING AND INVESTMENT be found by solving the equation pK = 1 where K Z1 .3 Rental Rates and Consumption Allocations Next consider the determination of real rental rates and consumption allo0K cation to each generation.74) 4.71) as a function of the endowment of capital. (4. 1 1 (4.9. K1 and the value of employment at the Keynesian equilibrium.70) is the physical value of output. Using (4. This is the same mechanism that was discussed in Chapters 2 and 3. α A (1 − α) K1 (1 − LK ) 1 ¡ ¢1−α ¡ ¢1−α α Y1K = AK1 LK 1 − LK .9.72) 1−α . 0K C1 = (1 − δ) K1 + K r1 K1 . LK .68) this gives the following expression for the money price pK 1 µ K ¶α L1 1 1 K p1 = (4. (4. reﬂecting the fact that the real wage falls as investors become more 1 optimistic and the economy moves up the aggregate supply curve. 4. Given I1 and pK it follows from the 1 ˜1 that deﬁnition of I ˜ I1 K K2 = K .

4.9.10 Fiscal Policy in a Keynesian Model A Keynesian equilibrium can result in any value of employment in the interval [0. 1]. (4.80) as 1K K C2 = (1 − δ) K2 + αY2K . 0K C1 = (1 − δ) K1 + αY1K .75) and (4.4 Second Period Prices ¡ ¢ Finally we can solve for pK / 1 + iK . 61 K The second period real rental rate r2 /pK is found from the ﬁrst-order con2 ditions. It follows that unless ˜ investors happen fortuitously to choose the correct value of I1 .82) It is worth pointing out that pK and iK are not separately deﬁned in this 2 model since there is no role for a separate unit of account in period 2.79) (4.81) 1 1 + iK which can be rearranged to give K g2 (1 − α) Z1 pK 2 = . from Equation 2 2 (4.4. pK 2 2 (4. (4. the Keynesian . 4.10 FISCAL POLICY IN A KEYNESIAN MODEL Equations (4.78) Generation 1’s consumption in period 2 is found from market clearing 1K 2K K C2 + C2 = (1 − δ) K2 + Y2K . 1K 1 + iK C2 (4. the present value of pK .77) pK K2 2 and generation 2’s consumption is 2K C2 = Y2K − K r2 K K = (1 − α) Y2K . K r2 YK = α 2K .13) as 1K pK C2 2 = g2 w1 LK . (4. but the social planner will choose L∗ = 1/2.76) imply.

This section describes the Keynesian remedy for this problem by putting ﬁscal policy into the model. Since there are three generations. to ∗ occur at the planning optimum Z1 . (4. L∗ . levied in period 1. (4. T } that implements the full employment level of employment. there exists a tax-transfer policy {τ . I will show that for any value of I1 . and a transfer payment T ˜ to generation 1. can ﬁscal policy maintain full employment? The answer to this question is yes and further.2 1 Conceptually. there are many policies that can implement full employment. .85) where ∗ Z1 = 2 1 . There are no taxes or transfers in period 2 and the tax rate on rental income is the same as the tax rate on wage income. I will be concerned with the question. Their labor income (1 − α) Z1 is taxed at rate τ 1 and they receive a transfer T1. The term in square brackets is after-tax income of the young generation. a ﬁscal policy could conceptually consist of a level of government expenditure and a set of taxes and transfers indexed by the age of the household. but most of these solutions will cause the government to accumulate debt that will need to be repaid in the second period. These assumptions imply that aggregate demand is given by the expression £ ¤ 0 1 ˜ D1 = (1 − τ 1 ) αZ1 + T1 + g1 (1 − τ 1 ) (1 − α) Z1 + T1 + I1 .83) The ﬁrst term on the right side is the consumption from after-tax rental in0 come of the old generation in period 1 and T1 is the transfer to the initial old. The parameter g1 is the marginal propensity to consume for these individuals.62 CHAPTER 4 SAVING AND INVESTMENT equilibrium may be one of over or under employment. 2 (1 − α) I have called this full employment in line with the language of the General Theory although the model introduced here admits of over employment as well as under employment. I will exclude government expenditure since that raises the issue of public goods and instead I will consider policies that consist of an income tax rate τ.84) (4. Instead. It is clear from this expression that there will be many choices 0 1 of T1 . T1 and τ 1 that force the equilibrium value. let us conﬁne ourselves to tax transfer policies for which 0 1 ∗ T1 + T1 = τ 1 Z1 . at which D1 equals Z1 . it is possible to tax wage income and capital income at diﬀerent rates and the generational burden of these taxes will diﬀer. To implement a policy that maintains full employment let τ 1 be the tax 0 1 rate on income and let T1 and T1 be lump-sum transfers to generations 0 and 1 in period 1.

11 CONCLUDING COMMENTS 63 is the value of aggregate supply in the social planning optimum. Substituting (4. T1 enters with a 1 K positive and T1 with a negative sign. and L1 . then a transfer to the old has a positive eﬀect on equilibrium 0 income and a transfer to the young has a negative eﬀect. 4. Z1 is “that expectations of proceeds [.4. K Z1 = 0 1 ˜ I1 + T1 (1 − α) (1 − g1) − α (1 − g1) T1 . the supply price measured in dollars. employment. of several models that embody Keynes’ theory of eﬀective demand.] that will just make it worth the while of the entrepreneurs to give that employment”.. In Chapters 2 and 3 I constructed one-period demanddriven models to address these criticisms.e... I have provided a microfounded model in which consumption expenditure is a linear function of income and investment expenditure is determined by beliefs of investors about future productivity.i.. Aggregate demand D1 is “the proceeds that entrepreneurs expect to receive from the employment of L1 men” and it can be broken into two components. and simplest. (1 − α) (1 − g1) (4.84) into (4.11 Concluding Comments The main early criticisms of Keynes’ work were theoretical. Both of these chapters were based on a search-theoretic model of the labor market. It was pointed out that the General Theory does not have a satisfactory theory of the labor market. The reason is that the young save a fraction g1 of their income while the old consume all of it and so a transfer to the old increases aggregate demand while a transfer to the young reduces it. It follows that if Z1 < Z ∗ (the case of underemployment in the Keynesian equilibrium) then the optimal policy is K to transfer income to the old and if Z1 > Z ∗ (the case of overemployment) it is to transfer income to the young. Recall that the aggregate supply function φ (L1 ) is a relationship between Z1 .83) and solving for the Keynesian equilibrium leads to the expression. . nominal gdp. Chapter 4 has developed the ﬁrst. as I have assumed. Their purpose was to provide a microfoundation to the Keynesian theory of aggregate supply.86) Notice that if the tax rate on wage and rental income is the same. not empirical. These are balanced budget policies. consumption and investment. each measured in dollars.

64 CHAPTER 4 SAVING AND INVESTMENT so called ‘animal spirits’. . is a value of employment at which aggregate demand and aggregate supply are equal. A Keynesian equilibrium. Keynes emphasized that saving and investment are equated not by the interest rate. formally deﬁned in this chapter as a demand constrained equilibrium. In Walrasian theory it is prices that clear markets and it is a change in the rate of interest that equates saving and investment. By adding a search externality and removing the spot market for labor I have provided a framework where there are not enough Walrasian prices to equate demands and supplies for all of the quantities. We are used to teaching macroeconomics in the language of Walrasian general equilibrium theory. This chapter has provided an interpretation of that idea. This framework goes beyond the General Theory by providing an explicit microfoundation to the Keynesian idea of aggregate supply. but by the level of economic activity.

Chapter 5 Presenting Business Cycle Facts The ﬁrst four chapters of this book have presented relatively simple models of the aggregate economy designed to illustrate the mechanisms that distinguish a Keynesian from a classical model of the business cycle. To present their common features in a way that is apparent to visual inspection it helps to separate the trend in each time series from the cycle. My purpose for presenting this alternative way of representing data is to illustrate some connections between medium frequency movements in economic time series that are not apparent in data that has been HP ﬁltered. Instead. Almost all recent papers on business cycles have removed these trends by passing each aggregate time series through the Hodrick-Prescott ﬁlter. As I describe how these economies work I will show how they explain business cycle facts. the measurement of aggregate variables using ‘wage units’. This chapter presents a way of presenting these facts that diﬀers from approaches taken in most recent work in macroeconomics. In subsequent chapters I will present progressively more elaborate versions of artiﬁcial economies that incorporate these same mechanisms with the ultimate goal of providing systems of equations that can be confronted with the data. Business cycles are recurrent events in which many diﬀerent time series move together. 65 . I will present a method suggested by Keynes’ discussion of measurement in Chapter 4 of The General Theory.

A good example is the Wharton model developed by Lawrence Klein at the University of Pennsylvania. These models were estimated with systems methods and used as guides to policy makers. ‘The Computational Experiment’ was to develop a new methodology. when simple RBC models were confronted with data they often performed poorly.1 What’s Wrong with the HP Filter? Before the advent of real business cycle theory in the 1970’s macroeconomists confronted models with data using econometric methods. that lowered the standards of what it means for a model to be successful by requiring that a good model should explain only a limited set of empirical moments. In the introduction to their 1981 book. The ﬁrst. In a related paper Hodrick and Prescott introduced the eponymous HodrickPrescott (HP) ﬁlter that soon became the dominant method for confronting . In the 1960’s and early 1970’s the state of the art in macroeconometrics consisted of the estimation of large simultaneous equation models identiﬁed by exclusion restrictions suggested by Keynesian theory. Lucas and Sargent argued for the development of econometric techniques that would recognize the crossequation restrictions imposed on a model by the rational expectations assumption. explained most clearly in Ed Prescott’s 1996 article. he argued instead that a new paradigm brings its own anomalies and puzzles and that as real business cycle theory is developed it will eventually solve these puzzles and supplant its predecessor. As a response to this road block in the development of a new paradigm. Since the parameters of these expectations should depend on the parameters of the rules followed by the policy authorities Lucas argued that rational expectations assumption would invalidate the practice of using ﬁxed parameter models as policy guides. was to develop appropriate econometric methods to estimate parameters in rational expectations environments. Ed Prescott argued that one could not expect that a science in its infancy would initially outperform established science. calibration. The second.66 CHAPTER 5 PRESENTING BUSINESS CYCLE FACTS 5. The Keynesian econometric methodology developed by Klein and associates was criticized by Lucas in his 1976 ‘Critique of Econometric Policy Evaluation’ on the grounds that microfounded structural equations should contain expectations of future variables. introduced to economists in the Lucas and Sargent (1981) book Rational Expectations and Econometric Practice. The profession responded to the Lucas Critique in two diﬀerent ways. In Prescott’s view this did not mean that economists should abandon the new approach. However.

1 WHAT’S WRONG WITH THE HP FILTER? 67 business cycle models with business cycle facts. Since the ﬁlter is two sided. Models in which the trend in data is assumed to be generated by a common non-stationary productivity shock should be ﬁltered by removing a common trend. Second.5. The ﬁrst issue of confronting models with data is beyond the scope of the current work and will be the focus of a subsequent companion volume. There are advantages to the presentation of HP ﬁltered data and. But the HP ﬁlter also has disadvantages that are often overlooked. These low frequency movements are critical in assessing explanations of unemployment that deny the natural rate hypothesis. First. measuring GDP in wage units.1 and 5. The second. 1 . See for example. I will make two separate but related arguments in this chapter. I will argue that the ubiquitous use of the HP ﬁlter masks a serious shortcoming of the RBC model and that the use of ﬁltered data to evaluate it overstates the model’s conformity with the facts.2 compare data detrended with the HP ﬁlter with my proposed alternative. the work of Thomas Lubik and Frank Schorfheide 2003. it is not consistent to assume that ﬁltered data can be modelled ‘as if’ it were chosen by a forward looking rational agent operating in a world with no trend in productivity. Despite this objection. Compare this with Figure 5.2 that the unemployment rate has low to medium frequency movements that move closely with real gdp. Gdp measured in wage units moves more closely with unemployment A second objection to the use of ﬁltered data is one that is often raised by those who favor a traditional econometric approach to the analysis of time series data. properly used. a number of inﬂuential papers do use HP-ﬁltered data in this way. Notice from Figure 5. the HP-ﬁlter removes a diﬀerent non-linear trend from every series thereby purging the data of potentially useful information. the issue of presenting limited sets of stylized facts by detrending data is the main focus of this chapter. I will develop an alternative methodology to the HP ﬁlter that corrects what I will argue is a serious shortcoming of the HP approach. the confrontation of theory with data can be simpliﬁed with its careful use. By ﬁltering out the low frequency movements.1 which plots unemployment against real GDP measured as percentage deviations from the HP trend. one ignores implications of these movements for the relationships between economic variables that could potentially be used to discriminate between theories. I will argue that the correct approach to confronting models with data is the one advocated by Lucas and Sargent and that the new paradigm is now ready to be confronted with a full set of empirical moments. Most business cycle models have implications for the comovements of variables at all frequencies.1 Figures 5. Instead.

45 1.50 1.2: Unempoyment and GDP per member of the labor force .08 Unemployment Rate Real GDP Figure 5.40 Wage units Unemployment Rate (Left scale) Gdp per member of labor force (Right scale) Figure 5.1: Unemployment and HP ﬁltered GDP 2 3 Percent of labor force (Inverted scale) 4 5 6 7 8 9 10 50 55 60 65 70 75 80 85 90 95 00 Shaded areas are NBER recessions 1.80 1.04 .68 CHAPTER 5 PRESENTING BUSINESS CYCLE FACTS 2 3 Percent of labor force (Inverted scale) 4 5 6 7 8 9 10 50 55 60 65 70 75 80 85 90 95 00 Shaded areas are NBER recessions .02 -.02 .08 .60 1.04 -.65 1.00 -.55 1.06 Percent deviation from trend .70 1.75 1.06 -.

