Proposal - Giving students a voice in macroeconomic debates
The core undergraduate courses in macroeconomics should grab the hearts and minds of students who have lived their teenage years through the biggest global financial crisis and recession since the Great Depression and who are witnessing the remarkable economic growth in China and India and its implications for the shift in world output toward Asia.
Their macroeconomics courses should equip them with the facts, concepts and confidence to address questions like these: What explains the wealth and poverty of nations and people? Capitalism and innovation – what is the connection? How, why, and when does increased income enhance the quality of life? Why does unemployment persist and why is inflation a problem? Why are there booms, recessions and financial crises? Can fiscal and monetary policy stabilize the economy?
Although the global financial crisis shook the world, the one thing it didn’t shake was the undergraduate macroeconomics curriculum. The severity, length and global scope of the crisis indicate that this is not a transitory shock that can be ignored in mainstream teaching.
I will concentrate on a subset of the questions macro courses should address. I will focus on how to teach about what is usually termed short- and medium run macro. I will argue that its horizons should be extended beyond the business cycle to include financial upswings and downswings. And I will propose a solution to the frustration students often report, which is that their teacher or their textbook can address important real-world problems but – with the models they are taught – the student cannot.
How can this be fitted in an already jam-packed curriculum? Won’t the baby have to be thrown out with the bath-water? Space can be created to enrich the curriculum by giving up on old models that don’t work and eschewing newer ones that are not fit for purpose.
What can be given up? The jumble of ad hoc models that are taught in first and second year courses comprising on the one hand, a ‘classical model’ with perfect competition and the Quantity Theory of Money, and on the other, a ‘Keynesian model’ with IS/LM and a Phillips curve tacked on.
What should be avoided? Twenty years ago the undergraduate microeconomics curriculum was transformed from a rag bag of models into a maths-lite version of the graduate course designed to culminate in the presentation of the Arrow-Debreu model of general competitive equilibrium. The popular textbooks by Hal Varian are characteristic of this approach.
Paul Seabright explains how this turn in the road leaves students alienated because it contrasts the elegance of the Arrow-Debreu model, which they can understand, with the messiness of real world problems, which are made to seem too complex for an undergraduate student.
Dissatisfied with the ad hoc models conventionally taught to undergraduates, some teachers of macroeconomics have turned toward watered down versions of the model that dominates the graduate macroeconomics curriculum, the elegant Real Business Cycle model.
This centres on the microeconomics of individual decision-making by ultra-far-sighted optimizing actors. Successful students master the techniques but with a model that treats the labour and financial markets like the market for shirts, concentrates on productivity shocks and omits the financial sector, they are not equipped to think about involuntary unemployment, demand shocks and persistent recessions, or financial crises.
What should be done? The good news is that we can teach the short- and medium-run part of core macroeconomics in a way that gives students a tractable model they can use to address problems that concern them. Many teachers will have their own solutions. Here is one.[1] There are three steps.
The first step is to present a simplified macro model – often referred to as the 3-equation model – that corresponds to the modelling used by central banks (and finance ministries). This is a well-understood (though often not taught) model of an inflation-targeting central bank. There are incomplete contracts in the labour market with the result that there is involuntary unemployment at the constant inflation equilibrium. After this first step, the student will have a model they can use to analyse a wide range of shocks to the macro-economy and they will be able to work out how a policy-maker who wishes to stabilize the economy around constant inflation should respond – and what kinds of policies can reduce equilibrium unemployment.
In the second step, the 3-equation model is extended by introducing the banking system. This allows the student to see how the central bank and the banking system interact to deliver stability in ‘normal times’.
In the third step, the model is extended further to include the way the financial system can operate to amplify and propagate shocks. This introduces the concepts of the financial accelerator and leverage, and requires the addition of one more economic actor, a stylized investment bank. The student will see how success with inflation targeting can nevertheless be consistent with the development of high indebtedness of banks and households, and how this makes the economy vulnerable to a financial crisis.
At the end of a macro course like this, students will have a unified framework they can use to discuss why unemployment persists and why inflation is a problem; why there are booms, recessions and financial crises, and what role the policy maker can play in guiding the economy to better outcomes. They can have a voice in the policy debates of the future.
[1] Presented in a new book, Wendy Carlin and David Soskice (2014, forthcoming). Macroeconomics and the Financial System (OUP).
