On the Time Inconsistency of International Borrowing in an Optimal Growth Model

This paper analyzes international borrowing and lending in an optimal growth model with adjustment costs for investment. We study the relation between optimal savings and investment, and the current account, in the transition towards the balanced growth path, and derive the implications of financial openness for both the transition path and the balanced growth path. A comparison with financial autarky reveals that, to the extent that countries start from different initial conditions, and there is pre-commitment to debt repayment, financial openness is beneficial for both “poor” and “rich” countries, as it allows them to engage in mutually beneficial inter-temporal trade. During the adjustment process, relatively “poor” countries experience higher consumption and investment compared to autarky, and thus cumulate current account deficits. There is an inter-temporal tradeoff, in that they experience lower steady state consumption, due to the need to service their accumulated foreign debt. The opposite happens in relatively “rich” countries. The inter-temporal tradeoffs implied by financial openness result in a time inconsistency problem. “Poor” countries reach a point in the adjustment process at which it is welfare improving to renege on their commitment to repay their foreign debt. In the absence of sufficient pre-commitment mechanisms, international lenders anticipate these incentives, and international borrowing and lending are driven to zero. This time inconsistency problem can thus explain both the Feldstein-Horioka puzzle and the Lucas paradox that capital does not flow from “rich” to “poor” countries. Credible sanctions in the case of default and ceilings on international borrowing are analyzed as partial solutions to the time inconsistency problem of international borrowing.

Keywords: time inconsistency, international borrowing, optimal growth, financial openness, debt default
JEL Classification: F43 F34 O11 D91 D92

PDF of Full Paper


The Clash of Central Bankers with Labor Market Insiders, and the Persistence of Unemployment and Inflation in the Main Industrial Economies

This paper analyzes the implications of optimal monetary policy for the dynamic behavior of inflation in a “natural rate” model characterized by endogenous unemployment persistence. We analyze a dynamic “insider outsider” model of the “Phillips Curve”, that accounts for the persistence of unemployment following nominal and real shocks. We derive optimal monetary policy under both discretion and commitment to an inflation target. We demonstrate that under discretion, because of the endogenous persistence of deviations of unemployment from its “natural” rate, deviations of inflation from target display the same degree of persistence as unemployment. Under full commitment to an inflation target there is no inflation persistence. An empirical investigation for the main industrial economies suggests that the persistence of deviations of inflation from a constant inflation target is of the same order of magnitude as the persistence of deviations of unemployment from its “natural” rate. This finding is consistent with the hypothesis put forward in this paper, of a clash between central bankers and labor market insiders, that cause both unemployment and inflation to persist.

Keywords: unemployment persistence, inflation, monetary policy, insiders outsiders, central banks

JEL Classification: E3, E4, E5

PDF of Full Paper


Unemployment Persistence, Inflation and Monetary Policy in A Dynamic Stochastic Model of the Phillips Curve

This paper puts forward an alternative “new Keynesian” dynamic stochastic general equilibrium model of aggregate fluctuations. The model is characterized by one period nominal wage contracts and endogenous persistence of deviations of unemployment from its natural rate. Aggregate fluctuations are analyzed under both a Taylor nominal interest rate rule and under the assumption of optimal discretionary monetary policy. Under both types of monetary policy, the persistence of unemployment results in persistent inflation as the central bank responds to deviations of unemployment from its natural rate. Econometric evidence from the United States since the 1890s cannot reject the main predictions of the model.

Keywords: aggregate fluctuations, unemployment persistence, inflation, monetary policy, insiders outsiders, natural rate
JEL Classification: E3, E4, E5

PDF of Full Paper

Working Paper no 04/16, Department of Economics, Athens University of Economics and Business



Dynamic Macroeconomic Theory

An evolving online textbook on modern macroeconomics.

by George Alogoskoufis

Macroeconomics focuses on the analysis of economies in the aggregate. This book is addressed to students of economics, as well as trained economists, who wish to deepen and broaden their knowledge of macroeconomics. It presents the main theories of economic growth and aggregate fluctuations, through a sequence of dynamic general equilibrium models, which are based on inter-temporal optimization on the part of economic agents, such as households, firms and the government.

These models are treated as tools for understanding the main macroeconomic phenomena of long run economic growth, aggregate fluctuations, inflation and unemployment as well as studying the effects of monetary and fiscal policy. The book highlights both the potential of such dynamic models, as well as their limitations. Dynamic general equilibrium models, such as the ones utilized in this book are the essence of modern macroeconomics.

The book assumes introductory knowledge of economic theory and mathematics for economists, and is suitable for advanced undergraduates, graduate economists and students in the first year of post-graduate degrees leading to an M.Sc or a Ph.D in economics and related subjects. The book has emerged from my lectures over many years at Birkbeck College, University of London and the Athens University of Economics and Business, both at undergraduate and postgraduate levels.

Chapter 1 is an introductory chapter, providing a brief review of the evolution of macroeconomics, as well as key facts about long run economic growth and aggregate fluctuations.

The remainder of the book is divided into four main parts.

