Postgrad teaching and Keynesian economics: a survey

This post is joint with André Moreira, an economist at the Bank of England

Three years ago one of us got into a discussion with Paul Krugman and Brad DeLong about how dominant, or otherwise, the New Keynesian model of business cycles was in academia. That post contained a footnote with an idea: why don’t we look at what the top schools actually teach their post graduates, to see if there are a large proportion of students who are not being taught any Keynesian economics. We came together with the idea of doing just that.

We initially thought that we could do this by ‘simply’ contacting the academics teaching core macro courses and asking them for their syllabus. You can probably guess the problem we encountered, although thanks to those who did respond. So instead we decided to survey recent students. That worked much better, with one exception we note below. (The results are written up in more detail as a short paper – see the top of the main list from this link).

We decided to ask a simple question: “Approximately what percentage of the core Macro sequence that you received covered models involving price and/or wage rigidities (including New Keynesian models)? Please round your answer to the nearest 5% mark.” We sent this question to graduate students at the top 15 schools during 2014/15 [1]. Here are the results

Table 2: Survey results

The one school missing is Chicago. Contact information for these graduates is not publicly available, and we were told by both the course administrator and the academic in charge of the course that they have a policy of not divulging the email addresses of postgraduates, even after we made it clear what we wanted them for. We also received no information from our earlier requests for a syllabus.

Of course no simple question like this is perfect: at NYU, for example, the first year teaching focuses on methods, and Keynesian analysis is covered in a later (but optional) course. We found no major discontinuities according to the year students entered the programme (a few variations are noted in the paper), and the information matched the syllabus information from those who had been good enough to respond to our first survey. We sent the results to course teachers a few months ago for any comments or corrections.

The main message we draw from these results is that, in at least the top schools, there is no major divide between a group that teaches Keynesian economics and those that do not. There is a large amount of variation among schools, but there is little evidence of the marked bifurcation among top universities that some discussions of a saltwater/freshwater divide might suggest. We suspect opinions will differ on whether the variation we still found is natural in a discipline like economics or is an indication that something is wrong.

We would be interested in any thoughts about whether it would be worth taking this analysis further in any way.

[1] Top 15 according to the IDEAS ranking of economic institutions as of September 2013.

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!

Greece and educating economists

My first and most important point: pretty well every economist I have read who has expressed an opinion on the matter recognises that a deal which gives Greece at least some of what it wants is both desirable and feasible. Yes, there is some disagreement about how bad a breakdown would be for both sides, but little doubt that both sides would be better off with an agreement that significantly reduces the degree of austerity imposed on Greece. As these negotiations are essentially about economic issues and consequences, that relative unanimity is worthy of an unprecedented intervention from the US President. (Just in case you think that sounds too complacent, in the previous link Ashoka Mody does make it clear the mistakes that some individual economists and economic institutions made getting to this point.)

The second argument I wanted to make was how this example shows the importance of knowing economic history. Defaults are not day to day events, particularly if your focus is on advanced economies, so it is important to know about how these events have gone before, and in particular how debt forgiveness in the past has had positive impacts. This includes Germany’s own history. There seems to be a growing recognition that - at least in some places - economics teaching at both degree and post-graduate levels has involved too little economic history.

Some have used events like the financial crisis to call for a complete overhaul of how economics is taught. Heterodox economists want much more pluralism, and many other social scientists want economists to be much more familiar with what they know and do. I have some sympathy with both views, but - as an economist would say - only at the margin. The reason is very simple: to go even half way towards what these heterodox economists and social scientists want would involve throwing out much that is even more valuable.

That is my third point. What has it got to do with Greece? To be able to say intelligent stuff about what is going on at the moment (which you would hope an economics education would enable you to do), you need to know quite a lot of economic theory. A lot of macro of course, but quite a bit of finance, and also at least some game theory. (Although those who know their game theory should realise that at the moment the last thing on the mind of Yanis Varoufakis is being academically accurate when speaking to particular audiences!) And if you want to get into all those ‘reforms’ imposed by the Troika, you need a lot of micro.

