building macro models

8/3/2019 Building Macro Models

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Tom Holden

www.tholden.org


2/18

Topics within macroeconomics. In the long run. And the short run.

Steps in building theoretical models. Objective functions. Deriving the models equations. Calibration/estimation.

Simulation.

Empirical macro.


3/18

Two big divides: Theoretical / empirical Long run (e.g. growth) / short run (e.g. cycles)

Long run theoretical macro usually works incontinuous time. Long run empirical macro usually runs reduced

form cross-country regressions. Short run theoretical macro usually works in

discrete time. Short run empirical macro usually runs structural

time series regressions.


4/18

Endogenous growth: what are the sources ofgrowth? This literature work with models that often contain a key

equation that looks something like = where isproductivity and

is research.

Read: Jones, Handbook of Economic Growth, Chapter 16(2005)

http://ideas.repec.org/p/nbr/nberwo/10767.html

And: Mankiw, Romer and Weil, A Contribution to theEmpirics of Economic Growth (1992)

http://www.jstor.org/stable/2118477
http://ideas.repec.org/p/nbr/nberwo/10767.htmlhttp://www.jstor.org/stable/2118477http://www.jstor.org/stable/2118477http://ideas.repec.org/p/nbr/nberwo/10767.html


5/18

Structural change: how can we explain e.g. the rise of the servicesector, or the increase in the skill premium for higher degrees? This literature often works with models in which the elasticity of

substitution between various factors of production is not equal to one.

Read: Duarte and Restuccia, The Role of the Structural Transformation inAggregate Productivity (2010)

http://qje.oxfordjournals.org/content/125/1/129.short

And: Acemoglu, Capital Deepening and Nonbalanced Economic Growth(2008)

http://www.jstor.org/stable/10.1086/589523

And: Ngai and Pissarides, Structural Change in a Multisector Model of

Growth (2007) http://www.aeaweb.org/articles.php?doi=10.1257/aer.97.1.429
http://qje.oxfordjournals.org/content/125/1/129.shorthttp://www.jstor.org/stable/10.1086/589523http://www.aeaweb.org/articles.php?doi=10.1257/aer.97.1.429http://www.aeaweb.org/articles.php?doi=10.1257/aer.97.1.429http://www.jstor.org/stable/10.1086/589523http://qje.oxfordjournals.org/content/125/1/129.short


6/18

What is the optimal policy for dealing withclimate change? This literature works with models in which climate

change either reduces productivity or decreases

utility.

Read: Golosov et al., Optimal Taxes on Fossil Fuelin General Equilibrium (2010)

http://www.nber.org/papers/w17348.pdf
http://www.nber.org/papers/w17348.pdfhttp://www.nber.org/papers/w17348.pdf


7/18

How should a country respond to discoveringa significant new source of natural resources? This literature works with multi-country models in

which the resource is a factor of prodution.

Read: van der Ploeg, Natural Resources: Curse orBlessing? (2008)

http://www.aeaweb.org/articles.php?doi=10.1257/

jel.49.2.366
http://www.aeaweb.org/articles.php?doi=10.1257/jel.49.2.366http://www.aeaweb.org/articles.php?doi=10.1257/jel.49.2.366http://www.aeaweb.org/articles.php?doi=10.1257/jel.49.2.366http://www.aeaweb.org/articles.php?doi=10.1257/jel.49.2.366http://www.aeaweb.org/articles.php?doi=10.1257/jel.49.2.366


8/18

What causes business cycles? Productivity shocks? News about future productivity? Investment specific technical change? Demand shocks?

Preference shocks? Shocks to financial intermediation? Monetary policy shocks? Tax policy shocks? Government spending shocks?

Read: Beaudry and Lucke, Letting Different Views aboutBusiness Cycles Compete (2009)

http://www.nber.org/chapters/c11806.pdf
http://www.nber.org/chapters/c11806.pdfhttp://www.nber.org/chapters/c11806.pdfhttp://www.nber.org/chapters/c11806.pdf


9/18

Can business cycles be stabilised throughmonetary policy? Only if there is a substantial nominal rigidity in the

economy. E.g. sticky prices or sticky wages.

Read: e.g. Gali, Monetary Policy, Inflation, and theBusiness Cycle: An Introduction to the NewKeynesian Framework (first few chapters) (2008)

And: Golosov and Lucas, Menu Costs and PhillipsCurves (2007)

http://www.jstor.org/stable/10.1086/512625
http://www.jstor.org/stable/10.1086/512625http://www.jstor.org/stable/10.1086/512625


10/18

Can business cycles be stabilised throughfiscal policy? Depends if Ricardian equivalence holds.

