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Marcus Nunes directed me to a post where Olivier Blanchard recommends some changes in the way we teach macro. In my view, all of these changes are in exactly the wrong direction, although I don't doubt that far more economists agree with the highly distinguished Blanchard than with me.

The IS relation remains the key to understanding short-run movements in output. In the short run, the demand for goods determines the level of output. A desire by people to save more leads to a decrease in demand and, in turn, a decrease in output. Except in exceptional circumstances, the same is true of fiscal consolidation.

In my 35 years of teaching macro, I never covered the IS/LM model. Instead, I used the AS/AD model (which Blanchard wants to eliminate.) The primary flaw in the IS relationship is that economists often misuse it, and engage in "reasoning from a price change." That is, they typically assume that changes in the interest rate reflect changes in Fed policy, with lower rates implying easier money. This is false. For instance, interest rates fell in late 2007 and early 2008 because of a weakening economy, not easy money. Admittedly the IS relationship can accommodate this possibility through a shift in the IS curve, but it's clear that most economists don't see this, as they frequently refer to low interest rates as easy money.

It is also false that an increased desire to save leads to lower demand and lower output. As Nick Rowe tirelessly points out, it is an increase in hoarding that matters, and whether that increase is accommodated by the central bank. Of course if one views the interest rate as "monetary policy" then it's easy to see why people could fall into this trap. When there is an increased propensity to save, then the central bank must reduce the money supply in order to hit its interest rate target. In fact, central banks target inflation, in which case an increased desire to save has no impact on demand.

The statement about fiscal consolidation is also wrong. Or at best you could say that fiscal consolidation is not contractionary, except at the zero bound. In other words, rather than the model only failing in "exceptional circumstances", Blanchard's model only holds true in exceptional circumstances. And this isn't just my view, as recently as 5 years ago Paul Krugman held the same view as I do.

The demand for goods, in turn, depends on the rate at which people and firms can borrow (not the policy rate set by the central bank, more on this below) and on expectations of the future. John Maynard Keynes rightly insisted on the role of animal spirits. Uncertainty, pessimism, justified or not, decrease demand and can be largely self-fulfilling. Worries about future prospects feed back to decisions today. Such worries are probably the source of our slow recovery.
This has things exactly backwards. Monetary policy determines the rate of growth in NGDP, which in turn determines the level of nominal interest rates. Interest rates are (for the most part) not the cause; they are the effect, an epiphenomenon.
The LM relation, in its traditional formulation, is the relic of a time when central banks focused on the money supply rather than the interest rate. In that formulation, an increase in output leads to an increase in the demand for money and a mechanical increase in the interest rate. The reality is now different. Central banks think of the policy rate as their main instrument and adjust the money supply to achieve it. Thus, the LM equation must be replaced, quite simply, by the choice of the policy rate by the central bank, subject to the zero lower bound.
In my view this is exactly the opposite of the lesson that we have recently learned. It's clear that zero rates will occur in future recessions. Thus we need to stop using a policy instrument that freezes up every time we need it, and replace it with a policy instrument that is not subject to the zero bound problem. I suggest using the price of NGDP futures, but there are other possibilities. For instance, Singapore uses the exchange rate. If the US is too big to use the exchange rate, there are always possibilities such as a basket of commodity prices, or some very broad measure of money. But please, anything but a policy instrument that is susceptible to the zero bound problem, which has been the biggest problem with central banking over the past decade. It's no coincidence that the one developed country that avoided the zero bound (Australia) also avoided the 2008-09 recession.

Furthermore, if we replace the LM equation with an interest rate, then students will be even more inclined to reason from a price change. No longer will a leftward shift in the IS curve lead to lower interest rates. Thus all declines in interest rates will look like easy money policies.