The first part consists of six (6) chapters, which present and analyze the process of economic growth. It presents the basic Solow model of savings, investment and economic growth (Ch. 2), the Ramsey model of the representative household (Ch. 3), overlapping generations models such as the models of Diamond and Blanchard and Weil (Ch. 4), models that highlight the inter-temporal effects of fiscal policy and the money supply (Ch. 5 and 6), and models of externalities, human capital accumulation, ideas and innovations and endogenous growth (Ch. 7).

The second part, which consists of three (3) additional chapters, analyses dynamic stochastic models of consumption (Ch. 8), investment (Ch. 9), as well as money demand, interest rates, the price level and inflation (Ch. 10).

The third part consists of six (6) additional chapters, which present and analyze dynamic stochastic general equilibrium models of aggregate fluctuations. We present the new classical view of aggregate fluctuations (Ch. 11), introduce the basic Keynesian model and the Phillips curve (Ch. 12), and then present a dynamic stochastic new keynesian model with periodic wage setting, (Ch. 13), an imperfectly competitive new keynesian model (Ch. 14), and a matching model of the determination of equilibrium unemployment (Ch. 15).

In the fourth and final part, which consists of four (4) additional chapters we analyze the role and the effectiveness of monetary (Ch. 16) and fiscal policy (Ch. 17), models of macroeconomics and politics (Ch, 18), as well as models of multiple equilibria and macroeconomic crises (Ch. 19).

Chapter 20 sums up on the state of macroeconomics and speculates about its likely future evolution.

Link to Dynamic Macroeconomic Theory




On the Taylor Rule and Optimal Monetary Policy in a “Natural Rate” Model

This paper investigates the stabilizing role of monetary policy in a dynamic, stochastic general equilibrium model of the “natural rate”, in which non indexed nominal wages are periodically set by labor market “insiders”.

This nominal distortion allows for nominal shocks to have temporary real effects, and thus, for monetary policy to be able to affect short run fluctuations in both inflation and real output.

We derive and analyze optimal monetary policy in the presence of real and nominal shocks, and highlight the properties of the optimal monetary policy rule.

The optimal policy rule is second best, as it cannot completely neutralize productivity shocks, and is associated with a tradeoff between the stabilization of inflation and output.

We also demonstrate that the optimal policy can be replicated by a set of appropriately parametrized Taylor rules, according to which deviations of the current nominal interest rate from its “natural” rate, depend on deviations of inflation from target and output from its “natural” level.

We prove that the optimal Taylor rule is not unique, as multiple sets of parameters are consistent with optimality.

Provided that the monetary authorities attach a sufficiently low weight to deviations of output from its “natural” level, the optimal policy could also be replicated through a unique, appropriately parametrized Wicksell rule, according to which deviations of the nominal interest rate from its “natural” rate depend only on deviations of inflation from target.

The optimal set of Taylor rules is a set of simple, but not too simple rules, as, the nominal interest rate must react to changes in the “natural” rate of interest, in addition to deviations of inflation from target, and output from its “natural”level.

Discussion Paper no. 5-2015, Department of Economics, Athens University of Economics and Business

PDF of Updated Paper, April 2016


Useful Links

Dynamic Macroeconomic Theory

An evolving on line textbook on dynamic macroeconomic theory, by Professor George Alogoskoufis


A very useful preprocessor for simulating and estimating dynamic and dynamic stochastic general equilibrium models in Matlab.

Penn World Tables

An important source of comparable data and estimates for per capita GDP and growth for a large set of developed and developing economies in the post war period

Maddison Project

An important source of available data and comparable estimates of historical data for the per capita output and income of a large set of countries and regions from 1AD till 2010 AD.

International Monetary Fund

Reports and data for all member economies and the world economy.

Organization of Economic Cooperation and Development (OECD)

Reports and data for a number of developed economies.

World Bank

Reports and Data for both the developed and the developing economies

Commission of the European Union (DG II)

Reports and data for the EU member states, the Euro Area and other economies.

National Bureau of Economic Research

Research papers from economists belonging to the most important research network in the USA.

Centre for Economic Policy Research

Research papers from economists belonging to the most important research network in Europe.


Research Based Policy Analysis and Comments from Academic Economists

Financial Openness versus Autarky in a Neoclassical Growth Model

This paper compares financial openness with autarky in a neoclassical growth model, with adjustment costs for investment.

We analyse the relation between growth and the current account in the transition towards the balanced growth path, and derive the implications of the two financial regimes for the balanced growth path.

For an economy with an initial capital stock which is lower than the rest of the world, output (GDP) per capita on the balanced growth path is the same under financial openness and autarky. However, Gross National Product (GNP) and consumption per capita are lower under financial openness than under autarky. The reason is that the economy has to pay interest on the foreign debt it has accumulated during the transition. During the transition, the economy runs current account deficits and accumulates net foreign debt. The opposite applies to an economy, whose initial capital stock is higher than the rest of the world.

There are benefits from financial openness and inter-temporal trade for either type of economy, as, during the transition, the path of the world real interest rate differs from the path of autarky real interest rates for either type of economy.