This is an accomplishment based renewal of a project that has made important contributions to macroeconomics, financial economics, economic growth and labor economics. This grant permits the investigator to continue research in two broad categories: (1) theories of price rigidity and economic fluctuations and (2) theories of economic growth. One of the fundamental questions of macroeconomics is: What determines the rate of inflation? Most macroeconomists agree that in the long run, the primary determinant of inflation is growth in the money supply. The short-run behavior of inflation, however, is more controversial. Certainly monetary policy and other determinants of aggregate demand have important roles. Yet since the 1970s, many economists have also emphasized the role of "supply" or "price" shocks. The contribution of this project comes from developing a rigorous theory on the way shifts in relative prices can affect the rate of inflation and conducting further empirical research on the fraction of the variation in inflation in the postwar United States that is explained by price shocks. Special emphasis is placed on the OPEC energy shocks: large increases in the prices of oil-intensive goods generated price shocks and aggregate inflation rose. This research is clearly relevant to understanding the economic implications of carbon taxes and other global environmental change policies or economic implications of future price shocks caused by global environmental catastrophes. The other part of the project continues research on the gap between standard growth theory and the evidence on convergence in standard of living. Researchers examining a wide variety of datasets have concluded that economies tend to converge--that is, poor economies tend to grow faster than rich economies. Yet standard models of economic growth cannot easily explain this fact. The project develops a model of economic growth that explains gradual convergence in output per person while allowing the real interest rate to be equal across economies at all times. The key to the model is that borrowing is possible to finance accumulation of physical capital but not accumulation of human capital. More generally, this project studies the restrictions that facts about poor and rich countries place on the form of the production function, such as complementarity among labor, human capital, and physical capital.
