Tuesday, 3 June 2014

Reforming Econ 101

Noah Smith has some good ideas on this, and the CORE project (here is a presentation at INET’s annual conference) should have a new curriculum by the end of this year. But the reactions of many will echo Noah’s: there is just no room for any new stuff. It is certainly true, speaking about the macro component, that there is a danger we teach much too much material at this level. Some of what we teach appears contradictory: like the AS curve and the Phillips curve.

So my first point, which I have made before, is that we can get rid of a lot of stuff that is simply out of date. Like the LM curve (and theories of money demand that go with it). And the Aggregate Demand curve which is derived from it. And Mundell Fleming which is an open economy version of it (and inconsistent with UIP to boot). And the money multiplier (which, apart from being very misleading, is unnecessary if we stop fixing the money supply). But why not really get this bonfire going? Do we need to teach the Keynesian multiplier? As there are good reasons to think that the closed economy government spending multiplier (with a given level of real interest rates) is around one, what is the point?

Of course a lot of this would come back, in some form, in a more advanced macro course. However I have always thought the acid test for what should be included in an introductory course is whether it is something that a person who studies no more economics really needs to know. I would submit that all of the above fail this test.

What has to stay in? The IS curve of course: monetary policy is all about using interest rates to control aggregate demand. However I agree with John Cochrane that this should be based on the two period consumption model (which students with large loans can relate to), and not investment theory. The Phillips curve is central to how pretty well everyone thinks about macro, so that has to be there. It can be taught as an empirical regularity, introducing the macro history of the 1970s at the same time.

Sometimes people have told me that you need to say something about money if you want to talk about Quantitative Easing (QE). I think exactly the opposite is true: QE shows up how ridiculous the LM curve stuff is. QE represents a huge increase in bank reserves - and the money supply hardly moves (thank you money multiplier). How much simpler, and more realistic, to just talk about short and long interest rates. Dispensing with money allows us to spend time talking about the zero lower bound, and events since the financial crisis. I would use this to motivate a discussion of fiscal policy and debt.

Would I replace the LM curve with a ‘monetary policy curve’, expressing preferences over inflation and output, or a Taylor rule? I’m tempted not to, because when you do something like this, students stop thinking about monetary policy as a choice. The example I sometimes use is an accidental (not countercyclical) temporary fiscal expansion that is foreseen. So many students let that increase output and inflation, and then have a Taylor rule react. But of course if the fiscal shock is known, any sensible monetary authority would attempt to completely counteract the impact of that shock.

What about the ‘supply side’. I agree with Mankiw’s text that we can treat labour supply as fixed at this level. Together with a medium term assumption of fixed capital gives us all we really need to motivate a Phillips curve with a natural rate. Deriving a labour demand curve from profit maximisation tells us that increases in labour saving technology do not lead to increases in unemployment, which is nice, but it has the cost of confusing students (and policymakers) when we subsequently assume demand determined output.

I would replace Mundell Fleming with a combination of a net export function (which gives us a relationship between aggregate demand and competitiveness) and Uncovered Interest Parity (UIP). A key idea that should be taught at this level is that in a small open economy, it is the real exchange rate and not the real interest rate that ensures aggregate demand equals supply in the medium term. I think introductory macro should also say something about fixed exchange rate regimes.  

So there you have it. Econ 101 with just three basic relationships: an IS curve, a Phillips curve and UIP. I would use some of the space created to talk about basic issues and common confusions, like the relationship between price flexibility and output gaps, or between involuntary unemployment and wage flexibility, or why Says Law does not hold and why the General Theory got written. Comments welcome on anything else that really should be in there. 


22 comments:

  1. As a current Oxford econ finalists, I love all the suggestions above - they would have made me not dislike macro in my first year, only to find it very intriguing in my second year!

    I was quite annoyed by the waste of time that first year seems to have been and I wish we had covered all this ground to begin with, as it would have allowed to make the second year course more technical, more in depth, and more resembling what graduate macro would be like.

