Business 33944, Economics 38201
John H. Cochrane and Tom Sargent
Updated June 20 2012 Hit refresh when you come back so you get the newest version!
4/19 Problem set 3 and problem set 2 answers are up.
3/29 Review session Fridays 10:30 Ro 301
3/29 If you want to take this sequence as your "exam field," you have to write a paper. See directions below.
I will be teaching half of this course, together with Tom Sargent. .
The first part of this website contains the required readings for my part of the course. The rest of the website is a larger set of reading suggestions.
The substantive question we will address is this: What determines the price level in a fiat-money economy like ours? I'll focus on the fiscal theory of the price level. But we'll think about MV=PY, interest rate targets, new- and old Keynesian models, and we'll study central bank policy in the recent crisis and recession.
Please read these articles ahead of time! While I encourage reading more, only the indicated page numbers are required reading and basis of classroom discussions. This is primarily a readings class.
Mechanics: Since this is a joint class, we will be understanding than usual about R or PF grades for those of you who want to focus on the material in one or the other half of the course. Auditors are also welcome, but we would much rather you registered in some way (R or PF) if you can, so the deans and department chairs know we weren't teaching to an empty room. If you come, though, you are expected to do the readings, participate in class discussion, do the written work, and come every week.
Make sure you are getting class emails! There will be a lot of communication via the class email list. All materials except Woodford’s text will be available on the class website.
Prerequisites: I presume most students have taken the first year Ph.D. macro courses. Your macroeconomics course should have covered some monetary economics, including a cash in advance and money in the utility function models. You should have one quarter of Ph.D. level time series, and be ready to use simple time series models like AR(1)s, take conditional expectations, interpret an impulse-response function, etc. with no fuss.
I will distribute occasional problem sets, which will include written response questions to the readings. However, most of our work will be on reading and understanding ideas rather than on developing further modeling abilities or econometric technique.
Bring a name card to every class at least until everyone in the class knows everyone else. If you don't use a name card, don't be disappointed when I don't learn your name.
We meet Tuesday and Thursday 10:30-12:00 in Rosenwald 301. Class is canceled for Thursday, April 5. We'll find a time to reschedule.
Week 1 notes. 4/2/2012 My lecture notes for week 1, cleaned up a bit. Warning: Many typos. This is not required reading, but may be a useful reference.
New Keynesian Models with Fiscal Price Determination. January 2011 These are some slides that I'll cover following "Determinacy and Identification." Maybe I can get you to write the paper.
Problem set 1 Due Tuesday April 10
Problem set 1 answers
Problem set 2 Due Tuesday April 17
Problem set 2 answers
Problem set 3
Problem set 3 answers
Final exam answers
Note: You should be able to get all the links to external sites when logged in to a U of C IP address or via VPN. I have local copies of many papers, which should always work. Please report any broken links.
The required readngs are marked with a bullet point
Links to other reading in the comments are not required.
Week 1 Fiscal theory of the price level.
The basic fiscal framework, comparison with quantity theory, commodity/gold standards, and interest rate targets; Ricardian and NonRicardian regimes; classic doctrines upheld or denied, unpleasant monetarist arithmetic.
You may find my "Inflation and Debt" in National Affairs also useful. It was designed as a nontechnical version of "Understanding policy," but also explains what I think is wrong with standard views. The Appendix to understandng policy with budget constraint algebra is a useful reference. Of course I think you should read all my earlier papers on fiscal theory and monetary economics, especially the long term debt paper. But of course you should read all of Tom Sargent and Chris Sims's too (and maybe first!)
Week 2 New Keynesian Model
Woodford, Michael, Interest and Prices Princeton: Princeton University Press, p. 1-319 (Part I). I won't make you buy it, or assign 320 pages in one day, but you should own this and read part I if you're gong to do monetary economics.
Week 3 Problems in the New Keynesian model. No, it is not just smoke and mirrors for ISLM
Week 4 Fiscal Stimulus
Background: In case you're not aware, I've been part of a bit of a blog war over stimulus. I thought Friedman, Lucas, Sargent, Kydland and Prescott got rid of it a generation ago. This essay Stimulus RIP is the best summary. If you google Krugman or Delong's blogs with "stimulus" you will find hours of entertainement on the subject.
In the sort of "classical" models you have been trained on at Chicago, stimulus really doesn't work. That's becaue you have been taught to analyze taxes and spending in terms of incentives for behavior rather than as flows of money and "spending." To you, taxes have an effect because they change margins, not because they "put money in people's pockets." Effects that appear like "stimulus" can occur, for example you can be made to feel poorer and hence work harder. (These effects are covered in the "neoclassical" parts of the above papers.) Most recently Uhlig, Harald "Some Fiscal Calculus." American Economic Review, 2010, 100(2), pp. 30-34.
