John C. Driscoll
Brown University and NBER1
December 3, 2001

Contents
1 Money and Prices 1
1.1 Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.1.1 Prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.1.2 Money . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
1.2 The History ofMoney . . . . . . . . . . . . . . . . . . . . . . . . 3
1.3 The Demand forMoney . . . . . . . . . . . . . . . . . . . . . . . 4
1.3.1 The Baumol-TobinModel ofMoney Demand . . . . . . . 4
1.4 Money in Dynamic General Equilibrium . . . . . . . . . . . . . . 6
1.4.1 Discrete Time . . . . . . . . . . . . . . . . . . . . . . . . . 7
1.4.2 Continuous Time . . . . . . . . . . . . . . . . . . . . . . . 10
1.4.3 Solving theModel . . . . . . . . . . . . . . . . . . . . . . 13
1.5 The optimumquantity ofmoney . . . . . . . . . . . . . . . . . . 14
1.5.1 The Quantity Theory ofMoney . . . . . . . . . . . . . . . 14
1.6 Seigniorage, Hyperinflation and the Cost of Inflation . . . . . . . 16
1.7 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2 Nominal Rigidities and Economic Fluctuations 27
2.1 Old Keynesian Economics: The Neoclassical Synthesis . . . . . . 28
2.1.1 Open Economy . . . . . . . . . . . . . . . . . . . . . . . . 31
2.1.2 Aggregate Supply . . . . . . . . . . . . . . . . . . . . . . 33
2.2 DisequilibriumEconomics . . . . . . . . . . . . . . . . . . . . . . 36
2.2.1 Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
2.2.2 TheWalrasian Benchmark Case . . . . . . . . . . . . . . 37
2.2.3 Exogenously Fixed Price . . . . . . . . . . . . . . . . . . . 38
2.2.4 Exogenously Fixed NominalWage . . . . . . . . . . . . . 39
2.2.5 Both prices and wages inflexible . . . . . . . . . . . . . . 39
2.2.6 Analysis of thismodel . . . . . . . . . . . . . . . . . . . . 40
2.3 Imperfect InformationModels . . . . . . . . . . . . . . . . . . . . 41
2.4 New KeynesianModels . . . . . . . . . . . . . . . . . . . . . . . . 43
2.4.1 ContractingModels . . . . . . . . . . . . . . . . . . . . . 43
2.4.2 PredeterminedWages . . . . . . . . . . . . . . . . . . . . 44
2.4.3 FixedWages . . . . . . . . . . . . . . . . . . . . . . . . . 47
2.5 Imperfect Competition and New Keynesian Economics . . . . . . 50
2.5.1 Macroeconomic Effects of Imperfect Competition . . . . . 50
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2.5.2 Imperfect competition and costs of changing prices . . . . 51
2.5.3 DynamicModels . . . . . . . . . . . . . . . . . . . . . . . 56
2.6 Evidence and New Directions . . . . . . . . . . . . . . . . . . . . 57
2.7 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
3 Macroeconomic Policy 65
3.1 Rules v. Discretion . . . . . . . . . . . . . . . . . . . . . . . . . . 66
3.1.1 The Traditional Case For Rules . . . . . . . . . . . . . . . 66
3.2 TheModern Case For Rules: Time Consistency . . . . . . . . . . 68
3.2.1 Fischer’s Model of the Benevolent, Dissembling Government 68
3.2.2 Monetary Policy and Time Inconsistency . . . . . . . . . 72
3.2.3 Reputation . . . . . . . . . . . . . . . . . . . . . . . . . . 75
3.3 The Lucas Critique . . . . . . . . . . . . . . . . . . . . . . . . . . 77
3.4 Monetarist Arithmetic: Links Between Monetary and Fiscal Policy 79
3.5 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80
4 Investment 87
4.1 The Classical Approach . . . . . . . . . . . . . . . . . . . . . . . 87
4.2 Adjustment Costs and Investment: q Theory . . . . . . . . . . . 88
4.2.1 The Housing Market: After Mankiw and Weil and Poterba 91
4.3 Credit Rationing . . . . . . . . . . . . . . . . . . . . . . . . . . . 93
4.4 Investment and FinancialMarkets . . . . . . . . . . . . . . . . . 95
4.4.1 The Effects of Changing Cashflow . . . . . . . . . . . . . 97
4.4.2 The Modigliani-Miller Theorem . . . . . . . . . . . . . . . 98
4.5 Banking Issues: Bank Runs, Deposit Insurance and Moral Hazard 99
4.6 Investment Under Uncertainty and Irreversible Investment . . . . 103
4.6.1 Investment Under Uncertainty . . . . . . . . . . . . . . . 107
4.7 Problems: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109
5 Unemployment and Coordination Failure 117
5.1 Efficiency wages, or why the real wage is too high . . . . . . . . . 117
5.1.1 Solowmodel . . . . . . . . . . . . . . . . . . . . . . . . . 118
5.1.2 The Shapiro-Stiglitz shirkingmodel . . . . . . . . . . . . 118
5.1.3 Othermodels of wage rigidity . . . . . . . . . . . . . . . . 120
5.2 Search . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120
5.2.1 Setup . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 121
5.2.2 Steady State Equilibrium . . . . . . . . . . . . . . . . . . 122
5.3 Coordination Failure and Aggregate Demand Externalities . . . . 123
5.3.1 Model set-up . . . . . . . . . . . . . . . . . . . . . . . . . 123
5.3.2 Assumptions . . . . . . . . . . . . . . . . . . . . . . . . . 125
5.3.3 Definitions . . . . . . . . . . . . . . . . . . . . . . . . . . 126
5.3.4 Propositions . . . . . . . . . . . . . . . . . . . . . . . . . 126
5.4 Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 127
Continuous-Time Dynamic Optimization 131