    What really does bother me a lot about intro macro at Oxford (and, looking at what I hear from other unis) is the complete and utter failure of macroeconomics professors to understand the most fundamental idea in microeconomics: opportunity costs! Why teach something that is wrong, why make people revise for exams on outdated stuff? Just because it is the "History" of macroeconomic thought? By that logic, the chemists would still be sitting over Phlogiston theory and I don't even want to think about what the astrophysics Dphil students must feel like when they hear that we orbit the sun in not quite perfect circles...

    ReplyDelete
  2. As an undergraduate student, I must confess to appreciate your suggestions. I completed two courses in macroeconomics and, to be frank, most of it was spent doing exactly what you just depicted as a waste of time.

    ReplyDelete
  3. Hi Simon

    Long time fan of your blog, only just allowed to comment (so be gentle...).

    I am surprised by your statement that monetary policy can be understood just through interest rates. doesn't it lead to people having very little useful to say about QE? It also leads to real confusion in the political class who somehow believed that monetary conditions in 2012 were getting easier through lose long term gilt rates, when they clearly were not. Finally, an increase in money has a liquidity effect but also an income effect and expected inflation effect. How does your interest rate only system deal with, say, a situation like 1933 and FDR effectively changing regimes and promising far easier money?

    Much obliged

    Giles

    ReplyDelete
  4. Very interesting post. Since I've just completed an intro macro textbook, I've had to tussle with all these issues, and, while I agree with several of your points, I ended up with quite a different approach. First, I wish I could have simply dispensed with some of the outdated material, like the money multiplier, but I feared that I would paint the text into a corner if I did. But the main point is that I felt that introductory students need, more than anything else, context and orientation. If they go on in economics they will get plenty of models, but at this stage they need to understand why the models were created, what questions they try to answer -- and what exactly is an economic model, anyway?

    So there is lots of discussion of the evolution of macroeconomic thinking. A whole chapter is given over to the concept of macroeconomic identities, with examples and lots of empirical evidence. There is much institutional description: how economic policies are made, how the financial system is organized, how data are collected, and so on. And much time is devoted to the worldviews of classical economists, Keynes, new Keynesians and Classicals, etc. As needed, a bit of hopefully uncontroversial political economy is blended in.

    The result is a long text, but relatively few models that require chalk and drill. In my own teaching I try to spend as much time as possible getting students to play with data, even in a rudimentary way. One of the reasons for having a chatty text is to reduce the amount of lecturing I have to do in order to convey the weltanschauung behind the theory.

    ReplyDelete
  5. One disadvantage it appears to me of your suggestion is that in the case of at least two of your three key relationships the evidence that they hold at the macro level is very thin. A a questioning student will soon find that there is virtually no evidence that the Euler equation in consumption holds in macro data - so your basis for the IS curve is shaky; and the evidence that Uncovered Interest Parity holds is also less than convincing.

    It will surely appear as though you are saying "microeconomic principles suggest these relationships damn well ought to hold at the macro level so I am going to assume they do even though they evidence suggests they don't".

    Is that really the way forward?

    ReplyDelete
  6. I should first note that from my experience and knowledge, although I haven't researched this, it's common in the US for students to be required to take econ 101 and 102. So, "econ 101" is really a three unit introductory micro course and a three unit introductory macro course. So there are six units of student time and effort to work with. You predominantly give just macro.

    My opinion on this is that with two required courses, which is all the vast majority of students will ever take, you really want to teach only for what's best for society, basically what will best maximize total societal utils, what will make them the smartest voters, and most help them to be smart and productive in their personal finances and on the job. Thus, here is a (slightly modified) comment I left at Noah's:

