Book Reviews
A History of Macroeconomics from Keynes to Lucas and Beyond by Michel De Vroey
Macroeconomics is going through a period of introspection, and looking from where the current theoretical and methodological body is coming can be insightful. Michel De Vroey’s new book is important in this regard. It shows how macroeconomics has gone through several revolutions, and may go through more. It describes how Keynes supplanted the Classics by looking at the time’s important economists through their eyes by with today’s language, not shying away from going through models in fair detail. The same exercise is performed with the revolution led by Robert Lucas and his contemporaries. A significant part of the book relates to how the field has evolved after the initial impetus by Lucas.
Several underlying themes emerge from this analysis, as economists from the various periods came to grips with empirical phenomena they could not explain with extant theory: first is the notion of equilibrium, second is price setting, especially wages, third external vs. internal consistency, and fourth the relationship between data and theory. Broadly, this can be summarized by a struggle between Marshallian and Walrasian approaches, which De Vroey not only describes but also does not hesitate to assess, for example in terms of policy readiness.
A History of Macroeconomics is published by Cambridge University Press.
Bayesian Estimation of DSGE Models by Edward Herbst and Frank Schorfheide
DSGE models are increasingly being estimated, and the Bayesian methods is a favorite in this regard. Frank Schorfheide was one of the pioneers of the method and he has teamed up with Edward Herbst to deliver a compact and readable manual that should suit everyone how wants to venture into these techniques.
Bayesian estimation is widely used for the small- and medium-scale New Keynesian models, thus the books starts with natural building blocks, the Smets-Wouters model on one side and Bayesian inference on the other. The two are then put together to show how a linearized DSGE model can be estimated using various techniques, the popular Random-Walk Metropolis-Hastings and the so far little-used Sequential Monte Carlo. A last part of the book shows how non-linear model can also be dealt with thanks to the SMC method. Code and data are available on the authors’ websites.
Bayesian Estimation of DSGE Models is published by Princeton University Press
Big Ideas in Macroeconomics
Kartik Athreya
Dynamic General Equilibrium theory and its application to macroeconomics is part of mainstream research in economics, but it is not easily accessible to laypeople and policymakers. It is a literature that requires tooling up, and it is difficult to follow a typical paper even for someone who is not solving for equilibria himself. The few graduate textbooks are very technical. The very few undergraduate textbooks that touch the subject can only cover extremely simplified models and need to cut corners to make the theory somewhat digestible to students.
If standard macroeconomic theory is to make a broader impact in policy and the educated public, it needs a serious translation into plain English. This is the goal of this book. There is no a single equation or figure. Indeed, Athreya is very careful, for example, to slowly and clearly build the definition of an equilibrium as used in macroeconomics. The book goes in great details through the Arrow-Debreu-McKenzie model by explaining its assumptions and intuition. It expands from this model to get to what modern macroeconomists do in their research.
This approach allows to make it understandable to the layman what typical macro models assume and what they leave out. Why the obsession with the Walrasian equilibrium? What about institutional arrangements? But the book also covers where the latest literature tries to go further, in particular in the light of the economic events of the last years: incomplete markets, search, overlapping generations.
This book should be a great read for advanced undergraduates who already had exposure to simple dynamic models, so as to learn what the “pros” do. Graduate students and faculty, including those not specializing in the field, may also find it interesting to deepen their understanding of modern macro. Policy makers and economic journalists, or anybody else interested in what is going on in macroeconomics and who is not tooled up to read papers, should also benefit greatly from this book.
Big Ideas in Macroeconomics is published by MIT Press.
Hansen and Sargent’s Recursive Models of Dynamic Linear EconomiesLars Peter Hansen and Thomas Sargent
This book was written twenty years ago, but was never really finished. At the occasion of the Gorman Lectures at the University College London, Hansen and Sargent decided to put the finishing touches on a work that was already well-known, if only thanks to its very popular MATLAB programs.
“Recursive Models of Dynamic Linear Economies” is about describing a class of dynamic stochastic models that can be represented in linear quadratic form. Hansen and Sargent provide general procedures to solve the equilibria of those models, as well as to estimate them. The book then becomes more concrete with a series of examples, both with representative agents and heterogeneous consumers, always accompanied with sample MATLAB programs. These chapters are preceded with preliminaries that can be useful in other contexts, such as introductions to linear stochastic difference equations, tricks for more efficient computing, elements of general equilibrium, and various statiscal representations of stochastic processes. The general theme is that these economies can be represented in some recursive form, have competitive equilibria, can be solved using linear optimal control theory, and generate interpretable vector autoregressions. It will thus prove useful to anybody working with this class of models.
