Dynamic Macroeconomics

particular countries or periods.
This observation by Lucas, based on the foundations laid out by Frisch
[1933], Slutsky [1937], and Burns and Mitchell [1946], brought about
significant changes in the way in which all schools of thought in modern
macroeconomics approach and try to explain aggregate fluctuations.
The traditional Keynesian macroeconomic and macroeconometric models,
from the 1950s to the 1970s, were deemed to have weaknesses in the
detailed study of aggregate fluctuations and the impact of monetary and fiscal
policy in relation to the criteria of Lucas. The most important of these
weaknesses was that the macroeconomic relationships assumed in traditional
models were not explicitly drawn from well-defined microeconomic
foundations, based on intertemporal optimization on the part of households
and firms. Therefore, one could not easily interpret their parameters and be
confident in their stability. This became the basis of the Lucas critique of
econometric policy evaluation. Lucas [1976, p. 41] concluded that
Given that the structure of all econometric model consists of optimal decision rules of economic
agents, and that optimal decision rules vary systematically with changes in the structure of series
relevant to the decision maker, it follows that any change in policy will systematically alter the
structure of econometric models.
Lucas arrived at this conclusion after having demonstrated the fragility of
traditional econometric models of aggregate consumption, investment, and
the Phillips curve. Pursuing this critique—and the quest for dynamic

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microeconomic 
foundations 
in 
macroeconomic 
models—the
macroeconomics of aggregate fluctuations shifted to the study of DSGE
models with explicit dynamic microeconomic foundations.
Modern macroeconomics is now almost entirely based on such dynamic
general equilibrium models, which may be either deterministic or stochastic.
For the study of economic growth, the main models are variants of the
representative household model (due to Ramsey [1928], Cass [1965], and
Koopmans [1965]) and overlapping generations models (such as the
Diamond [1965] and Blanchard [1985]–Weil [1989] models). These are
chiefly deterministic dynamic general equilibrium models, although
stochastic elements can be added to them. Models used for the study of
aggregate fluctuations combine elements from both new classical and new
Keynesian DSGE models to form the basis of the new neoclassical synthesis.
Naturally, such models form the backbone of the present book. I present the
main theories of economic growth and aggregate fluctuations through a
sequence of such dynamic models, based on intertemporal optimization on
the part of economic agents. For the most part, these models are transformed
into linear or log-linear systems of equations. In chapter 22, we also discuss
an alternative approach to aggregate fluctuations based on nonlinear
overlapping generations models that result in endogenous cycles, self-
fulfilling prophecies, and sunspots (Azariadis [1981], Azariadis and
Guesnerie [1986], Benhabib and Farmer [1999]). For completeness, I also
discuss some of the important precursors to these dynamic general
equilibrium models.
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The models presented and analyzed in this book are treated as tools for
understanding the main macroeconomic phenomena of long-run economic
growth, aggregate fluctuations, inflation and unemployment, and the role of
monetary and fiscal policies. The book highlights both their potential
strengths as well as their limitations.
It is worth keeping in mind that modern macroeconomics is not based on a
single, generally accepted, all-encompassing model. For this reason, this
book is eclectic and treats macroeconomics as applied and policy-oriented
general equilibrium analysis, based on various alternative, relatively simple
aggregate dynamic models. We examine a plurality of models, each of which
is suitable for investigating specific issues and addressing specific questions
but may be unsuitable for other issues or questions.
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Some key unifying principles are found in the models that we adopt. The
most important of these principles is the assumption that economic agents
base their decisions on intertemporal optimization of some well-defined
objective function under appropriate constraints. Thus, for the most part, we
rely on dynamic general equilibrium models with explicit intertemporal
microeconomic foundations. Where there are theoretical disagreements,
alternative approaches are juxtaposed, their pros and cons are analyzed, and
their compatibility with the empirical evidence is also briefly discussed.
Before we turn to the theory and the models themselves, it is worth
looking at the key empirical facts concerning long-run economic growth and
aggregate fluctuations. These key facts are what macroeconomics seeks to
explain and account for.
We start with some of the key facts about long-run economic growth and
then move on to some of the key facts about aggregate fluctuations.
Additional facts are also presented as we move to particular models in the
relevant chapters and the specific issues these models seek to explain.
Knowledge of these key facts will facilitate the process of evaluating the
relevance and usefulness of the theoretical models in the rest of this book.
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