Deﬂating all nominal series by a measure of the money wage should lead to time series that are stationary if data are well described by series that ﬂuctuate around trends that grow at the same rate. In a Keynesian model. It is for this reason that I am advocating the use of wage units as a way of measuring real magnitudes.2 by a decrease in real gdp. 5. low frequency movements in the unemployment rate are potentially explained by low frequency movements in aggregate demand. It grows because of changes in the value of the monetary unit but it also grows because the real wage increases as the economy becomes more productive. An example of the kind of movement I have in mind is the slow increase in unemployment that runs from 1969 through 1985 which is mirrored in Figure 5. This movement is absent from the GDP series in Figure 5. in contrast.3 and is measured in units of thousands of dollars per year. A natural series to use for this purpose is the nominal wage which grows for two reasons. described as per-capita ratios of nominal series.5. One would like to be able to ask the question: did the low frequency fall in gdp cause the increase in the unemployment rate or did causation run in the opposite direction? If one adopts a classical approach to the labor market then the low frequency movements in unemployment must be explained by movements in the natural rate of unemployment. The following ﬁgures depict US annual data from 1950 through 2004. deﬂated by the money wage.2 MEASURING DATA IN WAGE UNITS 69 at medium to low frequencies whereas these movements are ﬁltered out of the gdp series when it is detrended with the HP ﬁlter.2 Measuring Data in Wage Units What are wage units? The inﬂationary component of any two nominal series can be removed by taking their ratio. the nominal wage is constructed by dividing compensation to employees from the national income and product accounts by full and parttime equivalent employees. is to report all real magnitudes by dividing the corresponding nominal series by the nominal wage. Since these low frequency movements are not present in the HP ﬁltered data it is not possible to address the question of the possible dependence of the ‘natural rate’ on ﬁscal or monetary policy. explained in this chapter. My proposal.1 in which real GDP has been detrended with the HP ﬁlter. In all case. The wage series used is depicted in Figure 5. measured as compensation to employees divided by full and part time equivalent em- .

Simple Keynesian models account for changes in employment by assuming a ﬁxed or exogenous labor force and modeling changes in employment by assuming that the unemployment rate varies with aggregate demand. The following section discusses the best way to accomplish this. Because my goal is to end up with a stationary measure I also need to remove the growth in GDP that occurs from increases in the number of working people. First. 5. more or less people may choose to enter the labor force in response to changes in incentives or changes in tastes.3 Choosing a Per-Capita Measure The number of employed people may ﬂuctuate for two reasons.70 CHAPTER 5 PRESENTING BUSINESS CYCLE FACTS 50 Thousands of dollars per year Shaded areas are NBER recessions 40 30 20 10 0 1930 1940 1950 1960 1970 1980 1990 2000 Average annual wage Figure 5. These two reasons for ﬂuctuating employment correspond to diﬀerent economic mechanisms. I have chosen this measure of employment because it is continuously available from 1929 through the present day. the number of people employed may ﬂuctuate as members of the labor force enter and leave paid employment. Second.3: The average annual real wage 1929-2004 ployees. Real business cycle models abstract from unemployment and assume that all variations in employment are caused by variations in labor .

4 INTERPRETING WAGE UNITS 71 force participation. wL.2 and reproduced in Figure 5.1 billion dollars.5 for comparison with Figure 5. 37. In practice.4. In 1929 pY was equal to 103. An example of a non-economic cause is the experience of working women during WWII that caused many of these women to remain active in the labor force once the war ended and to inﬂuence their own daughters to prepare for a working role outside of the home.7 billion dollars. this series is reported in Figure 5. It is likely that the secular increase in labor force participation was caused by exogenous changes in household preferences although there were surely also economic factors at work.4. p is the dollar price per unit. compensation to employees was equal to 51. both margins are likely to be important. Second.1) where b is a the elasticity of labor.5 is approximately stationary and tracks unemployment very closely while that in Figure 5. and nominal gdp. suppose that the data were generated by an economy in which a unique good was produced by competitive ﬁrms from capital and labor with a Cobb-Douglas production function using a constant returns-to-scale technology.4 has a marked upward trend.5. pY . Because of the secular trend in post-war participation I have deﬂated all of the real measures presented in this book by the civilian labor force. We have data on compensation to employees. 5.4 Interpreting Wage Units To see what the use of wage units means in a concrete case. L. In this case the ﬁrst order condition for labor would imply bY p = wL (5.7 million full or part time equivalent people were employed and the labor force . Consider the following two alternative ways of removing the population trend. one might divide gdp in wage units by the adult population. First. Y is the quantity of output produced in physical units. L is the number of worker-hours used to produce Y and w is the wage per worker hour. The diﬀerence between them is accounted for by a substantial change in labor force participation in the post-war period that was accounted for by a big increase in the number of women who seek employment outside the home. the number of full and part time equivalent employees. a series constructed this way is reported in Figure 5. one might divide by the labor force (employed plus unemployed adults). Notice that the series in Figure 5.

40 Wage units Unemployment Rate (Left scale) Gdp per member of labor force (Right scale) Figure 5.75 .55 1.50 1.5: Unempoyment and GDP per member of the labor force .90 .4: Unemployment and GDP per adult 2 3 Percent of labor force (Inverted scale) 4 5 6 7 8 9 10 50 55 60 65 70 75 80 85 90 95 00 Shaded areas are NBER recessions 1.95 .65 1.75 1.60 1.55 Wage units Unemployment Rate Gdp per adult Figure 5.85 .80 1.80 .45 1.72 CHAPTER 5 PRESENTING BUSINESS CYCLE FACTS 2 3 Percent of labor force (Inverted scale) 4 5 6 7 8 9 10 50 55 60 65 70 75 80 85 90 95 00 Shaded areas are NBER recessions .65 .70 .60 .70 1.

000. government purchases. gdp measured in this way is a weighted multiple of the employment rate. private consumption expenditure and net exports with unemployment. The yearly wage is computed as 51.2) and (5. Since there are multiple goods produced in the real economy this statement oversimpliﬁes the deﬁnition but it is still true that all measurements in wage units have units of pure numbers and that to the extent that production technologies are close to Cobb-Douglas. Z= (pY ) L 1L 1 = = (1 − u) . 000 dollars per year. 000 1 pY 1 = × N w 47. 000 (wL) = = 1.1) implies that Z should be equal to the inverse of the elasticity parameter b multiplied by one minus the unemployment rate. In each of the panels of this ﬁgure one of the components of gdp is measured . N (wL) bN b In other words. 100.6 illustrates the comovements of private investment expenditure. Gdp is computed as Z= 103. 600.5. If we let u= N −L N be the unemployment rate then combining this deﬁnition with Eqns (5. 000.2) which for 1929 gives a value of gdp per member of the labor force of 1. 700.6 million people. 700. if the economy produced a single good then gdp in wage units would be equal to the inverse of the elasticity of labor in production (also equal to labor’s share of national income) multiplied by the employment ratio. 355 (5. Figure 5. 000 1. 355 w= L 37.5 The Components of GDP This section illustrates some comovements between the components of gdp and the unemployment rate that would be ﬁltered out by the HP ﬁlter but that are clear in the data represented in wage units.6 in units of pure number. 5.5 THE COMPONENTS OF GDP 73 (call this N) consisted of 47.

The Keynesian model suggests that consumption depends on government purchases through a multiplier eﬀect and in Chapter 7 I will explain this mechanism and develop a model that can account for the 1970’s slowdown.74 CHAPTER 5 PRESENTING BUSINESS CYCLE FACTS on the right axis in wage units and the unemployment rate is measured on the left axis in percentage points with an inverted scale.31. this reversal of trend unemployment is not accompanied by a parallel increase in government purchases which instead continue to decline. The scale of the left axis.5 and 1.22 and 0. By contrast net exports ﬂuctuate between plus . The Keynesian models I will develop in this book suggest that this slowdown was associated by an increase in the unemployment rate that itself was caused by the reduction in government purchases accompanying the end of the Vietnam War. is the same in all four panels but the right scale is diﬀerent for each graph. The dramatic turnaround in consumption is accompanied by an increase in the real interest rate at the time of the Volcker . The downward trend in the consumption series that runs from the late 1960’s to 1980 is sharply reversed in 1981 and the subsequent drop in trend unemployment accompanies an increase in consumption from 0.16 in 2004. Investment ﬂuctuates between 0. Figure 5.08.6). measuring the unemployment rate. In contrast to the stationary ﬂuctuations in investment over this period. consumption ﬂuctuates between 0.96 in 1981 to 1.4.16 and government purchases ﬂuctuate between 0.96 and 1. between 1969 and 1980 unemployment trends up (recall that the axis is inverted) where as investment ﬂuctuates around a constant level. This period is often referred to as the productivity slowdown since conventional measures of gdp per person grow at a slower rate in the 1970’s. These four series together add up to gdp which ﬂuctuates between 1.02 and minus .5) The top left panel illustrates that investment per member of the labor force moves quite closely with unemployment at high frequency. an obvious candidate is the dramatic change in monetary policy that occurred in 1980 when Paul Volcker took over as Chairman of the Fed. For example. consumption and government purchases trend down mirroring the increase in the unemployment rate (see the bottom left and top right panels of Figure 5.24 and 0.7 plots the ex-post real interest rate (measured as the t-bill rate minus the annualized rate of change of the gdp deﬂator) against consumption in wage units. but there are lower frequency movements that it does not pick up.74 over the same period (see Figure 5. This suggests that the same mechanism that accounts for the 1970’s slowdown cannot be what is happening in the 1980’s. If one is looking for policy induced explanations for movements in unemployment. Unlike the slowdown in the 1970’s.

5 THE COMPONENTS OF GDP 2 3 Percent of labor force (Inverted scale) 4 5 6 7 8 9 10 50 55 60 65 70 75 80 85 90 95 00 Shaded areas are NBER recessions .00 0.28 .06 -.24 .20 1.12 1.26 .00 0.04 -.36 .7: The real interest rate and consumption .96 0.20 Wage units 75 Unemployment Rate Pri vate investment Unemployment Rate Government purchases 2 3 Percent of labor forc e (Inverted scale) 4 5 6 7 8 9 10 50 55 60 65 70 75 80 85 90 95 00 Shaded areas are NBER recessions 1.04 1.20 .96 0.48 .12 Wage units Unemployment Rate Private c onsumption Unemployment Rate Net exports Figure 5.52 .40 .04 1.08 1.18 Wage units 2 3 4 5 6 7 8 9 10 50 55 60 65 70 75 80 85 90 95 00 Shaded areas are NBER recessions .44 .28 .02 .16 Percent of labor forc e (Inverted scale) 1.00 -.34 .08 -.10 -.24 .30 .92 0.32 Percent of labor force (Inverted scale) .02 -.16 1.88 Wage units 2 3 4 5 6 7 8 9 10 50 55 60 65 70 75 80 85 90 95 00 Shaded areas are NBER recessions .32 .04 .08 Wage units 1.12 1.92 1995 1970 1975 1980 1985 1990 Real Interest Rate Consumption Figure 5.5.22 .6: The Components of GDP measured in wage units 10 8 Percent per year 6 4 2 0 -2 1965 Shaded areas are NBER recessions 1.

By detrending data in the way described in this chapter a new set of stylized facts become apparent and their explanation provides a new set of puzzles that I will attempt to make sense of in the following chapters. In Chapter 8 I will provide a development of the Keynesian model that can account for these events. business cycle stylized facts have been those that were deﬁned by real business cycle theorists. By using this limited set of moments a generation of theorists has been starved of a set of the medium frequency facts.76 CHAPTER 5 PRESENTING BUSINESS CYCLE FACTS policy initiative. 5. . But the development of theory is guided by stylized facts and for the past twenty years.6 Concluding Comments The data presented in this chapter is suggestive and it does not constitute formal statistical evidence for or against any given theoretical model. The RBC agenda is to construct models that can match the volatility and cross correlations of time series data that has been ﬁltered by removing all but a narrow band of frequencies.

but he did not dispute the fact that unemployment in the depression was socially ineﬃcient.Chapter 6 The Great Depression In this chapter I develop an inﬁnite horizon model in which employment is determined by aggregate demand and I use it to tell the Keynesian story of the Great Depression. In so doing I will have cause to revisit an important debate that arose in the post-war literature. The competition to this explanation was not the RBC model of Kydland and Prescott (1982) but an alternative story of market failure promoted by Milton Friedman (1948). for him it was the failure of the Fed to maintain suﬃcient liquidity. In this chapter I will use the search model developed earlier to provide such a foundation. 77 . the stock market crash of 1929 was due to a loss of conﬁdence in the economy that caused a calamitous drop in aggregate demand. This story was taught to generations of undergraduates as the leading explanation of the Great Depression by Keynesian economists of the post war period. Lucas (1967) and Treadway (1971) estimated models of investment. This in turn caused an increase in unemployment that was socially ineﬃcient in the sense that the unemployed persons could and should have been proﬁtably employed in productive activity. Friedman disputed the impetus to the depression. Does ﬁscal policy matter? Before the rational expectations revolution of the 1970’s macroeconomists attempted to extend Keynesian economics to dynamic environments by building microfoundations to each of the components of the Keynesian model. Why do I need to revisit a story that was accepted by several generations of economists? The answer is that the theoretical foundations of this story have been discredited because Keynes did not construct a credible microfoundation to the theory of aggregate supply. According to this story.

The simpliﬁcation of non-reproducible capital enables me to draw out a relationship between the value of the stock market (represented by the value of capital) and the level of economic activity. In section 6. This goal ran into theoretical diﬃculties when Alan Blinder and Robert Solow (1973) pointed out that dynamic Keynesian models had no role for ﬁscal policy since a one dollar increase in government expenditure was predicted to crowd out an equal amount of private consumption expenditure if consumption and investment functions were derived from optimizing behavior by a representative family.78 CHAPTER 6 THE GREAT DEPRESSION Milton Friedman (1957) provided a permanent income theory of the theory of consumption function and Friedman (1956) breathed new life into the Quantity Theory of Money by making the case for a stable demand-for-money function.s ) . Hence. . (6. A central goal of this research was to provide a quantitative explanation of the eﬀects of government policy on employment and prices. All jobs last for one period and there is 100% labor market turnover. There are n consumption goods and Kt = 1 units of capital.12 I will show that crowding out is a logical consequence of the representative agent model in which government cannot inﬂuence the real rate of interest. 6.2) and the gi are preference weights. Each family sends a measure 1 of members to look for a job every period. the model developed in this chapter does not provide a good vehicle for explaining the wartime recovery. There is a unit measure of identical representative inﬁnitely lived families. These assumptions are very strong and are made to facilitate the exposition of the model.1) s=t i=1 where n X i=1 gi = 1.1 Preferences I will study a multi-commodity intertemporal representative family model in which there is a single capital good in ﬁxed supply. (6. Preferences are described by the following logarithmic utility function " # ∞ n X X Jt = β s−1 gi log (Ci.

