Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday, 11 April 2015

Macro teaching and the financial crisis

Some macro textbooks (not all) are a bit like extensively modified code. You can see the structure of the original code, even after extensive software development. This can mean that, as new capabilities were added to the programme, rather than rewrite the software from scratch, extra routines were just added on top. Not only is this inefficient, but the whole thing ends up looking like a confused mess.

Perhaps this is why we end up with textbooks that still have the completely out of date LM curve at their heart (and associated AD curves, plus Mundell Fleming, and even money multipliers), but additional chapters where the AS curve becomes a Phillips curve, and money targeting gives way to Taylor rules. The student ends up totally confused, if they ever get to those later chapters. And after the financial crisis, a new edition will have a chapter devoted to that crisis, but not much in earlier chapters will change.

This is not the case with the third textbook by Wendy Carlin and David Soskice. It has been around for a few months, but I at last got a chance to take a good look. 


I say third textbook rather than third edition because they do not do editions. This is a complete rewrite of their earlier ‘Macroeconomics: Imperfections, Institutions, and Policies’. Luckily all the features of that earlier book that I really liked are retained. For example, a supply side based on imperfect competition rather than perfect competition (although alas the price setting curve is still flat!). But most importantly, a core model (the 3 equation model) which dispenses with the LM curve, and replaces it with a ‘monetary rule’ curve, based on a central bank using interest rates to hit an inflation target. This is similar to the approach championed by David Romer. (So the 3 equations are the IS curve, the Phillips curve, and the monetary rule curve.)

There are also some major improvements compared to the second book. The open economy analysis is now fully integrated with the 3 equation model, and the remnants of Mundell-Fleming are gone. The Euler equation appears on page 22, as one of the foundations of the IS curve. It is a shame that the Phillips curve is still based on the traditional (this period’s expected inflation) rather than New Keynesian (next period’s expected inflation) version, but you cannot have everything.

But by far the most important change concerns the financial sector. After initial chapters on the demand side, supply side and 3 equation model, plus a fourth on expectations, we have three chapters on the financial sector. The first looks at the banking sector, and makes the key alteration to the 3 equation model: there is a wedge between the ‘policy’ interest rate and the interest rate relevant for the IS curve. You can see this chapter as looking at how the financial system works in ‘normal’ times, when the system is not a source of instability. The second chapter then looks at how the financial system can be a source of instability, through mechanisms like the financial accelerator or asset price bubbles. The third chapter applies this analysis to the financial crisis of 2008.

When I taught most of the finals macro course at Oxford, I used their earlier book. I did have a lecture on the financial crisis, but it was an add-on of the type I described above. This new book is almost enough to make me wish I was still teaching this course. It gives finance the position in macro that recent events suggest it deserves. Mark Gertler on the back cover writes: “This is an exciting new textbook. Overall, it confirms my belief that macroeconomics is alive and well”. That pretty well sums up my reaction.

Except to add that the front cover is a painting by Paul Klee. Perfect!


17 comments:

  1. I've been meaning to ask what would be the best text to read for someone who studied economics at university, about 18 years ago, but since then has been involved in property management. Through my very limited knowledge it appears to me that texts either do macro/micro or the financial services sector. Following, I assume, the line that financial markets are not related to the real world; clearly, an unsustainable line of thought, post financial crisis. I'll take a look at this text to access whether I can rise to the challenge of bridging an absence of so many years.

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  2. I wonder if you have seen Paul Klee's engraving 'Two Men Meet, Each Believing the Other to be of Higher Rank' from 1903 ( it can be seen on the net at the Art Institute Chicago at http://www.artic.edu/aic/collections/artwork/109334)?

    It suits the Very Serious People of Mediamacro perfectly.

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  3. Is this textbok an undergraduate or graduate level textbook - by American standards?

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  4. What strikes the scientific reader is the absence of statistic criteria when economists compare curves and models. Why not show that the LM curve has the poorest fit to the data points and thus the lowest R2 ?

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  5. Best monetary policy textbook?

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  6. "It is a shame that the Phillips curve is still based on the traditional (this period’s expected inflation) rather than New Keynesian (next period’s expected inflation) version"

    I would truly appreciate you elaborating on this point. Or, if you've already done so in the past, point out where I can find it. Thank you.

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  8. You might want to point this to David Andolfatto who is engaged in some dubious defence of the current system without any experience of it. But he claims to read your blog...

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  9. I really enjoyed the Carlin & Soskice textbook as an undergraduate. Then, it was "Macroeconomics and the Wage bargain". I can only surmise on the next edition - perhaps "Macroeconomics and technological innovation". Re ISLM, is it not legitimate for an undergraduate to ask, "how does the central bank set interest rates?" and "is the interest rate that the central bank sets the same as the one that enters the IS curve?". I think more detailed presentation on the cost of capital should be introduced, but it should focus on the determinants of the yield curve, the equity risk premium, and the impact of the supply of bank reserves ... no? Ignoring the price/earnings yield and Shiller PE is a major omission. Particularly as the stock market is a significant part of the transmission mechanism, if we are to believe Bernanke, Draghi, and indeed Keynes.

    I also don't get the antipathy towards the money multiplier. I was never taught that ratios were fixed, and I was taught the money multiplier in a way that was entirely consistent with "endogenous" deposit growth - in fact it was an obvious consequence. Indeed, the current vogue for “banks create money” seems to ignore the fact that you need loan demand – again something obvious in the multiplier framework. At its simplest the money multiplier is simply the observation that due to loans growth, deposits become a multiple of base money. The effects of base money on loan growth varies and is complex and contingent. The money multiplier presented well is a very clear way of introducing fractional reserve banking and why expanding the monetary base has had little effect: i.e. no loan growth. Also, if you want to understand currency boards and the eurozone, changes in base money driving aggregate liquidity conditions is key.

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    1. I am relieved to encounter somebody (other than me) defending the money multiplier for these reasons. Some textbooks (wrongly) use it to suggest that an increase in H will automatically lead to an increase in M, but you don't have to teach it that way, in fact getting undergrads to chart the ratio H to M is a very obvious first step when teaching this bit.

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    2. I agree with many of your other comments too! I think the multiplier framework is also extremely helpful when base money is shrinking - ie capital outflows under a currency board. I don't know enough about Volcker era, but from what I know restricting supply of reserves was important feature.

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  10. Does it have a chapter on how to spot an economic crash before it arrives?
    MrSauce.

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  11. I am a little worried by the approach presented. If one asks the question "what is it really important to have in your model so that you don't miss 2006-8 type situations?", then surely the answer would be "some sort of adding up constraint to make sure that no sector has its debt growing on an unsustainable path". This is what got missed about the financial sector - wedges between policy rates and borrowing rates were very much second order.

    And if you've got the economy set up with an IS curve, a Phillips curve and a central bank trying to reach an inflation target - well, there's nothing in this framework which is going to pick up a situation in which the central bank sets the rate at a level where personal sector consumption is growing faster than personal sector income.

    The way in which the financial system was a source of instability wasn't really much to do with the accelerator, and it didn't have really all that much to do with asset price bubbles in the Blanchard sense. What the financial sector did was facilitate the build up of masses of debt! It's a bit of a disappointment to see that the workhorse model is still going to be one which basically ignores stock effects.

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    1. you're right this simple 3-equation model isn't really built for it, but they do have sections on balance sheet recessions and talk about the stock of debt / desired wealth therein, so they are going closer to where you want them to be than most.

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    2. Oh that's good to know, thanks

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