Read: Ravn et al., Deep Habits (2006) http://www.blackwell-

synergy.com/doi/abs/10.1111/j.1467-937X.2006.00374.x

And: Ilzetzki et al., How Big (Small?) are FiscalMultipliers? (2010)

http://www.nber.org/papers/w16479.pdf
http://www.blackwell-synergy.com/doi/abs/10.1111/j.1467-937X.2006.00374.xhttp://www.blackwell-synergy.com/doi/abs/10.1111/j.1467-937X.2006.00374.xhttp://www.blackwell-synergy.com/doi/abs/10.1111/j.1467-937X.2006.00374.xhttp://www.blackwell-synergy.com/doi/abs/10.1111/j.1467-937X.2006.00374.xhttp://www.nber.org/papers/w16479.pdfhttp://www.nber.org/papers/w16479.pdfhttp://www.blackwell-synergy.com/doi/abs/10.1111/j.1467-937X.2006.00374.xhttp://www.blackwell-synergy.com/doi/abs/10.1111/j.1467-937X.2006.00374.xhttp://www.blackwell-synergy.com/doi/abs/10.1111/j.1467-937X.2006.00374.x


11/18

Do the costs of cycles outweigh the costs ofstabilisation? Not obvious a priori.

Read: Lucas, Macroeconomic Priorities (2003) http://home.uchicago.edu/~sogrodow/homepage/

paddress03.pdf

And: Gal et al., Markups, gaps, and the welfare cost

of business fluctuations (2007) http://www.mitpressjournals.org/doi/pdfplus/10.1

162/rest.89.1.44
http://home.uchicago.edu/~sogrodow/homepage/paddress03.pdfhttp://home.uchicago.edu/~sogrodow/homepage/paddress03.pdfhttp://home.uchicago.edu/~sogrodow/homepage/paddress03.pdfhttp://www.mitpressjournals.org/doi/pdfplus/10.1162/rest.89.1.44http://www.mitpressjournals.org/doi/pdfplus/10.1162/rest.89.1.44http://www.mitpressjournals.org/doi/pdfplus/10.1162/rest.89.1.44http://www.mitpressjournals.org/doi/pdfplus/10.1162/rest.89.1.44http://home.uchicago.edu/~sogrodow/homepage/paddress03.pdfhttp://home.uchicago.edu/~sogrodow/homepage/paddress03.pdf


12/18

Specify objective functions: Consumers maximise utility, e.g.:

log + +

=0

subject to a budget constraint, e.g.: + = 1 + where the capital stock evolves according to:

= 1 1 + .

Firms maximise profits, e.g.:1 1 1 where, productivity, evolves according to: log = log1 + , ~NIID 0,1


13/18

Derive the models equations: By taking First Order Conditions. And Market Clearing Conditions. Here on the consumer side we have:

Intra-temporal optimality: = Inter-temporal optimality:

1 + +1 = 1

And on the firm side we have: Labour price: = 1 Capital price: = where = + = 1 1.

Approximate the models equations. Solving nonlinear R.E. models is tricky, so they tend to be (log-)

linearised first. (Higher orders of approximation are becomingmore common too.)

Dynare (http://www.dynare.org/) will do this for you.
http://www.dynare.org/http://www.dynare.org/http://www.dynare.org/


14/18

Next, parameter values must be chosen. These may be estimated (again, using Dynare).

Or, they may be calibrated (chosen so that the behaviourof the model matches key moments of the data).

Here we choose: = 0.36 = 0.99

= 0.025 = 0.95 = 0.009


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Simulate the models response to a shock:

20 40 60 800

0.1

0.2y

20 40 60 800

0.05

0.1c

20 40 60 800

0.05

0.1k

20 40 60 80-2

0

2i

20 40 60 80-0.2

0

0.2l

20 40 60 800

0.05

0.1w

20 40 60 80

-0.2

0

0.2r

20 40 60 80

0

0.05

0.1a


16/18

One way of doing empirical macro is to directlyestimate models like the one we just saw.

Suppose we want to work in a theory free waythough. Difficult because policy variables (interest rates,

government spending) respond systematically to thevariables we are interested in (output, inflation).

Does lowering nominal interest rates lead to a boom, ordoes the central bank just always set low nominal

interest rates in expansions? Key idea: we need to see the response of variables to

unexpected changes in e.g. interest rates.


17/18

The residuals from estimating VARs contain amix of shocks.

Two approaches to identify the shock we areinterested in: Use theory to derive the additional restrictions we need.

E.g. we assume: Output does not respond contemporaneously to interest rate

shocks. Or: Interest rate shocks do not have a permanent effect on

output. Or: Increases in interest rates lead to falls in prices.

Use narrative evidence to identify shocks. E.g. look at transcripts of FOMC meetings.


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Modern Dynamic Stochastic GeneralEquilibrium (DSGE) macro does not look likethe ad hoc, arm-wavey subject you mighthave learnt at undergrad.

DSGE models are powerful tools forexplaining business cycles.

Macro is a big, broad subject, and there are alot of interesting topics still left to research.

building macro models

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