14.452 | Spring 2007 | Graduate

Macroeconomic Theory II


Course Meeting Times

Lectures: 2 sessions / week, 1.5 hours / session


This is the second course in the four-quarter graduate sequence in macroeconomics. Its purpose is to introduce the basic models macroeconomists use to study fluctuations. Topics include the basic model or the consumption/saving choice, the RBC model or the labor/leisure choice, non-trivial investment decisions, two-good analysis, money, price setting, the “new Keynesian” model, monetary policy, and fiscal policy.


It is essential that you be familiar with macroeconomics at the intermediate undergraduate level. If you have not yet done so, read an intermediate macroeconomics text. (Take this recommendation seriously. If you are not familiar with macroeconomics, the risk is high that you will perceive the course as a series of methods and models, not as an attempt to understand fluctuations.)

There are no textbooks for the course. Material will come from several sources.

Covers most bases, but is aging:

Buy at MIT Press [BF] Blanchard, O., and S. Fischer. Lectures on Macroeconomics. Cambridge, MA: MIT Press, 1989. ISBN: 9780262022835.

Focuses more on open economy issues:

Buy at MIT Press [OR] Obstfeld, M., and K. Rogoff. Foundations of International Macroeconomics. Cambridge, MA: MIT Press, 1996. ISBN: 9780262150477.

Focuses more on nominal rigidities, and the role of monetary policy:

[MW] Woodford, M. Interest and Prices: Foundations of a Theory of Monetary Policy. Princeton, NJ: Princeton University Press, 2003. ISBN: 9780691010496.

Macroeconomics is a rapidly changing field. To get a sense of the geography, you might find it useful to read two surveys (which are already on the verge of obsolescence…):

Blanchard, O. “What Do We Know About Macroeconomics that Fisher and Wicksell Did Not?” Quarterly Journal of Economics 115, no. 4 (November 2000): 1375-1410.

Woodford, M. “Revolution and Evolution in Twentieth-Century Macroeconomics.” June 1999. Paper presented at Frontiers of the Mind in the Twenty-First Century, U.S. Library of Congress, Washington, DC, June 1999.

For two more recent and more polemical, pieces, you may also want to read:

Chari, V. V. “Modern Macroeconomics in Practice: How Theory is Shaping Policy.” Journal of Economic Perspectives 20, no. 4 (2006): 3-28.

Mankiw, N. G. “The Macroeconomist as Scientist and Engineer.” Journal of Economic Perspectives 20, no. 4 (2006): 29-46.


Finally, I shall assume basic familiarity with MATLAB®. Dynare, a set of MATLAB® based programs freely available on the net, is particularly useful to simulate the models we shall see in the course.

Course Outline

The course is organized around ten topics or sections with subsections listed below.


Fluctuations facts

Covariance stationarity

Trends/cycles decompositions

Shocks and propagation mechanisms Wold representation


Impulse responses

Co-movements of GDP components

Correlations between real wages, interest rates, and output

The correlations of output and money

Cycles, slumps, and depressions



The basic model: The consumption/saving choice

Setting up the optimization problem

Intertemporal choice, shocks, uncertainty

The first order conditions

The Keynes-Ramsey condition

Solving the model numerically

Value functions

Log linearization

Special cases and other short cuts

Equivalence between centralized and decentralized economies

The consumption problem in the decentralized economy


Allowing for labor/leisure choice (the RBC model)

Movements in employment/unemployment

Interpreting the first order conditions

Solving the model numerically, and by log linearization

Special case: Log and full depreciation

Evidence on labor supply elasticity

Evidence on high frequency technological shocks

Solow residuals and their interpretation

Alternative approaches


Allowing for non-trivial investment decisions

Costs of adjustment for investment

Investment, consumption, and interest rates in the decentralized economy

The role of the term structure of interest rates

The stock market and investment

The effects of shocks on output, investment, the stock market, and the term structure

The open economy version

Shocks, investment, saving, and movements in the current account

Asset price bubbles, investment, and fluctuations


Allowing for two goods

Why introduce two goods?

The pitfalls of one-good models

Capital/consumption goods

Tradable/non tradable goods

Domestic/foreign goods

The consumer problem with two goods

Intratemporal and intertemporal first order conditions

Closing the model if tradables/non tradables

The Balassa-Samuelson effect

The transfer problem

Effects of technological shocks on relative prices, and on the current account

Global imbalances


Introducing money

Decentralized exchange and the use of money

Cash-in-advance models

Money in the utility function

The effects of money growth on capital accumulation

Dynamics of hyperinflation

The Cagan model

The budget deficit and money growth


Introducing price setting

Decentralized exchange, money, and price setters

A yeoman farmer model of price setting under monopolistic competition

The role of price above marginal cost, markups

Predetermined prices

The effects of money on output and welfare

Role of wage versus price setting

The behavior of real wages

Revisiting the effects of technological and other shocks


Macroimplications of the choice of numeraire

The monetary policy problem

Time consistency


The “new Keynesian” model

Staggering of price decisions

Fischer-Taylor-Calvo models

Coordination problems

The “modern Phillips curve”

Inflation inertia?

The “modern IS-LM model,” and the “modern AS-AD model”

A second look at productivity booms


Monetary policy

Time consistency

Inflation targeting

Interest rate rules

The liquidity trap


Fiscal policy

Effects of spending and taxes in models with flexible or sticky prices

Empirical evidence

Perverse effects of fiscal expansions

Course Info

As Taught In
Spring 2007
Learning Resource Types
Problem Sets
Lecture Notes