    1) Noah seems pretty sure that today, at least, micro and macro 101 does actually let students know about monumentally important flaws to the basic classical market model, including externalities, natural monopoly power, asymmetric and just poor information (and it should be expertise too), and so on. But this certainly did not seem true a generation ago, and I'm not so confident as Noah it is true today. That it's in the econ 101 text means very little. These texts are like 1,000 pages long and there's nowhere near enough time to cover everything in them well, or even close, in a mere three unit course. Professors could regularly consider market problems relatively unimportant extra material – amazingly look at the attitude of Chris House – as if ignoring pollution externalities, monopoly, and asymmetric information wouldn't really result in much harm; they're just "exceptions to the rule". Oh, just a cesspool for a planet, with devastated health and quality of life that's decades shorter, monopolies strangling the economy and advancement, little basic scientific or medical research, consumers having to do a dissertation on any purchase to make sure it won't kill their family,… It should be obvious that these "exceptions" are as important as the rule, and that today there's far more harm and inefficiency incurred from erring on the "exceptions" than from erring on the rules.

    2) There's this attitude of teaching econ 101 for econ majors. So you math them up with the classical model and figure later they'll learn the problems, and other important things. But for 99% of students – voting citizens – there is no later. So this is a horribly costly approach for society. 101 and 102 should be 100% made to teach the most important intuitions for society's citizens in two three-credit courses. So you teach only the most necessary math for intuition, get to the intuitions behind the classical model, then get to the intuitions behind all the most important market problems, and yes some empirics to quantify their magnitude and level of certainty. You do this, when all you have is 6 units of student time, and you've done awesome. I would be very wary of putting in much more, as it will take time and effort away from this crucial core, and may really hurt this crucial learning, making students rush through it.

    3) Some concepts especially important for smart personal finance and business should be included, like fixed, variable, and sunk cost, opportunity cost, and very basic time value of money.

    4) If there's enough time to do the above very well, I'd add the intuition of what good modeling is, and where many economists go wrong, as in this crucial paper from Stanford's Pfliederer, which should be required for anyone getting an econ degree at any level, any school:

    https://www.gsb.stanford.edu/sites/default/files/research/documents/Chameleons%20-The%20Misuse%20of%20Theoretical%20Models%20032614.pdf

    It basically says what I've always said, "A model is only as good as its interpretation.", but with great specifics and detail, and, of course, crucially, a big name saying it.

    ReplyDelete
  7. And I'll add what I think is a good, illustrative specific here, also modified from Noah's:

    My econ 101 and 102, a generation ago, were terrible. Learn the classical model, and problems with it are for intermediate, which few people ever take. In intermediate I finally learned about the income and substitution effects and the backward bending labor supply curve.

    Now, when one of our two major parties makes it's supreme goal taxes as low as possible for the rich, then it's important, obviously, for citizens to understand this issue well. So obviously, for compelling civics and utilitarian reasons, we should expect all college graduates to understand the income and substitution effects and the backward bending labor supply curve – and in intuitive terms – You might work 45 hours/week instead of 40, if your pay suddenly went from $8/hour to $12, but if it went from $8/hour to $8 million/hour, you easily might go from 40 hours/week to 40 hours/year, and spend the rest of the year on your island. Higher pay is a double edged sword in incentive to work.

    And the empirics of this economic concept are, of course, crucial too. My professor spent about 15 minutes just quickly saying what the consensus in the field was on the empirical evidence. It basically was this quote from MIT's Jonathan Gruber:

    "Changes in tax rates appear to have relatively modest effects on total gross income; the total amount of income actually generated through work or savings does not respond in a sizable way to taxation."

    – "Public Finance and Public Policy", 2nd edition, 2007, Page 734

    Now, this kind of thing is very valuable, and it doesn't require a lot of time learning the massive math of econometrics. It's analogous to global warming. I'm never going to be able to learn enough about climate science to really evaluate the literature in this field. But when pretty much 100% of the top climate scientists in the world say this is real and a catastrophic risk, that's overwhelming evidence that this is a profound risk to take seriously and try to insure against (Do you not buy fire insurance for your home bacause the odds of it burning down are significant, but still not 100%?). But you can survey this evidence pretty quick, and give the consensus of the top experts, and how strong it is. It's like Jonathan Chait said recently (paraphrasing), I'm not a chemical scientist, man, but I don't drink Draino, because the overwhelming consensus of chemical scientists is that this would be catastrophic.