Recursive Models of Dynamic Linear Economies is published by Princeton University Press.
Economic Dynamics in Discrete Time
Jianjun Miao
There was a time where teaching graduate level methods applicable in modern macroeconomic theory was a challenge for those who wanted to use a textbook. Now there is a plethora of books, each which their emphasis, but none comprehensive so that the material can be introduced and then expanded from a single book.
The newcomer, Miao’s book, is the first to offer the preliminaries, including the mathematical ones, the proofs, the applications and some review of the literature all in one book. The one limitation, as its title indicates, is that the book concentrates on discrete time. A future volume will cover continuous time, as well as topics that are best treated in continuous time.
So what does the book cover? The preliminaries cover difference equations, Markov and stationary processes. A section looks at dynamic programming and its variants, with several common applications. It goes as far as discussing partial information problems, different numerical methods, and structural estimation. The book then continues with a series of applications, such as complete and incomplete markets, search and matching, New Keynesian models, dynamic games and recursive contracts. The appendices cover all the mathematical ingredients that are required beyond a typical undergraduate curriculum. A solutions manual for some of the exercises, and Matlab and Dynare code are also available.
Economic Dynamics in Discrete Times is published by MIT Press.
Why is there Money? Walrasian General Equilibrium Foundations of Monetary Theory
Ross Starr
(Volume 14, Issue 1, November 2012)
The question why there is money seems an eternal academic research topic. In the context of the Arrow-Debreu general equilibrium framework, understanding why money would arise is very difficult. While the readers of this newsletter are familiar with the money search or the overlapping generation literature, other approaches try to understand money from assumptions that are not that different. Ross Starr presents one such approach in the a small and concise book: trading post models.
The book first introduces the Arrow-Debreu general equilibrium model, then the basic trading post model. It then goes through several iterations to understand what is needed for a monetary equilibrium to emerge in this context, in particular where there is a unique money as medium of exchange. What is the impact of government? Is the absence of double coincidence of wants necessary? Is the equilibrium efficient? These are all familiar questions, and the trading post approach allows to glean some new insights. For example, scale economies in transaction cost can account for uniqueness in equilibrium of the common medium of exchange. In 140 pages, this book is a useful overview of this literature.
Why is there Money? is published by Edward Elgar.
Money, Payments, and Liquidity
Ed Nosal and Guillaume Rocheteau
(Volume 13, Issue 2, April 2012)
Monetary theory has made rapid progress with a new field opening up within the past decade, money search. These new developments are somewhat difficult to follow for the outsider as there is no work that would summarize what it is about and what the main results are, except for a very recent handbook chapter by Steve Williamson and Randall Wright.
Ed Nosal and Guillaume Rocheteau fill this void with a book that tries to take the most modern approach to monetary theory. This is a book that is also meant to be a textbook for graduate classes. It uses as a starting point the Lagos-Wright model with alternating market structure. Each subsequent chapter builds on it to study the impact of credit, credit frictions, pricing mechanisms, and the properties of money. The books then expands on monetary policy, the coexistence of money and credit, and ultimately also other assets and how trading frictions impact asset markets, prices and liquidity.
The strength of the book is the unified framework. The same basic model is used to touch many issues, which also demonstrates the versatility of the approach. This comes at the cost of alternative approaches, which may be better suited for some questions, and which may prevail in this afterall very young literature. The pedagogy, however, dominates and delivers a very readable introduction into money search.
Money, Payments, and Liquidity is published by MIT Press.
References
Williamson, S. D., and Wright, R., 2010. “New Monetarist Economics: Models,” MPRA Paper 21030, University Library of Munich, Germany.
Unemployment Fluctuations and Stabilization Policies, A New Keynesian Perspective
Jordi Galí
(Volume 13, Issue 1, November 2011)
In business cycle policy analysis, it has become important to understand what makes unemployment fluctuate. One way to generate unemployment in a standard business cycle model is to introduce search friction &agreave; la Mortensen-Pissarides. With this book based on a series of lectures at the University of Copenhagen, Jordi Galí introduces another way that is applicable to new-Keynesian models with staggered wages. It is based on a reinterpretation of the model, thus there is no need for new bells and whistles.
In new-Keynesian models, the wage mark-up is central in determining fluctuations in employment and output. If one reinterprets wage mark-up shocks as what prevents full employment, then one can infer the unemployment rate from it and the unemployment rate fluctuates as market power changes, while this market power is constant in the Mortensen-Pissarides model.
After setting up the basic model, the book take a new look at efficiency through the business cycle and redefines the output gap. It can then analyze how monetary policy should be conducted within this model class if the central bank follows a Taylor rule.
