How I would like to teach Econ 101

Recently our friend Nick Rowe commented on what he considers to be wrong arguments by Joseph Stiglitz and Bryan Caplan. Nick obviously is a busy bee because he had time to write his comment in between exams (you might have noticed that the blogging among the Market Monetarist econ professors has gone down a bit recently – they have all been busy with exams I guess…). Nick’s comment and the fact that he was busy with exams inspired me to write this comment.

The purpose of my comment is not to comment on Nick’s view of Stiglitz and Caplan – Nick is of course right as usual so there no reason to try to disagree. However, something Nick said nonetheless is worthwhile commenting on. In his comment Nick states: “Macro is not the same as micro.”

That made me think – and this not to disagree with Nick but rather he inspired me to think about this – that maybe it is exactly the problem that the “normal” view is that macro and micro is not the same thing.

The fact is that when I started studying economics more than 20 years ago at the University of Copenhagen we where taught Micro 101 and Macro 101. There was basically no link between the two. In Micro with learned all the basic stuff – marginalism, general equilibrium, Walras’ Law and the Welfare theorems etc. In Macro 101 there was (initially) no mentioning of what we learned in Micro, but we instead started out with some Keynesian accounting: Y=C+I+G+X-M. Then we moved on to the IS-LM model. The AD-AS model did not get much attention at that time as far as I remember. Then we were told about some “crazy” people who thought that money matters, but that did not really fit into the models because we didn’t really differentiate between real and nominal. Why should we? Prices where fixed in our models. As a consequence most students of my time chose either to specialise in the highly technical and mathematically demanding microeconomic theory (that seemed very far away from the real world) or you focused on real world problems and specialised in macroeconomics which at that time was quite old school Keynesian. Things have since changed with the New Keynesian revolution and macroeconomics have now adopted a lot of the mathematical lingo and rational expectations have been introduced, but it is my feeling that most economics students both in Europe and the US to a very large degree still study Micro and Macro as very separated disciplines and that I think is a huge problem for how the average economist come to see the world.

While macroeconomics as discipline undoubtedly today has much more of a micro foundation than use to be the case the starting point often still is Y=C+I+G+X+M. So yes, we might have a micro foundation for how C (and I for that matter) is determined but we still end up adding up C (and I) with the other variables on the right hand side of the equation – leaving the impression that the causality runs from the right hand side of the equation to the left hand side of the equation. The next thing we do is to come up with some theory for inflation and then we add that on top of Y to get nominal GDP, but again this is rarely discussed. The world is just real to most econ students (and their professors). That then leave the impression that real GDP determines inflation (most often via a Phillips curve of some kind).

So what would I do differently? Well nothing much in terms of microeconomics. I guess that is more or less fine (To my Austrian friends: Maybe if somebody could elaborate on the entrepreneur and give a Nobel prize to Israel Kirzner for that then that could be part of Micro 101 as well). For the purpose of moving from micro the macro I think the most important thing is to understand general equilibrium and that in Arrow-Debreu world there are no recessions. Prices clear all markets. There are never over or under supply of goods and services.

“And then we move on to macroeconomics” the professors says. And instead of telling about Y=C+I+G+X-M he instead says…

“You remember that we had n goods and n prices and that one agent’s income was another person’s consumption/expenditure. Well, that is still the case in macroeconomics, but in the macroeconomy we also have something we call money!”

Lets assume we maintain the assumption that prices are flexible (wages are also prices). Then the professors tells about aggregation so instead we can aggregate prices into one price index P and all goods into one index Y.

And then professor smiles and says “its time to hear about the equation of exchange”:

(1) MV=PY

“Wauw!” screams the students. “You have just introduced money to the Arrow-Debreu World! Amazing!”. Did we just go from micro to macro? Yes we did!

The professor explains to the students that (1) can be rearranged into

(1)’ P=MV/Y

The professor tells the students that we call (1)’ the AD curve and that we can write a AS curve Y=f(K,L) (“you remember production functions from Micro 101” the professors notes).

The students are obviously very impressed, but they also think it is completely logical.

The professor has now introduced the AD-AS model (and the dynamic AD-AS model). Since AD is just (1)’ the professor has not started to talk about fiscal policy (what multiplier??). In his head the AD curve can be shifted by shocks to M or V, but that has nothing to do with fiscal policy. In “his” AD-AS model fiscal policy does really not exist, as it is basically a micro phenomenon – fiscal policy might have an impact on relative prices, but it has no impact on the PY aggregate and fiscal policy might impact the supply side of the economy, but not the AD-curve? No, of course not.

The students are of course eager to hear what their new tool “money” can be used for and a clever student asks “Professor, what is the optimal monetary policy?”.

The professors answers “Do you remember the welfare theorems?”.

Student: “Yes, of course professor”.