The variable QT represents the t relative price of date-T money in terms of date-t money and is given by the expression QT = t Qt t T −1 Y k=t 1 . t (6.10) where it is the money rate of interest between dates t and t + 1.9) = 1.7) The notation is deﬁned as follows. Kt is the family’s ownership of capital. (1 + ik ) T > t. All date t prices are in diﬀerent date-t units of account that I refer to as date-t money. Since all families are identical there will be no borrowing or lending in equilibrium..4) (6.t is the money price of good i.5) (6. T →∞ lim QT Kt+1 ≥ 0. wt is the money wage.t Ci.t Kt+1 = (pk.8) (6. Lt = qt Ht . and the ‘no-Ponzi scheme’ constraint.6..∞. (6. rrt is the rental price of capital and pk. pk.1 PREFERENCES The household faces the sequence of budget constraints pk. qt is ˜ the probability that a searching worker will ﬁnd a job.3) (6. ˜ Ut = Ht − Lt . I assume riskless borrowing and lending at money rate of interest it and a no arbitrage condition then implies that 1 + it = pk. . .t (6.t+1 + rrt+1 . All of these terms are deﬁned for each date t.t .6) Ht ≤ 1. t = 1. Lt is the measure that ﬁnd a job and Ut is the measure that remain unemployed. Ht is the measure of family members that search.t is consumption of good i.t + rrt ) Kt + wtLt − n X i=1 79 pi. pi. (6.t is the money price of a unit of capital. Ci.

˜ t (6. Ct is deﬁned as Ct ≡ n X i=1 (6. ht = 1 ∞ X s=t Qs ws Ls = t ∞ X s=t Qs ws qs . For completeness. all variables that it takes as given in equilibrium.t Ci.13) 1 + it be the human wealth of the family. measured in dollars. Here it is the net present value of labor income. . the entire labor force is rehired.11) describes how aggregate consumption expenditure. At the end of each period all workers are ﬁred and. The ﬁrst order conditions for the problem are represented by an Euler equation and a set of intertemporal ﬁrst-order conditions that together imply 1 β = (1 + it ) .7) human wealth can be written in terms of prices and hiring probabilities.11) pi. it will choose to send all of its members into the labor force to look for a job. Ct Ct+1 where consumption expenditure. it may be helpful also to write down the solution to the household’s problem by deriving an equation in which consumption expenditure is described as a function of prices. (6. I make this assumption to facilitate exposition.1 By iterating this equation forwards and using the no-Ponzi scheme constraint (6.t .12) Equation (6. its time endowment and the hiring probability. (6.80 CHAPTER 6 THE GREAT DEPRESSION 6. This equation will be central later in this chapter when I discuss crowding out. Dropping it is an important extension that I will leave for a later chapter. This solution requires ﬁrst that we deﬁne some alternative concepts of wealth. Let ht+1 ht = wt Lt + . evolves over time.2 The Consumption Function Since the household derives no disutility from work.14) This is a slightly non-standard deﬁnition since wealth would normally be deﬁned as the net present value of the labor endowment. in the next period.

6.3 TECHNOLOGY The household also has ﬁnancial wealth in the forms of claims to capital (pk,t + rrt ) Kt . The sum of ﬁnancial and human wealth is total wealth Wt , Wt = (pk,t + rrt ) Kt + ht .

81

(6.15)

The solution to the household problem is to spend a ﬁxed fraction of total wealth on consumption goods and consumption expenditure is given by Ct = (1 − β) Wt . (6.16)

I will need Equation (6.16) in Chapter 7 when I discuss a more complicated family structure although for the purpose of solving the representative agent model in this chapter it does not play a central role.

6.3

Technology

This section describes the production side of the economy. There is a unit measure of non-reproducible capital that must be allocated across industries in every period. There is also a unit measure of workers, all of whom will be allocated, in equilibrium, to the activity of labor market search. I assume that each industry is described by a Cobb-Douglas production function and that capital is rented in a competitive rental market. Labor is hired in a search market. I assume further that labor in each ﬁrm is divided between a recruiting department and a production department as in previous chapters. These assumptions lead to the observation that average and marginal products are equal and are equated to factor prices. Production is competitive and has the same structure as that described in chapter 3. Output of the i0 th commodity is denoted Yi,t , and is produced by a Cobb-Douglas function

ai bi Yi,t ≡ Ki,t Xi,t ,

(6.17) (6.18) (6.19)

where ai + bi = 1, and

n X i=1

Ki,t = Kt.

82

CHAPTER 6 THE GREAT DEPRESSION

Ki,t is the rental demand for capital by ﬁrm i and Xi,t is the ﬁrm’s allocation of labor to production. Market clearing in each industry implies that Ci,t = Yi,t . (6.20)

**Firms maximize proﬁts taking pi,t , wt , rrt and qt as given. Each ﬁrm solves the problem
**

{Ki,t ,Vi,t ,Xi,t ,Li,t }

max

ai bi pi,t Ki,t Xi,t − wtLi,t − rrt Ki,t

(6.21) (6.22) (6.23)

Li,t = Xi,t + Vi,t , Li,t = qtVi,t ,

where Li,t is total labor hired by ﬁrm i and Vi,t is the labor that it allocates to recruiting. Substituting Eqns (6.22) and (6.23) into (6.21) and deﬁning Qt = (1 − 1/qt ) , leads to the reduced form expression for proﬁts;

ai pi,t Qbi Ki,t Lbi − wt Li,t − rrt Ki,t t i,t

(6.24)

(6.25)

which is maximized when ai, pi,t Yi,t = rrt Ki,t , and bi pi,t Yi,t = wt Li,t . (6.27) (6.26)

These expressions are identical to those that hold in an economy with a competitive labor market. This economy diﬀers from the competitive model since the recruiting eﬃciency parameter Qt is endogenously determined by aggregate economic activity but is taken parametrically by the ﬁrm; hence there is an externality in the labor market that is not priced. The following section combines Eqns (6.26) and (6.27) with consumer ﬁrst-order conditions to obtain some simple aggregate equilibrium relationships.

6.4 AGGREGATE SUPPLY

83

6.4

Aggregate Supply

In this Section I will introduce the variable Zt to denote nominal gdp. Recall that Ct is the nominal value of aggregate consumption and since there is no investment or government expenditure these two variables will be identical as a consequence of accounting identities. My goal here is to ﬁnd a relationship between Zt and Lt that I refer to as aggregate supply. From the solution to the household’s problem it follows that the consumer allocates a fraction gi of total consumption expenditure to good i; that is, pi,t Ci,t = gi Ct . Since all production of good i is consumed, this also implies that pi,t Yi,t = gi Ct , and, deﬁning

n X i=1

(6.28)

(6.29)

pi,t Yi,t ≡ Zt ,

(6.30)

it follows that,

pi,t Yi,t = gi Zt .

(6.31)

Substituting (6.31) into the ﬁrst order condition for the choice of labor in industry i leads to the expression bi gi Zt = wt Li,t , (6.32)

**which can be summed over all industries to give the following expression, χZt = wt Lt , where χ≡
**

n X i=1

(6.33)

gi bi .

(6.34)

Since money in each period is simply an accounting device there is a degree of freedom in choosing a price normalization in each period. I will choose the date t numeraire to be labor by setting wt = 1, t = 1, ...∞. (6.35)

(6. A similar exercise using the ﬁrst order condition for rental capital yields the expression ψZt = rrt Kt .5 Search and the Labor Market As in Chapter 3 I assume there is an aggregate match technology that results in the following expression for aggregate employment.8 I will use equations (6.36) an equation that I referred to earlier (in Chapter 3) as the Keynesian aggregate supply curve. 1/2 Lt = Vt .t . (6.t = qtVi.36) and (6.39) where Lt is the measure of workers that ﬁnd jobs when a measure 1 of workers search and Vt workers are allocated to recruiting in aggregate by all ﬁrms. 6.41) (6.42) Lt . (6.40) These equations can be rearranged to ﬁnd an expression relating the measure of workers that can be hired by a single recruiter. which. Lt . yields the expression L t = qt V t .33) as Zt = 1 Lt . qt .37) where ψ≡ n X i=1 gi ai .84 CHAPTER 6 THE GREAT DEPRESSION This normalization implies that pi. to aggregate employment. (6.38) In Section 6.t is the inverse of the real product wage for each commodity and it allows me to write Eq (6. χ (6.37) to describe how the properties of aggregates behave in a demand constrained equilibrium. 1 qt = . when aggregated over all ﬁrms. Each ﬁrm faces an individual hiring equation Li. (6.

there is another economy. identical in all respects. the economy is hit by a sequence of technology shocks common to each industry.6 Expectations and Technology Shocks As in earlier chapters of this book. the labor market is cleared by sequence of spot market auctions. For every sequence of non-negative numbers {pk. a sequence {pk. . by solving a social planning problem. a Keynesian economy.6. If ﬁrms and workers take all wages and prices as given then there is an equilibrium for every value of the sequence of hiring eﬀectiveness parameters {Qs }∞ . I call this economy . As in earlier chapters in this book. In the General Theory. Keynes argued that the level of economic activity is pinned down by the state of long term expectations. Second. The purpose of this section is to deﬁne what this means. with three exceptions. First.t }. but the Keynesian equilibrium may fail to maintain full employment in a well deﬁned sense.t }. this concept is represented by a self-fulﬁlling sequence of values for the capital good. the household labor endowment is diﬀerent in every period and third. In our model.7 The Social Planning Problem Before discussing the properties of a Keynesian equilibrium I will provide a benchmark for what full employment means in this economy. I will call the economy deﬁned in this chapter. 6.the Walrasian analog economy. there corresponds a sequence of productivity shocks {Qt } and a sequence of labor endowments {Ht } such that every demand constrained equilibrium of the Keynesian economy is associated with a Walrasian equilibrium of the Walrasian analog economy. Associated with every sequence {pk. Parallel to it. the absence of markets for the search time of workers and recruiters leads to an equilibrium model with one less equation than unknown. There are many possible ways of resolving s=t this indeterminacy each of which corresponds to a diﬀerent possible belief about the future. that is. there exists a demand constrained equilibrium (a concept that I deﬁne carefully below) to the Keynesian economy. Consider the problem.6 EXPECTATIONS SHOCKS 85 6. one can show that the Keynesian equilibrium mimics the decisions of a Social Planner by allocating resources across industries in an eﬃcient fashion.t } in the Keynesian economy.

Li.s ) (6.s .47) (6.s ) (6.s . ∞ Vi.Ls } s=t i=1 subject to Eqn (6.s + Vi. . .s .50) Vs Equation (6.50) one can write the production function for good i as ai Ci. .Vi. i.. Xis and Vs from the problem.49) 1/2 Ls = Vs1/2 Hs .43) is the objective function of the social planner (identical to that of the representative agent) and Eqns (6.46) n X i=1 Ki. Using Eqns (6.44).50) deﬁne the constraint set.s Xisi i = 1. . .s = Li.43) ai b Ci. . .45) Xi. ∞.86 CHAPTER 6 THE GREAT DEPRESSION " # {C i.52) {Ci.s .s .51) Using this simpliﬁcation the social planning problem can be restated as " # ∞ n X X max Jt = β s−1 gi log (Ci.s . ∞ Hs ≤ 1. n X i=1 Li. As in earlier chapters. s = t. s = t. .Hs .s = Vs .48) (6. .44) (6. . (6.s (6. Vi. . ∞ (6. Li.s ≤ Ki.Xi.Ls ..51) for each commodity at each date and the set of labor constraints represented by Eqn (6.s .s = s = t.s = 1.s = Ls . . (6. n X i=1 (6.s ≤ Ki. s = t.46). ∞. .s . .n (6. this problem can be simpliﬁed by using the match technology to eliminate Vi.s Ls s = t.45) and (6. . .Li.Vs } max Jt = such that ∞ X s=t β s−1 n X i=1 gi log (Ci.s Lbi (1 − Ls )bi .44)-(6. .

