Reactions to Textbook Mundell Fleming

Some of the reactions to my earlier post, like Paul Krugman’s, have been that we no longer teach Textbook Mundell Fleming (TMF), but instead teach something along the lines I was suggesting. Which is great. [1] Of course I never meant to suggest everyone is taught TMF, but enough are to make the post warranted.

Another line, which I attempted (unsuccessfully) to head off in the original post, was UIP does not fit the data, so why build a core model that uses it? There are three replies to this:

1) Although UIP does terribly in the short run, its deficiencies in the longer term may not be so bad. Menzie Chinn sent me a summary of his own work that suggests this, which is here. In my two period model, where the first period is a Keynesian short run, then its the longer term predictive power that is relevant. Having said this, I also in my lectures stress that UIP is not well supported by the data, and that some people believe you can make money by betting against it (e.g. the ‘carry trade’).

2) However I do not think there is a more empirically based alternative that is satisfactory. Some people suggested a random walk for the exchange rate, and indeed - as Nick Rowe points out - we can recover TMF from UIP this way if expectations are formed on that basis. But a random walk model is inconsistent with almost any macroeconomic theory involving exchange rates that we might care to teach.

I know many people react negatively to rational expectations, but really all I’m arguing for here is common sense. Take again the example of a temporary (first period) fiscal expansion in a two period model without any backward dynamics. Unless the model contains hysteresis, we know the second period exchange rate will not change relative to the no fiscal expansion case. So to assume that agents expect any change in the first period exchange rate to carry through into the second period is the height of irrationality. I really do believe we should not be teaching models to undergraduates where people are that dumb.[2]

3) Its what macroeconomists use. I know many people do not like this, but I have always felt strongly that the core of first or second year undergraduate macro should be consistent with the macro that, say, central banks use. It is bound to be simpler, but it should be consistent. Of course we should emphasise its deficiencies, and mention alternatives, and also generally say something about the history of how we got here. The problem with too much undergraduate macro is that it is history in the wrong sort of way - its just out of date. [3]

In my earlier post I tried to emphasise the inconsistency between TMF and UIP, and not go on about the fixed money supply assumption. However, just as teaching up to date macro involves using the IS part of IS-LM along with, say, a Taylor rule, so it should be possible to adapt TMF to a world where central banks set interest rates if the model was any good. Yet if we dropped the LM curve from TMF, and assumed instead that interest rates were the policy instrument, we would conclude that an independent monetary policy in an open economy with flexible exchange rates was impossible. According to TMF, central banks cannot set interest rates to anything other than world interest rates. Why do we want to start students off with a model that suggests this?

And so finally to the LM curve itself. I have yet to hear a remotely convincing justification as to why this remains in the first macro model that we teach students. What great insight do students get when we pretend that the central bank fixes the money supply? I’ve talked about the muddles teaching the LM creates before - David Romer presents seven advantages of doing something more realistic here. [4] Is it really the conservatism of textbook writers that means that we are condemned to carry on confusing students, and cannot we do anything about this?  

[1] I always recommend students read Krugman, Obstfeld and Melitz when they get confused about open economy macro, but I had my sights trained on other macro texts.

[2] Yet I do teach a backward looking (static expectations) Phillips curve alongside a New Keynesian Phillips curve (NKPC). Why the double standard? I can suggest three reasons: (1) using static inflation expectations is not so obviously silly if the monetary authorities give us little clue about what they are doing, which describes the world a few decades ago, (2) there are empirical features (e.g. Phillips curve loops) which are difficult to rationalise with the NKPC (3) firms and workers do not spend large amounts of money trying to predict future inflation.

[3] So, for example, I’m happy mentioning TMF as a lead up to UIP. Saying something like “originally economists modelled capital flows as a function of only interest rate differentials, but this either ignored expected capital gains, or made a very naive assumption about exchange rate expectations. We now know better.” For much the same reason you might mention that the original Phillips curve did not have an expected inflation term in it, but we now know better.

[4] Oddly, although Romer carries through his arguments to an open economy, he does not embrace UIP: in fact I do not think he even mentions it.

Kill the Money Multiplier!

For students, and anyone who still teaches this

Nick Rowe is exasperated at how some bloggers think all mainstream macroeconomists believe in the money multiplier and did not realise that loans can create deposits. He says go and read a first year textbook. It is true that no macroeconomist I have ever talked to about this actually thinks the money multiplier is relevant to monetary policy today. And I am sure that Nick is right that good first year textbooks tell you that loans can create deposits as well as telling us about the money multiplier. But this does raise a rather embarrassing question for macroeconomists – why is the money multiplier still taught to many undergraduates? Why is it still in the textbooks?

One response might be that it takes time for textbooks to catch up with macroeconomic reality. But this would only be an excuse if central banks had been routinely using the money multiplier 20 or 30 years ago. It is true that there was a brief attempt to control monetary aggregates in the UK and the US in the early 1980s, but it was quickly abandoned. In the case of the UK, the money multiplier had nothing to do with how the monetary authorities tried to control monetary aggregates. So this hardly warrants inclusion in a first year macro textbook.

Another response is that there is no harm in including the money multiplier. It is a possible mechanism of monetary control, and a good intellectual exercise for students. Well, good intellectual exercises may be fine for more advanced textbooks, but they are a waste of precious time for students who may study no more macro. (I will not comment on how possible it actually is.) But I think it also does harm, because it gives the impression that banks are passive, just translating savings into investment via loans. If it is taught properly, it also leaves the student wondering what on earth is going on. They take the trouble to learn and understand the formula, and then discover that in the last few years central banks have been expanding the monetary base like there is no tomorrow and the money supply has hardly changed! (A more minor cost is that it can lead to debates over - as far as I can see - almost nothing of substance.)

I think I know why it is still in the textbooks. It is there because the LM curve is still part of the basic macro model we teach students. We still teach first year students about a world where the monetary authorities fix the money supply. And if we do that, we need a nice little story about how the money supply could be controlled. Now, just as is the case with the money multiplier, good textbooks will also talk about how monetary policy is actually done, discussing Taylor rules and the like. But all my previous arguments apply here as well. Why waste the time of, and almost certainly confuse, first year students this way?

I’ve complained about this before in this blog, and in print. (In both cases I was remiss in not mentioning Brad DeLong’s textbook, which does de-emphasise the LM curve.) The comments I received were interesting. The only real defence of teaching the LM curve was that it told you what would happen if monetary policy acted in a ‘natural’ way due to ‘impersonal forces’, whereas something like the Taylor rule was about monetary policy activism. Well, I count this as an excellent reason not to teach it, because it gives the impression that there exists such a thing as a natural and impersonal monetary policy. Anyone who was around during the monetarist experiments in the early 1980s knows that fixing the money supply is hardly automatic or passive.

I know this is a bit of a hobbyhorse of mine, but I really think this matters a lot. Many students who go on to become economists are put off macroeconomics because it is badly taught. Some who do not go on to become economists end up running their country! So we really should be concerned about what we teach. So please, anyone reading this who still teaches the money multiplier, please think about whether you could spend the time teaching something that is more relevant and useful.

Why introductory macroeconomics should ditch the LM curve

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.