Young Economics

Mathematics, Economics and Business

User Tools

Site Tools



  • deals with the performance, structure, behavior, and decision-making of an economy as a whole
  • study aggregated indicators such as GDP, unemployment rates, and price indexes
  • develop models that explain the relationship between such factors as national income, output, consumption, unemployment, inflation, savings, investment, international trade and international finance.
  • Particularly in the wake of the Lucas critique, much of modern macroeconomic theory has been built upon 'microfoundations'—i.e. based upon basic assumptions about micro-level behavior.
  • two main areas of research
    1. the causes and consequences of short-run fluctuations in national income GDP (Business Cycle)
    2. the determinants of long-run economic growth, i.e. increases in national income

Finance and Macroeconomics

The central task of absolute asset pricing is to understand and measure the sources of (aggregate or macroeconomic) risk that drive asset prices. Also, this is the central question of macroeconomics.
A lot of empirical work has documented to link between macroeconomics and finance. For example, expected returns vary across time and assets in ways that are linked to macroeconomic variables (or variables that also forecast macroeconomic events). A wide class of models suggests that a 'recession factor' lies behind many asset prices. Yet, theory lags behind; we do not have a well-described model that explains these interesting correlations.

There are also big difference between two disciplines. Standard macroeconomic models predict people really do not care much about business cycles (Lucas [1987]). However, asset prices reveal that they do care about business cycles - that they forego substantial return premia to avoid assets that fall in recessions.


  • Until the 1970s, Cowles macroeconometrics - estimating systems of ad-hoc aggregate relationships, e.g. VAR (Vector AutoRegression) model
  • Lucas Critique, Sargent and Wallace - DSGE (dynamic stochastic general equilibrium) model based on Optimal individual decision-making (micro foundation).
  • All are built on the representative-agent paradigm. Why?

The goal of macroeconomics is for understanding the business cycle dynamics of aggregate quantities and prices, or long-run economic growth.

  • Does incorporating household or firm heterogeneity that important?
  • Micro econometric work in labor economics and industrial organization has revealed enormous cross-sectional dispersion and individual volatility for workers and firms. e.g. Heckman

Why incorporating heterogeneity in household?

  1. heterogeneity can affect both the levels and dynamics of aggregate equilibrium quantities and prices
    1. (Huggett 1993) idiosyncratic uninsurable income risk implies a precautionary motive for saving that increases aggregate wealth and reduces the equilibrium interest rate
    2. (Heathcote 2005) changes in the timing of taxes that would be neutral in a representative-agent model (Ricardian equivalence), turn out to have large real effects in a model with heterogenous agents and incomplete markets.
  2. introducing heterogeneity can change the answer to welfare questions.
    1. (Lucas 1987) aggregate fluctuations have a very small impact on the welfare of a representative consumer. In other words, it may imply a macroeconomic model with incomplete-markets across heterogeneous agents may have a chance to model an economy where aggregate fluctuations can have asymmetric welfare effects across heterogeneous agents.
    2. (Storesletten et al. 2001) liquidity constrained households are particularly hard hit by aggregate productivity shocks.
  3. heterogeneity is essential to answer many macro questions
    1. (Heathcote et al. 2008b; Krueger and Perri 2006) One of the key macroeconomic trends of the recent past is the dramatic widening of the wage structure in the United States over the period 1975-1995. Average real wages for men barely changed, but wage dispersion within and between education groups increased dramatically. These trends and their implications for policy and welfare can only be explored within heterogeneous agent models of the macroeconomy

Trend in Macroeconomics

  1. From studying Average values to studying Distributions of variables - macroeconomics is expanding from the study of how average values for the inputs (capital and labor) and outputs (consumption) of production are determined in equilibrium to the study of how the entire distribution of these variables across households is determined.
    • welfare implications of policies that redistribute across agents as well as the implications of policies aimed at stabilizing the aggregates.
    • models that take into account both general equilibrium effects and the heterogeneous impact of policies across the population (Heckman 2000).
  2. Heterogeneity with complete markets - macro aggregates may not depend on the wealth distribution or, equivalently, they evolve exactly as in a representative-agent economy, even though agents may differ by initial tastes, skills, or wealth, and are subject to idiosyncratic (but insurable) shocks
  3. The standard incomplete-markets model (SIM) : The natural extension from a standard DSGE models: agents maximize expected lifetime utility in response to exogenous shocks to productivity by adjusting consumption, hours and capital accumulation. In aggregate, their choices determine the total amount of capital and effective labor available for production, and thus equilibrium prices. The only difference between the standard DSGE and the SIM model is that the SIM incorporates shocks at the individual in addition to the aggregate level.
  1. the sources of heterogeneity and inequality
  2. individuals’ key channels of insurance
  3. the interaction between idiosyncratic risk and aggregate dynamics

Why the assumption of 'complete markets' is rejected?

  • Complete market (i.e. existence of complete Arrow-Debreu securities in market) imply that there are “full insurance” for everybody. Thus, the initial ranking of individuals is preserved forever, which also means the vast inequality we see today, within and across societies, would not exist.

Inequality and Heterogeneity

economics/macroeconomics.txt · Last modified: 2016/09/21 16:44 by admin