Daniel Lin is teaching macro! Lets introduce his students to the IS/LM+ model

This semester professor Daniel Lin is teaching a class in Macro at the American University and I have a tradition to interfere with how Daniel should teach his students – so I will not let down the opportunity to do it once again.

I have already written a post on how I think Econ 101 should be taught. So I don’t want to go through that once again and I have also written about why Daniel should be happy about his earlier class on Micro.

I have for sometime been thinking about the impact on how macroeconomics is taught to economics students as I fundamentally think most “practicing economists” for example civil servants or financial sector economists think about macroeconomic issues based on what they learned by reading the first 150 pages of their first (and only?) macroeconomic textbook. Few practicing economists ever think about intertemporal optimization, rational expectations, monetary policy reactions functions etc. Yes, everybody know about New Keynesian models and most central banks will proudly show off their DSGE models, but the fact is that most central bankers, civil servants and commercial bankers alike really are just using a rudimentary paleo Keynesian model to think about macroeconomic issues.

My first macroeconomic textbook was Dornbusch and Fischer’s textbook “Macroeconomics”. It is a typical American textbook – far too many pages and far too many boxes and graphs. Nonetheless I still from time to time have a look in it – even though I read it first time in 1990. The book consists of three parts, but since we will only focus on the first 150 pages (remember that is what the practicing economists remember) so we will only get half through the first part of the book (yes, US textbooks are far too long).

On the first 150 pages we are introduced first to the simple (paleo) Keynesian model and we learn that Y=C+I+G+X-M. There are really no prices, no financial markets and no money in the model. A shocking number of practicing economists in reality think about macroeconomics based on these simple (and highly problematic) models. The more clever steudent gets to the next 50 pages, where money and a very rudimentary financial sector (the bond market) is introduced. This is the IS/LM model.

Daniel – lets try to introduce a monetary policy reaction function early on

I am really not happy about this way of introducing future economists to macroeconomics – I would much prefer starting from a more clear micro foundation as I have described in an earlier post. Anyway, lets assume that we are stuck with one of the standard macroeconomic textbooks so we will have to go along with the paleo Keynesian model and the IS/LM stuff.

But lets also assume that we can do that in 140 pages – so we now have 10 pages to add something interesting. I would use the last 10 pages to introduce a monetary policy reaction function into the IS/LM model – let call this model the IS/LM+ model.

The IS/LM+ model

Most economic students are taught that central banks have an inflation target, but that is not really a proper target in the IS/LM model as there is no inflation in the IS/LM model as prices are pegged (actually most students and there professors don’t even notice that there are prices in the model). So lets instead imagine that the Market Monetarists’ propaganda has been successful and that nominal GDP targeting has become commonly accepted at the target that central banks should have.

Lets return to the monetary policy target below, but lets first start out with the IS and LM curves.

We start out with the two standard equations in the IS/LM model. This is from my earlier post on the IS/LM model:

The money demand function:

(1) m=p+y-α×r

Where m is the money supply/demand, p is prices and y is real GDP. r is the interest rate and α is a coefficient.

Aggregate demand is defined as follows:

(2) y=g-β×r

Aggregate demand y equals public spending and private sector demand (β×r), which is a function of the interest rate r. β is a coefficient. It is assumed that private demand drops when the interest rate increases.

This is basically all you need in the textbook IS/LM model. However, we also need to define a monetary policy rule to be able to say something about the real world.

So lets introduce the NGDP target. The central bank targets a specific growth rate for NGDP: p*+y* and the central bank will change the money supply to hit it’s target. That gives us the following monetary policy reaction function:

(3) m=-λ((p+y)-(p*+y*))

Lets for simplicity assume that p*+y* is normalized at zero:

(3)’ m=-λ(p+y)

Put (1) and (3)’ together and we have a LM curve:

LM: r=((1+λ)/α)×(p+y)

And we get the IS curve by rearranging (2):

IS: r =(1/β)×g-(1/β)×y

Under normal assumptions about the coefficients in the model the LM curve is upward sloping and the IS curve is downward sloping. This is as in the textbook version.

Note, however, that the slope of the LM does not only depend on the money demand’s interest rate elasticity (α), but also on how aggressive  (λ) the central bank will react to deviations in NGDP (p+y) from the target (set at zero). This is the key difference between the IS/LM+ model and the traditional IS/LM model.

The Sumner Critique: λ=∞

The fact that the slope of the LM curve depends on λ is critical. Hence, if the central bank is fully committed to hitting the NGDP target and will do everything to fulfill it then λ will equal infinity (∞) .

Obviously, if λ=∞ then the LM curve is vertical – as in the “monetarist” case in the textbook version of the IS/LM model. However, contrary to the “normal” LM curve we don’t need α to be zero to ensure a vertical LM curve.