If anything, the crisis has shown the importance of the financial system for macroeconomics.
No, it's shown the importance of keeping NGDP expectations growing along a slow but stable path. Financial distress is mostly (albeit not entirely) an effect of NGDP instability.
Turning to the supply side, the contraption known as the aggregate demand-aggregate supply model should be eliminated. It is clunky and, for good reasons, undergraduates find it difficult to understand. Its main point is to show how output naturally returns to potential with no change in policy, through a mechanism that appears marginally relevant in practice: Lower output leads to a lower price level, which leads, for a given money stock, to a higher real money stock, which leads to a lower interest rate, which leads to higher demand and higher output. This is a long, convoluted chain of events with doubtful realism. Central to the adjustment is the assumption of constancy of the nominal money supply, which again is not the way central banks do business. And the notion that economies naturally return to normal has not held up well over the last seven years.
Unemployment in America is 4.7%, whereas the average rate over the past 50 years is 6.2%. Who says economies can't return to normal? I would do the opposite, eliminate the IS/LM model, and rely solely on AS/AD. I do agree that the interest rate-oriented transmission mechanism used by Keynesians is a confusing mess, and inaccurate. The much simpler monetarist version is far superior. The AD curve is simply a rectangular hyperbola, a given amount of NGDP, determined by the central bank. Nominal wages are sticky. When NGDP changes unexpectedly, there is a change in hours worked, as wages adjust slowly to reflect the new level of NGDP. Once wages have fully adjusted, output returns to the natural rate. This model has done an excellent job of explaining the economy since 2008.

Unfortunately, Blanchard wants to replace the AS/AD model with a much inferior Phillips Curve model, which focuses on demand shocks and makes it harder to see supply shocks. And even worse, this is not the Friedman version where unexpected inflation affects output, but a much inferior Keynesian version where low output reduces inflation:

These difficulties are avoided if one simply uses a Phillips Curve (PC) relation to characterize the supply side. Potential output, or equivalently, the natural rate of unemployment, is determined by the interaction between wage setting and price setting. Output above potential, or unemployment below the natural rate, puts upward pressure on inflation. The nature of the pressure depends on the formation of expectations, an issue central to current developments. If people expect inflation to be the same as in the recent past, pressure takes the form of an increase in the inflation rate. If people expect inflation to be roughly constant as seems to be the case today, then pressure takes the form of higher--rather than increasing--inflation. What happens to the economy, whether it returns to its historical trend, then depends on how the central bank adjusts the policy rate in response to this inflation pressure.

If we've learned anything recently, it's that low output does not lead to ever falling inflation. The Keynesians have reversed causation. NGDP shocks impact both inflation and output. This "musical chairs" interpretation of monetary non-neutrality has done vastly better than the Keynesian version during the Great Recession.

In my view macro needs to head in a different direction. We need to remove nominal interest rates and inflation from their central role in our models. We also need to de-emphasize the role of the financial system, which currently plays far too large a role in our money and banking textbooks. Instead we need to focus on a model with these characteristics:

1. A simple AS/AD model, where output can change due to supply or demand shocks.

2. AD is equal to NGDP and determined by monetary policy, which is implemented through changes in the supply of base money, not interest rates. NGDP futures prices are the best policy instrument, and also the best indicator of whether money is easy or tight.

3. Nominal hourly wages are sticky in the short run, leading to short run monetary non-neutrality, and flexible in the long run, leading to a self-correcting mechanism. If you want to add a bit of hysteresis that's fine, but I believe its importance is overrated.

In my view, if macroeconomists had adopted this framework in 2007, the Great Recession never would have happened (but the Great Stagnation would still have happened.)

PS. Over at TheMoneyIllusion, I use graphs to explain some of the ideas in this post.

Comments and Sharing

COMMENTS (26 to date)
marcus nunes writes:

"In my view, if macroeconomists had adopted this framework in 2007, the Great Recession never would have happened (but the Great Stagnation would still have happened.)"

Scott, but certainly a much less DEPRESSED SS!

Toby writes:

I read what Blanchard wrote and the first thing I thought was: Scott is not going to like this. Glad to see that you posted this. I hope it will attract attention and that we can see some debate between you and Blanchard and/or Krugman on this.

