We covered a lot macroeconomics this semester: growth theory, consumption, investment, real business cycle, Keynesian theory of the business cycle, unemployment, fiscal policy, and monetary policy. The assumptions behind so many of the models were just so unrealistic; it seemed absurd to be solving problems to see the conclusions ourselves.  I thought I’d outline a couple of the more counterintuitive things we learned and the implausible conclusions that they implied.

Neo-classical Growth Theory: concludes that in the long run economic growth cannot be achieved by physical or human capital accumulation, but instead is determined by the growth rate of technology – which the model takes to be exogenous.  So human capital accumulation doesn’t affect technology growth.

Consumption Theory: states that if optimizing our consumption over our lifetimes, we calculate the NPV of all future earnings and choose to a constant level of consumption over time.  So if we are learning less that our “permanent” income level, we will take out a loan, if we are earning more we will save.  If you knew with certainty that you would receive a million dollars in five years, would you buy a new house right now?  You should if you’re optimizing!

Ricardian Equivalence: states that if the government has a fiscal stimulus, it makes no difference if it’s paid for in taxes or by raising debt.  Since people realize that if debt is raised it will have to be paid back eventually via higher taxes, they save the stimulus in anticipation of future taxes.  In order to believe this one though, you have to believe that taxes are non-distortionary, credit markets work perfectly, the government can borrow at the same interest rate as everyone else, and my personal favorite -- that people behave as if they live forever (so they care about taxes infinitely far in the future).

Real Business Cycle Theory: This is the gem of the semester.  It’s a model of short-term economic fluctuations that concludes that fluctuations in the business cycle are the result of optimization on the parts of firms and workers. So there’s a negative productivity shock, firms lower wages, and workers choose leisure over work and leave their jobs, causing output to fall.  Know anyone who’s unemployed who chose not to work?
I think my favorite quote of the semester was, when looking at real business cycle theory and new Keynesian theory of the business cycle “Why are we even debating these two theories when one is based off ridiculous assumptions and the other is based on real life?”  I think the answer is so that we can engage in discussions with people basing policy opinions on these theories.  Though, if we didn’t teach them in the first place…