Teaching Graduate Students Useful Macro: In Which Noahpinion Calls the Spirit of Francis Bacon from the Vasty Deep...
Sufficient Cause for Breaking Cambridge University Press's Copyright

Paul Krugman: Back to The Future: Teaching Graduate Students Useful Macro

Paul Kreugman:

There's something about macro: Macro I... is supposed to cover the "workhorse" models of the field - the standard approaches that everyone is supposed to know, the models that underlie discussion at, say, the Fed, Treasury, and the IMF.... [Y]ou might think that any trained macroeconomist could teach it. But it turns out that that isn't true. You see, younger macroeconomists - say, those under 40 or so - by and large don't know this stuff.... [O]ur younger macro people are certainly very smart, and could learn the material in order to teach it - but they would find it strange, even repugnant. So in order to teach this course MIT has relied, for as long as I can remember, on economists who learned old-fashioned macro before it came to be regarded with contempt. For a variety of reasons, however, we can't turn to the usual suspects this year: Stan Fischer has left to run the world, Rudi Dornbusch is otherwise occupied, Olivier Blanchard is department head, Ricardo Caballero - who is a bit young for the role, but can swallow his distaste if necessary - is on leave. All of which leaves me.

Now you might say, if this stuff is so out of fashion, shouldn't it be dropped from the curriculum? But the funny thing is that while old-fashioned macro has increasingly been pushed out of graduate programs - it takes up only a few pages in either the Blanchard-Fischer or Romer textbooks that I am assigning, and none at all in many other tracts - out there in the real world it continues to be the main basis for serious discussion.... Why does the old-fashioned stuff persist in this way?.... [Not] intellectual conservatism.... There's something about primeval macro that pulls us back to it; if Hicks hadn't invented IS-LM in 1937, we would end up inventing it all over again....

Hicks... Value and Capital... as an extended answer to the question, "How do we think coherently about the interrelationships among markets - about the impact of the price of hogs on that of corn and vice versa? How does the whole system fit together?"... [T]hink about the simplest case in which something more than supply and demand curves becomes necessary: a three good economy.... [S]uppose you wanted a first-pass framework for thinking coherently about macro-type issues, such as the interest rate and the price level. At minimum such a framework would require consideration of the supply and demand for goods, so that it could be used to discuss the price level; the supply and demand for bonds, so that it could be used to discuss the interest rate; and, of course, the supply and demand for money.... [T]hat is essentially Patinkin's flexible-price version of IS-LM.

If you try to read pre-Keynesian monetary theory, or for that matter talk about such matters either with modern laymen or with modern graduate students who haven't seen this sort of thing, you quickly realize that this seemingly trivial formulation is actually a powerful tool for clarifying thought, precisely because it is a general-equilibrium framework that takes the interactions of markets into account. Here are some of the things it suddenly makes clear:

  1. What determines interest rates? Before Keynes-Hicks - and even to some extent after - there has seemed to be a conflict between the idea that the interest rate adjusts to make savings and investment equal, and that it is determined by the choice between bonds and money. Which is it? The answer, of course - but it is only "of course" once you've approached the issue the right way - is both: we're talking general equilibrium here, and the interest rate and price level are jointly determined in both markets.

  2. How can an investment boom cause inflation (and an investment slump cause deflation)? Before Keynes this was a subject of vast confusion, with all sorts of murky stuff about "lengthening periods of production", "forced saving", and so on. But once you are thinking three-good general equilibrium, it becomes a simple matter. When investment (or consumer) demand is high - when people are eager to borrow to buy real goods - they are in effect trying to shift from bonds to goods... both the bond-market and goods-market equilibrium schedules, but not the money-market schedule, shift; and the result is both inflation and a rise in the interest rate.

  3. How can we distinguish between monetary and fiscal policy? Well, in a fiscal expansion the government sells bonds and buys goods.... In a monetary expansion it buys bonds and "sells" newly printed money....

Of course, this is all still a theory of "money, interest, and prices" (Patinkin's title), not "employment, interest, and money" (Keynes'). To make the transition we must introduce some kind of price-stickiness, so that incipient deflation is at least partly translated into output decline; and then we must consider the multiplier impacts of that output decline, and so on. But the basic form of the analysis still comes from the idea of a three-good general-equilibrium model in which the three goods are "goods in general", bonds, and money.

Sixty years on, the intellectual problems with doing macro this way are well known... treating money as an ordinary good begs many questions... all the decisions that presumably underlie the schedules here involve choices over time... there is something not quite right about pretending that prices and interest rates are determined by a static equilibrium problem... sticky prices play a crucial role... the assumption of at least temporarily rigid nominal prices is one of those things that works beautifully in practice but very badly in theory.

But step back from the controversies, and put yourself in the position of someone who must reach a judgement about the likely impact of a change in monetary policy, or an investment slump, or a fiscal expansion. It would be cumbersome to try, every time, to write out an intertemporal-maximization framework, with microfoundations for money and price behavior, and try to map that into the limited data available. Surely you will find yourself trying to keep track of as few things as possible, to devise a working model - a scratchpad for your thoughts - that respects the essential adding-up constraints, that represents the motives and behavior of individuals in a sensible way, yet has no superfluous moving parts. And that is what the quasi-static, goods-bonds-money model is - and that is why old-fashioned macro, which is basically about that model, remains so useful a tool for practical policy analysis.