. i=1 i=1 As in the earlier models of this book. ∞. In a more general model. Deﬁnition 6. s = t. . Ki. I will proceed to show that a Keynesian equilibrium exists and that it is represented by a set of aggregate equations that determine employment and gdp and a separate set of equations that describe how labor and capital are allocated across industries. for the dynamic economy with multiple commodities. gi bi gi ai Li. s = t . .8 Demand Constrained Equilibrium I begin this section by deﬁning a demand constrained equilibrium. with a similar labor market structure. . I deﬁne the state of expectations to be a sequence of beliefs about the value of capital in all future periods.54) χ ψ P P where n gi bi = χ and n gi ai = ψ. there is an optimal unemployment rate of 50%.s }∞ with a bound B such that s=t pk. there will be a diﬀerent sequence of beliefs for every type of reproducible capital and discrepancies between expectations and the interest rate will cause changes in investment expenditures.1 (SP) The solution to the social planning problem has the following properties.6. I will return to this result below when I discuss whether ﬁscal policy can improve on the equilibrium.8 DEMAND CONSTRAINED EQUILIBRIUM 87 Proposition 6. In this model I am abstracting from investment spending by assuming that there is a unique non-reproducible capital good.1 A (bounded) state of (long-term) expectations is a non-negative sequence {pk. . 1 (6. 6. (6.53) Ls = . Aggregate employment each period is given by the expression.s = . which I refer to interchangeably as a Keynesian equilibrium.s = . . ∞ 2 and labor and capital are allocated across industries according to the equations.s < B for all s.

s . Xi. 1 + is Ci. 1 + is = 3) Search market equilibrium: qs = Ls .88 CHAPTER 6 THE GREAT DEPRESSION Even in this simple environment changes in beliefs about the value of capital will have an eﬀect on expenditure since long-term expectations inﬂuence wealth which.s .64) Ci.s .58) (6. (6.s + rrs ) Ks + hs .56) (6.s Xi.55) (6. Ki.s (6.s . Ci.s + Vi. n. . Deﬁnition 6.s .63) (6. The following deﬁnition is of a demand constrained equilibrium in the inﬁnite horizon economy. Vi.s . pi. I show that aggregate variables in a DCE follow a relatively simple equation.66) .s . inﬂuences consumption expenditure.s hs . Li.s Ks = 1.60) pi.s . Hs = 1. i=1 i=1 1 1 Ls = Hs2 Vs2 . pk.s (6.65) (6. Xi.2 (Demand Constrained Equilibrium) For any state of expectations a demand constrained equilibrium (DCE) is an n−tuple of price sequences {pi. .s = Li.62) (6.s . Li.s = Ki. 1 = bi.61) (6.s . Ks = Ki. n X i=1 Vs = Vi.59) (6.s = Yi.s = gi (1 − β) Ws .s .s . n n X X Ls = Li. .s }∞ i = 1. 2) Consistency with optimal choices by ﬁrms and households. ˜ qs = Ls . Hs }∞ and a pair of sequences of s=t numbers {˜s . in turn.s rrs = ai. . ∞: q s=t 1) Feasibility and Market Clearing.s Yi. . qs }∞ . a sequence of rental rates {rrs }∞ a set of s=t s=t quantity sequences {Yi.s . Vs hs = Ls + pk.s+1 + rrs+1 .57) (6. ai bi Yi. Following this deﬁnition. Ws = (pk. such that the following equations hold for all s = t.s Yi. .

60)) deﬁne technologies.64) are ﬁrst order conditions that deﬁne solutions to individual optimizing problems and (6. bi 1 − χZs (6.55)-(6. . Eqns (6. β Equations (6. χ (1 − β) In a DCE. aggregate expenditure.68) (6..s (1 − β) . .73) . rrs = pk.. ψ (6.gi Zs .s (1 − β) . .61)-(6.69).69) Ls = χZs . gi .71) Li.66) deﬁne search market equilibrium. adding up constraints and market clearing conditions..71). .n and all s = t..∞. The price in wage units of each commodity is given by the expression pi. which hold for all i = 1. ψ β (6.72) and the physical quantity of each good produced is given by the equation Yi. Proposition 6. ψ (6..s = bi. Ki.2 (DCE) There exists a unique Demand Constrained Equilibrium for every state of expectations with bound B≤ ψβ . aggregate employment and the rental rate are described by Equations (6. for s = t.70) (6. .s = ai. determine the allocation of factors across industries.65) and (6.70)-(6. Zs = 1 pk.67) (6.s µ ¶a i ai = (bi Zs )bi gi (1 − χZs )bi .6.8 DEMAND CONSTRAINED EQUILIBRIUM 89 Equations (6.67)-(6.s = µ ψZs ai ¶ai µ ¶bi µ ¶bi 1 1 .

Is this explanation consistent with the data? . In 1929 the stock market fell 13% in one day.1933 and as the economy moves down the aggregate supply βψ k. the Great Depression was caused by a failure of aggregate demand and the model developed in this chapter provides a simpliﬁed framework for understanding his explanation. On the ﬁgure. Z Z= 1− β pk . The economy did not recover until 1942 when the United States entered World War II. The drop in stock market value was followed by drop in expenditure on new capital goods from 16% of gdp in 1929 to 6% in 1932 and a corresponding dramatic increase in unemployment from 8% to 25% of the labor force.1929 Z= 1 βψ χ L Z= 1− β βψ pk .1929 βψ ∗ curve employment falls from L∗ 1929 to L1933 . In 1929 investors lost conﬁdence in the economy causing a self-fulﬁlling drop in stock market prices and a subsequent fall in investment purchases.1933 L*1933 L*1929 L Figure 6.1) illustrates the Keynesian explanation for these events.90 CHAPTER 6 THE GREAT DEPRESSION 6. This in turn triggered a drop in consumption expenditure through a multiplier eﬀect. Z falls from 1−β p to 1−β pk.1: The Keynesian Explanation for the Great Depression Figure (6. In the model of this chapter pk is an exogenous driving variable and a fall in pk causes an increase in unemployment.9 Keynes and the Great Depression According Keynes.

8 .3: Unemployment Investment and Government Purchases in the Recovery .3 .7 .0 1930 1932 1934 1936 1938 1940 1942 1944 0 5 10 % of labor force (Inverse Scale) 15 20 25 30 35 40 Unemployment Rate (right scale) Investment (left scale) Government Expenditure (left scale) Figure 6.6.5 . Stocks and Unemployment in the Depression .6 Wage units .2: Investment.2 .4 .9 KEYNES AND THE GREAT DEPRESSION 91 4 3 Normalized units 2 1 0 -1 -2 1930 1932 1934 1936 1938 1940 1942 1944 Investment in wage units (left sca le) Real stock market index (left scale) Unemployment Rate (right scale) 0 5 10 15 20 25 30 % of labor force (Inverse scale) Figure 6.1 .

Although the model I have described is inspired by the General Theory. The investment and government purchases data on this ﬁgure are measured in wage units and are comparable to each other. however. in addition it plots the data for government purchases. Keynes argued that unemployment was a waste of resources and that full employment could be restored by government expenditure ﬁnanced either by taxes or by borrowing.3) plots the investment and unemployment series from Figure (6. This ﬁgure shows that although the model does not explain the investment data. overemployment as well as underemployment is a possibility.2) and. In this section I will give the ﬁrst of these assertions a theoretical foundation in the model developed in this chapter by comparing the eﬃciency of a Keynesian equilibrium with that of the social planning optimum.10 Eﬃciency of Equilibrium Before discussing ﬁscal policy one would like to understand why it might be necessary. Notice that although investment falls. it does capture the increase in unemployment that accompanies the crash.neither is it accompanied by an increase in private investment expenditure. equilibrium gdp and employment are functions of autonomous expenditure which consists of the sum of investment and government purchases.2) plots the value of the Standard and Poors Stock Market index in constant dollars against an investment series and the unemployment rate plotted on an inverted scale. in the textbook static version of the model.92 CHAPTER 6 THE GREAT DEPRESSION Figure (6. Notice. Recall that the model-economy has a stationary eﬃcient employment level of 50% in every period. since capital is ﬁxed. it is not identical to it and. Any employment level greater than 50% would require that each ﬁrm allocate too many of its workers to the recruiting department and would result in a fall in the physical output produced in each industry and . Although a unit mass of workers searches for employment it is not eﬃcient for all of them to be employed. that the recovery in the unemployment rate that occurred in the 1940’s is not accompanied by an increase in the value of the S&P index . The Keynesian model explains the recovery with this fact since. Figure (6. as in previous chapters. government purchases shoot up as the United States enters World War II in 1942. I now turn to the question: Can the Dynamic Keynesian model developed in this chapter explain the wartime recovery? 6.

75) (6.t Equilibrium implements the social planning solution and Lt = 1/2. If pk. proportional to GDP.6. I have argued elsewhere (1999) that animal spirits should be modeled by building general equilibrium models in which there is an indeterminate continuum of equilibria. The model in this chapter is an extension of this idea to allow beliefs to inﬂuence the steady state itself. the belief of agents in the form of the animal spirits of investors becomes an independent driving force of the business cycle. pk. How does the Keynesian equilibrium compare with the social planning solution? The answer is that there is a continuum of Keynesian equilibria indexed by {pk. is equal to Lt = χZt.t > p∗ gdp and k. there will be ineﬃciently high unemployment and if pk.t is equal to p∗ . Keynes argued that the future cannot be quantiﬁed in a way that has become common in modern macroeconomics as agents are assumed to know the probability distributions of all uncertain future events. the Keynesian k. The value of pk. indexed by beliefs.t 1 . In an economy with a stock market.t is determined by the ‘state of long term expectations’.t } .t < p∗ .10 EFFICIENCY OF EQUILIBRIUM 93 a corresponding drop in social welfare. which was also famously described in the General Theory as the ‘animal spirits’ of investors.74) where α = (1 − β) / (βψ). Employment. In any given period there will be a unique value p∗ = k.t represents the value of equity. As a consequence.76) such that when the stock market price pk.t . In my earlier work these equilibria represented diﬀerent non-stationary paths each of which converged to the same steady state. In a Keynesian equilibrium the value of GDP is proportional to the value of physical capital and is given by the expression Zt = αpk. In this case gdp is high because prices are . (6. In the model of this chapter there is no underlying uncertainty in the physical environment but in reality technology. 2αχ (6. preferences and endowments as well as political and social variables are themselves changing in unknown ways.t employment will be too high.t k.

In a calibrated model one might expect the socially eﬃcient unemployment rate to be considerably less than 50%. n are the same as the preference weights of the consumer. The following section explores the possibility of telling a similar story in the context of the intertemporal representative agent model of this chapter. During the 1930’s government spending was widely discussed as a possible remedy to the Great Depression but the remedy was not eﬀectively put into practice until 1942 when the United States entered World War II. perhaps 5% would be a good guess. In this simple model an increase in government spending causes an increase in equilibrium income that in eﬀect. The assumption that there is no capital tax is not inconsequential since one might wish to use capital taxes or subsidies to inﬂuence intertemporal prices.t = gi Gt (6. consumption and government spending. 6. if pk. To pay for its purchases. the implied welfare loss would be substantial. the government levies an income tax at rate τ t on labor income. This assumption allows me to abstract from distribution eﬀects associated with changes in the composition of aggregate demand between consumption and government purchases. In the textbook Keynesian model consumption is a function of income that is itself the sum of investment. . Since tax-subsidy schemes of this .11 Household and Government Consider the following variation on the model developed so far. or it may borrow money from households by issuing debt Bt . the economy is overheating. In either case.t in each period. Even if only half of this additional unemployment was due an ineﬃciency of the kind modeled in this chapter. the Keynesian equilibrium will be ineﬃcient in the sense that a diﬀerent belief by investors would result in an unambiguous increase in social welfare.94 CHAPTER 6 THE GREAT DEPRESSION high and welfare and physical output could be increased by an increase in the unemployment rate: in common parlance.77) where the weights gi for i = 1. Let there be a government that purchases commodities Gi. pays for itself. . If unemployment rose to 20% (or higher) as it did in the early 1930’s the additional 15% represents workers that could have been gainfully employed in producing consumption and investment goods. To keep the model simple I will assume that Gi. .t is too high or too low.

s } s=t i=1 When we introduce taxes and government debt into the model the budget constraint faced by the household becomes Ã n ! ∞ ∞ X X X Qs pi.s ≤ Qs τ s L s + A t .84) . .78) lim QT BT ≤ 0. How does the introduction of a government that spends. with the no-Ponzi scheme condition T →∞ (6.83) represents its initial wealth.78) together with Eqn (6. " # ∞ n X X s−1 max Jt = β gi log (Ci.80) where I have replaced Lt by χZt from the aggregate supply curve. Ct Ct+1 (6.11 HOUSEHOLD AND GOVERNMENT 95 kind are not the focus of the expansionary ﬁscal policies that I am interested in I will abstract from capital taxation in this section and I will return to the issue later in the book. taxes and issues debt. (6.. Bs+1 = Bs (1 + is−1 ) + Gs − τ s Ls . inﬂuence the solution to the consumer’s problem? Recall that the household solves the problem..t + rrt + Bt (1 + it−1 ) . s = t. Aggregating ﬁrst-order conditions for this problem leads to the consumption Euler equation.81) {Ci. The government faces the following sequence of constraints. is equivalent to the single inﬁnite-horizon constraint ∞ X s=t Qs G s t + Bt (1 + it−1) ≤ ∞ X s=t Qs χτ s Zs .82) t t s=t i=1 s=t where At = pk. (6. τ tLt is the tax revenue from the labor income tax and I have used the normalization ws = 1 to remove ws from the ﬂow budget constraint.s Ci.79) . t (6. t (6.79) Here. The sequence of constraints (6. 1 β = (1 + it ) .6.s ) . (6.

t+1 + rrt+1 . First. Bs }∞ s=t is called a ﬁscal policy. Deﬁnition 6. 1 + it = pk.12 Crowding Out In this section I deﬁne a government expenditure plan and a ﬁscal policy and using these deﬁnitions I describe the characteristics of an equilibrium in an economy with government.96 CHAPTER 6 THE GREAT DEPRESSION and riskless arbitrage implies. it is a decision by government to purchase a given quantity of goods and services in every period. I deﬁne a class of ﬁscal policies that restricts spending by government to have the same distributional pattern as spending by households. the assumption simpliﬁes the characterization of an equilibrium. t (6. If there exists a pair of sequences {τ s . An expenditure policy together with a pair of sequences {τ s . It would not be surprising if expenditure by government on a particular sector of the economy has distributional consequences by changing relative prices but that is not what one normally means by the eﬀectiveness of ﬁscal policy.86) for all s.85) It follows from this analysis that the introduction of government purchases does not alter the household’s consumption-Euler equation. Bs }∞ such s=t that the budget equation ∞ X s=t Qs G s t + Bt (1 + it−1 ) ≤ ∞ X s=t Qs χτ s Zs . 6. pk.3 (Expenditure Policy) A (distributionally neutral) expenditure policy is a set of non-negative sequences {Gi.87) . This fact has an important implication for the usefulness of the representative agent model in telling the story of the 1940’s recovery.t (6. Second.s = gi Gs (6. Although this restriction is not strictly necessary in the sense that one could deﬁne an equilibrium without it. it is a decision on whether those purchases should be ﬁnanced by raising taxes or by borrowing. A ﬁscal policy as I deﬁne it has two components.s }∞ and an initial debt s=t level Bt (1 + it−1 ) such that Gi.

s . ai bi Yi.92) (6. Vs = n X i=1 n X i=1 Vi.90) Ks = n X i=1 Ci.93) 1 Ls = Hs2 Vs2 . Given these deﬁnitions I now provide a relatively straightforward extension of Deﬁnition 6.s = Li. (6. a set of quantity sequences {Yi. . Hs }∞ . q t s=t such that the following equations hold for all s = t. Ci. Bs }∞ do not depend s=t on s.s .91) (6.s = Yi.s .s pi.12 CROWDING OUT 97 is satisﬁed then the expenditure policy {Gi.s }∞ and any s=t distributionally neutral expenditure policy {Gi. τ s . Li.s . Deﬁnition 6. . Ks = 1. a sequence of rental rates {rrs }∞ and implied present value s=t prices {Qs }∞ .s . (6.s .s .s Yi.s rrs = ai. .2 to show how a Keynesian equilibrium is modiﬁed in the presence of government expenditure.4 (Stationary Fiscal Policy) A feasible (distributionally neutral) ﬁscal policy is stationary if the sequences {Gi. 2) Consistency with optimal choices by ﬁrms and households. Xi.s .s = Ki.89) (6. Ls = Li.s Yi. n. . Ki.s . t Given this deﬁnition. . Xi. a particular class of stationary policies is of particular interest.s .s . .s .s }∞ s=t i = 1. Hs = 1. ∞: 1) Feasibility and Market Clearing.94) . Deﬁnition 6.s Xi. Li.5 (DCEG) For any state of expectations {pk.s }∞ a demand constrained s=t equilibrium with Government (DCEG) is an n−tuple of price sequences {pi. 1 = bi.88) (6. a t s=t s=t set of tax and debt sequences {τ t .s (6. Bs }∞ such the the policy is feasible for s=τ the present value prices {Qs } .s }∞ is said to be feasible for price s=t sequence {Qs }. 1 Ki.6.s . qs }∞ . Vi.s .s + Vi.s pi. and a pair of sequences of numbers {˜s .s + Gi.

