Advanced macroeconomics (4e david romer)

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ADVANCED
MACROECONOMICS
Fourth Edition

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ADVANCED
MACROECONOMICS
Fourth Edition

David Romer
University of California, Berkeley

iii

Romer-1820130

rom11374˙fm˙i-xx

February 17, 2011

8:12

iv

ADVANCED MACROECONOMICS, FOURTH EDITION
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To Christy

v

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ABOUT THE AUTHOR

David Romer is the Royer Professor in Political Economy at the University of California, Berkeley, where he has been on the faculty since 1988.
He is also co-director of the program in Monetary Economics at the National
Bureau of Economic Research. He received his A.B. from Princeton University and his Ph.D. from the Massachusetts Institute of Technology. He has
been on the faculty at Princeton and has been a visiting faculty member
at M.I.T. and Stanford University. At Berkeley, he is a three-time recipient
of the Graduate Economic Association’s distinguished teaching and advising awards. He is a fellow of the American Academy of Arts and Sciences,
a former member of the Executive Committee of the American Economic
Association, and co-editor of the Brookings Papers on Economic Activity.
Most of his recent research focuses on monetary and fiscal policy; this work
considers both the effects of policy on the economy and the determinants
of policy. His other research interests include the foundations of price stickiness, empirical evidence on economic growth, and asset-price volatility. He
is married to Christina Romer, with whom he frequently collaborates. They
have three children, Katherine, Paul, and Matthew.

vii


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CONTENTS IN BRIEF

Introduction
Chapter 1

THE SOLOW GROWTH MODEL
Chapter 2
INFINITE-HORIZON AND
OVERLAPPING-GENERATIONS
MODELS
Chapter 3
ENDOGENOUS GROWTH
Chapter 4
Chapter 5
Chapter 6
Chapter 7

Chapter 8
Chapter 9
Chapter 10
Chapter 11
Chapter 12
Epilogue

CROSS-COUNTRY INCOME
DIFFERENCES
REAL-BUSINESS-CYCLE THEORY

1
6

49
101
150
189

NOMINAL RIGIDITY
DYNAMIC STOCHASTIC GENERALEQUILIBRIUM MODELS OF
FLUCTUATIONS
CONSUMPTION
INVESTMENT

238

UNEMPLOYMENT
INFLATION AND MONETARY
POLICY
BUDGET DEFICITS AND FISCAL
POLICY

456

THE FINANCIAL AND
MACROECONOMIC CRISIS OF 2008
AND BEYOND

References
Indexes

ix

312
365
405

513
584

644
649
686


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CONTENTS

Preface to the Fourth Edition
Introduction
Chapter 1
1.1
1.2
1.3
1.4
1.5
1.6
1.7
1.8

Part A
2.1
2.2
2.3
2.4

2.5
2.6
2.7
Part B
2.8
2.9
2.10

1
THE SOLOW GROWTH MODEL

Some Basic Facts about Economic Growth
Assumptions
The Dynamics of the Model
The Impact of a Change in the Saving Rate
Quantitative Implications
The Solow Model and the Central Questions of
Growth Theory
Empirical Applications
The Environment and Economic Growth
Problems

Chapter 2

xix

INFINITE-HORIZON AND
OVERLAPPING-GENERATIONS
MODELS

6
6
10
15
18
23
27
30
37
45

49

THE RAMSEY–CASS–KOOPMANS MODEL

49

Assumptions
The Behavior of Households and Firms
The Dynamics of the Economy
Welfare
The Balanced Growth Path
The Effects of a Fall in the Discount Rate
The Effects of Government Purchases

