Undergraduate economics teaching moves into 21st century

The CORE economics curriculum, designed to provide an introduction to economics that reflects economics as it is today rather than as it was decades ago, has won justified praise from John Cassidy. I also think it is brilliant, not just for first year undergraduates but also for interested non-economists. To wet your appetite, read this short account by two of the leading lights behind the project.

Rather than spend the rest of this post singing its praises, I want to ask why first year undergraduate textbooks represent a clear example of market failure. The failure I have in mind is the inability to teach economics as it currently is, rather than as it was decades ago. If you look at the standard first year, Econ 101 textbook, it does contain more modern stuff, but normally in later chapters after presenting the basic models/frameworks which have not changed for 30 years or more. As a result, textbooks tend to be both dull, seemingly irrelevant and much too large. (This is a blanket generalisation and I’m sure there some exceptions.)

Here is my theory, which I will try and explain in plain english rather than with economics jargon. Although the ultimate consumers of textbooks are students, they are chosen by teachers who set the course textbook. So why are Econ 101 teachers not demanding textbooks that are less dull and more up to date?

Suppose someone had written something like the Core material, and a publisher (as publishers do) had sent it out to people currently teaching Econ 101 for comments. The reaction they will have got from a good proportion of Econ 101 teachers would have been ‘that is interesting, but can we include at the start some of the stuff I have taught for the last five years’. They, naturally, do not want to completely rewrite their courses, and I fear in a few cases learn material that is new to them.

The publisher reports back to the author: ‘we cannot publish this as it stands, but if you start with the traditional material then maybe’. It is a market failure because publishers are looking at the current set of Econ 101 teachers, and not those who will one day teach it and would love to have something more up to date. Another force for conservatism is that the big names who dominate the market find it much easier to add new stuff on at the end as extra chapters than rewrite their textbook from scratch.

I could add more, but I have been rude to enough of my colleagues already. Let we add two other specific points about CORE. The first is that it is clearly mainstream: this is not the pluralist text that many heterodox economists would like. That I fear is inevitable: economics is mainly a vocational subject, not a liberal arts subject. (Thats upset a few more.) But I was surprised to see MMT people describe this textbook as not for them. I have, after all, argued that MMT is just standard macro without what I have called the Consensus Assignment. [1] So I had a look.

In the section on government finances (14.8) we get

“When there is a budget deficit, this means the government must borrow to cover the gap between its revenue and its expenditure. The government borrows by selling bonds.”

This is not correct, and nor does it follow modern macro. [2] There we write the government budget constraint to include a term in the change in the stock of high powered money. (If money does not appear, it is because the paper explicitly chooses to work in a moneyless world for simplicity.) In short, the government can finance the gap between revenue and expenditure by creating money. Ignoring money in this section is obviously an oversight, as the discussion in section 10 clearly shows. But it is an oversight that should be corrected. [3]

That apart, I was already a fan of the macro approach adopted in CORE, because it is a simplified version of the Carlin and Soskice textbook. I like the consistent claims approach as a way of talking about inflation. It emphasises the elementary point that you need both wage and price inflation to get sustained increases in inflation, something monetary policy makers seem to keep forgetting right now.

I like, as some may remember, abandoning the LM curve and explicitly talking about central bank policy. I also like the way that banks are now incorporated as part of the monetary transmission mechanism. If there was a clear manifestation of how outdated (at best, we could also say just plain misleading) most textbooks are, it is their continued use of LM curves and the money multiplier.

I really hope that CORE continues to be successful. It is time we stopped boring and confusing first year undergraduates, and started inspiring them with an understanding of the economic ideas that allow them to address the countless real world economic issues that they will have to face.

[1] The Consensus Assignment gives monetary policy the goal of macroeconomic stabilisation and fiscal policy the goal of stabilising government debt.

[2] We can go back to the work inspired by Carl Christ together with Blinder and Solow. I should add that CORE is not alone among textbooks in failing to properly set out the government’s budget constraint.

