**Advanced Macroeconomics, Fifth Edition**

By David Romer

**CONTENTS**

Preface to the Fifth Edition xvii

Introduction 1

Chapter 1 THE SOLOW GROWTH MODEL 6

1.1 Some Basic Facts about

1.2 Assumptions 10

1.3 The Dynamics of the Model 15

1.4 The Impact of a Change in the Saving Rate 18

1.5 Quantitative Implications 24

1.6 The Solow Model and the Central Questions of

Growth Theory 28

1.7 Empirical Applications 30

1.8 The Environment and Economic Growth 37

Problems 45

Chapter 2 INFINITE-HORIZON AND OVERLAPPINGGENERATIONS

MODELS 50

Part A THE RAMSEY CASS KOOPMANS MODEL 50

2.1 Assumptions 50

2.2 The Behavior of Households and Firms 53

2.3 The Dynamics of the Economy 59

2.4 Welfare 65

2.5 The Balanced Growth Path 66

2.6 The Effects of a Fall in the Discount Rate 67

2.7 The Effects of Government Purchases 72

Part B THE DIAMOND MODEL 76

2.8 Assumptions 76

2.9 Household Behavior 78

2.10 The Dynamics of the Economy 80

2.11 The Possibility of Dynamic Inefficiency 87

2.12 Government in the Diamond Model 90

Problems 91

Chapter 3 ENDOGENOUS GROWTH 99

3.1 Framework and Assumptions 100

3.2 The Model without Capital 102

3.3 The General Case 109

3.4 The Nature of Knowledge and the Determinants of the

Allocation of Resources to R&D 114

3.5 The Romer Model 121

3.6 Empirical Application: Time-Series Tests of Endogenous

Growth Models 132

3.7 Empirical Application: Population Growth and

Technological Change since 1 Million B.C. 137

3.8 Models of Knowledge Accumulation and the Central

Questions of Growth Theory 142

Problems 144

Chapter 4 CROSS-COUNTRY INCOME

DIFFERENCES 149

4.1 Extending the Solow Model to Include Human Capital 150

4.2 Empirical Application: Accounting for Cross-Country

Income Differences 155

4.3 Social Infrastructure 162

4.4 Empirical Application: Social Infrastructure and

Cross-Country Income Differences 164

4.5 Beyond Social Infrastructure 169

4.6 Differences in Growth Rates 178

Problems 183

Chapter 5 REAL-BUSINESS-CYCLE THEORY 188

5.1 Introduction: An Overview of Economic Fluctuations 188

5.2 An Overview of Business-Cycle Research 193

5.3 A Baseline Real-Business-Cycle Model 195

5.4 Household Behavior 197

5.5 A Special Case of the Model 201

5.6 Solving the Model in the General Case 207

5.7 Implications 211

5.8 Empirical Application: Calibrating a Real-Business-

Cycle Model 217

5.9 Empirical Application: Money and Output 220

5.10 Assessing the Baseline Real-Business-Cycle Model 227

Problems 233

Chapter 6 NOMINAL RIGIDITY 238

Part A EXOGENOUS NOMINAL RIGIDITY 239

6.1 A Baseline Case: Fixed Prices 239

6.2 Price Rigidity, Wage Rigidity, and Departures from Perfect

Competition in the Goods and Labor Markets 244

6.3 Empirical Application: The Cyclical Behavior of the Real

Wage 253

6.4 Toward a Usable Model with Exogenous Nominal Rigidity 255

Part B MICROECONOMIC FOUNDATIONS OF

INCOMPLETE NOMINAL ADJUSTMENT 268

6.5 A Model of Imperfect Competition and Price-Setting 269

6.6 Are Small Frictions Enough? 276

6.7 Real Rigidity 279

6.8 Coordination-Failure Models and Real Non-Walrasian

Theories 286

6.9 The Lucas Imperfect-Information Model 293

Problems 303