One of the comments on an earlier post of mine said that economists should try and be less like doctors, and more like scholars. I completely disagree. For all our imperfections, economists know a lot of useful stuff. If the last six years has taught me anything, it is how wrong things can go when basic economics is ignored. Those with economic problems to solve know this most of the time (even if advice is often ignored), which is why economics is essentially a vocational subject, not a liberal arts subject.

Of course we are not as good as doctors, and make more mistakes, although sometimes we get blamed for things that probably would have happened anyway even if we had got it right. I rather liked this study entitled ‘The Superiority of Economists’. It ends as follows:

“Thus, the very real success of economists in establishing their professional dominion also inevitably throws them into the rough and tumble of democratic politics and into a hazardous intimacy with economic, political, and administrative power. It takes a lot of self-confidence to put forward decisive expert claims in that context. That confidence is perhaps the greatest achievement of the economics profession—but it is also its most vulnerable trait, its Achilles’ heel.”

When I read this, I think of Greek finance minister Yanis Varoufakis - academic economist, and former economics blogger - and hope on this occasion the confidence is retained, and that his Achilles’ heel is just a myth.

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. 

Sticky prices: how we confuse students, and sometimes ourselves

For teachers and students of macroeconomics.

I’m about to teach a small number of first year undergraduate students Keynesian macroeconomics, and my aim will be not to tell them that this is the macroeconomics of sticky prices. Yet I realise I’ve already gone wrong. In week one I talked about time periods in macro, and how the ‘short run’ was the length of time ‘it takes prices to fully adjust’. I must have been saying this for years. But it is at best highly misleading.

In both the New Keynesian closed economy model, and the IS/LM model, the short run is the length of time it takes the central bank to stabilise inflation (output goes to its natural rate), or less precisely to achieve full employment. For students we could equally say it is the period it takes monetary policy to achieve the real rate of interest implied by the RBC, or Classical, model.  Calling this the time period it takes prices to fully adjust only makes sense when monetary policy involves some kind of nominal anchor, like a fixed money target in IS/LM. It makes no sense when monetary policy involves a central bank trying to choose the best nominal interest rate. The impact of an unexpected but subsequently known preference/demand shock, for example, would be very short lived when such a central bank knew what it was doing. (See this excellent post from Nick Rowe.)  

The big danger in equating Keynesian economics with sticky prices is that students forget about the crucial role monetary policy is playing. Too many think that after an increase in aggregate demand, if contracts and menu costs were absent, higher prices would in themselves choke off the increase in aggregate demand.  As they have just learnt micro, it is a natural mistake to make. They then get very confused when price flexibility does (at best) nothing at the zero lower bound.

Yet the linking of the short run with sticky prices is ubiquitous. In the edition of Mankiw I have to hand it says

“In the long run, prices are flexible and can respond to changes in supply or demand. In the short run, many prices are sticky at some predetermined level. Because prices behave differently in the short run than the long run, economic policies have different effects over different time horizons.”

This kind of statement makes sense in a fixed money supply world, but it makes much less sense in the real world. (Mankiw uses the term ‘long run’ where others would use ‘medium run’, but let us not worry about that.) Compare it with this alternative statement:

“In the long run, monetary policy adjusts to achieve steady inflation, which means output goes to its ‘natural’ or Classical level. In the short run, monetary policy fails to achieve this, so we need to look at movements in aggregate demand to explain output.”

This works for any sensible monetary policy.

In my second year lectures, I ask my students to think about a monetary policy that involved moving real interest rates in response to the output gap, but not to excess inflation.  If that policy stabilised a closed economy, then what impact would the speed of price adjustment have on anything except inflation? Inflation aside, a world where price adjustment was quick would look much like a world where prices were much stickier. The ‘short run’ would have the same length, irrespective of how quickly prices adjusted.