Market Fiscalist writes:

'they typically assume that changes in the interest rate reflect changes in Fed policy, with lower rates implying easier money'.

I can see that lower rates may not be easy money (for example an inadequate response to a demand shock), but can lower rates ever not be 'easier money' (compared to everything else being the same but no rate cut) ?

TravisV writes:

Prof. Sumner,

Excellent post, thank you very much! Personally, I'd like to see evidence indicating whether Bernanke's thinking typically is closer to Blanchard's or yours.

Scott Sumner writes:

Marcus, Does that mean a less depressed Scott Sumner (yes), or a less depressed supply-side (I'm not so sure)?

Thanks Toby.

Market, You said:

"compared to everything else being the same but no rate cut"

If everything else is the same, how can the fed funds rate decline? Think of changes in interest rates as the effect of something else.

Travis, I'm guessing it's closer to Blanchard's. But back in 2003 I believe his thinking was closer to mine.

Market Fiscalist writes:

'If everything else is the same, how can the fed funds rate decline? Think of changes in interest rates as the effect of something else.'

Well, I'm thinking of the change in interest rates as being the effect of the CB deciding to change its interest rate target and adjusting the money supply accordingly. if the change is a change to lower rates, then how can that not be easier money than if they had not decided to lower the rate ? (It may not lower them enough to actually make it 'easy money' if NGDP still falls).

Scott Sumner writes:

Market, OK, but then that's no longer "everything else equal". If the money supply increases and that causes rates to fall then you are correct that it would be easier money than if the money supply had not increased, ceteris paribus.

Benjamin Cole writes:

Call me cynical, but no longer do central bankers-macroeconomists seem to ask, "How do we get to economic prosperity?"


"How can frame the discussion to support my biases or ideologies or dogmas?"

Scott Sumner has fought a brave war (on the monetary front) against the framing of the discussion, which is so routine as to be conventional.

The incredible obscurity of monetary policy (what are reverse repos again?) helps this cherry-picking of frames.

I wonder if a simple program of exclusive reliance on money-financed fiscal programs (as monetary policy) would help, as framing the discussion would have to take place along lines everyone understood.

That is:

"How big or small should the helicopter drop be now?"

As a nation, we can look at real output and inflation, and make a decision on the size of drops.

Some people may disagree with the level of helicopter drops, but at least there would be a sensible focal point for discussion. It would be more democratic, and the president should set the level of chopper drops, and van be booted out of office if the results are poor

Kurt Schuler writes:

"We also need to de-emphasize the role of the financial system, which currently plays far too large a role in our money and banking textbooks."

So, you propose to take the banking out of money and banking?

Brian Donohue writes:

Clearly, your work is far from done here. Very good post. Keep on keepin' on.

I formed an opinion about macroeconomics when taking macro courses during my most recent (2009-13) return to school. Macro exists because states exist. The aggregates studied in macro pertain to sums over geographic regions — regions delimited by the borders of states.

Conceivably, there would be other ways to sum economic variables. For example, I have interest in the income of all people whose last name starts with 'H'. But no one tries to estimate this vital aggregate. No one tries, obviously, because there is no power, no policy apparatus, which might receive guidance from statistics about the welfare of me and my 'H' kindred.

Another macro alternative: Aggregates could be computed for river valleys, like the Danube or (much smaller) Rio Grande. But again, to my knowledge, there is no organization which pretends to represent the people so implicated, so there is no motive to compile and argue over such aggregates.

For a libertarian who doubts the goodness of any act of state, macro looks like a growth which has occurred because states:

  • have given themselves certain powers;
  • gain legitimacy in exercise of those powers by consulting experts.
So there is a demand for these experts. That's the soil in which macroeconomics grows.

I do not imply that macro is all bad. But I would prefer that the practice be accompanied with more awareness of its parent, the state, and more awareness of the state's primary, self-feeding interest.

