Chapter One

Advanced Macroeconomics
(DECON521)
By:
Haile Girma (Assistant professor)

Salale University
College of Business and Economics
Department of Economics
December 2020
CHAPTER ONE:
INTRODUCTION
 Presentation outline
1.1. Who is who in Macroeconomics

1.2.Breakdown of consensus
1.3. Contemporary Macroeconomic
School of Thoughts
1.1. Who is who in Macroeconomics?
 This chapter refers to the evolution and stages of development of
macroeconomics.
 The main objectives of macroeconomics are:-
 Growth of output
 Reducing inflation/stable price
 Reducing unemployment/ raising employment
 Maintaining stable exchange rate
 Maintaining B.O.P.
 As an arbitrary dichotomization; the evolution of
macroeconomics can be classified in terms of the dominant school
of thoughts (i.e., who dominates who) into four.
 Macroeconomics as a branch of economics was emerged with the
writing of Adam Smith “The wealth of Nation” in 1776.
 The classical school of thought 1776-1870
 The Neo classical school of thought 1870-1936
 The Keynesian school of thought 1936-1975
 Contemporary macroeconomics schools 1975 present

1)THE CLASSICAL SCHOOL OF THOUGHT (1776-1870):
During this period macroeconomics ideas were not distinct from
that of microeconomics.
The dominant idea was the invisible hand which implies market
price will always correct any market imbalances.

It also implies that the government should stay away from
intervening in the economy

The government is regarded as “the necessary evil”
According to them wages and prices are flexible.
If unemp’t is high workers should cut the nominal wage and if
products are not sold suppliers should cut price.

2)THE NEO CLASSICAL SCHOOL OF THOUGHT
(1870-1936):
 Their ideas are much more similar to the classical.
 According to this school product’s price is determined by
consumer’s perception of its value, according to classical
product’s price is determined by cost of production.
 The action of private agents is to maximize their
welfare; that of firms is to maximize profits and
consumers is to maximize utility- will bring
equilibrium in an economy.
 Thus, government intervention in an economy will disturb the
smooth operation of the economy.
 Fig 1 Equilibrium in the labour market, Neo classical case.do
cx
 3)THE KEYNESIAN SCHOOL OF THOUGHT
(1936-1975):
 Keynes challenged the existing wisdom of the
classical and neo-classical macroeconomics
arguments since 1936, through, his book “ The
general theory of interest rate, inflation, and
unemployment”. He said
I)The private sector is subjected to
coordination failure
 That is, in contrast to the classical propositions Keynes said
market prices by themselves are not adequate to correct
market imbalances.
II)Wages and prices do not adjust quickly to restore
equilibrium in markets.
 In other words, he argued that there is wages and price
stickiness/rigidity.
 Nominal wages are sticky due to the existence of nominal
wage contracts determining nominal wages in advance.

III)There is excessive fluctuation in real
economic activities.
 In other words, the equilibrium is not inherently
stable.
 What are the policy implications of the above
three arguments?
 The policy implications of the above three propositions of
Keynes are the government has a role to play to fine
tune the economy using macro policy instruments.
 Accordingly, the Keynesian arguments and hence the
policy proposition were taken as conventional or
standard macro polices until the early 1970’s.
 Put differently, there was consensus in macroeconomics
until the early 1970s.
(1)The Philips curve framework:
 That is one would maintain a permanently low level of
unemployment merely by tolerating a permanently high
level of inflation (say by increasing average money
supply.
FIG2: The Philip Curve
(2)Nomal wages and price stickiness/ rigidity

(3)Effectiveness of monetary and fiscal policies in
restarting equilibrium in the long run.
1.2 Breakdown of Consensus
 The consensus in macroeconomics that prevailed until the

early 1970’s were broken down due to two reasons.
 Empirical reason:
 That is the consensus/Philips curve view did not adequately

cope with the rising rates of inflation and unemployment
during the 1970’s.
 Theoretical reason:
 That is, there is gap between microeconomic principles

and macroeconomic practices.
 The earlier challenge of the Keynesian argument came
from the monetarist Friedman and Phelps (1968).
 They argued that the Philips curve lacks micro
foundation.
 That is they argued from microeconomic principles that
this empirical relationship between inflation and
unemployment would breakdown if policy makers
attempted to exploit it.
 Because, the equilibrium level of unemployment
should depend on :-
i. Labour supply
ii. Labour demand
iii. Optimal search time and
iv. Other microeconomic consideration not
on the average rate of money growth.
 Suppose the government increases money
supply to increase inflation and reduce
unemployment.
 However, in the long run economic agents using adaptive
expectations (i.e., correcting mistakes using lessons from
experience) may adjust themselves to the outcome of policy
change (i.e., MS  P, then the increase in P 
reduce real wage ( W/P)  LD by firms output
P(or  inflation).
 But defenders of the consensus viewed much of the
stagflation (stagnant economic growth, but high rate of
inflation and unemployment) of the 1970’s to the OPEC SS
shocks
1.3. CONTEMPORARY MACROECONOMIC
SCHOOL OF THOUGHTS
 This include the New classical school (NCS), the Real Business
cycle (RBC), and the New Keynesian schools (NKS).
1.3.1 The New classical school (NCS)
 The breakdown of the Philips curve when Friedman and
Phelps argument proved correct when inflation rose