All this is about how Keynesian economics is taught, rather than about how it is done. Yet how it is taught can also influence how it is eventually understood. One of the problems some people have with understanding that we are still in a situation of deficient demand is that it is five years after the recession ‘and surely prices should have adjusted by now’. There is also a rather more profound point. Many anti-Keynesians use this misunderstanding about price adjustment to dismiss Keynesian economics. When they say ‘I ignore Keynesian economics, because I think prices adjust rapidly’ they are really saying ‘I ignore Keynesian economics because I think monetary policy is very successful’. And in the real world, monetary policy can only be very successful by understanding Keynesian economics! 

Looking for the flimflam

According to Thomas Palley, Paul Krugman and my defence of mainstream economics is “pure flimflam”. The definition of flimflam is ‘nonsensical or insincere talk’ or ‘a confidence trick’. Nonsensical I guess is possible, but insincere or a confidence trick it most definitely is not. But I guess this no worse than ‘pure drivel’, which is how Lars Syll once described one of my posts.

Despite all this, I would like to have a debate about macroeconomics with heterodox economists, and have tried to initiate one in the past. A debate that gets beyond generalities (and name calling), and talks about actual macroeconomic mechanisms and what policy makers should do. This is because I’m genuinely puzzled about what I am doing that heterodox economists find so wrong.

According to Thomas Palley, New Keynesian economics “retained the nonsense of marginal productivity distribution theory while discarding the foundations of Keynesian economics”. We “use price and nominal wage rigidity to explain cyclical unemployment”. Now I admit to not being terribly concerned about what Keynes really meant, but I’m at a loss to see marginal productivity distribution theory at the centre of New Keynesian theory. What New Keynesian theory does need is that falls in real interest rates stimulate aggregate demand (i.e. some form of IS curve), and in the basic model this comes from changing the intertemporal pattern of consumption. Is that wrong? What explains cyclical unemployment is real interest rates being at the wrong level. Movements in wages and prices get us out of a recession because they lead the central bank to reduce real interest rates. At the zero bound they cannot do that, and in those circumstances wage and price flexibility could make things worse. Is that wrong?

Now it is true that the standard New Keynesian model assumes a labour market that clears, but a model that replaces this with labour market imperfect competition would not behave very differently. That is what I actually teach. Equally the basic New Keynesian model assumes rational expectations, but if we want to change this to a case where agents make predictable errors that is easy enough to do. I also teach this to undergraduates. (For a pretty good guide to what I teach, see this paper by Carlin and Soskice. I use their textbook.)

Which brings us back to teaching. As I said in my original post, I would like to make students aware of heterodox critiques, but I want to point out where in my mainstream account that critique would enter. (I think what I teach is pretty close to how many central bankers think, if not the rest of 'my tribe'!)  I believe I can do that for what I call anti-Keynesians (freshwater or whatever), although I remain at a loss as to how flexible prices can get us out of a liquidity trap when central banks target inflation (see here and here). So where (in terms of macroeconomic mechanisms) do I locate the heterodox (post-Keynesian or whatever) critique of New Keynesian analysis? This is not an insincere or trick (flimflam) question.   

When economics students rebel

I read the Manchester Post-Crash Economics Society’s (PCES) critique of economics education in the UK with a bewildering mixture of emotions. (Claire Jones has a short FT summary here.) It is eloquently and intelligently written, but I believe in some respects fundamentally misguided. It is indicative of a failure of mainstream economics education, but not (as it thinks) a failure of mainstream economics. Yet even after all these years, it is a position I can empathise with.

At its heart the critique is an appeal for plurality in economics. Rather than pretend that there is one right way to do economics (what the critique calls neoclassical), the critique says we should recognise that there are many alternative perspectives which have significant worth (and which therefore undergraduates should have significant exposure to). These alternative perspectives have become marginalised within economics over the last few decades, and the critique suggests that the financial crisis is evidence that this process should be reversed. This is not an unusual complaint, and I hear it frequently from those working in other social sciences.