    ReplyDelete
  8. What about this from Shiller's Nobel address:

    'There is a troublesome split between efficient markets enthusiasts (who believe that market prices incorporate accurately all public information and so doubt that bubbles even exist) and those who believe in behavioral finance (who tend to believe that bubbles and other such contradictions to efficient markets can be understood only with reference to other social sciences such as psychology). I suspect that some of the apparent split is illusory, from the problem that there is not a widely accepted definition of the term “bubble.”'

    ReplyDelete
  9. It may sounds strange or irrelevant but, what about a simple Marxian reproduction scheme?

    2-3 sectors of production, simple dynamic analysis, simple and distinct flows yet very useful conclusions about growth and distribution.
    Also, a good introduction to crises theories like underconsumption, disproportionality and the tendency of the rate of profit to fall.

    This way you can provide an alternative yet good introduction to endogenous crises, distribution and growth issues.
    I'd really like to know why this kind of economics is not being taught in econ 101.

    ReplyDelete
    Replies
    1. I think it would be difficult for anyone to teach this in the UK or North America. Marxian thought has not been taught in economics courses in such countries for a generation. Marxian/Neo Marxian theory is massive and complex - the learning curve would be too steep. Most people have no idea really what it involves. One possibility would be for economics undergraduates to take units in political science courses where a knowledge base in such theory still exists (and actually thrives).

      Delete
    2. They should hire some heterodox economists then.
      I guess you're right. Maybe some political economy courses can fill the gap. It's indeed more complex but I think it's worth investing some effort and time in classical theory.

      Delete
  10. "the evidence that Uncovered Interest Parity holds is also less than convincing."

    Here Marxian theory could be useful and may explain why it is not all about capital controls and risk premia and that capital flows can move, for example, from a periphery to a core.

    More generally I think the role of 101 courses, in any subject, but particularly in the humanities and social sciences is to develop critical reasoning. And introduction to Marxian theory would explain why we may not have equilibrating outcomes and convergence, rather we may get, for example, concentrations of capital, divergence and inequalities. Classical economics and its derivatives is a subset of liberal and neo-liberal political theory. To put it into perspective you need to compare it with something that is based on a separate philosophical foundation. Such theories should not be subsumed into Classical theories, but taken on their own terms, because otherwise they quickly become debased and irrelevant.

    I feel though it is in post-graduate economics where the real problems lie.

    ReplyDelete
  11. Any room for the economic growth? I know in the long run we are all dead, but if it is not covered in macro, where would it be covered? This would also be the place to look at long run tendencies in capitalist systems, we might hear much more of this post-Piketty.

    ReplyDelete
    Replies
    1. That's why I proposed a marxian reproduction scheme above. It's a good opportunity to learn about expanded reproduction (and the long run capitalist tendencies). More useful than an exogenous growth model and easier than Hamiltonian dynamics.

      Delete
  12. First and foremost, teach students that there are distinct phases of the economy ("normal" - near-full employment; transient - shocks, bubbles, crisis; borderline conditions - severe crisis where some "normal" rules should be completely set aside, like today's zero-bound case) and that most of the models, especially the most complex ones, can't deal with more than one phase. After that, models can be introduced, stressing which should be able to handle the whole area of possible events, and which (probably) can't.

    ReplyDelete
  13. "As there are good reasons to think that the closed economy government spending multiplier (with a given level of real interest rates) is around one, what is the point?" Surely not in the case of the zero-bound?

    ReplyDelete
  14. Simon: interesting post. And if we were teaching macro of the here and now only, it would be a good way. But we should be teaching general principles that can be applied not just in the here and now. Because university is not just about the here and now. It is about past and future, and especially about possible different futures.

    My response: http://worthwhile.typepad.com/worthwhile_canadian_initi/2014/06/teaching-general-principles-of-macro.html

    ReplyDelete
  15. "or between involuntary unemployment "

    There is no such a thing.