Unemployment Fluctuations and Stabilization Policies is published by MIT Press.
Job Matching, Wage Dispersion, and Unemployment
(Volume 12, Issue 2, April 2011)
Dale Mortensen and Christopher Pissarides
This volume was assembled by Konstantinos Tatsiramos and Klaus Zimmermann to celebrate the awarding to Dale Mortensen and Christopher Pissarides of the 2005 IZA Prize in Labor Economics. After their co-winning the 2010 Nobel Prize, the book takes another dimension.
The meat of the book is comprised of five chapters that are reprints of classics of Mortensen and Pissarides that shaped labor search theory. One chapter discusses matching as a non-cooperative process, the second introduces a model of short-run dynamics of vacancies and unemployment, which the next chapter applies to the United Kingdom. Chapter 4 uses the now famous Mortensen-Pissarides matching function to study job creation and job destruction. And the last chapter studies wage distributions in equilibrium. These five chapters are lead by an introduction by the laureates that presents their view on how flows on the labor market should be modelled, in particular how equilibrium theory is more coherent than the disequilibrium theory it replaced.
Job Matching, Wage Dispersion, and Unemployment is published this month by Oxford University Press.
The New Dynamic Public Finance
Narayana Kocherlakota
(Volume 12, Issue 1, November 2010)
“New Dynamic Public Finance” is a term Narayana Kocherlakota coined for a plenary talk given at the 2004 Society for Economic Dynamics meeting, and the term stuck. It describes a theory of taxation that takes minimal restrictions on the instruments available for tax design and takes explicitly into account various uncertainties people face. It is therefore inherently forward-looking. Also, this theory is normative as it does not seek to understand why our current tax system is like it is.
The book is based on a series of lectures given in Toulouse that can be thought of as a graduate course on the topic. Thus, this supposes knowledge of dynamic methods in macroeconomics and is really appropriate as a second year PhD course or beyond. Beyond theory, it covers also some numerical applications of the theory. The research agenda is ambitious, and so are the implementations that sooner or later have to get down to concrete numbers.
The material is rather technical, but the reader who wants to just explore the topic should not be put off by this. Kocherlakota is careful to offer plenty of intuition along the way. The book starts with the classic Ramsey approach and shows how it may become problematic. Before expanding on it, some dynamic social contract theory is introduced. The core of the book is about dynamic optimal taxation and its various applications, in particular how the reciprocal Euler equation is important to characterize equilibria with private information where the standard Euler equation fails. The theory is then applied to two-period, infinitively-lived and overlapping-generation econonomies. The latter has become quite relevant as it allows to study intergenerational transfers and bequests and how taxes influences them. The book concludes with suggestions for further research.
The New Dynamic Public Finance was published in July 2010 by Princeton University Press.
Asset Pricing for Dynamic Economies
(Volume 10, Issue 2, April 2009)
Sumru Altug and Pamela Labadie
This book offers an introduction into dynamic economics using asset pricing as the guiding theme. It is useful to graduate students of both macroeconomics and financial economics in that it offer in the same language and approach a unified treatment of discrete time dynamic economies. This book is self-contained: it offers the basic tools and goes through the basic models, in each case discussing various extension, empirical issues and suggesting exercises. As implied by the title, it starts with the basic asset pricing models APT, CAPM and CCAPM. It covers also production economies, non-separable utility, q-theory of investment, real business cycles, international asset markets, cash-in-advance, frictions, borrowing constraints and overlapping generations. The level of the treatment should make any graduate student comfortable with the material. Plenty of references are offered for further developments and readings. Instructors should also find plenty of inspiration for new approaches to teaching.
Asset Pricing for Dynamic Economies is published by Cambridge University Press.
Economic Growth: Theory and Numerical Solution Methods
(Volume 10, Issue 2, April 2009)
Alfonso Novales, Esther Fernández and Jesús Ruíz
Over the past years, a number of textbooks have been published that present computational methods for dynamic general equilibrum models. Typically, they would concentrate on business cycle models and only mention growth models in passing. The new book by Novales, Fernandez and Ruiz does the opposite: focus on numerical solution methods for growth models, with the addition of extensions on business cycles models (and growth theory, too).
The main sections cover the Neoclassical growth model, optimal growth in continuous and discrete time, endogenous growth and monetary economies. For each topic, the theory is introduced with various extensions, then numerical solution methods are discussed, along with some exercises. Note that Excel and Matlab codes are available on the web for various applications.
The book is self-contained and aimed at graduate students, but can also be used as a reference book. The unusually high cost for a graduate textbook (US$199) may discourage its widespread adoption, though, until the paperback version is published.