49
51
57
63
64

66
71

THE DIAMOND MODEL

77

Assumptions
Household Behavior
The Dynamics of the Economy

77
78
81

xi


xii

CONTENTS

2.11
2.12

The Possibility of Dynamic Inefficiency
Government in the Diamond Model
Problems

Chapter 3

3.1
3.2
3.3
3.4
3.5
3.6
3.7
3.8

Framework and Assumptions
The Model without Capital
The General Case
The Nature of Knowledge and the Determinants of
the Allocation of Resources to R&D
The Romer Model
Empirical Application: Time-Series Tests of
Endogenous Growth Models
Empirical Application: Population Growth and
Technological Change since 1 Million B.C.
Models of Knowledge Accumulation and the
Central Questions of Growth Theory
Problems

Chapter 4
4.1
4.2
4.3
4.4
4.5
4.6

5.2
5.3
5.4
5.5
5.6

CROSS-COUNTRY INCOME
DIFFERENCES

Extending the Solow Model to Include Human
Capital
Empirical Application: Accounting for Cross-Country
Income Differences
Social Infrastructure
Empirical Application: Social Infrastructure and
Cross-Country Income Differences
Beyond Social Infrastructure
Differences in Growth Rates
Problems

Chapter 5
5.1

ENDOGENOUS GROWTH

REAL-BUSINESS-CYCLE THEORY

Introduction: Some Facts about Economic
Fluctuations

An Overview of Business-Cycle Research
A Baseline Real-Business-Cycle Model
Household Behavior
A Special Case of the Model
Solving the Model in the General Case

88
92
93

101
102
104
111
116
123
134
138
143
145

150
151
156
162
164
169
178
183

189
189
193
195
197
201
207


CONTENTS

5.7
5.8
5.9
5.10

Implications
Empirical Application: Calibrating a Real-BusinessCycle Model
Empirical Application: Money and Output
Assessing the Baseline Real-Business-Cycle Model
Problems

Chapter 6
Part A
6.1
6.2

6.3
6.4

Part B
6.5
6.6
6.7
6.8
6.9
6.10

211
217
220
226
233

238

EXOGENOUS NOMINAL RIGIDITY

239

A Baseline Case: Fixed Prices
Price Rigidity, Wage Rigidity, and Departures from
Perfect Competition in the Goods and Labor
Markets
Empirical Application: The Cyclical Behavior of the
Real Wage
Toward a Usable Model with Exogenous Nominal
Rigidity

239

255

MICROECONOMIC FOUNDATIONS OF INCOMPLETE
NOMINAL ADJUSTMENT

267

A Model of Imperfect Competition and Price-Setting
Are Small Frictions Enough?
Real Rigidity
Coordination-Failure Models and Real NonWalrasian Theories
The Lucas Imperfect-Information Model
Empirical Application: International Evidence on the
Output-Inflation Tradeoff
Problems

Chapter 7

7.1
7.2
7.3
7.4

NOMINAL RIGIDITY

xiii

DYNAMIC STOCHASTIC GENERALEQUILIBRIUM MODELS OF
FLUCTUATIONS

Building Blocks of Dynamic New Keynesian Models
Predetermined Prices: The Fischer Model
Fixed Prices: The Taylor Model
The Calvo Model and the New Keynesian Phillips
Curve

244
253

268
275
278
286
292
302
306

312
315
319
322
329


xiv

CONTENTS

7.5

7.6
7.7
7.8
7.9

State-Dependent Pricing
Empirical Applications
Models of Staggered Price Adjustment with
Inflation Inertia
The Canonical New Keynesian Model
Other Elements of Modern New Keynesian DSGE
Models of Fluctuations
Problems

Chapter 8
8.1
8.2
8.3
8.4
8.5
8.6

Consumption under Certainty: The PermanentIncome Hypothesis
Consumption under Uncertainty: The RandomWalk Hypothesis
Empirical Application: Two Tests of the RandomWalk Hypothesis
The Interest Rate and Saving
Consumption and Risky Assets
Beyond the Permanent-Income Hypothesis
Problems