Let me first say what I agree with here. Students should certainly be shown something of heterodox (non-mainstream) thought. I’d like to think that if we taught economics to undergraduates as a more problem solving discipline, with less emphasis on its axiomatic/deductive structure, that would become easier. We should certainly get more economic history in there, and again that would be easier with a problem solving approach.

What I disagree with strongly is that the current dominance of mainstream economics should be reversed, and that we should go back to ‘schools of thought’ economics. There are three reasons for this.

●     Of course mainstream theory can be conservative. It has been used by some to support a particular ideology. I complain a lot about both. But the most important reason mainstream economics has become dominant is not because of these things, but because it has proved far more useful than all of its heterodox alternatives put together. I agree with Roger Farmer here: economics is a science. Its response to data and events may be slow compared to the normal sciences, for obvious reasons, but it is progressive. I cannot see any fundamental barriers to its continuing development.

●     This is because mainstream economics can be remarkably flexible. One of the sad things about the way economics is often taught is that students do not see much of the interesting stuff that is going on in both micro and macro, and instead just learn what the discipline looked like 50 years ago.

Let me give one example. Students get taught that under perfect competition the wage is equal to the marginal product of labour. If that was all there was to say, then you might indeed believe that economics was just a means of excusing current levels of executive pay or arguing against the minimum wage. But instead it is just the start of what economics has to say. Read Alan Manning, who argues that because firms generally set wages and changing jobs is costly, monopsony is the more relevant default model. Read the Piketty et al paper I referenced here which talks about rent seeking by executives, and how cutting top rates of tax encouraged this rent seeking. These are powerful and effective critiques of marginal productivity theory.

●     At first reading, heterodox writers can seem like a breath of fresh air, because they are more holistic and often less formalist. But while many complain, with some justice, that mainstream economics can be resistant of radical ideas, I have personally found at least as much intolerance on the other side. Some heterodox economists appear to reject almost everything that is mainstream, which is frankly just silly. 

I think there may be a particular problem for students who are exercised by what they see as economic injustices around them. Economics in its studied neutrality can appear indifferent to that. It is natural for those who take an anti-establishment, left wing view to react to this perceived indifference by asking for revolution rather than evolution, by looking for a new paradigm. Perhaps those on the right, who may be happier with the status quo, find it easier to work within the mainstream, and use it to their own advantage. Yet any discipline where a utilitarian view is routine, and where diminishing marginal utility is standard, can hardly be described as inherently biased towards the status quo.

I think it is true that economics as a discipline has tried too hard to emphasise that it is an objective, politically neutral discipline, thereby underplaying value judgements when it makes them. Worse still, sometimes heavily value laden ideas like the importance of Pareto optimality are portrayed as being value neutral, which is clearly nonsense (see above). Yet the idea that it should be possible to build a science of human behaviour which is independent of ideology or politics is a noble ideal, and one which has been partly achieved. We may need (and are getting) more political economy, in the sense of recognising that economics works alongside and interacts with social and political forces, but I do not think we need more partisan economics. 

Let me get personal. Over the last few years, I have been in charge of a macroeconomics course at Oxford. For better or worse, if past evidence is anything to go by, one or two of those taking this course will end up helping run the economy. There is so much important mainstream theory that needs to be covered in that course, because it is theory that is essential to trying to understand what is currently going on in the world. At its core is Keynesian theory, which has proved its worth since the recession. (Interest rates didn’t rise because of all that government debt, inflation didn’t take off because of all the money that has been created, and austerity did delay the recovery.) It would be a great step backwards if I had to stop teaching part of that, and instead teach Austrian or Marxian views about the macroeconomy, or still worse spend time worrying about what Keynes really meant. I would much rather a future Chancellor, Prime Minister, or advisor to either, remembered from their undergraduate degree that mainstream theory said austerity was contractionary, rather than ‘well it all depends on whether you are a Keynesian or an Austrian’.