Chapter 7 DYNAMIC STOCHASTIC GENERALEQUILIBRIUM

MODELS OF

FLUCTUATIONS 309

7.1 Building Blocks of Dynamic New Keynesian Models 312

7.2 Predetermined Prices: The Fischer Model 316

7.3 Fixed Prices: The Taylor Model 320

7.4 The Calvo Model and the New Keynesian Phillips Curve 326

7.5 State-Dependent Pricing 329

7.6 Empirical Applications 335

7.7 Models of Staggered Price Adjustment with Inflation Inertia 341

7.8 The Canonical New Keynesian Model 350

7.9 The Forward Guidance Puzzle 354

7.10 Other Elements of Modern New Keynesian DSGE Models

of Fluctuations 360

Problems 365

Chapter 8 CONSUMPTION 368

8.1 Consumption under Certainty: The Permanent-Income

Hypothesis 369

8.2 Consumption under Uncertainty: The Random-Walk

Hypothesis 376

8.3 Empirical Application: Two Tests of the Random-Walk

Hypothesis 379

8.4 The Interest Rate and Saving 385

8.5 Consumption and Risky Assets 389

8.6 Beyond the Permanent-Income Hypothesis 398

8.7 A Dynamic-Programming Analysis of Precautionary Saving 407

Problems 413

Chapter 9 INVESTMENT 420

9.1 Investment and the Cost of Capital 421

9.2 A Model of Investment with Adjustment Costs 424

9.3 Tobin’s q 429

9.4 Analyzing the Model 431

9.5 Implications 435

9.6 Empirical Application: q and Investment 441

9.7 The Effects of Uncertainty 444

9.8 Kinked and Fixed Adjustment Costs 449

Problems 453

Chapter 10 FINANCIAL MARKETS AND

FINANCIAL CRISES 458

10.1 A Model of Perfect Financial Markets 460

10.2 Agency Costs and the Financial Accelerator 463

10.3 Empirical Application: Cash Flow and Investment 475

10.4 Mispricing and Excess Volatility 479

10.5 Empirical Application: Evidence on Excess Volatility 488

10.6 The Diamond Dybvig Model 491

10.7 Contagion and Financial Crises 501

10.8 Empirical Application: Microeconomic Evidence on the

Macroeconomic Effects of Financial Crises 508

Problems 514

Chapter 11 UNEMPLOYMENT 520

11.1 A Generic Efficiency-Wage Model 523

11.2 The Shapiro-Stiglitz Model 532

11.3 Contracting Models 543

11.4 Search and Matching Models 550

11.5 Implications 558

11.6 Empirical Applications 564

Problems 572

Chapter 12 MONETARY POLICY 578

12.1 Inflation, Money Growth, and Interest Rates 579

12.2 Monetary Policy and the Term Structure of Interest

Rates 583

12.3 The Microeconomic Foundations of Stabilization Policy 588

12.4 Optimal Monetary Policy in a Simple Backward-Looking

Model 596

12.5 Optimal Monetary Policy in a Simple Forward-Looking

Model 602

12.6 Some Additional Issues Concerning Interest-Rate Rules 607

12.7 The Zero Lower Bound on the Nominal Interest Rate 615

12.8 The Dynamic Inconsistency of Low-Inflation

Monetary Policy 630

12.9 Empirical Applications 637

12.10 Seignorage and Inflation 642

Problems 652

Chapter 13 BUDGET DEFICITS AND FISCAL POLICY 660

13.1 The Government Budget Constraint 662

13.2 Ricardian Equivalence 669

13.3 Tax-Smoothing 673

13.4 Political-Economy Theories of Budget Deficits 678

13.5 Strategic Debt Accumulation 681

13.6 Delayed Stabilization 691

13.7 Empirical Application: Politics and Deficits in

Industrialized Countries 696

13.8 The Costs of Deficits 700

13.9 A Model of Sovereign Debt Crises 704

Problems 710