Economic Growth is published by Springer.
The Economics of Inaction: Stochastic Control Models with Fixed Costs
(Volume 10, Issue 1, November 2008)
Nancy Stokey
A reality mostly ignored in economic modeling is that we do nothing most of the time: portfolios lay unadjusted, prices are unchanged, investment is chunky, hiring and firing are lumpy. One way to explain this is that some fix cost is involved, generating a region of inaction. This book lays the foundations on how to think about fix costs in a dynamic setting. It turns out that continuous-time models are very appealing in the context of such costs and Nancy Stokey delivers a series of example models using this methodology.
The book is self-contained, thus it includes a substantial part with mathematical preliminaries on stochastic processes, Brownian motions and other diffusions. It covers the essential theorems for these concepts and then applies them to various situations. There are essentially two types of models. First, impulse control models, where a fix cost leads to a lumpy decision. Examples are exercising an option, pricing with menu costs, inventory management and portfolio adjustment. Second, instantaneous control models, where the fix cost leads to a change in a rate of adjustment. Examples are inventory management again and irreversible investment. Finally, the book covers the issue of aggregating individually lumpy decisions.
This is a very technical book, but it tackles a hard and important problem. As it covers the necessarily preliminaires, someone with only passing familiarity with Brownian motions should be able to work through it. This book will prove to be a timeless reference.
“The Economics of Inaction” is published by Princeton University Press.
Robustness
(Volume 9, Issue 2, April 2008)
Lars Peter Hansen and Thomas Sargent
Modelling, especially under rational expectations, assumes that agents know the true underlying structure of the economy, including the parameter values. So does the researcher. What if the research is wrong, and he knows that he could be wrong? Model misspecification is a recognized, but often neglected problem in econometrics. It is mostly ignored in theoretical work. But it becomes particularly important if policy prescriptions differ significantly according to model specifications.
Hansen and Sargent tackle this “fear of model misspecification” by using recent advances in control theory: robust control. This book is not only an introduction to robust control for economists, it also extends robust control to areas particularly relevant to economic theory, for instance discounting, multiple agents, calibration of fear of misspecification.
The basic principle is based in relative entropy, a measure of distance with the true model. One represents misspecification as a set of perturbations to an approximating model. Hansen and Sargent apply this to a standard linear-quadratic dynamic programming problem with a maximin objective: while the agent maximizes over strategies, the researcher minimizes over entropy.
This is an incredibly rich book. It covers a lot of material with plenty of examples. Obviously, as for any pioneering work, disgesting it is somewhat challenging, but with high returns.
“Robustness” is published by Princeton University Press.
Money, Interest, and Policy
(Volume 9, Issue 1, November 2007)
Jean-Pascal Bénassy
In his latest book, Bénassy argues that while dynamic stochastic general equilibrium theory has been successful in explaining many aggregate phenomena, several stylized facts regarding money are still puzzling. For example, DSGE models find it difficult to replicate the liquidity effect found in the data (nominal interest rates decrease in response to a positive money shock). These models also typically advocate the Friedman rule, zero nominal interest rates, which leads to price indeterminacies.
The author suggests that one important reason for these deficiencies of the theory is that it relies on the Ricardian models, where Ricardian equivalence holds, and notably money and government bonds do not constitute real wealth. One way to make the model economy non-Ricardian is to assume newborns, and Bénassy shows that this assumption alone can solve many of the existing puzzles. This is first done in a model with population growth and infinitely lived agents, which allows for analytical ease, then within an overlapping generation framework.
This book builds a lot on existing research, but is not a collection of works. It seeks to demonstrate that current research should be looking at some classics and learn from them again. Unavoidably, the discussion is technical, but short and to the point. An essential read for anybody interested in monetary theory.
“Money, Interest, and Policy” is published by MIT Press.
Structural Macroeconometrics
by David DeJong with Chetan Dave
Methods for Applied Macroeconomic Research
by Fabio Canova
(Volume 8, Issue 2, April 2007)
More and more, dynamic stochastic general equilibrium (DSGE) models are not just calibrated but also estimated, at least in part. There are, however, few works that allow newcomers to enter this field of research. Both books cover this gap and both try to deliver a self-contained treatment of the material. They first detail how to extract stylized facts from the data (filters, impulse responses), and how to approximate and solve a few standard DSGE models. Then, they focus on empirical methods: calibration, moment matching (GMM, SMM), maximum likelihood, and Bayesian methods. In each case the methods are first exposed in general terms, then implemented with examples.