None of this implies that there are not large gaps in the discipline, large elements that will not stand the test of time, and that there is much still to be done. But I agree with Diane Coyle (about economics, if not DSGE) that “the Naked Emperor needs to be reclothed rather than dethroned”. New ideas could perhaps come from heterodox thought, although I suspect that they are more likely to come from other social science disciplines. But they will be developed within the mainstream, leading to the evolution of mainstream thought. If students want to change the world, I think they are much more likely to do this by working within mainstream economics than heterodox thought.

Price level targeting intuition

For students and maybe teachers of macroeconomics. The analysis here is standard: a more general discussion can be found in Woodford's Interest and Prices for example (see pages 497-501 in particular). All this adds is a bit of intuition which I at least found helpful. If there are any mistakes in the algebra or numbers below, please let me know and I will correct them 

When monetary policy can commit (i.e. follow a time inconsistent policy), why does the optimal response to an anticipated cost-push shock involve bringing the price level back to its original value? I do not think it is obvious why it should, yet the result is an important part of the justification for price level or nominal income targeting, so here is my attempt at some intuition.

To make things simple, ignore discounting in both the monetary policymakers objectives and the New Keynesian Phillips curve (NKPC). For notational clarity, assume perfect foresight. So the monetary policymaker tries to minimise the weighted sum of the output gap (y) and inflation (π), both squared (the inflation target is zero), from period zero onwards, subject to a series of NKPC constraints. The shock is a cost-push shock (u) in period zero, which is observed at the beginning of period zero.

To start us off, assume that the policymaker can only set period zero output and inflation. Expected inflation in period 1 is zero (the shock is not persistent, and the central bank is credible.) So the problem can be expressed as choosing output and inflation to minimise the Lagrangian:

This gives us two first order conditions:

which can be combined as

Equation (1) can be thought of as a policy rule: the combination of the output gap and inflation that optimal monetary policy would select if it cannot achieve zero for both. So, for example, if output has a large impact on inflation, then (1) gives a larger ‘weight’ to inflation. If people like diagrams, we can represent the loss function by indifference curves around the ‘bliss point’ zero, which are circles if β is one. The monetary rule (1) is the line joining the points where these indifference curves are tangent to the Phillips curves.

To take a concrete example, let the cost push shock be 10, and set α=β=1. Adding (1) to the Phillips curve implies that the central bank creates a negative output gap of 5, which gives an inflation rate of 5. The optimal policy involves one of intratemporal smoothing, balancing the costs of inflation against the costs of lower output. The welfare cost is 50, compared to a cost of 100 if the policymaker allowed no fall in output.

Suppose now that the policymaker can make promises about period 1 only. The Lagrangian then becomes

The first order conditions always imply that the Lagrange multiplier for any time period is equal to the output gap for that period divided by α. In addition to the first order condition (1) for period zero inflation, we also obtain

We can add (1) to this, to get

Equation (2) gives us the key intuition behind the price targeting result. Suppose αβ is large, so the final term is small. In this case (2) tells us that the sum of inflation in the two periods will be close to zero. Higher inflation in period zero will be almost balanced by negative inflation in period one. A moment’s thought implies that this must mean the price level at the end of period one will be close to its original value.

Inflation in period zero will be positive as a result of the cost push shock. We can reduce its size by creating negative inflation in period 1. By creating negative inflation of x in period 1, we reduce inflation in period zero by x. With a cost push shock of 10, creating negative inflation of 5 in period 1 balances positive inflation of 5 in period zero, which is the optimum combination. Creating less negative inflation in period 1 will lead to a greater welfare loss, but so will reducing inflation by more than 5 in period 1.

However, what if αβ is not large? Specifically, suppose we return to the example where α=β=1. Combining this with the NKPC for each period implies the optimal policy is

The optimal policy creates negative inflation in period one, but not by enough to keep the price level unchanged. Prices end up higher by 2, compared to 5 when we could only change period zero values. The welfare cost is now 40, which is an improvement on 50.

