For teachers and students of economics
For the next two years I will be taking a break from teaching tutorials in first year undergraduate macro. That will be a relief for just one reason. I have become more and more embarrassed at having to teach the IS-LM model. The IS curve is fine, but the LM curve is not. The reason is obvious enough: central banks do not operate a fixed money supply policy. It would be nice to tell students that the fiction that the monetary authorities fix money is a harmless fairy story, but I do not believe this. Here are just three mistakes or confusions caused by using the LM curve.
1) Is that real or nominal rates on the vertical axis? It does not matter if expected inflation is constant, but we use the apparatus to look at price changes.
2) IS-LM leads to AS/AD. If your goal is controlling inflation, the AS curve suggests that all you need to do is to return to somewhere on the vertical AS curve. If you use a traditional Phillips curve with backward looking expectations then returning to the natural rate will not be enough. Which is the student supposed to believe?
3) IS-LM leads to textbook Mundell Fleming, which in its simplest form has domestic interest rates stuck at world levels. Everyone then learns that fiscal policy is ineffective under floating rates, which is unfortunate, because this is a special consequence of assuming fixed money. The IS curve plus UIP is a much better way to think about this, and gives a more relevant answer: a temporary demand shift is not crowded out by an appreciating real exchange rate if domestic interest rates are unchanged.
I’m currently lecturing on Oxford’s second year undergraduate macro course. There I largely ignore the LM curve, and (following the textbook by Carlin & Soskice) instead teach a three equation model involving an IS curve, a Phillips curve, and a monetary rule. The monetary rule captures the idea that the monetary authority has preferences over excess inflation and the output gap, and combining this with the IS curve and Phillips curve we can derive a Taylor rule. While the monetary rule curve is far from ideal, representing the result of a static rather than dynamic optimisation exercise, it at least captures the spirit of what central banks try and do today.
The introductory course in macro at Oxford starts with IS-LM, but it also includes the Phillips curve and the Taylor rule, presumably because they are more relevant than the AS curve and the LM curve. So first year students learn about the AS curve and the Phillips curve, the LM curve and a Taylor rule. Perhaps not surprisingly, many get very confused. It would seem to make much more sense to switch things around. Use only the IS curve, Phillips curve and monetary/Taylor rule in a first year introductory course, and only introduce the LM curve in subsequent years. (I would introduce the LM curve in stages. First, think about replacing an inflation target with a price level target for monetary policy. Maybe think about nominal GDP targets, using the current situation as clear motivation. Then go to money supply targets, with of course some discussion of money demand.)
This sequencing seems clearly preferable, so I find it puzzling that most Principles textbooks do not take this approach, but instead continue to start with IS-LM. Why are they so devoted to the LM curve? Is learning about the LM curve meant to impart some deep wisdom to students? Is there a feeling that because money is important in understanding how business cycles and inflation work, it should be introduced as part of the core model come what may? This seems strange, and is probably counterproductive. Perhaps the explanation is more mundane: that the economics of high volume textbook publishing is such that innovation is difficult to do.
I sometimes say to master’s students just starting the core macro course that they will spend some time learning about the same stuff as they did when they were undergraduates: inflation, unemployment, business cycles. The key difference is that what they learn will only be 5 or 10 years out of date, compared to material that is 30 years out of date for undergraduates. Strange, but unfortunately true.