[3] Now we all know (and as MMT also clearly states) that there are limits to money financing: too much of it is inflationary. But this should not be internalised by teachers to the extent that money financing is ignored. In particular it gives the impression that to finance a deficit a government has to find someone to lend them money, an incorrect belief that can have very misleading consequences if the government controls its own currency. It is more complicated with independent central banks, but again they are not an excuse to ignore money financing.  

Reforming Econ 101

Noah Smith has some good ideas on this, and the CORE project (here is a presentation at INET’s annual conference) should have a new curriculum by the end of this year. But the reactions of many will echo Noah’s: there is just no room for any new stuff. It is certainly true, speaking about the macro component, that there is a danger we teach much too much material at this level. Some of what we teach appears contradictory: like the AS curve and the Phillips curve.

So my first point, which I have made before, is that we can get rid of a lot of stuff that is simply out of date. Like the LM curve (and theories of money demand that go with it). And the Aggregate Demand curve which is derived from it. And Mundell Fleming which is an open economy version of it (and inconsistent with UIP to boot). And the money multiplier (which, apart from being very misleading, is unnecessary if we stop fixing the money supply). But why not really get this bonfire going? Do we need to teach the Keynesian multiplier? As there are good reasons to think that the closed economy government spending multiplier (with a given level of real interest rates) is around one, what is the point?

Of course a lot of this would come back, in some form, in a more advanced macro course. However I have always thought the acid test for what should be included in an introductory course is whether it is something that a person who studies no more economics really needs to know. I would submit that all of the above fail this test.

What has to stay in? The IS curve of course: monetary policy is all about using interest rates to control aggregate demand. However I agree with John Cochrane that this should be based on the two period consumption model (which students with large loans can relate to), and not investment theory. The Phillips curve is central to how pretty well everyone thinks about macro, so that has to be there. It can be taught as an empirical regularity, introducing the macro history of the 1970s at the same time.

Sometimes people have told me that you need to say something about money if you want to talk about Quantitative Easing (QE). I think exactly the opposite is true: QE shows up how ridiculous the LM curve stuff is. QE represents a huge increase in bank reserves - and the money supply hardly moves (thank you money multiplier). How much simpler, and more realistic, to just talk about short and long interest rates. Dispensing with money allows us to spend time talking about the zero lower bound, and events since the financial crisis. I would use this to motivate a discussion of fiscal policy and debt.

Would I replace the LM curve with a ‘monetary policy curve’, expressing preferences over inflation and output, or a Taylor rule? I’m tempted not to, because when you do something like this, students stop thinking about monetary policy as a choice. The example I sometimes use is an accidental (not countercyclical) temporary fiscal expansion that is foreseen. So many students let that increase output and inflation, and then have a Taylor rule react. But of course if the fiscal shock is known, any sensible monetary authority would attempt to completely counteract the impact of that shock.

What about the ‘supply side’. I agree with Mankiw’s text that we can treat labour supply as fixed at this level. Together with a medium term assumption of fixed capital gives us all we really need to motivate a Phillips curve with a natural rate. Deriving a labour demand curve from profit maximisation tells us that increases in labour saving technology do not lead to increases in unemployment, which is nice, but it has the cost of confusing students (and policymakers) when we subsequently assume demand determined output.

I would replace Mundell Fleming with a combination of a net export function (which gives us a relationship between aggregate demand and competitiveness) and Uncovered Interest Parity (UIP). A key idea that should be taught at this level is that in a small open economy, it is the real exchange rate and not the real interest rate that ensures aggregate demand equals supply in the medium term. I think introductory macro should also say something about fixed exchange rate regimes.  

So there you have it. Econ 101 with just three basic relationships: an IS curve, a Phillips curve and UIP. I would use some of the space created to talk about basic issues and common confusions, like the relationship between price flexibility and output gaps, or between involuntary unemployment and wage flexibility, or why Says Law does not hold and why the General Theory got written. Comments welcome on anything else that really should be in there.