89) is modiﬁed to recognize the allocation of resources between household and government sectors. pk.s = gi (1 − β) Ws . ﬁnancial wealth of the household sector. k Stationarity is a strong assumption but a useful one since it is the case that Keynes believed was characteristic of the Great Depression.s + rrs ) Ks + Bs (1 + is−1) Ws = As + hs . deﬁned in Eqn (6. I now have enough machinery to deﬁne the main idea of this section.98 CHAPTER 6 THE GREAT DEPRESSION Ci. the deﬁnition of human wealth in Eqn (6.96) (6.97) (6.101) This deﬁnition diﬀers in three ways from (6. pk.96) is modiﬁed to include only the after tax value of labor income. In the General Theory he argued that unemployment may be an equilibrium phenomenon (in the sense of a stationary state).99) 3) Search market equilibrium: qs = Ls . hs (1 − τ s ) hs = Ls + . Eqn (6.95) (6.s+1 + rrs+1 1 + is = . The following proposition demonstrates that the representative agent environment is not a good vehicle with which to make this case because one dollar of government expenditure is predicted to crowd out an equal amount of private consumption expenditure. Third. Second. 1 + is As = (pk. To capture this feature I assume that agents’ expectations are unchanging and that the economy is in a stationary Keynesian equilibrium with an unemployment rate that is ineﬃciently high. ˜ qs = Ls . Deﬁnition 6. First.100) (6. I would like to be able to model Keynes’ prescription of increased government expenditure as a way out of the Great Depression.6 (Stationary DCEG) A DCEG is stationary if all variables are independent of calendar time.2).97) includes government debt. Vs (6.98) (6. I will deal with the case in which households have stationary pessimistic expectations in the sense that pk is constant and permanently less than p∗ .s (6. .

s = Li = bi. .102) Zs = Z = ψ β Ls = L = χZ. . (6.104). .103) pk (1 − β) rrs = rr = .s } be a bounded stationary state of expectations such that pk.106) The price in wage units of each commodity is given by the expression µ ¶ µ ¶ µ ¶bi ψZ ai 1 bi 1 pi. 1 pk (1 − β) .6... ∞.s . . .s = Yi = (bi Z)bi gi (1 − χZ)bi .105)-(6. . Ci.∞.106).. (6. s = t . gi . (6.s = (6. . which hold for all i = 1. ai.n and all s = t.s = Ki = ψ Gs = G ≤ Li.107) ai bi 1 − χZ Let {Gs } be a stationary sequence of expenditures such that and the physical quantity of each good produced is given by the equation µ ¶a i ai Yi. (6. determine the allocation of factors across industries. (6.s = pk < ψβ . ψ β There exists a unique stationary Demand Constrained Equilibrium with government.102)-(6. (6. (6. gi Z.s = Yi.105) Ki.12 CROWDING OUT 99 Proposition 6..104) β Equations (6.s = pi = .108) ψ Consumption and government purchases of each commodity are allocated as follows µ ¶ Z −G Yi. Aggregate expenditure. s = t. (6.s (1 − β) . This equilibrium has the following characteristics.109) Z µ ¶ G Gi.3 (Crowding Out) Let {pk. aggregate employment and the rental rate are described by Equations (6. χ (1 − β) 1 pk. .s .∞.110) Z .

‘permanent income’.100 CHAPTER 6 THE GREAT DEPRESSION The proof of this proposition mirrors that of Proposition 6. In aggregate. using the ﬁrst order conditions from production.s+1 + rrs+1 β 1 .112) (6.113) Equation (6. (6.s In a stationary equilibrium this implies µ ¶ 1 1−β . (6. Zs = pk ψ β (6. The static consumption function modeled consumption as a function of income but it was soon realized that a forward looking agent should be concerned not just with current income but with wealth or in Friedman’s terms. This is exactly the point made by Blinder and Solow in 1973 and since government spending and private spending is allocated in the same proportion across industries the allocation of each commodity to households and government is in proportion to aggregate spending as in Eqns (6. µ ¶ 1 β pk.2 and it hinges on the fact that the household Euler equation is unchanged by the introduction of government.110). 6. Since Z = C + G.13 Concluding Comments What have we learned from this exercise? When economists of the postwar period began to provide microfoundations to Keynesian economics they turned to the Ramsey model of a representative agent as the simplest formal framework within which to model the evolution of dynamic equilibrium models.s+1 + ψZs = .s or.114) it follows that a one dollar increase in government expenditure must crowd out one dollar of private consumption expenditure. it can be written as µ ¶ pk.113) implies that gdp in a stationary equilibrium is independent of government expenditure and is a function only of the state of expectations. Cs Cs+1 pk.109) and (6. .111) = Cs Cs+1 pk.

. The rational expectations revolution of the 1970’s threw out the Hicks-Hansen apparatus because it did not cope well with the simultaneous appearance of high inﬂation and high unemployment in the 1970’s. But the model could not have been rejected so quickly on empirical grounds if it was not already on weak theoretical foundations. The ﬁrst part of this book has attempted to shore up the theoretical foundations of aggregate supply by providing a sound microfoundation to the idea that there may be a continuum of stationary equilibrium unemployment rates indexed by beliefs. This has led us down a road and towards a conclusion that was trod in 1973 by Blinder and Solow.6. Chapter 7 moves forward by breaking away from the representative agent framework and providing a model in which ﬁscal policy matters.13 CONCLUDING COMMENTS 101 The Keynesian remedy to unemployment was to replace investment by government expenditure and the Hicks-Hansen framework illustrated in a relatively simple model why this ought to work.

36).115) (6. Proof of Proposition 6.2. Let λi. from Eq (6.117) Combining (6.122) .118) To obtain the allocations of labor across industries combine Eqns (6. β s−1χ = μ (1 − Ls ) . By aggregating the consumer Euler equations one obtains Eq (6. The following three ﬁrst order conditions follow from the choice of Ci. (6. µ ¶ 1 β pk.117) yields.115) with (6.s . The proof of existence is constructive.116) and summing over i gives.116) and (6.60) and rearranging terms. Combining (6.46).s λi. Ls = χZs .s = μ.102 CHAPTER 6 THE GREAT DEPRESSION 6.1.s Using Eq (6.119) (6. and since. these equations imply Ls = 1/2. (6.116) (6.37).s = μ.s+1 + rrk.118).s+1 βψ = + .s bi Ci.s+1 = .s .14 Appendix to Chapter 6 Proof of Proposition 6. and let μ be the multiplier on (6.115).11) which can be combined with (6.s pk.115) with (6.10) and the market clearing conditions to give µ ¶ 1 β pk. The allocation of capital follows from a similar analysis using the ﬁrst-order condition for capital. Ci.s n X λi.s (6. Together.51) at date s. (6.121) Zs Zs+1 pk. Since labor supply is bounded above by 1. 1 − Ls ι=1 β s−1χ = μLs .s be the multiplier on the i0 th constraint (6.s and Ls β s−1 gi = λi. (6.s bi Ci.120) (6. Zs is bounded above by χ−1 . in a DCE. Li. Li. Zs Zs+1 pk. (6.

67).72).6. Since Zs is bounded above by χ−1 .s = Yi. Equations (6.36)..123) converges to (1 − β) and rearranging this expression then leads to Eq (6. . it follows that a valid equilibrium requires pk. .36) and (6.125) and (6.s and Li.72).71) leads to Eq (6.24) (6.127) pi.127).73) is derived similarly.14 APPENDIX which can be iterated forward to obtain the expression ¢ βψ ¡ 1 = 1 + β + β 2 .s (6. note that the production function for good i can be written. in reduced form.s from (6.s 103 (6. Equation (6. Zs pk. To obtain Equation (6. and (6.70) and (6.123) Since β ∈ (0. 1) the inﬁnite sum on the RHS of (6.s = Qbi Ki.s Lbi . s i. (6.67) with (6.68) follows from (6. (6. substituting for Ki. χ (1 − β) (6.69) follows from combining (6.126) Using the fact that the consumer spends a fraction gi on good i leads to the equation gi Zs .71) follow directly from rearranging the ﬁrst order conditions for the ﬁrm.121).70) and (6. as ai Yi.s ≤ ψβ .124) Eq (6.125) where it follows from (6.42) that Qs = (1 − χZs ) .s Combing Equations (6..

.

indexed by date of birth. but also for the war-time recovery 7. Every period a measure (1 − π) of households dies and.Chapter 7 The War-Time Recovery This chapter builds a dynamic model in which ﬁscal policy matters.1 Household Structure In the model studied in this chapter there is a continuum of agents. a measure (1 − π) of new ones is created. There are no bequests in this economy and no population growth although these are features that 105 . Each household survives into the subsequent period with a ﬁxed probability π. each generation has a diﬀerent consumption allocation based on its date of birth. to keep the population ﬁxed. I refer to them interchangeably as households or dynasties. Because each generation has logarithmic preferences and the same human wealth it is possible to derive a simple set of equations in aggregate variables that describes the properties of an equilibrium. These equations are very similar to those of the representative agent economy. The main purpose of this chapter is to demonstrate that this model can account quantitatively not only for the Great Depression. but the representative agent’s Euler equation is replaced by an aggregate consumption equation in which income and wealth can aﬀect consumption in the steady state. The taking oﬀ point is a paper by Olivier Blanchard (1985) who showed how to combine the properties of an overlapping generations model with those of the inﬁnite horizon model in a tractable way. There are many generations alive at the same time. The resulting model is similar to that of Chapter 6 with a few key diﬀerences.

n X i=1 gi = 1. qt is the probability that a ˜ h searching worker will ﬁnd a job and Ci. The superscript on Ci.8) As in Chapter 6.7) lim QT Ah ≥ 0.s denotes the birth date of the dynasty and as in the previous chapter s and t index calendar time and i indexes commodity. Preferences of a typical dynasty created at date h are described by the logarithmic utility function " # ∞ n X X ¡ h¢ Jth = (πβ)s−t gi log Ci. wt is the money wage. pi. Ut = Ht − Lt .t is the money price of good i. (7.2) t = h.tCi. The dynasty faces the sequence of constraints Ah t+1 = (1 + it−1) Ah t + wtLt + T Rt − Tt − At = 0.6) (7.t . I have omitted the index h from Ht and Lt because the assumptions that families are large and the labor market turns over every period implies that .3) (7. ˜ L t = qt H t . Ht is the measure of family members that search.s . t Ht ≤ 1. T →∞ n X i=1 h pi. t t+1 (7.t is consumption of good i by dynasty h. t ≥ h (7. (7. Lt is the measure that ﬁnd a job and Ut is the measure that remain unemployed.. As in Chapter 6 there are n consumption goods and Kt = 1 units of capital. All jobs last for one period and there is 100% labor market turnover.4) (7.1) s=t i=1 where the gi are preference weights and π is the probability that the dynasty surh vives into the subsequent period..5) (7. Each dynasty sends a measure 1 of members to look for a job every period.∞. . and the ‘no-Ponzi scheme’ condition.106 CHAPTER 7 THE WAR-TIME RECOVERY can be added with little diﬃculty.

t . t For the reasons discussed below. eﬀectively.1 HOUSEHOLD STRUCTURE 107 every family will have the same employment level. All terms are deﬁned for each date t.12) t−1 + (pk. denoted Bt . QT t represents the relative price of date T labor in terms of date t labor and is given by the expression QT = t Qt t T −1 Y k=t 1 . Since the annuities sector is competitive.t is the inverse of the real product wage. Assets Ah are claims against a competitive annuity sector that owns the t capital stock and outstanding claims to government debt. the stream of government interest payments and corporate rental payments received is paid out in aggregate to families. The terms T Rt and Tt represent lump-sum transfers and taxes that are independent of household. this is greater than the interest rate paid by government or by ﬁrms. ¡ ¢ At = Bt 1 + ig (7. pk. Assets of this sector are equal to the capital stock Kt .t where it is the money rate of interest between dates t and t + 1 received by families. When a family dies its assets are returned to the annuity company and in return it receives a return greater than the interest received on the company’s assets. Although all date t prices are in date t units of account this is a real model and I choose the normalization wt = 1 for all t. At is the total liabilities of the annuities sector. valued at price pk.11) t h where the sum is over all agents alive at date t.9) (7. Hence. all variables are measured in wage units and pi. Bt. (7. I assume riskless borrowing and lending at money rate of interest it and a no arbitrage condition then implies that µ ¶ pk.13) t pk.t is the value of a capital good.t+1 + rrt+1 π (1 + it ) = = (1 + ig ) .7. rrt is the rental rate and ig is the t . (7. (1 + ik ) T > t. I assume X Ah = At (7.10) = 1. In aggregate. and a stock of outstanding government liabilities. Hence.t + rrt ) Kt . and it is the interest rate received by households. Ah is the family’s assets.