The books are not perfect substitutes, however. DeJong and Dave take a more verbose approach and assume less prerequisites from their readers. They cover thoroughly three examples in each chapter, thus allowing students to learn about these models along with this book. DeJong and Dave additionally cover nonlinear approximations and their empirics.
In contrast, Canova’s treatment of the material is more terse, but covers a myriad of examples and includes also a lot of exercices within the text. Those who have appreciated Stokey and Lucas or Ljundqvist and Sargent should find themselves at home. This book therefore need more preparation than the former and should be suitable for a second year PhD course. Canova additionally covers extensively VARs (traditional and Bayesian) as well as panels.
Compared to previous treatments of this topic, both books provide extended coverage of Bayesian methods, in light of their increasing popularity of estimating DSGE models with these methods or using DSGE models for priors. Also, both have up-to-date references to recent literature using all mentioned methods.
“Methods for Applied Macroeconomic Research” and “Structural Macroeonometrics” are both published by Princeton University Press.
Empirical Dynamic Asset Pricing
by Kenneth Singleton
(Volume 7, Issue 2, April 2006)
This book is at the intersection of modern time series and modern asset pricing theory, two fields that are by themselves already challenging for all graduate students. For those how have mastered the basics, Ken Singleton gives us the ultimate treatise of empirical asset pricing.
The book is structured such that it can be read in different ways: there are purely econometric chapters, only a few of which are required reading for the rest, followed by chapters that cover dynamic asset pricing theory, focussing on pricing kernels, linear and consumption-based models, each first covering theory, then empirical methods that can test them. The last part of the book treats no-arbitrage models in the same way. The author does not just present models and methods, but also likes to discuss results, both from his own, well-known research (with updates) and from the current frontier. Thus it is possible to teach with this book either empirical methods, asset pricing theory itself, or a combination of both.
This book is not an easy read, and thus clearly destined to teach the advanced PhD student or serve as a reference to the researcher. But it is sure to become a classic work in this field. It has all the necessary ingredients: a systematic and thorough coverage of the relevant topics, both the seminal and the latest, and an author who is a pioneer of the field.
“Empirical Dynamic Asset Pricing” is published by Princeton University Press
Income Distribution in Macroeconomic Models
Giuseppe Bertola, Reto Foellmi and Josef Zweimüller
(Volume 7, Issue 2, April 2006)
There is a renewed interest in distributional issues in macroeconomics in responses to challenges in the social security system in many countries and concerns about the link between growth and inequality. This textbook fills a gap especially in the analysis of the growth model. There are various kinds of inequalities and the text tries to address all of them mostly with closed-form solutions: inequality in the remuneration of factors, inequality in the distribution of individual income and wealth, and inequality in the product mix.
This textbook does not attempt to be at the very cutting edge of research. Rather it tries to show how one can extend the representative agent model in interesting ways, i.e. how aggregates may influence distributional indicators or vice-versa. Results are generally of analytic nature and focus on key insights.It starts with the neoclassical growth model, gradually making it more complex by endogenising more variables, adding uncertainty in income or lifetimes, introducing market imperfections, market power and multiple goods. The analysis is complemented by numerous exercices and each chapter is concluded by a literature review of extensions.
While this book is probably not appropriate for a standalone graduate macroeconomics class, it can certainly complement one or serve as the basis for a second course. Researchers should also find the book useful to refresh their intuition or to discover new avenues.
“Income Distribution in Macroeconomic Models” is published by Princeton University Press.
Dynamic General Equilibrium Modelling, Computational Methods and Applications
(Volume 7, Issue 1, November 2005)
Burkhard Heer and Alfred Maussner
Yet another book on computational methods, but that does not mean the market is crowded yet. While several other books already focus on applications of discrete time stochastic dynamic general models with representative agents, this one distinguishes itself in two respects. First, it aims at being more practical, for example by giving tips on how to overcome various traps like initial conditions. Second it expands into heterogenous agent models, including those with aggregate uncertainty. All algorithm examples are supported by programs in FORTRAN and/or Gauss on a companion website.
The representative agent part, after going through some modelling basics, covers the most popular methods: the linear-quadratic method, parametrized expectations and projection methods. In the heterogeneous agent part, the authors introduce the Hansen and Imrohoroglu (1992) borrowing contraint model and show how to obtain its invariant distribution. From there, various models and methods are discussed, including transition dynamics. Aggregate uncertainty in these models is tricky, and recent advances have made it somewhat tractable to address it. Heer and Maussner discuss the Krusell and Smith (1998) method and apply it to various models. The books concludes with a discussion of overlapping generation models and how to solve them, with and without aggregate uncertainty. One last part contains various mathematical tools (or refreshers) that complement the discussion in the previous chapters.
