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Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
Teaching Macroeconomics after the Crisis:
What have we learnt?
Peter Bofinger
Universität Würzburg
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
Nothing
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
Survey by Gärtner et al. (2011)
• Are these topics and models included in your
institution‘s mandatory macro courses?
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
Finding the right trail head is important
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
Axel Leijonhufvud (2011, p.1)
• “The IS-LM model which originated as an attempt to formalize the verbal economics of Keynes, led after years of debate to the seemingly inescapable conclusion that unemployment had to be due to the downward inflexibility of money wages. This old neoclassical synthesis thus casts Keynesian economics as a stable system with a “friction”, rather than a theory of an economy harboring dangerous instabilities.”
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
Flaws of the IS/LM-AS/AD model
• Logical inconsistencies: 2 supply curves (45°-lien, AS-
curve), 2 demand curves (aggregate demand in
income/expenditure model, AD-curve)
• No analytical explanation of involuntary
unemployment
• No analysis of fiscal and monetary policy on the basis
of loss functions
• No systematic analysis of shocks
• No zero-bound of interest rates: deflation is stabilizing
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
IS/LM-AS/AD: a world of inconsistencies
i
P
0P
0i
dY
YYs
Y
YnY
45
Expenditure
)LM(M/P0
AS
AD
IS
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
Reinterpretation
• 45°-line (income/expenditure): Keynesian short-term supply curve
• Expenditure-line (income/expenditure): aggregate demand curve
• IS-Curve (IS): Demand equals supply curve
• LM-Curve (LM): Interest rate line for monetary targeting
• AD-Curve (AD): Monetary policy rule for monetary targeting
• AS-Curve (AS): Phillips-Curve for the price level
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
The re-interpreted model in comparison
Expenditure
i
P
0P
IS-LM / AS-AD
0i
dY
YYs
Y
YnY
45
)LM(M/P0
AS
AD
IS
AD
i
P
0P
Macro 2.0
0i
dY
YYs
Y
YnY
Phillips-curve for price level (PC)
Monetary policy rule (MP) (monetary targeting)
Demand = Supply (DS)
Short-run aggregate supply (SRAS)
Interest rate rule (IR) (monetary targeting)
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
Cyclical unemployment in the reinterpretation
Unemployment
SRAS
AD
AD´
Notional Labor
Demand
Effective Labor
Demand
Output
Gap
YYs
dY
nYY'
sN
dN
nNN' N
0w
w
45°
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
The destabilizing effect of monetary policy in standard textbooks
0P
P
YnY
0AS
00 MAD
11 MAD
1P
1AS
• Expansionary monetary policy shifts AD-curve to the right
• This leads to higher inflation expectations (AS-curve shifts upwards)
• Monetary expansion has no permanent output effect only price level changes from
P0 to P1
Problem:
Monetary policy guided by a loss-function (e.g. L=(P-P0)2+𝜆(Y-Y0)
2) would have no
incentive to do such a monetary expansion!
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
The stabilising effect of monetary policy after a demand shock P
YnY
0AS
11 MAD
00 MAD
1P
0P
1Y
• Negative demand shock moves AD-curve to the left
• For a central bank (characterized through a loss-function) P1/Y1 implies a loss
Implications for monetary policy:
Central bank perfectly compensates the demand shock by increasing the money
supply from M0 to M1 (P1/Y1 is reached)
Demand shock causes no trade-off for the monetary authority
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
Deflation as a self-stabilizing mechanism
• “Even without action by policy makers, the
recession will remedy itself over a period of time.
(…) Even though the wave of pessimism has
reduced aggregate demand, the price level has
fallen sufficiently (…) to offset the shift in
aggregate demand.” (Mankiw and Taylor, 2010,
p.714).
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
Deflation in the standard model
• Negative demand shock moves AD-curve to the left
• Downward adjustment of price expectations shifts AS-curve to the right
Implications in the standard model:
The deflationary tendency is a desirable phenomenon which helps to stabilize the
output level (Y1 to Yn) following a negative demand shock without policy intervention
P
YnY
0AS
1AD
0AD
1P
0P
1Y
1AS
2P
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen 15
Severe demand shock and the zero lower bound
LM0
IS
IS‘
AS
AS‘
AD
AD‘
i0
iZLB
P0
P1
i
P
LM*
-iFE
Yn Y* Y
Y
P2
Y1
i1
• Strong negative demand shock shifts
IS&AD-curve sharply to the left
• Output level with full employment Yn would
require a negative nominal interest rate –iFE
• Maximum output level Y* is fully restricted
by the binding zero lower bound
• AD-curve is kinked
• Deflation (downward shift of AS-curve) only
has an impact on the price level (P1 to P2)
but does not influence the output level which
remains at Y*
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
More flaws
• IS-LM/AS-AD: Central bank targets the price
level with the instrument of the money stock
• Reality: Central bank targets the inflation rate
with the instrument of the interest rate
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
An alternative approach: The BMW-model
• Only 3 simple equations needed:
IS-Curve
(New Keynesian) Phillips-Curve
Loss-function (Central bank)
1y a br
0 2dy
2 2
0L y
y
r
PC
0
yny
ryd
0r IR
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
y
r
PC
0 2
y2yyn
ryd
0
0r
ryd
1
1
1r
0IR
1IR
1y
BMW-Model: Demand Shock
• Negative demand shock shifts
IS-curve to the left
• If the central bank does not
react (r0 stays constant) the
shock causes a negative output-
gap (y1) and a lower inflation
rate ( )
• If the central bank reacts with
lowering the interest rate
then the old equilibrium can
be reached again
1
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
Useful applications
• Taylor rule
• Time inconsisteny problem
• Open economy macroeconomics
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
Other areas for new macroeconomc
teaching
• Loanable funds theory: Banks as intermediaries
of a given stock of savings
• Reality: Banks create loans and thereby create
deposits and savings
• The process of money supply by the central
bank (price-theoretic money supply model,
Bofinger, 2001)
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
Implications of the flawed introductory
approach for advanced models (DSGE)
• No involuntary unemplyoment
• No co-ordination problem between saving and
investment plans
• No role for banks
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
Summary
• Basic macroeconomic models create the illusion
of a self-stabilzing mechanism
• Last decade: Belief in „great moderation“
• Today: Underestimation of negative demand
effects of fiscal consolidation
Teaching Macroeconomics after the Crisis
Lehrstuhl für Volkswirtschaftslehre, Geld und internationale Wirtschaftsbeziehungen
Literature
• Peter Bofinger, Eric Mayer and Timo Wollmershäuser,
"The BMW Model: A New Framework for Teaching
Monetary Economics", The Journal of Economic
Education, vol. 37, no. 1, pp. 98-117, 2006.
• Peter Bofinger, "Teaching Macroeconomis after the
crisis", Würzburg Economic Papers, Dezember 2011.
• Peter Bofinger, „Monetary policy: Goals, institutions,
strategies, and instruments”, Oxford University Press
2001.