Chapter 9
9.1
9.2
9.3
9.4
9.5
9.6
9.7
9.8
9.9
9.10

INVESTMENT

Investment and the Cost of Capital
A Model of Investment with Adjustment Costs
Tobin’s q
Analyzing the Model
Implications
Empirical Application: q and Investment
The Effects of Uncertainty
Kinked and Fixed Adjustment Costs
Financial-Market Imperfections
Empirical Application: Cash Flow and Investment
Problems

Chapter 10
10.1
10.2
10.3

CONSUMPTION

UNEMPLOYMENT

Introduction: Theories of Unemployment
A Generic Efficiency-Wage Model
A More General Version

332
337
344
352
356
361

365
365
372
375
380
384
389
398

405
405
408
414
415

419
425
428
432
436
447
451

456
456
458
463


CONTENTS

10.4
10.5
10.6
10.7
10.8

The Shapiro–Stiglitz Model
Contracting Models
Search and Matching Models
Implications
Empirical Applications
Problems

Chapter 11

11.1
11.2
11.3
11.4
11.5
11.6
11.7
11.8
11.9

Inflation, Money Growth, and Interest Rates
Monetary Policy and the Term Structure of
Interest Rates
The Microeconomic Foundations of Stabilization
Policy
Optimal Monetary Policy in a Simple BackwardLooking Model
Optimal Monetary Policy in a Simple ForwardLooking Model
Additional Issues in the Conduct of Monetary
Policy
The Dynamic Inconsistency of Low-Inflation
Monetary Policy
Empirical Applications
Seignorage and Inflation
Problems

Chapter 12
12.1
12.2
12.3
12.4

12.5
12.6
12.7
12.8

INFLATION AND MONETARY
POLICY

BUDGET DEFICITS AND FISCAL
POLICY

The Government Budget Constraint
The Ricardian Equivalence Result
Ricardian Equivalence in Practice
Tax-Smoothing
Political-Economy Theories of Budget Deficits
Strategic Debt Accumulation
Delayed Stabilization
Empirical Application: Politics and Deficits in
Industrialized Countries
12.9 The Costs of Deficits
12.10 A Model of Debt Crises
Problems

xv
467
478
486
493
498

506

513
514
518
523
531
537
542
554
562
567
576

584
586
592
594
598
604
607
617
623
628
632
639


xvi

CONTENTS

Epilogue

THE FINANCIAL AND
MACROECONOMIC CRISIS OF 2008
AND BEYOND

644

References

649

Author Index

686

Subject Index

694


EMPIRICAL APPLICATIONS

Section 1.7

Section
Section
Section

Section

2.7
2.11
3.6
3.7

Section 4.2
Section 4.4
Section
Section
Section
Section
Section
Section

4.5
5.8
5.9
6.3
6.8
6.10

Section 7.6
Section 8.1
Section 8.3
Section
Section
Section
Section

Section

8.5
8.6
9.6
9.10
10.8

Section 11.2
Section 11.6
Section 11.8
Section 12.1
Section 12.8

Growth Accounting
Convergence
Saving and Investment
Wars and Real Interest Rates
Are Modern Economies Dynamically Efficient?
Time-Series Tests of Endogenous Growth Models
Population Growth and Technological Change since
1 Million B.C.
Accounting for Cross-Country Income Differences
Social Infrastructure and Cross-Country Income
Differences
Geography, Colonialism, and Economic Development
Calibrating a Real-Business-Cycle Model
Money and Output
The Cyclical Behavior of the Real Wage
Experimental Evidence on Coordination-Failure Games

International Evidence on the Output-Inflation
Tradeoff
Microeconomic Evidence on Price Adjustment
Inflation Inertia
Understanding Estimated Consumption Functions
Campbell and Mankiw’s Test Using Aggregate Data
Shea’s Test Using Household Data
The Equity-Premium Puzzle
Credit Limits and Borrowing
q and Investment
Cash Flow and Investment
Contracting Effects on Employment
Interindustry Wage Differences
Survey Evidence on Wage Rigidity
The Term Structure and Changes in the Federal
Reserve’s Funds-Rate Target
Estimating Interest-Rate Rules
Central-Bank Independence and Inflation
The Great Inflation
Is U.S. Fiscal Policy on a Sustainable Path?
Politics and Deficits in Industrialized Countries
xvii