14) The government faces the sequence of constraints.. The switch to lump-sum taxes.15) lim QT BT ≤ 0. ¡ ¢ Bs+1 = Bs 1 + ig s−1 + Gs − Ts + T Rs .t in each period and it allocates its expenditure across commodities in the same way as consumers. . These facts plus the assumption that Kt = 1 allow me to rewrite Eqn (7.t + rrt ) . In competitive models with a single inﬁnite horizon representative agent the equilibrium is dynamically eﬃcient and competitive equilibria are Pareto optimal.. and the Interest Rate As in Chapter 6. is equivalent to the single inﬁnite-horizon constraint ∞ X s=t Qs t (Gs + T Rs ) + Bt (1 + it−1 ) ≤ ∞ X s=t Qs Ts .15) together with Eqn (7. The sequence of constraints (7. 7. Dynamic eﬃciency implies that the interest rate will exceed the growth rate. of which the Blanchard structure used in this chapter is an example. with the no-Ponzi scheme condition T →∞ (7.t = gi Gt .2 Government. t (7.12) as At = Bt (1 + it−1 ) π + (pk. as opposed to the proportional labor income tax in Chapter 6.108 CHAPTER 7 THE WAR-TIME RECOVERY interest rate paid by the government on a one period security. has no important consequences because labor is inelastically supplied. Gi. (7. It has the beneﬁt of simplifying the algebra. t (7.17) Recall that I assume that there a single unit of capital that does not depreciate and thus there is no investment expenditure in this model.16) . This assumption is not inconsequential. the government purchases commodities Gi. Dynamic Eﬃciency. s = t. this result no longer holds and equilibria may be both dynamically . In overlapping generations economies.16) As in the previous chapter I assume no tax on capital and I have used the normalization ws = 1.

in a representative agent economy.t π Rt is the gross real interest rate in wage units at which households can trade with annuity companies. (pk. One might nevertheless expect that. they are ruled out in this one by the assumption that capital does not depreciate. . In a stationary equilibrium Rg = 1 + rr p and since rr ≥ 0. Since this endowment is owned by a single impatient individual an equilibrium price path that valued the aggregate endowment at inﬁnity would be inconsistent with market clearing.2 DYNAMIC EFFICIENCY 109 ineﬃcient and Pareto ranked. This places a lower bound of zero on the rate of interest for equilibria in which capital is held.t is the gross real return on capital held in these company’s portfolios and Rg is the gross real return at which t the government can borrow and lend. One would not expect Pareto eﬃciency to hold in the economy described in this chapter since there is a missing market: this leads to the ineﬃcient search unemployment that is the focus of this book. the interest rate paid by government. one would expect that in an overlapping generations model with Keynesian unemployment.t+1 + rrt+1 Rg = t. Rt ≡ (1 + it ) = π pk.t+1 + rrt+1 ) /pk. of the interest rate earned by households since R is greater than Rg by the multiple 1/π. Further. This must be true. Pareto ineﬃcient equilibria that arise as a consequence of dynamic ineﬃciency have the property that the interest rate is less than the growth rate. a fortiori. Rg − 1. Although Keynesian equilibria with a low interest rate are possible in some models with an inﬁnite number of agents. Equilibria of this kind can never arise in models in which there is a single representative agent since the net present value of the aggregate endowment becomes inﬁnite. the equilibrium interest rate would always be greater than the growth rate for the same reason that this property holds in Walrasian economies.7. In any such equilibrium. Inﬁnite aggregate wealth is feasible in equilibrium as long every single individual has ﬁnite wealth: this requires that the model have an inﬁnite number of agents as they do in this model. µ ¶ 1 pk. must be greater than or equal to zero. The argument is the same as that put forward by Shell (1971) for the case of the standard overlapping generations model. one might ﬁnd equilibria in which the interest rate is less than the growth rate. the following condition will hold.

4 draw on the ideas developed in Blanchard’s (1985) paper to develop an analogue of the consumption Euler equation that holds for aggregate consumption in the economy with births and deaths. Deﬁne aggregate consumption and aggregate ﬁnancial wealth as X X Ct = Cth .19) (1 + it ) and notice that ht is independent of dynasty because all agents have the same expected future. Deﬁning Cth as n X h h Ct = Ci.110 CHAPTER 7 THE WAR-TIME RECOVERY 7.t (7.18) {C} s=t i=1 subject to the constraints (7. together with that of logarithmic preferences. (7. Future income is discounted by the survival probability π. Ah and ht are all measured t in wage units.20) i=1 which states that the dynasty devotes a constant fraction (1 − βπ) of its wealth to consumption in each period where Cth .3 The Household Problem Sections 7.3) and (7. Deﬁne human wealth by the expression ht = Lt + T Rt − Tt + πht+1 . I restate the problem of each dynasty which chooses a consumption sequence © hª Ci. First. (7.s . one can derive the following expression for the value of dynastic consumption expenditure at date t £ ¤ Cth = (1 − βπ) Ah + ht .21) t 7.8). (7. (7. At = Ah . makes aggregation possible.3 and 7.22) t h h .4 The Aggregate Consumption Function Blanchard’s idea was to give every household the same death probability. This assumption.s to solve the problem " # ∞ n X X ¡ h¢ max Jth = (πβ)t−t gi log Ci. independent of age.

The last equality in (7.23) h where ht is independent of superscipt-h because a dynasty that has existed for a thousand years has the same survival probability as one newly created.4 THE AGGREGATE CONSUMPTION FUNCTION 111 Household wealth Ah and household consumption expenditure Cth will be t diﬀerent across dynasties with diﬀerent histories but.26) pi.t .23).21). The clever assumption that makes this work is that X ht = ht = ht. Deﬁnitions (7. (7. leads to the following representation of aggregate consumption Ct = Ct+1 + α (pk.23) follows from the fact that I maintain a unit measure of dynasties at all time by assuming that there are as many births as deaths.28) Formally. the summation sign represents the integral over a unit measure. π Zt = α= ˜ n X i=1 (1 − βπ) (1 − π) . . ˜ 1 ˜ β = − 1 + βπ. α and β are deﬁned as follows.7. the literal interpretation would be that a ninety year old man has the same life expectancy as a new born baby. (7. Eq (7. combined with the individual consumption function (7.24) Combining this with the deﬁnition of human wealth. ˜ πβ (7. (7. since the preferences lead to a consumption function that is linear in wealth. A more reasonable interpretation is that of Philippe Weil (1989) who suggested that we think of these agents as dynasties in which occasionally children are unloved and left no bequest.27) is the value of gdp measured in dollars and Rt ≡ (1 + it ) . 1 (7.1 If one thinks of dynasties as people. lead to the expression Ct = (1 − βπ) [At + ht ] .tYi.t + Rt−1 πBt + Zt + T Rt − Tt ) ˜ ˜ βRt (7.22) and (7.19).25) ˜ where the compound parameters. the consumption functions of individual households can be aggregated.

112 CHAPTER 7 THE WAR-TIME RECOVERY is a compact notation for the rate of return between periods t and t + 1. Bt .30) (7.32) Bt+1 = Bt πRt−1 + Gt + T Rt − Tt .t + Rt−1 πBt + Zt + T Rt − Tt ) .t + ψZt pk. My goal is to derive a graphical apparatus than can be used to analyze ﬁscal policy in a steady state equilibrium.t and the value of government debt. 7. Since this is a perfect foresight model (at least for aggregate variables) expected future consumption is equal to realized future consumption. it follows α = 0. ˜ In the case π = 1.25) is contained in Appendix 7. The deﬁnition of equilibrium given in Chapter 6 can be modiﬁed in a natural way to give a deﬁnition of equilibrium for this economy with many .24) and (7. Zt = Ct + Gt . β = β and the model collapses ˜ to a representative agent economy.29) (7. The equations are as follows. Although one might expect α to be small if β and π are close ˜ ˜ to 1.31) (7. (7.31) is the government budget constraint and (7. Wealth includes the value of the stock market. ˜ ˜ βRt Rt−1 1 = π µ pk.t−1 ¶ .5 Aggregate Equations of Motion This section brings together four equations that together determine the properties of an equilibrium in this economy. the model with positive α may still behave very diﬀerently from the ˜ representative agent version. represented by pk. Equation (7. The derivation of Equations (7.29) is an aggregate consumption function that describes how current consumption expenditure depends on expected future consumption expenditure.32) is the gdp accounting identity. aggregate consumption depends not only expected future consumption but also on income and wealth with a coeﬃcient α. Equation (7. the model behaves very diﬀerently from the representative agent model even when π is close to 1. For the case in which 0 < π < 1. Ct = Ct+1 + α (pk.8. For values of π less than 1.30) follows from the zero proﬁt assumption in the ﬁnancial services industry. income and wealth. Equation (7.

7.6 STEADY STATE EQUILIBRIA

113

agents. The main complication involves recognizing that the allocations of each dynasty will diﬀer according to its date of birth. Once this modiﬁcation is made, the equations that describes aggregate variables, for any given bounded price sequence, are those represented by Equations (7.29) — (7.32). Notice that when π = 1, there is a single representative agent and, in this case, the model collapses to that of the representative agent economy studied in Chapter 6. One might be tempted to think that for π close to 1, the model behaves in essentially the same way. This assumption is not correct as the following analysis shows.

7.6

Steady State Equilibria

Imposing the assumption that all variables are time independent leads to the following representation of a steady state equilibrium µ ¶ 1 = α (pk + RπB + Z + T R − T ) , ˜ C 1− (7.33) ˜ βR pk Z= (Rπ − 1) , (7.34) ψ T − G − T R = B (Rπ − 1) , (7.35) Z = C + G. (7.36) A given state of long term expectations is captured by the self-fulﬁlling belief that the stock market price will equal pk . Taking pk as given and given a feasible ﬁscal policy {B, T, T R}, this system describes four equations in the four unknowns R, Z, C and G. The following analysis reduces this system to two equations in R and Z by eliminating G and C using Eqns (7.35) and (7.36) and replacing their values as functions of Z and R in Eqns (7.33) and (7.34). To facilitate the description and analysis of the steady state of the model ³ ´ 1 consider the following deﬁnition of the function g : β , ∞ → R+ , deﬁned ˜ as follows, 1 ´. g (R) = ³ (7.37) 1 1 − Rβ ˜ ³ ´ 1 This function is decreasing on β , ∞ and has the property that g → 1 as ˜ R → ∞.

114

CHAPTER 7 THE WAR-TIME RECOVERY

Using the deﬁnition of g one can rearrange Equations (7.33) — (7.36) to give the following two expressions IS Curve: and, IR Curve: Z= p (Rπ − 1) . ψ (7.39) Z= αg (R) ˜ (pk + B) + G, 1 − αg (R) ˜ (7.38)

Equation (7.38) is a steady state variant of the equation that, following Alvin Hansen and John Hicks, has been referred to in generations of Keynesian textbooks as the IS curve. It diﬀers in two ways from the usual representation of the IS curve. First, the equation recognizes that the government budget constraint must be satisﬁed and it replaces government expenditure by a function of debt and the interest rate. Second, textbook treatments of this equation assume that the savings rate is constant and the IS curve slopes down because investment expenditure is interest sensitive. In this model there is no investment and instead, the IS curve slopes down because the Blanchard model requires that saving is a function of the interest rate. Equation (7.39) represents combinations of the interest rate and aggregate expenditure that are consistent with a zero proﬁt equilibrium. On Figure 7.1 I have labelled this curve “IR” for interest rate. This curve replaces the vertical aggregate supply curve (gdp independent of R) of textbook classical models. Note also that I have plotted expenditure, Z on the vertical axis in contrast to the usual textbook convention of plotting R on this axis. The ﬁgure illustrates, in this model, the predicted eﬀect of a drop in the value of the stock market. The point {Z ∗ , R∗ } represents the model’s description of the state of the economy in 1929 before the market crash. This point is chosen in a way such that pk implements the social planning optimum.2 The point {Z1, R1 } is the position in 1933; after the crash. The eﬀect of a fall in pk is to shift the IS curve to the left and the AS curve to the right. Since the positions of both AS and IS curves depend on p, Z is predicted unambiguously to fall, but the eﬀect on R is ambiguous and depends on B. The picture draws the situation for B = 0 in which R is predicted to remain unchanged.