without any permanent reduction in unemployment
made macroeconomics ready for Robert Lucas (1976) more
comprehensive attack of the consensus view known as the
“Lucas critique”
1. Lucas pointed out that many of the empirical
relationships that made up large scale macroeconomic
models were not better founded on microeconomic
principles than was the Philips curve.
2. In particular the decisions that determine most
macroeconomic variables, such as consumption and
investment depend critically on expectations on the
future state of the economy.
 Hence, Lucas pointed out that one important feature of
most policy interventions is that they change the way
individuals form expectations about the future.
 The NCS of the 1970’s were in large part
focus on correction of faulty notions
presented in the Keynesian macroeconomics
of the 1950’s.
 Thus, the above three arguments have the
following two policy implications.
I) Policy ineffectiveness/irrelevance
 The result of Sargent and Wallace (1975) shows that
systematic monetary policy is irrelevant to the path of
output and employment is one of the earliest and most
controversial applications of rational expectation (RE).
 They applied RE to the natural rate of Philips curve of
Friedman and Phelps that posits that expected inflation
does not affect unemployment, but that unexpected
inflation temporarly lowers unemployment below the
natural rate.
 Since the assumption of RE rules out surprising
people systematically, Sargent and Wallace
concluded that systematic monetary policy can
affect only expected inflation, not unexpected
inflation & unemployment.
 This implies that the advice such as “ increase
money growth when the economy looks like it is
going in to a recession” would render ineffective
policy.
II)Dynamic time inconsistency of optimal policy
 This means that any attempt by policy makers to push up
output, will make the economy worse off because
 People may not know what the level of output is (collusion
lag)
 Implementation Lag and
 Effect lag thus, the NCS argued that government

intervention is unnecessary
 E.g., it may be optimal for a government to announce that it
will not tax capital in order to encourage accumulation, but
once the capital is accumulated, the government may wish to
renege on its promise.
 Another example, the government may wish to
announce that it will prosecute vigorously all
tax evades, but ones the taxes have been evaded,
the government may wish to announce a “tax
amnesty” to collect some extra revenue.
 In each case, rational agents understand the
incentive of the government to renege and this
expectation affects their behavior.
 Thus, it can be inferred that the goal of the NCS has been
to rebuild macroeconomics while maintaining the axioms
that individuals always optimize and more importantly
the market always clear.
1.3.2 The real Business cycle (RBC):
Modeling the economy as an efficient system in w/c
upturns & down turns in the economy are beyond the

control of the governments- animal sprits of
economic agents create volatile & unpredictable
economy that oscillates between boom & recession.
It emphasized inter-temporal substitution of
consumption and leisure caused by exogenous technological
disturbance (Barro & King, 1984; Prescott, 1986)
 The RBC models have been rigorously founded on
microeconomics principles.
 The RBC theory contrasts sharply with the consensus view
of the 1960’s.
The four main propositions of RBC are
 The economy experiences large and sudden changes
in the available production technology

 Leisure is highly substitutable overtime
 Fluctuations in employment are fully voluntary &
socially optimal.
 Monetary policy has no ability to affect real variables,
such as output and employment.

1.3.3 THE NEW KEYNESIAN SCHOOL (NKS): It is a
modified version of the Keynesian school of 1960’s.
It shares some of the NCS assumptions such as RE and
micro foundation but rejects their proposition of policy

ineffectiveness.
The core proposition of the NKS rests on the assumption that
the economy is explained as in disequilibrium rather than

equilibrium state because of real wages and price rigidity.
 Why real wages rigidity exists?
 it exist because of wage indexation, labour unions,
Menu costs and efficiency wages.
 Wage indexation means wages are specified in advance in
accordance to changes in the prices of goods and services.
 Thus, workers negotiate for real wages consistent on the
basis of wage indexation, which makes w/p constraint.
 Efficiency wage: Firms have an incentive to
pay high wages to increase productivity
by reducing shaking moral hazard.
 Thus, the disequilibrium will not be adjusted
overtime.

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Advanced Macroeconomics

Haile Girma (Assistant professor)

1.1. Who is who in Macroeconomics

 Reducing inflation/stable price

 Reducing unemployment/ raising employment

 Maintaining stable exchange rate

 The Neo classical school of thought 1870-1936

 The Keynesian school of thought 1936-1975

 Contemporary macroeconomics schools 1975 present

price will always correct any market imbalances.

intervening in the economy

According to them wages and prices are flexible.

products are not sold suppliers should cut price.

wage contracts determining nominal wages in advance.

(2)Nomal wages and price stickiness/ rigidity

 The consensus in macroeconomics that prevailed until the

 That is the consensus/Philips curve view did not adequately

 That is, there is gap between microeconomic principles

Phelps argument proved correct when inflation rose

 Effect lag thus, the NCS argued that government

upturns & down turns in the economy are beyond the

in the available production technology

 Fluctuations in employment are fully voluntary &

such as output and employment.

micro foundation but rejects their proposition of policy

the economy is explained as in disequilibrium rather than

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