30
32
36
75
90
134
138

156
164
174
217
220
253
289
302
337
340
368
375
377
387
395
425
447
498
501
504
520
548
562
564
590
623


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PREFACE TO THE FOURTH
EDITION

Keeping a book on macroeconomics up to date is a challenging and neverending task. The field is continually evolving, as new events and research
lead to doubts about old views and the emergence of new ideas, models,
and tests. The result is that each edition of this book is very different from
the one before. This is truer of this revision than any previous one.
The largest changes are to the material on economic growth and on shortrun fluctuations with incomplete price flexibility. I have split the old chapter
on new growth theory in two. The first chapter (Chapter 3) covers models
of endogenous growth, and has been updated to include Paul Romer’s nowclassic model of endogenous technological progress. The second chapter
(Chapter 4) focuses on the enormous income differences across countries.
This material includes a much more extensive consideration of the challenges confronting empirical work on cross-country income differences and
of recent work on the underlying determinants of those differences.
Chapters 6 and 7 on short-run fluctuations when prices are not fully flexible have been completely recast. This material is now grounded in microeconomic foundations from the outset. It proceeds from simple models with
exogenously fixed prices to the microeconomic foundations of price stickiness in static and dynamic settings, to the canonical three-equation new Keynesian model (the new Keynesian IS curve, the new Keynesian Phillips curve,
and an interest-rate rule), to the ingredients of modern dynamic stochastic
general-equilibrium models of fluctuations. These revisions carry over to the
analysis of monetary policy in Chapter 11. This chapter has been entirely
reorganized and is now much more closely tied to the earlier analyses of
short-run fluctuations, and it includes a careful treatment of optimal policy
in forward-looking models.
The two other chapters where I have made major changes are Chapter 5
on real-business-cycle models of fluctuations and Chapter 10 on the labor
market and unemployment. In Chapter 5, the empirical applications and the
analysis of the relation between real-business-cycle theory and other models of fluctuations have been overhauled. In Chapter 10, the presentation of
search-and-matching models of the labor market has been revamped and
greatly expanded, and the material on contracting models has been substantially compressed.
xix

xx

PREFACE

Keeping the book up to date has been made even more challenging by
the financial and macroeconomic crisis that began in 2008. I have deliberately chosen not to change the book fundamentally in response to the
crisis: although I believe that the crisis will lead to major changes in macroeconomics, I also believe that it is too soon to know what those changes
will be. I have therefore taken the approach of bringing in the crisis where
it is relevant and of including an epilogue that describes some of the main
issues that the crisis raises for macroeconomics. But I believe that it will be
years before we have a clear picture of how the crisis is changing the field.
For additional reference and general information, please refer to the
book’s website at www.mhhe.com/romer4e. Also available on the website,
under the password-protected Instructor Edition, is the Solutions Manual.
Print versions of the manual are available by request only—if interested,
please contact your McGraw-Hill/Irwin representative.
This book owes a great deal to many people. The book is an outgrowth of
courses I have taught at Princeton University, the Massachusetts Institute of
Technology, Stanford University, and especially the University of California,
Berkeley. I want to thank the many students in these courses for their feedback, their patience, and their encouragement.
Four people have provided detailed, thoughtful, and constructive comments on almost every aspect of the book over multiple editions: Laurence
Ball, A. Andrew John, N. Gregory Mankiw, and Christina Romer. Each has
significantly improved the book, and I am deeply grateful to them for their
efforts. In addition to those four, Susanto Basu, Robert Hall, and Ricardo
Reis provided extremely valuable guidance that helped shape the revisions
in this edition.
Many other people have made valuable comments and suggestions concerning some or all of the book. I would particularly like to thank James
Butkiewicz, Robert Chirinko, Matthew Cushing, Charles Engel, Mark Gertler,
Robert Gordon, Mary Gregory, Tahereh Alavi Hojjat, A. Stephen Holland,