Most policy is conducted within "Old-Keynesian models. For example read Romer and Bernstein to see the scientific basis on which $800 billion of your money got spent. I'll dig up an undergraduate textbook to cover ISLM "models," and we will have covered them a bit in "Determinacy and Identification."
You will see that much of my "understanding policy" describes "fiscal stimulus" as inflation. Current and future deficits cause inflation, and if you believe in a Phillips curve, you get some stimulus out of that. But that is usually considered "monetary" policy with fiscal coordination.
Finally, the assigned reading. Recently, New-Keynesian modelers have claimed very strong fiscal stimulus effects, though their models (unlike ISLM) are coherent economic models, with budget constraints and everything. Let's read one to see if it makes sense, or whether it suffers from the "Determinacy and Identification" problems. Blog Post "New Keynesian Stimulus" gives a sense of what I think we'll find.
Valerie Ramey has a nice review of empirical work. You'll learn basically that everyone runs the same regressions and nobody has solved the identification problem. Valerie Ramey, "Can Government Purchases Stimulate the Economy?"Journal of Economic Literature 2011, 49:3, 673–685 local copy.
Week 5. Monetary policy yesterday and today; the role of the central bank. credit allocation, financial regulation, credit-spread targeting, quantiative easing,
I wrote an oped saying QE2 had no effect, Is QE2 a Savior, Inflator or a Dud?.Local copy. Central banking really is the last refuge of central planners, which should embolden your search for rules, institutions and mechanisms to do a better job. One expression of that view: Geithner's Global Central Planning Wall Street Journal, October 26 2010. Local copy (This is a literary analysis of Treasury Secretary Tim Geithner's Letter to the G-20.) Blog posts Fed Independence 2025, World's biggest Hedge Fund describe some of my thinking on the question, whither the Fed?
A few papers I wish I had time for. :
The Euro, optimal currency areas, how to invent a better "government equity"
This is the readiung list from the last time I taught the full course. It has a larger focus, trying to cover all of monetary economics in 10 weeks.
Economics 33600 / Business 33941
John H. Cochrane email@example.com HPC 459 702-3059
Class web page
Sept 28 2004
This will be primarily a “readings” course. I will assign some exercises, primarily reproducing or extending simple pieces of empirical work. Our primary task though will be meeting and discussing articles. You must read and think about the readings before class, and be ready to discuss the readings in class. I will occasionally ask students to lead discussions on papers or parts of papers. You should be ready to do this. All the readings will be on the class website, except you need to buy a copy of Woodford’s Interest and Prices. It’s impossible to read every word of every paper here; you, like me, will have to develop the skill of figuring out what is important in each papers (usually not the introductions and conclusions).
Grades will reflect class participation, homework, and an exam.
Hanno Lustig Christopher Sleet, and Şevin Yeltekin Fiscal hedging with nominal assets Journal of Monetary Economics Volume 55, Issue 4, May 2008, Pages 710-727
1. Friedman and the big picture
The (supposed) effects of monetary policy.
The attempt to document Friedman’s views in data.
Questions: What is a shock anyway? Why is it important to study policy shocks? Does studying responses to shocks mean we implicitly assume a model in which only unanticipated shocks have effects? How important is orthogonalization to the results? Vars are simple and deceptive!
This one gets at the question of anticipated vs. unanticipated shocks:
What do the VARs Mean? Measuring the Output Effects of Monetary Policy Journal of Monetary Economics 41:2 April 1998 277-300 (Revision of NBER WP 5154 June 1995; (Manuscript with a bit clearer pdf). Responses to monetary policy shocks seem long and drawn out. Do we need models with extensive frictions? No, because the response of policy to polich shocks is also drawn out. If you allow expected policy to affect output and inflation, you can make sense of drawn out impulse-response functions with a very short structural response, but a long-lasting impulse.
“Shocks” Carnegie-Rochester Conference Series on Public Policy 41, (December 1994) 295-364. A comprehensive look at which shocks matter and which don’t, including technology, money, oil and credit. None of the above accounts for much of economic fluctuations or inflation. Monetary policy shocks in particular account for very little output fluctuation and zero inflation variation. Sorry, Friedman! “Consumption” shocks, reflecting information agents see but we do not see do a pretty good job, but are harder to integrate into economic theory.