References 715

Author Index 752

Subject Index 761

Introduction 1

Chapter 1 THE SOLOW GROWTH MODEL 6

1.1 Some Basic Facts about

**Economic**Growth 61.2 Assumptions 10

1.3 The Dynamics of the Model 15

1.4 The Impact of a Change in the Saving Rate 18

1.5 Quantitative Implications 24

1.6 The Solow Model and the Central Questions of

Growth Theory 28

1.7 Empirical Applications 30

1.8 The Environment and Economic Growth 37

Problems 45

Chapter 2 INFINITE-HORIZON AND OVERLAPPINGGENERATIONS

MODELS 50

Part A THE RAMSEY CASS KOOPMANS MODEL 50

2.1 Assumptions 50

2.2 The Behavior of Households and Firms 53

2.3 The Dynamics of the Economy 59

2.4 Welfare 65

2.5 The Balanced Growth Path 66

2.6 The Effects of a Fall in the Discount Rate 67

2.7 The Effects of Government Purchases 72

Part B THE DIAMOND MODEL 76

2.8 Assumptions 76

2.9 Household Behavior 78

2.10 The Dynamics of the Economy 80

2.11 The Possibility of Dynamic Inefficiency 87

2.12 Government in the Diamond Model 90

Problems 91

Chapter 3 ENDOGENOUS GROWTH 99

3.1 Framework and Assumptions 100

3.2 The Model without Capital 102

3.3 The General Case 109

3.4 The Nature of Knowledge and the Determinants of the

Allocation of Resources to R&D 114

3.5 The Romer Model 121

3.6 Empirical Application: Time-Series Tests of Endogenous

Growth Models 132

3.7 Empirical Application: Population Growth and

Technological Change since 1 Million B.C. 137

3.8 Models of Knowledge Accumulation and the Central

Questions of Growth Theory 142

Problems 144

Chapter 4 CROSS-COUNTRY INCOME

DIFFERENCES 149

4.1 Extending the Solow Model to Include Human Capital 150

4.2 Empirical Application: Accounting for Cross-Country

Income Differences 155

4.3 Social Infrastructure 162

4.4 Empirical Application: Social Infrastructure and

Cross-Country Income Differences 164

4.5 Beyond Social Infrastructure 169

4.6 Differences in Growth Rates 178

Problems 183

Chapter 5 REAL-BUSINESS-CYCLE THEORY 188

5.1 Introduction: An Overview of Economic Fluctuations 188

5.2 An Overview of Business-Cycle Research 193

5.3 A Baseline Real-Business-Cycle Model 195

5.4 Household Behavior 197

5.5 A Special Case of the Model 201

5.6 Solving the Model in the General Case 207

5.7 Implications 211

5.8 Empirical Application: Calibrating a Real-Business-

Cycle Model 217

5.9 Empirical Application: Money and Output 220

5.10 Assessing the Baseline Real-Business-Cycle Model 227

Problems 233

Chapter 6 NOMINAL RIGIDITY 238

Part A EXOGENOUS NOMINAL RIGIDITY 239

6.1 A Baseline Case: Fixed Prices 239

6.2 Price Rigidity, Wage Rigidity, and Departures from Perfect

Competition in the Goods and Labor Markets 244

6.3 Empirical Application: The Cyclical Behavior of the Real

Wage 253

6.4 Toward a Usable Model with Exogenous Nominal Rigidity 255

Part B MICROECONOMIC FOUNDATIONS OF

INCOMPLETE NOMINAL ADJUSTMENT 268

6.5 A Model of Imperfect Competition and Price-Setting 269

6.6 Are Small Frictions Enough? 276

6.7 Real Rigidity 279

6.8 Coordination-Failure Models and Real Non-Walrasian

Theories 286

6.9 The Lucas Imperfect-Information Model 293

Problems 303

Chapter 7 DYNAMIC STOCHASTIC GENERALEQUILIBRIUM

MODELS OF