With  λ=∞ the budget multiplier will be zero – said in another way any increase in public spending (g) will just lead to an increase in the interest rate (r) as the central bank “automatically” will counteract the “stimulative” effects of the increase in public spending by decreasing the money supply to keep p+y at the target level (p*+y*). This of course is the Sumner Critiquemonetary policy dominates fiscal policy if the central bank targets NGDP even in a model with sticky prices and interest rates sensitive money demand.

Daniel lets change the thinking of future practicing economists

I think this is all we need to fundamentally change the thinking of future practicing economists – one more equation (the monetary policy reaction function) in the IS/LM model. That would make practicing economists realize that we cannot ignore the actions of the central bank. The central bank – and not government spending – determines aggregate demand (NGDP) even in a fundamentally very keynesian model.

Take if away Daniel!


Related post:

The thinking of a Great Moderation economist

Daniel Lin will be teaching Intermediate Micro – Robert Clower would have told him to be happy about it

See this Facebook update from Daniel Lin who teaches at American University:

Just learned that the economics department has an urgent need for more Intermediate Micro classes in spring 2013. My Public Choice class has been cancelled, and I’ve been reassigned to Intermediate Micro. Disappointing. I’ll keep requesting it, and maybe it’ll happen in another semester.

I can understand Daniel’s hopes to teach Public Choice theory. It is a wonderful and interesting topic. In fact had I not been such a monetary theory nerd I would probably have been blogging about Public Choice theory. However, who can seriously imagine public choice theory without microeconomics?

What do we learn in microeconomics? We learn that individuals make choices. Microeconomics – or rather economics – is about choice. With choices comes benefits and costs. All choices come with costs. If I choose to do something I will not be able to do another thing. I can not write this post and sleep at the same time even though I badly needs sleep. It is the cost of writing the post. However, we can also deduct (we do that a lot in microeconomics – no fancy pancy econometrics here…) that my expected marginal utility of writing this post is higher than my expected marginal cost of doing it. The cost obviously include the opportunity cost of not sleeping.

In microeconomics we learn about comparative advantages, we learn about marginalism. We learn about Welfare Theory – Pareto Optimality. These are terribly important concepts. Unfortunately far too many economists soon forget about these concepts and then instead remembers rather misguided ideas that they learn in “traditional” macroeconomics. That is extremely unfortunate. Microeconomics is the foundation for our science. Economics without microeconomics is Marxism – or something worse.

And Daniel remember that no Public Choice theory is possible without microeconomics. Just imagine my favourite Public Choice model – William Niskanen’s Bureaucrat model. It is 100% microeconomics. We start out with an economic agent. The bureaucrat. He is maximizing utility. Niskanen assumed that what would give the  Bureaucrat maximum utility would be to maximize his institution’s budget. A quite fair assumption I think. Niskanen introduces asymmetrical information in his model. Something that might enter into Daniel’s class quite late in the semester, but nonetheless he will probably have to tell a story about peaches and lemons at some point during the semester. So Daniel have the fun of telling your students that when Joseph Stiglitz tells you why there is information problems in the market for used cars it also teaches us why the World Bank is an overblown bureaucracy.

However, it is not only Public Choice theory that is standing on the shoulders of Microeconomics. That is also the case for monetary theory – and of course macroeconomics. The problem with old-school keynesian macroeconomics – before the days of New Keynesian macroecomomics – was exactly that there was no microeconomic foundation for the “theory” and as a result the policy conclusions from old-school keynesian economics lead us to the insanities of price and wage controls and the idea of the fiscal multiplier (yes, Scott feel free to scream at the screen!).

I have earlier suggested that we can not teach macroeconomics with out starting with microeconomics. Or said in another way we start with microeconomics. In the most generalized form that is some kind of general equilibrium theory – a Walrasian economy.

Let imagine the simplest Walrasian economy. We got two goods A and B. The price of A is PA and the price of B is PB. The production of A and B is terms YA and YB. In the Walrasian economy there is no money. So it mean to buy something we will have to produce something. To buy A I must produce B. That is basically Say’s Law:


This is a recession free economy. Supply and demand will also be in equilibrium. There will never be an net excess supply of either A or B.

This is exactly how Robert Clower started out when he was teaching monetary theory. We have a Walrasian model of the world. What he then did was to introduce a third good called M. He would then set the price of M at 1. Then we have


Hence, we can buy the production of A and B for the production of M. We can also call M for money. Hence, the production of money – what we call the money supply – must equal the production. This is also what we know as the equation of exchange:


Where PY is an aggregation of the total production in the economy –  PA*YA+PB*YB. V is as we know money-velocity.

So Daniel, Robert Clower would tell you that if you don’t teach your students proper microeconomics how are we able to teach them about monetary policy?  And William Niskanen would equally tell you – with out microeconomics we will never be able to understand the behavior of bureaucrats.

And David Eagle would tell you that you would never figure out the optimal monetary policy rule without Welfare theory (John Taylor did you miss micro 101?) – as would I.

So Daniel go teach your students Intermediate Micro and make sure that they never forget that if they fail to understand Micro they will really never understand anything else. Not even why Sumo wrestlers cheat.

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