Really short, but brings up an important issue – why aren’t we using interest rates, which arguably have the best power to forecast both output and future interest rates, in VARs? :
I learned quite a bit more about what are and are not shocks by this one:
For some directions on the mechanics of VARs, beyond obvious textbooks such as Hamilton, see my notes on Time series for macroeconomics and finance
Can the fed nail the price level by setting the price of chewing gum in the C concourse of the United Airlines terminal at O'Hare? Also, we don’t do helicopter drops, we do open market operations. The Modigliani-Miller theorem says they should have no effect.
A model in which velocity is completely endogenous. More M must means less V not more PY. Also a nice “near rational” analysis of money demand that might help to explain Lucas’ troubles with interest rates. I’ll quickly remind you of background you should know; the Baumol-Tobin and Miller-Orr inventory models of money demand. If these are totally new to you, look at any textbook.
Friedman’s response to Woodford’s (and others’) response to Friedman
These papers are the tip of an iceberg of worrying that the Fed is powerless. For example, the entire July 1983 Journal of Monetary Economics v12, n1 (July 1983) dealt with the problem. (Fama and Hall’s papers are particularly good)
An excellent reading on the details of fed procedures. What is the quantity side of the 50 bp experiment? – what is the path of reserves/open market operations?
It’s always been a puzzle that so large interest rate movements result from such tiny open market operations. In New Zealand, they don’t even do any open market operations. These are two of a recent slew of papers analyzing “open mouth operations.” There is a whiff here of “the fed matters because people think it matters” reflected in some more serious modeling we’ll do below.
For the class, only read from 7.1 on, pp. 99-108. This is why we can’t do Friedman and Schwartz for the fiscal theory. (I’ll do a 5 minute summary of the rest)
Thursday Nov 11:
As private firms should issue equity, so should governments issue money. Also starts on the important task of mixing fiscal theory with optimal taxation theory
Thursday Nov 18:
6. Interest rate rules and “New Keynesian” Economics
We thought for a long time that interest rate targets lead to unstable price levels. And yet, the Fed does follow an interest rate target, and the price level doesn’t seem to be exploding. McCallum then pointed out that perhaps the price level could be stationary with a reactive interest rate – if the interest rate rises faster than inflation, perhaps inflation could be stabilized. Taylor noticed that a rule in which the interest rate rises more than inflation seems to characterize Fed behavior.
There is a huge literature now on “optimal Taylor rules”. For example, should the Fed react to actual or expected inflation? What happens if the Fed reacts to expected inflation, and expected inflation reacts to the Fed?
Questions: Is there a sensible model out there in which the Fed raises real rates to contain inflation? There are two schizophrenic strands to the literature; in one the Fed raises real interest rates in response to inflation and this action lowers future inflation; in the more popular strand threats of explosion select equilibria. Did the Fed conquer inflation by moving to a Taylor rule with a coefficient greater than one on inflation? Does the Fed in fact move the funds rate more than one for one with inflation -- how will it respond to a replay of 1973?
Famous for the claim that the Fed switched from “Passive” (coefficient on inflation less than one) to “active” (coefficient larger than one) around 1980, and this stopped inflation. Also we need to read the theory section to see how this is supposed to work.
Maybe the “fact” isn’t even true – you make a lot of excuses for output responses in looking at the inflation response.
This is an excellent preview.
Thursday December 2
If that wasn’t enough….Believe it or not this is the pared down reading list. Here are some good extra readings on each of the topics.
The whole book is pretty much a classic. Chapter 14 on Spanish hyperinflation seems to me to document the fiscal underpinnings of inflation quite well.
This is a classic you should read at some point. Maybe the output effect has nothing to do with money – maybe blowing up the banks has some independent effect. This view may explain Japan today. This started the whole “credit channel” literature.
Uhlig takes to heart what people are evidently doing: identifying the shocks by the results, i.e. getting a pretty picture out of the result.
No money but nice (I think) use of cointegrated VARs. Also gets at Blanchard-Quah identification of shocks by long run restrictions, i.e. the money shock is the one with no long run effect on output.
I presumed you’d heard of money demand estimation, the debate starting with Friedman whether it is “stable” and the counterargument that you have to keep muddling with the aggregates to make it look “stable” ex-post. The best paper I know of to document a classic view of money demand is
Lucas (re) discovers and brilliantly uses cointegration. Previous writers ran it in growth rates, got nice errors and junk coefficients. The latest from Lucas on Money demand is
I also like
A cool use of moving averages to show money is neutral in the “long run”
A medium frequency analysis of the interest elasticity, to go with Lucas’ long run income elasticity: Band pass filters give money growth negatively correlated with interest rates in the “medium run”
Reynard, Samuel. Universithy of Chicago thesis.