Hiroo Iwanari, Frederick Joutz, Pok-sang Lam, Gregory Linden, Maurice
Obtsfeld, Jeffrey Parker, Stephen Perez, Kerk Phillips, Carlos Ramirez,
Robert Rasche, Joseph Santos, Peter Skott, Peter Temin, Henry Thompson,
Matias Vernengo, and Steven Yamarik. Jeffrey Rohaly prepared the superb
Solutions Manual. Salifou Issoufou updated the tables and figures. Tyler
Arant, Zachary Breig, Chen Li, and Melina Mattos helped draft solutions
to the new problems and assisted with proofreading. Finally, the editorial
and production staff at McGraw-Hill did an excellent job of turning the
manuscript into a finished product. I thank all these people for their help.


INTRODUCTION

Macroeconomics is the study of the economy as a whole. It is therefore concerned with some of the most important questions in economics. Why are
some countries rich and others poor? Why do countries grow? What are the
sources of recessions and booms? Why is there unemployment, and what
determines its extent? What are the sources of inflation? How do government policies affect output, unemployment, inflation, and growth? These
and related questions are the subject of macroeconomics.
This book is an introduction to the study of macroeconomics at an advanced level. It presents the major theories concerning the central questions
of macroeconomics. Its goal is to provide both an overview of the field for
students who will not continue in macroeconomics and a starting point
for students who will go on to more advanced courses and research in
macroeconomics and monetary economics.
The book takes a broad view of the subject matter of macroeconomics. A
substantial portion of the book is devoted to economic growth, and separate
chapters are devoted to the natural rate of unemployment, inflation, and
budget deficits. Within each part, the major issues and competing theories
are presented and discussed. Throughout, the presentation is motivated
by substantive questions about the world. Models and techniques are used
extensively, but they are treated as tools for gaining insight into important

issues, not as ends in themselves.
The first four chapters are concerned with growth. The analysis focuses
on two fundamental questions: Why are some economies so much richer
than others, and what accounts for the huge increases in real incomes over
time? Chapter 1 is devoted to the Solow growth model, which is the basic
reference point for almost all analyses of growth. The Solow model takes
technological progress as given and investigates the effects of the division
of output between consumption and investment on capital accumulation
and growth. The chapter presents and analyzes the model and assesses its
ability to answer the central questions concerning growth.
Chapter 2 relaxes the Solow model’s assumption that the saving rate is
exogenous and fixed. It covers both a model where the set of households in

1


2

INTRODUCTION

the economy is fixed (the Ramsey model) and one where there is turnover
(the Diamond model).
Chapter 3 presents the new growth theory. It begins with models where
technological progress arises from resources being devoted to the development of new ideas, but where the division of resources between the production of ideas and the production of conventional goods is taken as given. It
then considers the determinants of that division.
Chapter 4 focuses specifically on the sources of the enormous differences in average incomes across countries. This material, which is heavily
empirical, emphasizes two issues. The first is the contribution of variations
in the accumulation of physical and human capital and in output for given
quantities of capital to cross-country income differences. The other is the
determinants of those variations.