FLUCTUATIONS 309

7.1 Building Blocks of Dynamic New Keynesian Models 312

7.2 Predetermined Prices: The Fischer Model 316

7.3 Fixed Prices: The Taylor Model 320

7.4 The Calvo Model and the New Keynesian Phillips Curve 326

7.5 State-Dependent Pricing 329

7.6 Empirical Applications 335

7.7 Models of Staggered Price Adjustment with Inflation Inertia 341

7.8 The Canonical New Keynesian Model 350

7.9 The Forward Guidance Puzzle 354

7.10 Other Elements of Modern New Keynesian DSGE Models

of Fluctuations 360

Problems 365

Chapter 8 CONSUMPTION 368

8.1 Consumption under Certainty: The Permanent-Income

Hypothesis 369

8.2 Consumption under Uncertainty: The Random-Walk

Hypothesis 376

8.3 Empirical Application: Two Tests of the Random-Walk

Hypothesis 379

8.4 The Interest Rate and Saving 385

8.5 Consumption and Risky Assets 389

8.6 Beyond the Permanent-Income Hypothesis 398

8.7 A Dynamic-Programming Analysis of Precautionary Saving 407

Problems 413

Chapter 9 INVESTMENT 420

9.1 Investment and the Cost of Capital 421

9.2 A Model of Investment with Adjustment Costs 424

9.3 Tobin’s q 429

9.4 Analyzing the Model 431

9.5 Implications 435

9.6 Empirical Application: q and Investment 441

9.7 The Effects of Uncertainty 444

9.8 Kinked and Fixed Adjustment Costs 449

Problems 453

Chapter 10 FINANCIAL MARKETS AND

FINANCIAL CRISES 458

10.1 A Model of Perfect Financial Markets 460

10.2 Agency Costs and the Financial Accelerator 463

10.3 Empirical Application: Cash Flow and Investment 475

10.4 Mispricing and Excess Volatility 479

10.5 Empirical Application: Evidence on Excess Volatility 488

10.6 The Diamond Dybvig Model 491

10.7 Contagion and Financial Crises 501

10.8 Empirical Application: Microeconomic Evidence on the

Macroeconomic Effects of Financial Crises 508

Problems 514

Chapter 11 UNEMPLOYMENT 520

11.1 A Generic Efficiency-Wage Model 523

11.2 The Shapiro-Stiglitz Model 532

11.3 Contracting Models 543

11.4 Search and Matching Models 550

11.5 Implications 558

11.6 Empirical Applications 564

Problems 572

Chapter 12 MONETARY POLICY 578

12.1 Inflation, Money Growth, and Interest Rates 579

12.2 Monetary Policy and the Term Structure of Interest

Rates 583

12.3 The Microeconomic Foundations of Stabilization Policy 588

12.4 Optimal Monetary Policy in a Simple Backward-Looking

Model 596

12.5 Optimal Monetary Policy in a Simple Forward-Looking

Model 602

12.6 Some Additional Issues Concerning Interest-Rate Rules 607

12.7 The Zero Lower Bound on the Nominal Interest Rate 615

12.8 The Dynamic Inconsistency of Low-Inflation

Monetary Policy 630

12.9 Empirical Applications 637

12.10 Seignorage and Inflation 642

Problems 652

Chapter 13 BUDGET DEFICITS AND FISCAL POLICY 660

13.1 The Government Budget Constraint 662

13.2 Ricardian Equivalence 669

13.3 Tax-Smoothing 673

13.4 Political-Economy Theories of Budget Deficits 678

13.5 Strategic Debt Accumulation 681

13.6 Delayed Stabilization 691

13.7 Empirical Application: Politics and Deficits in

Industrialized Countries 696

13.8 The Costs of Deficits 700

13.9 A Model of Sovereign Debt Crises 704

Problems 710

References 715

Author Index 752

Subject Index 761