Our textbooks teach macro in a very strange way. We often start off the core material with a chapter that discusses the “classical dichotomy.” We try to convince students that if you double the money supply then all you’ll do in the long run is double the price level. But we also explain that nominal shocks can have real effects in the short run, as wages and prices are sticky. We often present the equation of exchange and the quantity theory of money. And velocity!!
And then we proceed to entirely ignore this framework for the rest of the textbook. The QTM is treated like a crazy aunt that has to be hidden away in the attic. Time for more serious stuff! On to the AS/AD model, and the various components of GDP. Of course economists understand the linkages between these two approaches; they understand that real shocks are sort of like supply shocks and nominal shocks are sort of like demand shocks. But not exactly.
Unfortunately students don’t see this at all. And why should they? It’s like we started teaching the course in one language they don’t understand (say ancient Greek) and half way through switch over to another language they don’t understand (Latin.)
I have a modest proposal. If we are going to start the course in Greek, why not continue in that language all the way through? Why not do inflation and business cycles using the language of nominal and real shocks, instead of AS/AD shocks? After all (as Nick Rowe frequently points out) all definitions of AD are arbitrary. So why not pick the one that corresponds to “nominal shocks,” i.e. to changes in M*V?
So our AS/AD models starts out as a LRRO/NS model (that’s long run real output and nominal spending.) The LRRO line is obviously vertical, and is obviously identical to the LRAS line. The NS line is a rectangular hyperbola representing a given level of P*Y. AD shocks (M or V) move the NS line. We use this model to explain why poor countries can’t get rich by printing money.
Then we move on to business cycle chapters, and bring in sticky wages and prices. Now we add the SRRO line, which is identical to the SRAS line. Now we can explain why nominal shocks have real effects in the short run. We tell students that the SRRO line partitions changes in nominal spending (M*V) into real growth and inflation (P and Y.)
This approach is also a far better way of teaching fiscal and monetary policy. Both monetary and fiscal policy can, ceteris paribus, impact the NS line. Some types of fiscal policy also may also be able to impact the LRRO and SRRO lines.
When I presented this idea to a co-author of one of the top principles texts, he seemed quite impressed, and encouraged me to submit it to the Journal of Economic Education. I never had any luck with that journal, so I’ll present it here instead. It’s in the public domain now, feel free to submit it to the JEE.
PS. My hidden agenda is that this framework makes it much easier to see what went wrong in 2008-09.
And to make sure it never happens again.
PPS. The fact that I think in terms of this framework is probably the main reason my blog has become somewhat successful. I immediately saw what went wrong in 2008.