2026 Final Exam

Slides (these are also on Canvas under “Files”, which is where you need to go for the ones that I felt have copyright issues)

Supplementary Readings for the Final Exam

YouTube Video to Watch for the Final Exam

Songs pointing to additional things covered in lecture

How Output Above the Natural Level Causes Higher Inflation and Output below the Natural Level of Inflation Causes Lower Inflation.

For this, I thought carefully about what I have written in research papers. Importantly, “There Is No Such Thing as Decreasing Returns to Scale,” so an upward-sloping supply curve does not come from a long-run U-shaped average cost curve. Rather, it comes from workers, factories and equipment in the factories being at least somewhat attached to particular firms. But also, tight labor markets and tight markets for rental spaces for business and other rentals shift a firm’s supply curve upward.

Firms “daydreaming” about price hikes or price cuts alludes to the “instantaneously optimal desired price” that a firm would wish to have right now if it were the only firm to have perfectly flexible prices. But, in fact, changing prices can be costly—at least if a firm thinks carefully about how to incorporate macroeconomic information into how it changes prices. (Decision-making costs can be substantial. Think of the level of education required to even be involved usefully in incorporating macroeconomic information into price-setting.) But eventually, firms do change prices, and macroeconomic information does percolate into those price changes. Exactly how that happens is a complex and contested area of macroeconomics. So the line “Dreams become what happens” refers to this complex process. A key aspect of this is that firms care not only about the instantaneously optimal desired price now, but the instantaneously optimal desired price in the future, since they might be sticking with the price they set for a while. If there is trend inflation, the instantaneously optimal desired price in the future will be higher than it is now, so trend inflation makes firms set prices higher when they do change their prices. The upshot is that inflation tends to sustain itself, unless output diverges from the natural level. Here are two songs, one for each direction.

(This was in danger of being very dry, I’m afraid, so I thought to put a little color on it by asking Suno to make Country songs about this. Hence the emphasis on farmers.)

The Fed’s Monetary Policy Job

The Fed has non-monetary jobs, such as bank and financial regulation. But in monetary policy, here is what the Fed needs to do:

  1. Decide on a long-run inflation target. Like many other major central banks (such as the European Central Bank, the Bank of Japan, the Bank of England) the Fed has chosen 2% per year inflation as its target. I argue instead for a zero inflation target coupled with being ready and willing to use negative rates—including deep negative rates—when needed. See “The Costs of Inflation” and “The Costs and Benefits of Repealing the Zero Lower Bound...and Then Lowering the Long-Run Inflation Target.”

  2. Once it has chosen an inflation target and gotten the economy to that level of inflation, the Fed’s job (as for other central banks) is to keep inflation steady at that rate. Because output above the natural level causes inflation to go up and output below the natural level causes inflation to go down, keeping inflation steady (“stabilizing” inflation) is the same thing as keeping output at the natural level of output. The fact that steadying inflation and keeping output at the natural level are the same thing is called “The Divine Coincidence” by economists. Here is its song:

3. The one other big decision is what to do after a mistake that knocks inflation up or down and therefore knocks the price level off track. (a) Return to the original planned price level track (which required a period of below-target inflation to compensate for above-target inflation, or a period of above-target inflation to compensate for below-target inflation) or (b) follow a permanently different price level track that parallels the original path, either higher or lower. (a) is called “price-level targeting.” (b) is called “inflation targeting.” A zero inflation target would make price-level targeting more attractive because it is then simply trying to keep the price level the same. (Price-level targeting with a 2% per year inflation target is harder to explain. That has a target that is an upward-sloping path for the price level, decided on in advance.)

Monetary Dominance and Fiscal Follows the Fed

For the next song, you need to know that “the fisc” means the taxing and spending policies of the government.

The Rational Expectations Revolution and the Lucas Critique

The adaptive expectations models of the 1960s treated humans as stupider than they really are. Rational expectations models, which have dominated macroeconomics from the 1970s to now treat humans as smarter than they really are. Unfortunately, it is very, very, very hard to model human intelligence as being at an appropriate intermediate level of intelligence. I discuss these difficulties in my paper “Cognitive Economics.” The Rational Expectations Revolution, which picked up steam in the 1970s, when I was in college, got us out of assuming humans are stupider than they are, but got us into assuming humans are smarter than they are. Overall it was progress: helping those who hold the rational expectations assumption lightly and gingerly understand things better, but causing a certain amount of blindness for those who hold the rational expectations assumption too tightly.

For the next song, I wrote a generalized version of the Lucas Critique and the prescription for what to do as a macroeconomist with which I agree 100%. Any problems with the implementation of a strategy in response to the Lucas Critique come from faults in how (a) what people want is modeled (for example, people care about feeling happy as well as about money and leisure time), (b) how limitations people face are modeled (sometimes inadequate technical shortcuts are used) and crucially (c) the assumption that people are infinitely intelligent—or at least are so smart that they make perfect economic decisions given what they knew at the time.

Supply and Demand for the Monetary Base: How the Fed Has the Power to Determine the Safe Interest Rate

Highly Visible Real-World Consequences of Imperfect Competition and Increasing Returns to Scale

For more on this, see “Why I am a Macroeconomist: Increasing Returns and Unemployment.” This point by Martin Weitzman inspired me to switch from being a micro-theorist to being a macroeconomist.

Here are some consequences of imperfect competition:

On this last, why are sticky prices important to the argument? Here’s why: if the firm could instantly adjust its prices, its reaction to more customers might be a mix of serving more customers and raising its price —which would lose some potential customers. (One reason it might want to raise its price is that in a boom that generates more demand, wages and rental rates will rise, raising marginal cost.) With a sticky price, the firm serves all the additional customers who show up willing to pay the stuck price.

AI Alignment

Next Generation Monetary Policy (Miles’s Wishlist for Monetary Policy Improvements)

The Solow Growth Model