Not because he says anything daft, but precisely because what he says seems so sensible a set of minor modifications. But it's a set of minor modifications that takes us in precisely the wrong direction globally, even if it does lead towards a local maximum. I understand and sympathise with where he's going; I really do.
And because I probably won't teach intermediate macro again (I'm burned out). And even if I did teach it again, I would feel myself inexorably drawn to teaching it using the same sort of approach that he advocates. Because intermediate macro is just one small step that is part of a staircase, and you aren't doing the students any favours if you shift one of those steps so it doesn't line up with all the other steps. (Economics tends to be like that.)
I launched a mini-Tweetstorm in response, which I copy (with minor edits) here:
- Trying to hide money in the ISLM model is exactly the wrong way to adjust your teaching in response to a monetary crisis.
- The ISLM model is *not* a model of a barter economy. The AD curve (function) is a *monetary* demand for goods. Monetary exchange is central.
- Though adding a (second) wedge between IS & LM curves makes sense. See my (very old) post: "IS, LM, and two wedges: understanding the second wedge"
- And the slope of LM curve depends on the interest-elasticity of BOTH the demand AND the supply of money, and it's flat if latter is infinite.
- Students must be taught that AD & AS curves are NOT the summation of micro Demand & Supply curves. We must confront this fallacy head-on, not hide it.
- And we must teach that AD curve will slope the "wrong" way (so there will be no "automatic" tendency to LR equilibrium) *unless* monetary policy is sensible.
- And we should not succumb to Inflation Targeting's "fetish of the first derivative" and treat the inflation rate (as opposed to the price level) as fundamental.
- Because the relevance of what we teach should outlive the Here & Now of particular peculiar policy regimes like Inflation-Targeting.
- [And I ReTweeted Matthew Martin's:] "disagree. failure of N[ew] K[eynesian] models to make this [LM relation between Liquidity Preference and Money Supply] explicit is their biggest weakness, leading to neo-fisherism etc."
But simply saying "No!" to Olivier Blanchard's proposed changes doesn't resolve the underlying problem.
The ISLM model is a theory of Aggregate Demand, which when coupled with an assumption of price (or wage) stickiness (like a Short Run Phillips Curve) provides a theory of recessions as due to deficiences in Aggregate Demand. I am broadly in agreement with that approach to understanding recessions. So what's wrong with teaching ISLM?
The first problem with ISLM is the horizontal axis. "Y" is (real) GDP. Recessions are not about GDP. I can imagine a world where GDP is exogenous and never changes (all goods fall like manna from heaven) and yet we still get recessions for exactly the same reason we get recessions in the real world because people fail to trade enough of those goods, and are stuck consuming too much of their own endowment and consuming too little of someone else's endowment. Which is exactly what happens to unemployed workers in recessions; they are stuck consuming too much of their own labour services and too little of some other workers' labour services (or the goods that could be produced therewith).
Recessions are failures to exploit mutually advantageous exchanges. For some reason the volume of trade drops below the proper level, and some trades that should be done and that normally get done don't get done. Thinking of macro in this way integrates macro into micro in a way that "microfoundations", as commonly understood and practised in e.g. New Keynesian macro models, can never do. The second thing students learn in Intro Micro (after PPFs) is that trade (normally) makes people better off, so if something stops a lot of trades from happening it's easy to understand why that should (normally) make a lot of people worse off. That's why recessions are Bad Things. The fall in GDP, if it happens, is merely a side-effect.
The second problem with ISLM is that it is only implicitly and not explicitly a model of a monetary exchange economy. "Money buys goods, and goods buy money, but goods do not buy goods", to quote Clower, IIRC. If unemployed workers could easily barter themselves back to full employment, they would do so. But few of them can easily do so, so few do. And students need to be explicitly taught that their intermediate macro model assumes a monetary exchange economy, where barter is impossibly hard, and no Walrasian auctioneer exists, and that their macro model is different from what they were taught in micro for precisely this reason. Because students won't figure it out for themselves. And they will be even less likely to figure it out for themselves if we do what Olivier Blanchard suggests and get rid of any mention of money by replacing the LM curve with an interest rate set by the central bank.
The first and second problems with the ISLM model go together. It is an excess demand for the medium of exchange that prevents mutually advantageous exchanges being made that we call "recessions".
The third problem with ISLM is the IS curve. This teaches students that Investment and Saving are central to understanding recessions. This teaches them something that is false. It is monetary exchange, not Investment and Saving, that is central to understanding why monetary economies sometimes suffer from recessions. It is possible to have a one-period model, where by definition "Investment" and "Saving" are meaningless, which has exactly the same sorts of recessions that we observe in the real world. Those with an apple endowment want to trade with those with a banana endowment, but if apples and bananas can only be traded for Mangoes, and if there's an excess demand for Mangoes, we get a recession. But all fruit rots, unless it is eaten at the end of the period, so there cannot be any investment or saving (not even of Mangoes). Adding Investment and Saving to a model of recessions is an optional extra that does not change the underlying essentials.
The fourth problem with the ISLM model is the vertical axis. This teaches students that the rate of interest is central to understanding recessions, and that recessions are caused by the rate of interest being too high. This teaches them something that is wrong, and it is wrong whether we are talking about the real or nominal interest rate. It is wrong because we can get recessions even in a one-period model, where interest rates do not exist. And it is wrong because the rate of interest is an intertemporal relative price, and even the Euler equation in a simple textbook New Keynesian model says that a too high (real) interest rate tells us only that the ratio of current consumption relative to expected future consumption is too low. It does not tell us that the level of current consumption is too low, and it does not tell us that cutting the (real) interest rate will cause current consumption to rise, unless we just assume that people expect future consumption to be pinned down at full employment. Which is begging the very question Keynes set out to answer. And if we add investment to the model it does not even tell us that; a low (real) interest rate can be a consequence of the collapse in investment demand that is caused by the recession itself, because firms will not invest to produce more output if they cannot sell their existing level of output for money. The IS curve may slope the wrong way.
"OK Nick, but if you don't like teaching ISLM, what would you teach instead?"
Which is a perfectly reasonable question. Which is why I despair. Because what could I teach instead? Well I expect I could start out by teaching my one-period Minimalist Macro Model. That would work fine as a beginning, but what would I teach next? And how would I teach students who (quite reasonably) wanted to understand current monetary and fiscal policy debates in Canada? My little model wouldn't work very well for that, because it's far too simple and abstract. And just too different. I would do much better teaching them the same sort of model everyone else uses, because it will help them understand that debate by using the same language and framework that everyone else in that debate uses. Plus, intermediate macro is the prerequisite for advanced macro, so I can't get too far out of line with the rest of the staircase.
Oh shit. Sure Olivier, just give me the textbook. Whatever.
Which is why I despair. I'm burned out.
Update: Here are Scott Sumner's thoughts on Blanchard's post. Scott is less sympathetic to ISLM than I am. In some ways, I'm a bit more Keynesian than Scott, but my keynesianism is filtered through Clower and Howitt.