While the authors claim this book to be accessible to advanced undergraduates, it is really for graduate students (and former ones), who are the ones most likely to need to customize algorithms to their needs beyond what is already available on the Internet. This book is most helpful for this purpose, and it can be used as a textbook for a “methods” class.
“Dynamic General Equilibrium Modelling” is published by Springer.
Microfoundations of Financial Economics
Yvan Lengwiler
(Volume 6, Issue 2, April 2005)
This textbook is written for Masters or PhD students in Finance and Macroeconomics and builds the classic theories of financial economics from the ground up. Starting with contigents claim makets and the welfare theorems, the book gradually builds equilibrium concepts and different representations of risk. It covers the basic theories, CAPM, CCAPM, and dynamic trading. The main empirical puzzles are exhibited along with the main attempts to explaim them.
This book can be a great asset for PhD students that are overwhelmed by asset pricing as it is covered in, say, Ljungqvist and Sargent and need a less concise presentation. In this sense, it nicely complements the more advanced textbooks. It also makes asset pricing accessible to even moderately quantitatively inclined MBA or terminal Masters students. Yvan Lengwiler produced a nice addition to recent publications that bridge the gap between undergraduate and advanced PhD textbooks.
“Microfoundations of Financial Economics” is published by Princeton University Press.
Models for Dynamic Macroeconomics
Fabio Cesare Bagliano and Giuseppe Bertola
Yet another textbook on dynamic macroeconomics, one may think. This book is different from the others in terms of the target audience. It aims at advanced undergraduates, say in an Honors program or in programs that can go more in depth in Economics. It is also suited for beginning graduates, say those in terminal Master’s programs for which the standard graduate textbook may be overwhelming. It covers material that is treated in an undergraduate textbook in a more technical fashion, but without drawing on tools that go beyond undergraduate mathematics. This allows to concentrate on a rigorous treatment of Economics without burdening students with many new mathematical concepts.
The topics are standard for any good treatment of dynamic macroeconomics: permanent income and consumption, precautionary savings, CCAPM, optimal investment with adjustment costs, dynamics of the labor market, dynamic general equilibrium, endogenous growth as well as search models. It also includes exercices with answers.
While is does not cover some popular topics, like overlaping generations and business cycle models, it provides the right amount of technical analysis and economic intuition that is required of the target audience. This book is an excellent addition to the toolbox used in teaching dynamic macroeconomics.
Models for Dynamic Macroeconomics is published by Oxford University Press.
Wage Dispersion: Why Are Similar Workers Paid Differently?
Dale Mortensen
In in latest book, Dale Mortensen reviews the evidence and the latest theoretical findings on a long standing puzzle: why would different firms pay differently for the same workers? Observable worker characteristics explain at most 30% of wage differentials across individuals. This raises doubts about the wage equation that yields such results, the efficacy of the standard competitive model or the functioning of labor markets.
There is now mounting evidence that firm size and industry matter. This may mean that imperfect competition is in order which would allow different firms to offer different pay policies. Also, explicitly modeling the frictions on the labor market may be needed. Mortensen addresses this by laying out a simple matching model with wage posting and demonstrates that this can leads to wage dispersion even when all firms and workers are identical. It is then shown how this model can be extended to various environments where firms differ along some dimension.
The model is then extended to an intertemporal setup, the Burdett-Mortensen model. Dale Mortensen then discusses empirical work done with co-authors on a Danish data set and shows that including productivity differences across employers allows the model to better match observed distributions. What these results imply in terms of workers flows and job tenure is the discussed in two further chapters.
This book in essential for anyone interested in some serious modeling of the labor market. It assembles the research frontier on labor search, both on the theoretical and empirical fronts.
“Wage Dispersion” was published in January 2004 by MIT Press.
Economic Dynamics
Jerome Adda and Russell Cooper
Yet another book has been published that provides an introduction to dynamic methods in Economics, “Economic Dynamics” by Jerome Adda and Russell Cooper. Like its predecessors, it gives a overview of the main solution strategies to multiperiod models and their numerical analysis. But what distinguishes this book from others is its more extensive treatment of the estimation of the fundamental parameters of such economies. It goes through the particulars of maximum likelihood, GMM, and simulation-based estimation, thus providing a natural entry to empirical methods often neglected in textbooks.
Particular emphasis is put on linking solution procedures with estimation strategies by providing several simple examples that are examined repeatedly through the first half of the book. The second half covers more complex applications from the litterature, focusing on stochastic growth, the consumption of durables, and non-durables, investment, and employment adjustment. A concluding chapter discusses what the authors think are the most promising areas for future development in the field.