    ReplyDelete
  16. I think it would be worthwhile if I expand on topics I think are important in maximizing the societal utility of econ 101 and 102 (which is what I think should by and large be the goal):

    Let's start with long term growth, which is so important for voting citizens to understand – and again there's no, oh that's not 101, you learn that in a 400 level econ. The vast majority are never taking a 400 level econ; 101 and 102 are the only required ones, and that's all their taking! Yet they have to vote on crucial long-term economic growth related issues all the time, and it's obviously profoundly important to vote well on this.

    So, of course we should teach what is most important for long-term growth in a modern high-tech economy, including the need for public investments in basic scientific and medical research, infrastructure, education, including Heckman's early education and development, and so on, and what the empirical research shows about whether we are underinvesting in this, and how to invest smartly in it.

    Also, we should discuss things that may stimulate short-term growth, but hurt long-term growth, like some tax-cuts. Now, I know, oh my goodness, that's political! We have to be apolitical. Well, we should be; our "bias" should be towards what the science says, put in an accurate, **non-misleading** way. What if there's some scientific disagreement? We should give the sides, and say what the consensus is, and how strong it is. It should be truth-based, and if the truth has a "bias" against one party, so be it. It's what the science says, and how strong the consensus is, and with how much certainty. You don't "Balance" with respect to politics, at the expense of disregarding what the science says, or misleading, otherwise we teach global warming is established science and global warming is a myth equally, evolution and creationism equally.

    More: The issue of technological unemployment, and will it be different this time, very important today, and the basic economic issues in healthcare. Now, I see another objection. These things are like a whole course, each one. But to cover the basic important intuitions and empirics does not take that long. All this can be fit in two three-unit courses.

    Next issue, it used to be one of the courses was micro and the other macro. When you take a "the most useful economic teaching to society prioritization" it won't fit 50-50 neat like that. So, it should be changed to just introductory economics 1 and 2.

    What else? As mentioned a lot of personal finance and business related econ is very useful and important. I noted fixed cost, variable cost, and sunk cost. I'd also include the basic risk-return tradeoff, a basic intuitive explanation of the CAPM and its lessons (modern portfolio theory), basic efficient market hypothesis and it's problems and limitations, and insurance concepts (which should include talking about global warming – insuring against a catastrophic risk, requiring less than the risk-free rate for catastrophic insurance). Now, an objection: This is for finance 101, and other business courses! Again, the big problem, most students never take these courses, and so they and society are really hurt by their resulting lack of knowledge and expertise throughout their lives.

    So, you see the idea, relentless pragmatism to make econ 101 and 102 add the most to total societal utils.

    ReplyDelete
  17. I think what we will be covered in UK universities will increasingly consumer-driven. This is a result of the introduction of costly tuition fees. This will not work well for heterodox economics - or humanities subjects in general. Increasingly the student body is foreign. They want something that will get them into PHD courses with a view to working in lucrative jobs, such as the financial sector. PHD courses in economics resemble applied mathematics courses. I expect both undergraduate and post-graduate economics to increasingly take that character ever further.

    ReplyDelete
  18. I don't think there is a major problem with Econ 101 as typically taught today. Many of the insights are useful (more so than a lot of material taught as graduate level) and the stuff that is "wrong" is still useful for getting students to think through the issues in a systematic way, as well as giving a sense of the history of the subject. It seems to me that a lot of the stuff you would cover is more difficult and would be better studied in the second year, building on classic, simple models like Mundell-Fleming and the money multiplier.

    Having said that, if Simon would care to write a textbook along these lines I would be eager to read it!

    ReplyDelete
  19. Mathijs Janssen17 June 2014 at 16:57

    Maybe this is a stupid question, but here goes anyway. How do you explain the zero lower bound without an LM curve? I am genuinely curious. I was frustrated by a lot of the stuff that seemed irrelevant in the undergraduate macro-courses that I took and I would love to be able to think about these issues in the simplest and most economic (in that other sense of the word) way possible.

    ReplyDelete