Chapters 5 through 7 are devoted to short-run fluctuations—the year-toyear and quarter-to-quarter ups and downs of employment, unemployment,
and output. Chapter 5 investigates models of fluctuations where there are
no imperfections, externalities, or missing markets and where the economy
is subject only to real disturbances. This presentation of real-business-cycle
theory considers both a baseline model whose mechanics are fairly transparent and a more sophisticated model that incorporates additional important
features of fluctuations.
Chapters 6 and 7 then turn to Keynesian models of fluctuations. These
models are based on sluggish adjustment of nominal prices and wages,
and emphasize monetary as well as real disturbances. Chapter 6 focuses
on basic features of price stickiness. It investigates baseline models where
price stickiness is exogenous and the microeconomic foundations of price
stickiness in static settings. Chapter 7 turns to dynamics. It first examines the implications of alternative assumptions about price adjustment in
dynamic settings. It then turns to dynamic stochastic general-equilibrium
models of fluctuations with price stickiness—that is, fully specified generalequilibrium models of fluctuations that incorporate incomplete nominal
price adjustment.
The analysis in the first seven chapters suggests that the behavior of
consumption and investment is central to both growth and fluctuations.
Chapters 8 and 9 therefore examine the determinants of consumption and
investment in more detail. In each case, the analysis begins with a baseline
model and then considers alternative views. For consumption, the baseline
is the permanent-income hypothesis; for investment, it is q theory.
Chapter 10 turns to the labor market. It focuses on the determinants of an
economy’s natural rate of unemployment. The chapter also investigates the
impact of fluctuations in labor demand on real wages and employment. The
main theories considered are efficiency-wage theories, contracting theories,
and search and matching models.
The final two chapters are devoted to macroeconomic policy. Chapter 11
investigates monetary policy and inflation. It starts by explaining the central

INTRODUCTION

3

role of money growth in causing inflation and by investigating the effects
of money growth. It then considers optimal monetary policy. This analysis
begins with the microeconomic foundations of the appropriate objective
for policy, proceeds to the analysis of optimal policy in backward-looking
and forward-looking models, and concludes with a discussion of a range of
issues in the conduct of policy. The final sections of the chapter examine
how excessive inflation can arise either from a short-run output-inflation
tradeoff or from governments’ need for revenue from money creation.
Chapter 12 is concerned with fiscal policy and budget deficits. The first
part of the chapter describes the government’s budget constraint and
investigates two baseline views of deficits: Ricardian equivalence and
tax-smoothing. Most of the remainder of the chapter investigates theories
of the sources of deficits. In doing so, it provides an introduction to the use
of economic tools to study politics.
Finally, a brief epilogue discusses the macroeconomic and financial crisis
that began in 2007 and worsened dramatically in the fall of 2008. The
focus is on the major issues that the crisis is likely to raise for the field
of macroeconomics.1
Macroeconomics is both a theoretical and an empirical subject. Because
of this, the presentation of the theories is supplemented with examples of
relevant empirical work. Even more so than with the theoretical sections, the
purpose of the empirical material is not to provide a survey of the literature;
nor is it to teach econometric techniques. Instead, the goal is to illustrate
some of the ways that macroeconomic theories can be applied and tested.
The presentation of this material is for the most part fairly intuitive and
presumes no more knowledge of econometrics than a general familiarity

with regressions. In a few places where it can be done naturally, the empirical material includes discussions of the ideas underlying more advanced
econometric techniques.
Each chapter concludes with a set of problems. The problems range from
relatively straightforward variations on the ideas in the text to extensions
that tackle important issues. The problems thus serve both as a way for
readers to strengthen their understanding of the material and as a compact
way of presenting significant extensions of the ideas in the text.
The fact that the book is an advanced introduction to macroeconomics
has two main consequences. The first is that the book uses a series of formal models to present and analyze the theories. Models identify particular
1

The chapters are largely independent. The growth and fluctuations sections are almost
entirely self-contained (although Chapter 5 builds moderately on Part A of Chapter 2). There
is also considerable independence among the chapters in each section. Chapters 2, 3, and 4
can be covered in any order, and models of price stickiness (Chapters 6 and 7) can be covered
either before or after real-business-cycle theory (Chapter 5). Finally, the last five chapters are
largely self-contained. The main exception is that Chapter 11 on monetary policy builds on
the analysis of models of fluctuations in Chapter 7. In addition, Chapter 8 relies moderately
on Chapter 2 and Chapter 10 relies moderately on Chapter 6.