While the focus of the examples and applications is clearly macroeconomic, this book can be useful in introducing dynamic methods to graduate students in a more general context. The level of the material is not too high (and the authors refer to other textbooks for more formal presentations and proofs), which should make these techniques available to a much broader audience.
“Dynamics Economics” was published in October 2003 by MIT Press. Program codes and more information are available at http://www.eco.utexas.edu/~cooper/dynprog/dynprog1.html.
A Theory of Economic Growth: Dynamics and Policy in Overlapping Generations
David de la Croix and Philippe Michel
Just published by Cambridge University Press, this book covers most of everything you would ever want to know about growth and fiscal policy in overlapping generations models. For those interested in growth theory, it is an important complement to the existing textbooks that focus more on the Solow growth model and its infinite-lived derivatives. For those interested in overlapping generations models per se, it complements the book by McCandless and Wallace that focuses on monetary equilibria.
The book has six main parts. The first studies equilibria in the basic overlapping generations model and its main extensions, the second considers their optimality and the properties of optimal paths. Chapter 3 is devoted to fiscal issues: transfers, pensions, public spending and second-bests. Chapter 4 introduces public debt. The last chapter deals with other extensions, such as altruism, education, inter-generational externalities and full Arrow-Debreu markets. Finally, a technical appendix shows various tools and functions some students may need.
Note that the book focuses entirely on theory. The theory is not motivated by some analysis of the data, an aspect that other growth textbooks have clearly emphasized. The predictions of the theory are not compared to some stylized facts or tested in some other ways. In that sense, “A Theory of Economy Growth” should really be understood as a manual on the inner workings of overlapping generation models, a toolbox that a researcher can keep handy, or as a guide on how to prove properties of models related to the ones presented. Many will come to appreciate this book for its analytic depth and its attempt to provide a systematic and precise presentation of overlapping generations.
“A Theory of Economic Growth” has been published by Cambridge University Press in October 2002.
Classical General Equilibrium Theory
Lionel W. McKenzie
Just published by MIT Press, this book covers the main theorems of general equilibrium theory that are usually taught through notes or articles. Thus it offers a serious basis for any student of GE. The core focuses on “Classical” GE, i.e. the theory launched by Arrow, Debreu, Samuelson and the author, with some of the important extensions: demand theory, tâtonnement, Leontief production, comparative statics, the core, existence and uniqueness of the competitive equilibrium. While much of this theory is also applicable to dynamic settings (just define the set of goods appropriately), a chapter also covers some specificities of time: the von Neumann and Ramsey models as well as turnpikes.
Obviously, this is a rather technical subject matter. This book is therefore not accessible to everyone. Indeed, the point of the book is to state and prove rigorously the theorems with a unified language and unified notation. A lot of material is covered, from the fundamentals of demand theory to some frontiers of research, like the use of supermodularity for comparative statics. As a consequence, the writing is dense but still does not compromise on completeness and clarity.
Some teachers like to use Debreu’s Theory of Value complemented with some articles. They may want to consider adopting this book that covers all this material.
“Classical General Equilibrium Theory” has been published by MIT Press in August 2002.
Bossaerts’ The Paradox of Asset Pricing
Several models of asset pricing models are held is high esteem both in the research literature and among practitioners. For example, CAPM is consistently used for investment strategy. Yet, there is little empirical support for it. Dynamic models do not fare much better. Peter Bossaerts argues that empirical tests assume much more than theory does. Indeed, models do not require the efficiency markets hypothesis (EMH), yet empirical tests do. The book shows that one can do away with EMH, and historical data give more convincing results.
The book brings forward two interesting points. The first is that EMH can be replaced by efficiently learning markets, that is markets update their beliefs correctly, but their priors may be wrong, instead of correct with EMH. Empirical testing is still in its infancy, though, and is not that simple. Bossaerts raises here a second point: controlled experiments in the lab may be used to test the theory. By appropriately setting the experiment, one can use the same assumptions for theory and test, and theories like CAPM hold well, but others not (like instantaneous equilibration).
While venturing in a very complex literature, the book is kept at a level that advanced undergraduates should be able to follow. Bossaerts gives an rapid outline of the major theories, insisting on assumptions while bypassing the difficult proofs. A good read, even if you are already familiar with asset pricing theory.
“The Paradox of Asset Pricing” has been published by Princeton University in February 2002.
