Or, How to adapt the intermediate macro syllabus to an altered world
This semester is the first time I’ve taught intermediate macroeconomics link in over two years. The last time I taught this course in the Spring of 2007, the key topics were inflation, the possibility of stagflation, and the possibility of containing the ongoing housing slowdown.
As I started the semester, I knew that I’d have to alter the emphases, and be ready to account for developments. The two big concerns were (1) dealing with the Taylor rule, and (2) dealing with the banking sector. A less difficult-to-deal issue is the consumption function.
Figure 1: Source: Deutsche Bank, Global Economic Perspectives, December 9, 2009 [not online]
Figure 1 highlights the first challenge. Over the past ten years, the trend in macro textbooks has been to dispense either partly or fully with the IS-LM construct, where the quantity of money enters into the determination of GDP, and substitute in a monetary reaction function, where the arguments are the output and inflation gaps, i.e., the Taylor rule. This was a useful innovation, but was difficult to apply to Japan (as I stressed in my lectures) and as of late 2008 as the zero interest bound became a reality for American policymakers.
The problem is even more obvious once one punches in the numbers and obtains the implied Fed Funds rate (below is the St. Louis Fed estimate, based on the CBO output gap, and differing inflation targets for PCE inflation).
Figure 2: Source: St. Louis Fed Monetary Trends.
As is well known, using plausible estimates of the output gap, the implied Fed Funds rate is negative. It’s at this point that one has to start waving one’s hands, and talking about quantitative easing…
So, IS-LM still seems to be a useful construct for analyzing fiscal and monetary policy efficacy. The IS-LM framework — and more broadly the Aggregate Demand-Aggregate Supply (aka “NeoClassical Synthesis”) — can accommodate the fiscal policy pessimists (as I discuss in my post here), and (of course) the liquidity trap critique of monetary policy (keeping in mind Joe Gagnon’s point). Of course, conveying the idea of credit easing is still hard to convey in this simple construct.
Which leads me to challenge number (2), namely how to incorporate different aspects of the financial sector. I chose to use a fairly simple framework, namely the Bernanke-Blinder CC-LM model (discussed in this post). The exposition is here; this is essentially a linearized version of the CC-LM model. The comparative statics are fairly straightforward.
While the CC-LM model heightens the amount of complexity, it does provide a rationale for Fed actions in terms of quantitative easing shifting out both the CC and LM curves. (On the other hand, it does highlight the fact that payment on reserves has limited the outward shift in the two curves). Of course, even incorporating the bank sector doesn’t mean that all the channels for monetary policy are accounted for (see this post for the others).
Finally, it is of interest to note that a discussion of the prospects for US economic growth, and consumption behavior, cannot be realistically appraised using the standard Keynesian consumption function. Rather, some discussion of how consumption depends on both current disposable income and net household wealth is essential.
Figure 3: Log real consumption, in billions Ch.2005$, SAAR (blue, left scale), and log real household net worth, in billions Ch.2005$, deflated by PCE deflator (red, right scale). Source: BEA, 2009Q3 2nd release, and Federal Reserve Board Flow of Funds, December 10 release.
Next semester, I’ll be considering how to incorporate the longer term implications of the Great Recession. One important macro factor involves the implications of the financial sector turmoil for the capital accumulation, and unemployment and the decline in asset values for labor force participation rates. In my seminar on the Great Recession, I discuss the recent OECD Economic Outlook Chapter 4 on this subject.
Of course, in adding new material to the undergrad course, some material has to be dropped. In my case, I reduced the time devoted to the New Classical models (the Lucas supply curve, and Real Business Cycle models).