Why does the case non-negligible αβ stop approximate price level targeting in this two period case? Think about what exact price level targeting would imply. It would involve inflation of 5 in period zero and -5 in period one. This could be achieved with an output gap of -5 in period one, but no output gap in period zero. So although inflation would be balanced, output gaps would not be. A more balanced output combination involves a higher final price level.

(The policy is now time inconsistent: at t=1 there is an incentive for the policymaker to not carry through and reduce output, but instead set the output gap to zero. Unfortunately if this change in policy is anticipated in period 0, inflation will be 6 rather than 4 in period 0, and the overall welfare cost will be 52 (36+16), which is worse than the case where policy only operated in period zero.)

Suppose we now allow the policymaker to make promises in period 0 about the output gap in period 1 and 2. Instead of just reducing output in period one, we can spread lower output over periods one and two. The output costs become more balanced, which reduces the extent to which we fail to achieve a balanced inflation profile. We can then derive the following policy rule

                                                                  

As the fall in output in period 2 is likely to be lower than the previous fall in output in period 1, the deviation from price level targeting is reduced.

If we allow the policymaker to make commitments T periods ahead, then we can derive the following first order condition:

                                                  

High inflation in period 0 can now be balanced by negative inflation in many later periods. Intuitively the output gap in period T will become very small as T becomes large. This implies that the sum of inflation over all periods is almost zero. That means that the price level in period T is almost the same as the original price level. Thus the optimal policy in effect involves a long term price target, although that target is approached gradually.

Attacks on mainstream economics and reforming economics teaching

Mainstream (orthodox) economics is having a hard time in the pages of the Guardian. First Aditya Chakrabortty writes “How do elites remain in charge? If the tale of the economists is any guide, by clearing out the opposition and then blocking their ears to reality. The result is the one we're all paying for.” Then Seumas Milne adds “Any other profession that had proved so spectacularly wrong and caused such devastation would surely be in disgrace.” In this post I want to say why such attacks are wide of the mark, but also say something about how these attacks gain traction, and why they suggest changing the way the subject is taught.

One frequent accusation, very evident in Milne’s piece, and often repeated by heterodox economists, is that mainstream economics and neoliberal ideas are inextricably linked. Of course economics is used to support neoliberalism. Yet I find mainstream economics full of ideas and analysis that permits a wide ranging and deep critique of these same positions. The idea that the two live and die together is just silly.

The absurdity of linking mainstream economics to all our current problems is also obvious if you think about austerity. As I never tire of saying, the proposition that austerity was a crazy thing to try in this recession is prominent in the pages of undergraduate and graduate textbooks. It is what mainstream economics, as practiced in central banks, tells us. Now I agree that it is a great shame that some influential economists sometimes seem to ignore or have forgotten what is in these textbooks, or put their own textbooks aside to provide support for particular political parties. However it remains the case that the most effective critic of austerity is using totally orthodox economics.

Nearly all complaints about that mainstream start off with the economics profession’s failure to foresee the financial crisis. Again it’s important to make some fairly basic points. First economics is not just (or even mainly) about trying to forecast the future. The percentage of the profession that made this mistake is tiny. Another one of my favourite lines back from when I did forecasting is that macro forecasts are only slightly better than guesswork. We know that, both from past evidence and the models themselves. It is a difficult message to get across, because a very visible part of economics - making decisions about interest rates - necessarily involves forecasts, and the media loves simplistic messages, but institutions like central banks do their best to emphasise the uncertainty involved.

It is also obviously not true that mainstream economics is incapable of understanding what led to the crisis, and what needs to be done to avoid it happening again. I think it’s fair to say that much that is in Admati and Hellwig’s The Bankers New Clothes is pretty mainstream. Perhaps in the past economists have been rather narrow, and even politically naive, in issues from regulation to overseas aid, but that is clearly changing and has been changing for some time. 