Professor: “Good, then it is simple – we need a monetary policy that ensures a Pareto optimal allocation of consumption between different goods (including capital goods) and periods”.

Student: “But professor in the Arrow-Debreu world the market (relative prices) took care of that”.

Professor: “Exactly! So we should ‘emulate’ that in the macro world – how do we do that?”

Student: “That’s easy! We just fix MV!”

Professor: “Correct – you are absolutely right. In the world of monetary policy we call that Nominal Income Targeting or NGDP level targeting. It is one of the oldest ideas in monetary theory”.

Student: “Wauw that is cool. So when we fix that we don’t really have to think about aggregation and the macroeconomy anymore – correct?”

Professor: “Correct – and we could easily move back to Micro now”

That is of course not the whole story – the professor will of course introduce rigid prices and rational expectations. And of course when the NGDP targeting is sorted out then the students realise that generating wealth and prosperity is about increasing productivity – and of course they will learn about the supply side, but again they learned about production functions and savings and investments in Micro 101. But there is no need to introduce Y=C+I+G+X-M. Obviously it still holds formally, but it is not really interesting in the sense of understanding macroeconomics.

So Nick is not totally correct – macro and micro is basically the same thing if we have NGDP targeting. Where things go wrong is when we mess up things with another monetary policy rule (for example inflation targeting), but that kind of imperfects we will introduce in the next semester!

—-

PS The very clever student might ask “who produces money?” – Professor Selgin would answer “that is up to the market” and the student will reply “that makes sense – the market produces and allocates other goods very well so why not money?”.

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19 Comments

  1. Lars: Yep. What I should have said was: General equilibrium is not partial equilibrium. And money prices are not the same as real (relative) prices. And you can’t talk about AD without talking about money.

    Reply
  2. Martin

     /  December 23, 2011

    “Professor: “Good, then it is simple – we need a monetary policy that ensures a Pareto optimal allocation of consumption between different goods (including capital goods) and periods”.

    Student: “But professor in the Arrow-Debreu world the market (relative prices) took care of that”.

    Professor: “Exactly! So we should ‘emulate’ that in the macro world – how do we do that?”

    Student: “That’s easy! We just fix MV!””

    And then we’re back where Alfred Marshall started basically. If I recall correctly, he assumed that the monetary unit was fixed before proceeding (ie. money doesn’t matter: monetary equilibrium) with what today would be called microeconomics in his principles v1.

    Reply
  3. Nick – that is exactly correct. Anyway, I actually think it is far more important to get rid of Y=C+I+G+X-M.

    Martin, I am not sure about that, but of course Milton Friedman always says the reason that keynesians misunderstood was because a Marshallian.

    Reply
  4. Martin

     /  December 23, 2011

    I decided to look it up.

    “‘Unlike Walras, Marshall did not dichotomise his system into an abstract moneyless system and monetary system. Money does exist from the beginning, though its purchasing power is assumed to be constant when
    relative prices are considered’” p. 217 in P. Groenewegen Classics and Moderns in Economics Vol 2 (2002, Routledge).

    It’s in a chapter titled: “Unemployment and price stability Aspects of the Marshallian legacy on the monetary economy”

    Reply
  5. David Pearson

     /  December 24, 2011

    It occurs to me that there is an irony in that the focus on M*V seems to downplay the dynamics of “V”. Financial crises can occur due to leverage primarily. Stability-seeking regimes tend to promote that leverage. Gary Gorton’s study of the 2007/2008 crisis is essentially an analysis of the behavior of velocity, not in response to a “nominal shock”, but in response to the structure of financing of financial intermediaries (shadow banks).

    In other words, there is a particular class of “V” effects that micro has something to useful to say about. I think if MM’s incorporated the work of people like Gorton, Shin, Brunnemeier, Diamond, Rajan, Adrian, etc. in understanding leverage/liquidity crises, their discussion of M*V would be far improved.

    Reply
  6. Martin, maybe I should indeed get Marshall out of my bookshelf and for once read his contribution.

    David, you are right that Market Monetarists have not spend much time on the “micro” process of money and especially on what determine velocity. Is that a weakness? Maybe and I certainly think for example Gorton has done very interesting work on shadow banking. That said, I am actually more inclined to say that there is a need to separate financial and banking from money – both theoretically and in terms of policy making. Obviously the two are connected, but this to a large extent is because central banks “say” they have to be connected.

    Reply
  7. Martin

     /  December 26, 2011

    Lars, I can also send you Groenewegen, I have it digital somewhere. The chapter might be worth a read. I am not so sure whether it makes sense to re-read Marshall.

    Reply
  8. “Then we were told about some “crazy” people who thought that money matters, but that did not really fit into the models because we didn’t really differentiate between real and nominal. ”
    My own experience in the Bank of Spain

    Reply
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