Of course thee is no presumption that the economy was at the social planning optimum in 1929. Indeed, there is considerable circumstantial evidence to suggest that pk in 1929 was well above p∗ . I have nevertheless chosen this starting point for illustrative purposes. k

2

7.6 STEADY STATE EQUILIBRIA

115

Z

* IR ( pk )

Z

*

IR ( p1 )

Z1

* IS ( pk )

IS ( p1 )

R* , R1

R

Figure 7.1: The Keynesian Equilibrium in 1929 contrasted with that in 1933

Z

First best

IR ( p1 )

Z* Z1

Effect of fiscal, expansion

IS ( p1 , B2 )

IS ( p1 , B1 )

R * , R1

R

Figure 7.2: The Expansionary Eﬀect of Fiscal Policy

Although calibration of the survival probability is ultimately an empirical question.4 1. 1.2 0.3 shows the historical values of the debt to gdp ratio for the period 1929 through 1950 which went from 40% of gdp in 1933 to 120% in 1945.6 0.2 1.116 CHAPTER 7 THE WAR-TIME RECOVERY Figure 7.4 0. its 1945 value and Figure 7. to B2. intuition suggests that crowding out will hold approximately and that wealth eﬀects in consumption in the steady state will be small.2 illustrates the predicted eﬀect of a ﬁscal expansion that raises government debt in the steady state from B1 its 1933 value. But if π is close to 1.3: The magnitude of changes in debt in the US data These pictures and equations are suggestive but they raise an important empirical question: How well can a calibrated model account for the magnitudes of the changes observed in the data? A ﬁrst guess at this question might give a pessimistic answer precisely because of the crowding out issue raised in Chapter 6.0 30 32 34 36 38 40 42 44 46 48 50 Government debt as a fraction of gdp Figure 7.8 0. This intuition turns out to be incorrect because the magnitude of aggregate wealth eﬀects in consumption depends on the ratio of two factors. In the numerator of this ratio is the compound parameter α ˜ . a model that required very low values of π would not be plausible since it would suggest that the horizon of the average family is short.0 0.

73 281 0.1: 1929 1933 1945 1929 1933 Data 0.73 281 0.40 60 0.47 181 0.66 The table compares the values of gdp. In 1929.67 100 Gov.98. it fell to 1.47 181 0. government debt. χ = 0. I argued in Chapter 6.6. π = 0.14 100 11. In calibrated models these two terms approximately balance each other and there are thus sizeable wealth eﬀects in the steady state.7.14 100 0.8 50 0.18 129 0.26 100 0.3 29 0.18 129 5. that the Keynesian model can explain the fall between 1929 and 1933 but that the representative agent version would have diﬃculty explaining the war-time recovery.60 100 0. gdp measured in wage units was 1. Table 7 1 documents this assertion by studying the eﬀects of a government ﬁscal expansion in a calibrated model. (wage units) exp.67 100 0.97. In the denominator is the term ˜ ¶ µ 1 1− ˜ βR 117 ˜ which is also small if the interest rate is close to β.7 100 0.63 450 0.. Table 7. (wage units) debt (% of 1929) 0.64 102 1945 Simulation Gov.63 450 3.18 in 1933 (its lowest value of the decade) and in 1945 had rebounded to its 1929 value.18 74 0.06 29 1.21 100 1.26 100 0. 1933 and 1945.10 50 1. By adding the Blanchard generational structure the theoretical possibility arises that the recovery might also . (% of 1929) S & P index number price Gdp (% of 1929) (wage units) (% of 1929) Fiscal Policy as a Response to a Fall in the Value of the Stock Market β = 0. government purchases and the value of the Standard and Poors stock market index for the years 1929.6 STEADY STATE EQUILIBRIA which is close to zero if π is close to 1. The stock market fell 50% from 1929 to 1933 and had fallen even further by 1945 when it was just 29% of its 1929 value.

The result is reported in the table. Since the model excludes investment . The main feature that the reader should take away from this table is the fact that a model with long lived dynasty’s. Notice also that the model produces GDP of 0. The simulated data is reported in the left panel of Table 7. in that structure. To pick this constant I chose a value that matched as closely as possible the return of gdp to its 1929 value in my computational experiment.this is also perhaps not surprising.66. π and χ.118 CHAPTER 7 THE WAR-TIME RECOVERY be explained since government debt. 3 . the model can reproduce the percentage drop in gdp but it understate the magnitude of the recovery. Since the government purchase and debt data are measured in wage units they are comparable and I fed these number directly into the calculation.97.98 which implies that the expected duration of a dynasty is 50 years. I deﬂated the stock market index by wage units to account for changes in the value of the labor standard during the depression.1.3 The table shows that the model can reproduce a large drop in gdp although it overstates the magnitude. but. 1933 and 1945 are all steady states it is perhaps not surprising that the numbers cannot come closer than this to the data. The results are not highly sensitive to plausible variations in these numbers although I plan to estimate these parameters formally in a separate exercise. But can the model explain the magnitude of the depression and of the recovery? To address this question I simulated the steady state of the model for three diﬀerent values of government purchases. each of which has an expected duration of 50 years. Since my computations assume that 1929. generated large wealth eﬀects from government debt I used a factor that set the stock market price equal to 80% of the eﬃcient price in 1929 in a world with no government. I chose plausible values of the three parameters β. government debt and the stock market.6. since the Standard and Poors value is an index number and not a dollar value it must still be scaled by a constant to bring it into units that are directly comparable with the dollar value of government debt. β is the discount factor and I chose an annual discount factor of 0. is net wealth. The parameter π represents the survival probability of a dynasty and here I chose 0. Here I am merely interested in the answer to back of the envelope calculation to ﬁnd out if the model has a hope of explaining the data quantitatively. The parameter χ is labor’s share of gdp which I set to 0.67 in 1929 whereas the true value is 1. If the stock market price is calibrated to a higher value. simulated gdp in 1933 is 60% of its 1929 value in the model but 74% in the data.

this is not the case for realistic values of the model parameters.S.7. it seemed that the model could not account for the wartime recovery. 119 7. data can inﬂuence the equilibrium of the economy in a quantitatively signiﬁcant way.7 Concluding Comments I ended Chapter 6 on a pessimistic note . . In this chapter I amended that model by adding a richer generational structure and showed that ﬁscal policy of the same magnitude as that observed in the U.although the search model of unemployment developed in that chapter could potentially explain the magnitude of the Depression.7 CONCLUDING COMMENTS and government purchases. We saw that in practice. This is perhaps surprising since agents in the model have realistically long horizons and one might think that the model behaves much like the representative agent economy of Chapter 6.

43) where human wealth ht is deﬁned as ht = and h Cs = ∞ X s=t Qs π s−t (Ls + T Rs − Ts ) . Ah t+1 = Rt−1Ah t + Lt + T Rt − Tt − h pi. together with the no-Ponzi scheme condition T →∞ lim QT Ah ≥ 0.46) s=t i=1 . A promise to pay one unit of account at date s if and only if the agent is alive at that date will trade for price Qs π s−t at date t < s.40) forwards and making use of (7.s Ci. t Iterating Eqn (7.8. t t+1 (7.8 7.41) Since we assume the existence of perfect life insurance markets the agent may trade future claims to consumption that occur if and only if the agent is alive at that date.t . (7.41) allows one to write a single lifetime budget constraint ∞ X s=t Qs πs−t t n X i=1 h pi.120 CHAPTER 7 THE WAR-TIME RECOVERY 7. The objective function of the family is " # ∞ n X X ¡ h¢ s−t Jth = (πβ) gi log Ci.s Ci.45) is consumption expenditure at date s. t ≥ h.42) or more compactly ∞ X s=t h Qs πs−t Cs ≤ ht + Ah Rt−1 .40) where I deﬁne (1 + it ) ≡ Rt .44) (7. t t (7.s ≤ ∞ X s=t Qs π s−t (Ls + T Rs − Ts ) + Ah Rt−1 .1 Appendix to Chapter 7 The Household Problem n X i=1 The budget constraints of the household consist of the sequence of equations.s . t ≥ h (7. t X i h pi.s . t t (7. (7.t Ci.

52) Rt 1 − βπ which can be rearranged to give µ ¶ h ¡ ¢ πCt+1 1 − π (1 − βπ) h h = Lt + T Rt − Tt + At (1 − π) + .50).8. (7.48) that consumption expenditure at date t is equal to £ ¤ Cth = (1 − βπ) ht + Rt−1Ah .46) subject to (7.47) P where λ is the Lagrange multiplier on (7.53) .51) Rearranging Eqn (7.48) into (7.49) It follows from (7.2 The Consumption Function This subsection derives an aggregate expression for the consumption function. Ct 1 − βπ Rt (1 − βπ) (7. Cth − Rt−1 Ah = Lt + T Rt − Tt t (1 − βπ) ∙ h ¸ ¡ ¢ Ct+1 π h h + − Rt Rt−1 At + Lt + T Rt − Tt − Ct .40) gives the following expression. t (7. t h Ci. Eqn (7.7.42) leads to to the ﬁrst order condition gi (πβ)s−t = λQs π s−tpi.48) β s−t = λQs Cs . Rt (7.50) t 7.8 APPENDIX 121 and maximizing (7. Recall that human wealth at dates t and t + 1 are related by the recursion ht = Lt + T Rt − Tt + πht+1 . (7. h (7. Since i gi = 1.43) gives the following solution for λ−1 £ ¤ λ−1 = (1 − βπ) ht + Rt−1 Ah . t Substituting (7.42).51) and making use of (7.s (7.47) can be summed over all goods at each date to give the following expression relating consumption expenditure at date s to its present value price and the multiplier λ. substituting it into (7.s .

Kt = 1 from the non-reproducability of capital and Lt = χZt from the aggregate supply equation (6. Ct+1 Lt and Ah it can be summed over t the unit measure of households to yield the aggregate expression ¶ µ 1 − π (1 − βπ) πCt+1 Ct = (Lt + T Rt − Tt + At ) (1 − π) + . (7.56) α= ˜ (1 − βπ) (1 − π) .55) yields the result.t + Rt−1 πBt + Zt + T Rt − Tt ) ˜ ˜ βRt (7.57) which is the equation we seek. Using the facts that Lt + rrt Kt = Zt from the national income accounting identity.54) 1 − βπ Rt (1 − βπ) Deﬁne the following constants: 1 ˜ β = − 1 + βπ.55) Substituting this into Eqn (7.t + Rt−1 πBt + Zt .54) and making use of deﬁnition (7. (7. Lt + At = pk. .t + rrt ) Kt.122 CHAPTER 7 THE WAR-TIME RECOVERY h Since this equation is linear in Cth . ˜ πβ (7.36) developed in Chapter 6. we have the following intermediate expression. π and notice that At = Rt−1 πBt + (pk. Ct = Ct+1 + α (pk.

A series of recessions in the 1950’s was followed by an economic expansion in the 1960’s and during the 1970’s growth slowed down. inﬂation increased. Before that date the Fed had agreed to a policy of buying treasury bills at a ﬁxed low interest rate. At the same time that growth slowed.1 Introduction This chapter is about the economic history of the United States in the period from 1951 through to the present. 123 . The coincidence of low growth. by 1981 it had reached a peak of 11% . In 1952 the annual rate of wage inﬂation was 3%. In 1980 the Fed took aggressive action to end inﬂation by raising interest rates to unprecedented levels and 1 Robert Hetzel and Ralph Leach 2001. With the end of war-time price controls. The chapter begins in 1951 when the accord between the Fed and the treasury allowed the Fed to conduct active monetary policy. the fear was a recurrence of the Great Depression1 but inﬂation soon took over as a more immediate concern.Chapter 8 The Post-War Experience: After the Accord 8. high unemployment and high inﬂation was dubbed ‘stagﬂation’ in the popular press. a measure that was introduced to facilitate war time ﬁnancing. In the period after 1951 the Fed began actively to manipulate the short-term interest rate in an eﬀort to manage the economy. Page 34. The increase in inﬂation was accompanied by a simultaneous increase in the unemployment rate. This slowdown is often attributed to increases to the price of oil in 1973 and again in 1979.

The rate of wage inﬂation is constructed from the same annual wage series that was used in Chapters 6 and 7 to generate data in wage units. The period after 1951 is one of less volatile ﬂuctuations in wages but more volatile interest rate movements. The ex-post real rate is constructed as Rt = (1 + it−1 ) wt−1 wt (8. This shift in the real rate will be an important part of the picture I will paint and I will return to it in Section 8. low unemployment and low inﬂation. The interest rate is the three month treasury bill rate for the period from 1934 to 2006 and for the years from 1929 to 1934 it is a six month commercial paper rate spliced and scaled to equal the t-bill rate in 1934.1 reveals that for much of the period from 1951 through 1980. and wt is the money wage in year t constructed as compensation to employees divided by full and part-time equivalent employees. that is. 8.2 The Impact of the Fed-Treasury Accord Figure 8. From 1951 through 1980 it ﬂuctuates around a constant mean that is a little less then one.1 illustrates the behavior of a short term interest rate. Notice that before 1951 the t-bill rate is smooth and wage inﬂation is volatile.2 Active monetary intervention in the form of counter-cyclical interest rate movements begins in 1951 with the Accord and for this reason I have chosen to focus on this period in the current chapter. This chapter documents the facts beginning in 1951 and ending in 2006.1) where it−1 is the annualized t-bill rate between years t − 1 and t. The real rate appears to have a trend break in 1980. In 1983 it reaches a peak of a little over 5% and slowly returns to its pre 1980 trend. It is likely that some. 2 . but not all. the real interest factor is less than one. wage inﬂation and the implied ex post real interest rate for the period from 1929 through 2006. In contrast. the real interest rate is negative.4. of the reduction in wage volatility is due to improved methods of data collection as pointed out by Christina Romer 1986. A close inspection of Figure 8. the expansion of the 1980’s and 1990’s are accompanied by positive real rates.124 CHAPTER 8 POST WAR EXPERIENCE the subsequent decades through the early part of the 21st century have been a period of high growth.

Unemployment begins the decade at 4. From 1970 . The behavior of gdp and unemployment is depicted in Figure 8.10 1.3 REAL ECONOMIC HISTORY 1.90 0.95 0.2. During the 1950’s there is a downward trend in gdp and a slow but steady increase in the unemployment rate. NBER recessions are shaded in grey.15 1.1: Interest Rates and the Accord 8.8. The period can broadly be divided into four sub-periods for the analysis of the medium frequency movements that concern me.85 0.3 The Economic History of the Post-War Period: Real Variables This section describes the behavior of real variables in the period from 1951 through 2006 and interprets these movements using the theory developed in Chapter 7.20 1.80 1930 1940 1950 1960 1970 1980 1990 Gross Treasury Bill Rate Wage inflation Gross Real Rate in Wage Units Fed Treasury Accord 125 2000 Figure 8.5% and ends at over 7%.00 0.05 1. The 1960’s see a reversal of this movement and there are seven years of uninterrupted expansion ending with a recession in 1969. Gdp is measured on the left axis in wage units and unemployment is plotted on the right axis and measured as percent of the labor force on an inverted scale.