A response to Ben Friedman
More on open mouth operations
These are some of the classic papers (along with Leeper, cited) that established the fiscal theory. I think what they have to say is covered in our readings and in Woodford’s interest and prices, but if you’re interested in this stuff the originals are a must-read
This really brought the fiscal side of price determination to modern attention. Note that debt is real, and the reliance on seignorage. It’s taken 20 years to improve on that. We might write a slightly different model for the four hyperinflations now.
Some of the analysis is not as good as in later papers, but I got to tell more fun stories here.
I plan to ignore the theory and concentrate on the facts in the following papers. They are follow-ups to prospective deficits, and should help us to see if the story works.
I can’t find pdfs so I won’t assign this, but you really should read it at some point!
Interest rate rules
A really nice, detailed and persuasive account of Fed policy in the 80s. You see the Fed reacting to expected inflation as embodied in long term bonds.
shows that the errors of a Taylor rule are likely to be serially correlated inducing a false persistence measure
A quick review of Taylor rules, equilibrium. Then questions whether potential (defining the gap) is the right target, whether a constant intercept rather than a time varying natural rate is optimal, etc.
Another paper with explosion threats to “stabilize” the price level.
In particular, Chapter 6, “Microeconomic foundations of incomplete nominal adjustment” 241-308. is a good introduction to “neo-keynesian” models;
Notes that NeoKeynesian Phillips curves are forward looking. This is at great variance with the data which want a backward looking Phillips curve. An expected deflation is a boom to a forward looking Phillips curve!
They analyze Taylor rules without neo-keynesian economics.
Why did US inflation rise and then fall in the 1970 and 1980s? (Preliminary list, and we may not get this far)
Any theory of inflation must have an account of the rise and fall of inflation in the US in the 1970s.. You should know the standard stories.
This is a very important strain of monetary economics, which I don’t cover for lack of time.
Romer, David Advanced Macroeconomics Ch. 9 “Inflation and Monetary Policy”;
Walsh, Carl, Monetary Theory and policy. See http://www.business.uiuc.edu/seppala/econ421/
Some followon work in international, with Burnside, Eichenbaum and Rebelo's prospecitve deficits in mind :
Corsetti, Giancarlo,Bartosz Mackowiak Fiscal Imbalances and the Dynamics of Currency Crises with , (previously Economic Growth Center at Yale University 2000 and CEPR 2001). European Economic Review 2006
Corsetti, Giancarlo, Bartosz Mackowiak A fiscal perspective on currency crises and “original sin”, with, in Barry Eichengreen and Ricardo Hausmann (eds), "Other People's Money: Debt Denomination and Financial Instability in Emerging Market Economics," Chicago University Press.
•Sargent, Thomas, and Francois Velde The Big Problem of Small Change Princeton University Press 2003. This is great. Sargent and Velde think it's an intellectual history of how the world discovered MV=PY. Point taken, but many of the stories also ring of fiscal constraints. There's a short version in the JMCB
Any theory of inflation has to grapple with the event of our time, as Friedman and Schwartz grappled with the 1930s. That is the inflation of the 1970s and the disinflation of the 1980s. Yes, more interesting things happened to smaller economies, but those events are too easily dismissed as being peculiar to their institutitons. We alluded to the conventional view (Clarida Gali Gertler) that the Fed raised phi\pi from below one to above.
•Sargent, Thomas J., The Conquest of American Inflation Princeton University Press 2001.
This book gives a story of how the Fed learned (and potentially forgot) central lessons. I disagree -- I think the 70s were a fiscal disaster, as outlined in the not very successful "A Frictionless model of U.S. Inflation" but you need to understand Sargent's view.
•Sderstrom, Ulf, and Anders Vredin, “The Conquest of Inflation: and Introduction to Sargent’s analysis.” Svierges Riksbank Economic Review 2000:3 5-11.
•Sargent, Thomas J. and Ulf Soderstrom, “The conquest of American Inflation: A Summary.” Svierges Riksbank Economic Review 2000:3 12-45
A history of the Federal Reserve A Conversation between Paul Volcker and Allan H. Meltzer. American Enterprise Institute
•You should just spend a day or two browsing Chris Sims' webpage
•Eric Leeper has written a slew of recent great paeprs on fiscal issues.
•Read the original Sargent unpleasant monetarist arithmetic