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Having just concluded a seven-year run as chief economist of the International Monetary Fund, and having to rewrite the seventh edition of my undergraduate macroeconomics book , I had to confront the issue: How should we teach macroeconomics to undergraduates after the crisis? Here are some of my conclusions (I shall focus here on the short and medium runs; it will take another blog to discuss how we should teach growth theory).
The Investment-Saving (IS) Relation
The IS relation remains the key to understanding short-run movements in output. In the short run, the demand for goods determines the level of output. A desire by people to save more leads to a decrease in demand and, in turn, a decrease in output. Except in exceptional circumstances, the same is true of fiscal consolidation.
I was struck by how many times during the crisis I had to explain the “paradox of saving” and fight the Hoover-German line, “Reduce your budget deficit, keep your house in order, and don’t worry, the economy will be in good shape.” Anybody who argues along these lines must explain how it is consistent with the IS relation.
The demand for goods, in turn, depends on the rate at which people and firms can borrow (not the policy rate set by the central bank, more on this below) and on expectations of the future. John Maynard Keynes rightly insisted on the role of animal spirits. Uncertainty, pessimism, justified or not, decrease demand and can be largely self-fulfilling. Worries about future prospects feed back to decisions today. Such worries are probably the source of our slow recovery.
The Liquidity Preference/Money Supply (LM) Relation
The LM relation, in its traditional formulation, is the relic of a time when central banks focused on the money supply rather than the interest rate. In that formulation, an increase in output leads to an increase in the demand for money and a mechanical increase in the interest rate. The reality is now different. Central banks think of the policy rate as their main instrument and adjust the money supply to achieve it. Thus, the LM equation must be replaced, quite simply, by the choice of the policy rate by the central bank, subject to the zero lower bound. How the central bank achieves it by adjusting the money supply should be explained but can stay in the background. This change had already taken place in the new Keynesian models; it should make its way into undergraduate texts.
Integrating the Financial System into Macro Models
If anything, the crisis has shown the importance of the financial system for macroeconomics. Traditionally, the financial system was given short shrift in undergraduate macro texts. The same interest rate appeared in the IS and LM equations; in other words, people and firms were assumed to borrow at the policy rate set by the central bank. We have learned, dearly, that this is not the case and that things go very wrong.
The teaching solution, in my view, is to introduce two interest rates, the policy rate set by the central bank in the LM equation and the rate at which people and firms can borrow, which enters the IS equation, and then to discuss how the financial system determines the spread between the two. I see this as the required extension of the traditional IS-LM model. A simple model of banks showing the role of capital, on the one hand, and the role of liquidity, on the other, can do the trick. Many of the issues that dominated the crisis, from losses and low capital to liquidity runs can be discussed and integrated into the IS-LM model. With this extension, one can show both the effects of shocks on the financial system and the way in which the financial system modifies the effects of other shocks on the economy.
(Getting Rid of) Aggregate Demand–Aggregate Supply
Turning to the supply side, the contraption known as the aggregate demand–aggregate supply model should be eliminated. It is clunky and, for good reasons, undergraduates find it difficult to understand. Its main point is to show how output naturally returns to potential with no change in policy, through a mechanism that appears marginally relevant in practice: Lower output leads to a lower price level, which leads, for a given money stock, to a higher real money stock, which leads to a lower interest rate, which leads to higher demand and higher output. This is a long, convoluted chain of events with doubtful realism. Central to the adjustment is the assumption of constancy of the nominal money supply, which again is not the way central banks do business. And the notion that economies naturally return to normal has not held up well over the last seven years.
These difficulties are avoided if one simply uses a Phillips Curve (PC) relation to characterize the supply side. Potential output, or equivalently, the natural rate of unemployment, is determined by the interaction between wage setting and price setting. Output above potential, or unemployment below the natural rate, puts upward pressure on inflation. The nature of the pressure depends on the formation of expectations, an issue central to current developments. If people expect inflation to be the same as in the recent past, pressure takes the form of an increase in the inflation rate. If people expect inflation to be roughly constant as seems to be the case today, then pressure takes the form of higher—rather than increasing—inflation. What happens to the economy, whether it returns to its historical trend, then depends on how the central bank adjusts the policy rate in response to this inflation pressure.
Again, this way of discussing the supply side is already standard in more advanced presentations and the new Keynesian model (although the Calvo specification used in that model, as elegant as it is, is arbitrarily constraining and does not do justice to the facts). It is time to integrate it into the undergraduate model.
The IS-LM-Phillips Curve Model
Put together, these modified IS, LM, and PC relations can do a good job of explaining recent and current events. For example, financial dislocations lead to a large spread between the borrowing and policy rates. The zero lower bound (or as we have learned, the slightly negative lower bound) prevents the central bank from decreasing the policy rate by enough to maintain demand. Output falls. Inflation decreases, potentially to the point where it turns into deflation, increasing real interest rates, and making it even harder to return to potential output.
One can go much further, and, as in the previous editions, after having presented the basic model, I consider two extensions. The first explores the role of expectations, the second the implications of openness. Here, also, there are important lessons from the crisis. To list just two:
First, I used to present the yield curve based on the pure expectations hypothesis: The long interest rate was derived as the average of future expected short rates, with a fixed term premium. Quantitative easing policies have shown that monetary policy can affect this premium. Second, I used to derive the movement of exchange rates from the uncovered interest rate parity condition, an equation that implicitly assumes infinitely elastic capital flows. The crisis has shown the equation to be essential but incomplete. Capital flows have finite elasticity and are subject to large shocks beyond movements in domestic and foreign interest rates. Periods of “risk on-risk off” and large movements in capital flows have been an essential characteristic of the crisis and its aftermath.
Macroeconomics is a tremendously exciting subject. Most of what we taught before the crisis remains highly relevant. But it needs some dusting and updating. My hope is that a model along the lines above can contribute to it.