56 1. Both series are in wage units.64 1. I will argue in this chapter that consumption and government purchases are more important causes of post-war movements in output and employment.2: Unemployment and Gdp through 1980 growth slows down and unemployment moves from a low of 5% in the late 1960’s to over 9% in 1980.76 1.52 1. In the Keynesian models developed in this book unemployment is caused by deﬁcient aggregate demand which is divided into three components.48 CHAPTER 8 POST WAR EXPERIENCE 3 4 5 6 7 8 9 10 55 60 65 70 75 80 85 90 95 00 05 Gdp (Wage units) Unemployment Rate Figure 8. 3 .60 1.126 1.72 1. Finally. investment.3 Investment is highly correlated with business cycles at typical business cycle frequencies but it does not seem to be correlated with the more important medium term movements in employment that are the focus of this enquiry. this medium term trend is reversed in the 1980’s and 1990’s with a long expansion punctuated by a single brief recession in 1990 and ending with a second recession in 2001. consumption and government purchases of goods and services. Casual inspection The drop in investment spending in the 1930’s was a secondary consequence of the drop in stock market wealth that rendered the existing capital stock overvalued.3 which plots investment (measured on the right scale) and gdp on the left scale. Whereas a fall in investment spending is often blamed by Keynesians for the Great Depression.68 1. Consider Figure 8.

3 REAL ECONOMIC HISTORY 127 of this ﬁgure reveals that local peaks and troughs in the series often occur together. These productivity shocks are autocorrelated and cause consequent movements in investment as businesses expand to take account of future opportunities. but the broad decade long swings in gdp are not associated with similar movements in investment. investment ﬂuctuations and gdp ﬂuctuations are both caused by the same driving force: productivity shocks.20 Gdp (Wage units) Private Investment (Wage units) Figure 8.these series are measured in .72 1.34 . It is these movements that mod1.52 1. This explanation may well be correct and there is certainly an element of truth to the idea that some movements in aggregate economic activity are caused by supply side shocks of this nature. If the two are series are passed through the Hodrick-Prescott ﬁlter with a smoothing parameter of 100 (typical for annual data) the ﬁltered series reveal a much closer correlation of investment and gdp at typical business cycle frequencies.56 1.48 55 60 65 70 75 80 85 90 95 00 05 .32 .30 .26 .68 1.76 1. Figure ?? illustrates the HP-ﬁltered movements in investment and gdp . the long contraction of gdp that begins in 1967 and ends in 1982 is not associated with any similar discernible trend in investment. For example.22 .24 . In this explanation.60 1.3: Gdp and Investment ern business cycle theorists focus upon and the RBC explanation for business cycles is that they occur as a consequence of technology shocks that cause random ﬂuctuations in aggregate productivity.64 1.28 .8.

I am excluding movements of this kind from those associated with supply driven business cycles since although they are associated with a spike in HP ﬁltered investment in 1967.06 -.08 55 60 CHAPTER 8 POST WAR EXPERIENCE 65 70 75 80 85 90 95 00 05 Gdp in wage units (HP filtered) Investment in wage units (HP filtered) Figure 8.3 that begins with the 1967 peak and ends with the 1980 trough is a movement of 2 wage units from 1. because a productivity shock should cause gdp and investment to move together.04 -. movements in wealth and consumption. the medium frequency movement in GDP depicted in 8. Figure 8. driven by movements in wealth and income.52.06 .6 wage units. Figure 8. The movements from 1970 through 1980 on Figure ?? are the kind that have in mind. in 1981. These movements should be compared with the mean value of gdp over the period of 1. In addition to investment spending.08 .3 reveals that investment was acyclic over the period from 1967 to 1980 and.04 . or movements in government purchases. and a trough. In contrast.02 .4: Gdp and Investment (HP Filtered) wage units and a typical movement in investment and gdp at business cycle frequencies is plus or minus 0. .72 to 1. aggregate demand movements may be due to consumption.02 -. it seems diﬃcult to attribute the medium term downward trend in gdp to a ﬂuctuation in productivity.5 illustrates the behavior of two forms of wealth. Consider ﬁrst.128 . these extrema are not associated with the medium term trend in gdp.3 units.00 -.

Compare this with Figure 8. is determined by the equation Z = H (R) (pk + B) + G. 1 − βR ˜ (8.34) and g (R) ≡ 1 1 . but what of the period from 1951 to 1980? . C = αg (R) (pk + B + Z) ˜ where Eq (8. (8.2) and (8.2) Income.5) 1 − αg (R) ˜ Recall that Z is gdp. steady state consumption is the following function of wealth and income.2) and (8. where H (R) ≡ (8. The following explanation is based on the two steady-state equations.6 plots consumption on the right axis and gdp on the left.33) and (7. The post 1980s movements in consumption can potentially be explained by the simultaneous increase in stock market wealth and government debt.8. Over this period consumption trends down in the ﬁrst part of the sample and begins a sharp upward trend in 1980. the steady state equations will give a rough picture of the plausibility of a demand driven explanation. in the steady state. The units of debt are pure numbers whereas the units of the S&P series are $−1.3) (8. In the model developed in Chapter 7. Government debt is measured on the right axis and the value of a stock market index (the Standard and Poors 500) is on the left axis.4) αg (R) ˜ . (8. and although the relative importance of the diﬀerent determinants of consumption and income will depend on the timing of events and on equilibrium dynamics. How well does a theory based on Equations (8.5 which plots wealth and income over the same period. B is government debt.4) explain the facts? Figure 8.2) combines (7. both measured in wage units. The units of the Standard and Poors index (henceforth the S&P) are not comparable with those of government debt since the S&P is an index number divided by the money wage while debt is a dollar value divided by the money wage. From 1951 through 1980 government debt and the stock market move in diﬀerent directions.4).3 REAL ECONOMIC HISTORY 129 government debt and the value of the stock market. pk is the value of the stock market and R is the gross rate of interest.

60 1.5: Two Wealth Measures 1.04 1.4 1.12 1.1 .00 0.6: Gdp and Consumption .8 S and P 500 (Index weighted by Wage) Government debt (Wage Units) Figure 8.16 1.76 1.48 55 60 65 70 75 80 85 90 95 00 05 1.08 1.4 .4 1.64 1.56 1.72 1.0 55 60 65 70 75 80 85 90 95 00 05 0.20 1.130 CHAPTER 8 POST WAR EXPERIENCE 1.0 0.3 0.92 Gdp (Wage units) Private Consumption (Wage units) Figure 8.2 .68 1.6 .96 0.52 1.2 .

In the period since 1951 the major movements in government purchases have been driven by the requirements of wartime ﬁnancing and it is those movements that were mainly responsible .7 plots gdp and government purchases of goods and services. economic activity is determined by aggregate demand which has three main determinants.38 .3 REAL ECONOMIC HISTORY 1.56 1. The history of this period is one of wartime ﬁnance.60 1. government debt and the value of the stock market. Government purchases are measured on the right axis and gdp on the left.76 1.40 .34 . The changes in government purchases over this period are responsible for the decline and subsequent increase in gdp.64 1. government purchases.48 55 60 65 70 75 80 85 90 95 00 05 .32 .72 1. This drop in government purchases was reversed in 1959 when America entered the Vietnam conﬂict and the period from 1959 through 1967 was one of increased government expenditures driven largely by defense.30 . a major component of gdp.68 1.8.28 131 Gdp (Wage units) Government Purchases (Wage Units) Figure 8. both measured in wage units.7: Government purchases and GDP Figure 8.42 . The Korean war ended in 1953 and was followed by a decline in government purchases and a corresponding drop in gdp.52 1. To summarize.36 . Notice from this ﬁgure that the medium frequency movements in government purchases from 1951 through 1980 are mirrored by the movements in gdp.

.5%. These changes in debt were associated with a wealth transfer from future to current generations that caused a consumption led boom in economic activity after 1980. government debt is net wealth to the community and is an important component of aggregate demand. A complete integration of monetary policy with a theory of real behavior based on wealth requires a discussion of how the interest rate on treasury securities is related to the stock market return.8% with a standard deviation of 13%.132 CHAPTER 8 POST WAR EXPERIENCE for a slowdown in the 1950s and a subsequent expansion in the 1960s.3% with a standard deviation of 2. the fact that stock market returns are. 8.4 The Economic History of the Post-War Period: Monetary Variables The explanation I given to this point is missing a critical element . Over this period the real return on the S&P averaged 6. This panel illustrates the equity premium puzzle.8 plots the ex-post real return on three month treasury bills against the ex post real stock market return on the S&P 500. on average much higher than the return to government securities. A third major component of the movements in demand has been a slow moving but largely unpredictable movement in the value of the stock market caused by changes in market psychology. Most economic models of business cycles ignore this discrepancy and it is typical to calibrate a model to the stock market return.the role of monetary policy. It is to this that I now turn. Both real returns are computed by multiplying the gross nominal return by the ration wt/wt+1 where wt is the money wage series computed in the way explained in Chapter 5. 8. I cannot aﬀord to take that approach in this chapter since the behavior of the t-bill rate is crucial for understanding the evolution of government debt and in the model I will build. The average return on t-bills was negative 0. Superimposed on the movements in government purchases there was a decline in government debt from 1951 through 1979 that was then reversed and followed by a period of increasing debt.5 The Equity Premium The top panel of Figure 8.

8.00 0.92 55 60 65 70 75 80 85 90 95 00 05 0.0 0.8 0.96 0.8: Debt and the Interest Rate .2 1.08 1.1 1.8 1.04 1.7 55 60 65 70 75 80 85 90 95 00 05 Gross Real Rate in % (Wage is numeraire) Real Stock Return in % (Wage is numeaire) 1.4 1.6 0.4 1.4 Gross Real Rate in % (Wage is numeraire) Government debt (Wage Units) Figure 8.0 0.5 THE EQUITY PREMIUM 133 1.2 1.9 0.3 1.

9 provides additional support for this statement.2 0. The main point of this graph is to illustrate that the behavior of debt. Debt fell because the economy grew faster than the interest rate that was paid by government on its debt.8 0.2 1. is explained principally by the interest rate. It illustrates the behavior of debt along with the real value of the primary deﬁcit. in wage units. measured in wage units. in fact the government borrowed approximately 0.0 55 60 CHAPTER 8 POST WAR EXPERIENCE 65 70 75 80 85 90 95 00 05 Government debt (Wage Units) Primary budget deficit (Wage units) Figure 8.9: Debt and the Deﬁcit The lower panel of Figure 9.0 0. This graph shows that debt did not fall because it was paid oﬀ.4 1. The value of debt fell from a little over 1. against the real t-bill rate from the top panel.134 1.06 wage units more than it received on average over the period from 1951 to 2006.5 wage units in 1980. During this period the real return to t-bills was negative in almost every year and never exceeded 1/3 of 1%.2 wage units (about 75% of gdp) to 0.6 0. .1 illustrates the behavior of government debt. deﬁned as government purchases plus transfers minus all government receipts (including payments into the social security trust fund).4 0. Debt is measured on the right scale and the interest rate is on the left. Figure 8.

6 THE THEORY SUMMARIZED 135 8. Superimposed on this are unpredictable ﬂuctuations in the real value of the stock market and temporary but important movements in government purchases driven by the Korean war (19501953). the lowest ﬁgure since 1957. but together they present a fairly complete explanation of business cycle feature of the period. The beginning of the period coincides with the accord in 1951 and the end of the Korean war in 1953. .6 The Theory Summarized What does the theory developed in this book have to say about the events described in Section 8. a fall in aggregate demand and a steady increase in unemployment over the decade which reaches a peak of 7% in 1960. Seven years of peace are associated with a drop in government purchases. the Vietnam war (1959-1975) and end of the cold war in 1989. A secular downward movement in government debt began at the end of World War II and continued until 1980. None of these individual features can account for the movements in unemployment.7% in 1969. During the period from 1951 through This reduction in debt came to an abrupt end in 1980 as a direct consequence of the actions of the Fed which temporarily raised the real interest rate and caused the treasury to shift the debt burden to future generations. features can account for the Reagan prices that are unpredictable features. Debt that was accumulated during WWII was paid oﬀ in the immediate post-war period as a natural consequence of the growth of the economy and from seigniorage revenues on government debt that private agents are willing to hold for a roughly 7% discount over corporate equity. Unemployment falls during this period to a low of 4.3? The story I will tell is one of movements in aggregate demand driven by two broad trends. In 1959 America enters the Vietnam war and the period from 1959 through 1968 is associated with a big increase in defense expenditure and a corresponding increase in aggregate demand. expand raised has liquidity value to the ﬁnancial system that movements are explained by actions of the Fed.8. thereby generating a wealth eﬀect that prompted current generations to increase consumption.

.

t−1 Bt+1 = Bt πRt−1 + Gt + T Rt − Tt . Since all variables are measured in wage units this assumption leads to the following modiﬁcation of Eq (9.Chapter 9 Explaining Stagﬂation To be completed The starting point of the model developed in the Chapter is the real model of Chapter 7 that I repeat below. π pk. (9.4) In that chapter I used labor as the numeraire and set the money wage in each period to one. Ct = Ct+1 wt+1 + α (pk. Here I assume instead that the money wage may change each period.2) (9. 137 .t + ψZt Rt−1 = .1) (9. Zt = Ct + Gt .1).3) (9.t + Rt−1 πBt + Zt + T Rt − Tt ) ˜ ˜ β (1 + it ) wt where wt is the money wage and it is the interest rate on treasury bonds that I take to be set by the Fed through open market operations. Ct = Ct+1 + α (pk.t + Rt−1 πBt + Zt + T Rt − Tt ) ˜ ˜ βRt µ ¶ 1 pk.

1 Adding Money to the Model Explain money in production function.Concluding Comments . Explain why it doesn’t matter much. Explain why log assumption is not quite right.138 CHAPTER 9 EXPLAINING STAGFLATION 9.

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