Kotlikoff’s Essays on Saving, Bequests, Altruism, and Life-Cycle Planning
Laurence J. Kotlikoff is now well known for his work on intergenerational issues. 14 of his essays, 5 not previously published, on this general topic have been reunited in a book that offers the various facets of his work. Three fields are covered. First, 3 essays on savings and bequests documents that the life-cycle theory is capable of explaining the secular decline in the U.S. savings rate with the massive redistribution between generations introduced after WWII in which older people receive annuities that reduce incentives to save. This increased wealth inequality and reduced the wealth equalizing effect of unintentional bequests.
The next five essays tackle voluntary bequests. Kotlikoff and coauthors show that intergenerational altruism is largely absent from the data: the distribution of average within-cohort consumption changes depends on that of average within-cohort resource changes, the same applying within extended families, and families with transfers have only small and insignificant voluntary transfers compared to the forced ones. Barro’s Ricardian Equivalence then looses credence not only empirically, but theoretically as well as two essays show: strategic transfer behavior between parents and children are altered by exogenous redistribution, and asymmetric information prevents parents from enforcing efficient effort of their children.
The last 6 essays pertain to life-cycle planning, already the subject of a recent book by Kotlikoff. Here, some the new book present some older evidence that households do not optimize intertemporally, namely that consumption does not only depend on new information, household over-discount future earnings, both in experiments and in empirical data, households are largely financially illiterate and often poorly advised. Then a financial planning tool is introduced and used to show how people close to retirement are under-saving, except for low-income households who can rely on social security.
Any student of life-cycle behavior and savings should have this collection of essays on his/her bookshelf. It provides several challenges to current modelling of intertemporal household behavior that should keep researchers (and practitioners) busy for quite a while.
“Essays on Saving, Bequests, Altruism, and Life-Cycle Planning” is published at MIT Press.
Evans & Honkapohja’s Learning and Expectations in Macroeconomics
Much of modern macroeconomics relies on the rational expectations (RE) hypothesis, but such theories are often silent on whether the equilibria are actually attainable by people who do not initially have RE. This books sets out conditions on the learnability of the equilibrium. This has important implications. First, a RE equilibrium is moot if it cannot be learned. Second, learnability may help select among multiple equilibria. Third, learning dynamics themselves may be of interest, for example after major economic events or policy shifts. In fact, learning dynamics can lead to endogenous cycles quite similar to those in the data.
Evans and Honkapohja emphasize econometric learning, that is agents use versions of recursive least squares to update their beliefs about the structure of the economy. Actual aggregate outcomes are in turn influenced by such beliefs. They provide conditions under which a given RE equilibrium is learnable. The first four chapters of the book offer a non-technical overview that is quite useful for just curious about macroeconomic learning. The following chapters are more rigorous and discuss many variations of econometric learning, such as learning with misspecified models, sunspots, multivariate and nonlinear models.
A more detailed review by James Bullard is available at http://www.stls.frb.org/research/econ/bullard/.
References:
Ljungqvist & Sargent’s Recursive Macroeconomic Theory
Long available on Tom Sargent’s home page, this impressive work is now finally available in print at MIT Press. This graduate textbook is excellent on bringing the students’ (and teachers’) attention on the power of recursive methods for many issues in macroeconomics today. The tools of trade are covered just sufficiently at the start of the book for students to be quickly able to appreciate their usefulness, and then their coverage in deepened with specific examples. But this is a macroeconomics text foremost, focusing on many topics that have been addressed recently at the frontier of research. In fact, many recent working papers are cited, which is unusual for a textbook.
The book covers the usual subjects in dynamic macroeconomics plus several problems that have emerged in the past decade, like incomplete market models or dynamic contract design, often by reviewing some important papers. The models are generally simplified in order to facilitate a compact (and sometimes necessarily terse) presentation. This should prove very useful for students as it gives a quick yet rigorous overview of the field. Also, for those who are intimidated by the original papers, the book offers sufficient background and intuition to make the reading of the original paper more fruitful. The authors always encourage to read the original works, refer to various extensions and give sometimes detailed indications on how to solve the complex problems.
Established researchers should find this book a good read, too. First, it helps to find a better understanding of the fields one does not follow as intensively as one’s own. Second, it is a great source of inspiration as the book shows how the various theories are intertwined through a common way to approach problems. This reaches beyond the methodology: Microeconomic theory is now firmly integrated in macroeconomics, and dynamic general equilibrium is now an essential ingredient to any question in the field. This book, along with Stokey and Lucas (1989) and Judd (1998), constitute must-reads for any serious macroeconomist.
References:
Ljungqvist, L. and Sargent, T. 2000, “Recursive Macroeconomic Theory,” MIT Press.
Stokey, N. and Lucas, R. (w/ Prescott, E.) 1989, “Recursive Methods in Economic Dynamics,” Harvard University Press.