Having said all this, it would also be a mistake of equal magnitude to think that everything is just fine in the land of academic economics. I am struck about how economists, while at least partially defending their own particular field, are quite happy to express grave concern about what some of their colleagues in other fields do. I’ve noted Andy Haldane and Diane Coyle’s criticisms of DSGE modelling before, and you will find plenty of economists who can be very rude about their colleagues doing finance. More generally I suspect slightly less shrill versions of the sentiments expressed by the two Guardian columnists would attract considerable sympathy from lots of very sensible people who know quite a lot about economics.

Whether this should, or will, lead to any major upheaval in economic thinking – as suggested by Martin Wolf in this lecture for example – is a question for perhaps another post. What I want to focus on here is how the subject is taught, if only because that has a large influence on how the subject is perceived and how it develops. Both Guardian articles talk about student dissatisfaction (as expressed here for example), and there seems to be widespread support for the idea that economics teaching needs some fairly radical reform: see this recent meeting at the UK Treasury (which followed this) and Wendy Carlin’s article in the FT.

I think part of the problem with economics, which is very evident in the way it is taught, is how economists see themselves. (I think Alex Marsh describes this well.) The vision that I think many economists are attached to is that economics is like a physical science. So there is a body of knowledge, which has been accumulated over time in much the same way as the physical sciences have developed. This approach plays down the context in which that knowledge was developed - it may provide a bit of diversion in a lecture, but is not essential. There is certainly no need to worry about the methodology behind the way the discipline works.

An alternative and I now think better, vision would give more emphasis to how economics developed. Economic history would play a central role. Economic theory would be seen as responding to historical events and processes. For example placing Keynesian theory in the context of the Great Depression is clearly useful, given the events of the last five years. I think it is also important to recognise the links between economic theory and ideology. This is partly to understand why governments might not act on the wisdom of economists, but it also leads naturally to recognising that economists need to adapt to the social and political context in which they work. We should also be more honest that our wisdom might be influenced by ideology. Given the limits to experimental and econometric evidence, but with a very clear axiomatic structure, methodology is always going to be an important issue in economics. [1]

Of course this alternative vision can be taken too far. I do not think it is helpful to teach the subject like a course in the history of economic thought. The insight gained from trying to understand what some past great economist actually said (or still worse, actually meant) is small. We do not necessarily need to know the details of every historical debate. In addition some important ideas in economics do not come from problems thrown up by major historical events or ideology: rational expectations is a clear example. We do try and integrate solutions to new problems into a coherent overall framework. I do not want to go back to teaching a schools of thought type of macro, because the mainstream is much more integrated.

There is an additional problem in teaching economics relative to the sciences. The world that we attempt to describe and advise changes rapidly. This makes a model in which teaching is based on textbooks problematic. Not just because it takes time for textbooks to be produced and updated, but because they tend to want to appeal to those who learnt their subject many years ago, and are not actively researching in the field. How else can you explain the continuing centrality of things like the money multiplier in nearly every undergraduate textbook?  

So I look forward to seeing what comes out of the Institute of New Economic Thinking’s project to reform the undergraduate syllabus, headed by Wendy Carlin. Her macro textbook with David Soskice is innovative in replacing the IS-LM framework with a more realistic and up to date three equation model (IS, Phillips curve, monetary rule), and by giving imperfect competition a central role, and a new version where the financial sector has much more prominence is due out soon. While it is plainly nonsense to say that mainstream economics cannot explain the financial crisis and critique neoliberal policies, we need to do what we can to make that clear, and we should start with our students.

[1] In fact, I think the lack of interest in methodology among mainstream economists is itself revealing. The combination of a highly deductive theoretical structure with many alternative but problematic ways of getting evidence makes economics a fairly unique discipline from a methodological point of view, so it would be natural to want to explore the methodology of economics. However you might want to shy away from this if you pretended economics was just like biology of physics.