James writes:

Richard's observation might explain why most macro models involve equations where output and employment are determined by some policy variables like interest rates and budget deficits. It can be an instructive exercise to set GDP and unemployment to some arbitrary values and solve those equations for the policy variables. If you take some of those models literally, it looks like we could have a world with no poverty, unemployment or inflation and arbitrarily high rates of economic growth. All that it would take is for state officials to choose the right values for the policy variables in the model.

Never mind that most variation in economic outcomes is attributable to variables which are unrelated to monetary or fiscal policy. The most neglected fact about macro is that the policy variables in standard macro models account for only a small fraction of the variation in the economic outcomes that those models are supposed to explain.

Nylund writes:
Admittedly the IS relationship can accommodate this possibility through a shift in the IS curve.

I think that should read, "Admittedly, if you use the IS-LM model correctly, this relationship will show up as a shift in the IS curve."

For example, if you think interest rates went down because of something, say a decrease in investment demand, and I asked you on an exam to show the effects of that with the IS-LM model, I'd take off points if this didn't show up as a shift in the IS curve."

As for the "easy money" comment. I think what you're objecting to is that the phrase an economist might use when the IS curve shifts and there is no offsetting shift in the LM curve to keep rates stable, may sound a lot like the phrase economists use when there is no shift in the IS curve, and the LM curve shifts due to a policy change. That is if the Fed "allows" money to become easier (IS shifts, no offsetting LM shift) vs. the Fed pushes for money to become easier (IS stable, LM shifts), both may be described as "easy money policies."

But then the critique of the model becomes, "I don't like how some people use similar phrases to describe different scenarios in this model, therefore the model is bad."

Yes, there are good reasons to distinguish passive allowance from an active push. The model does that. People's poor word choice may bug you, but it's not really evidence of a flaw in the model itself.

Henry writes:

" It's no coincidence that the one developed country that avoided the zero bound (Australia) also avoided the 2008-09 recession."

The reason Australia avoided recession was because of a massive government expenditure programme.

rayward writes:

We are moving into a new era of globalization, from one where production in developing (low cost) countries is mostly determined by firms in developed (high cost) countries to one where production in developing countries is mostly determined by the developing countries themselves. And developed countries don't like the move: "excess supply" is a euphemism for competition (and independence). Will the developing countries absorb the "excess supply" or will we be in for a long period of deflation and financial instability? Fine tuning the money supply in, for example, the U.S. won't solve what is a global problem. I say "problem", but shifting production to low cost countries from high cost countries is not a "problem" if the benefits from it are widely shared, which so far hasn't been sufficiently the case to avoid deflation and financial instability absent government spending to absorb the "excess supply".

Scott Sumner writes:

Kurt, Yes, I taught "Monetary Economics" for many years at Bentley. I did cover banking, but only because I haven't been able to convince my profession that it should be taken out. So I didn't want to do a disservice to my students.

Richard, Many of the macro models basically apply to currency areas, such as the USA, or the eurozone.

Nylund, You said:

"That is if the Fed "allows" money to become easier (IS shifts, no offsetting LM shift) vs. the Fed pushes for money to become easier (IS stable, LM shifts), both may be described as "easy money policies.""

I strongly disagree. When rates fall due to a leftward shift in IS it certainly is not easy money. Unless you want to claim that high rates during hyperinflation is "tight money". Is that your view?

Henry. I don't agree about the fiscal stimulus, it was not very large, and other countries also did fiscal stimulus:

Rayward, Deflation is caused by tight money, not globalization.

rayward writes:

Is there a "savings glut"? Is a "savings glut" even possible? Is it possible to simultaneously have "tight money" and a "savings glut"? Saturday I had lunch with the mayor of a large city in Guangdong province - he was visiting the US, I wasn't there. A fascinating experience. His role as mayor is so very different from what we think of as the role of mayor. I shared my view about the new era in the relationship between developing countries (I actually identified China) and the US (the "excess supply" problem as Treasury Secretary Lew describes it). He didn't disagree (or agree) but did agree that the future belongs to the US and China. He also didn't seem all that anxious about China and its economy. Of course, "excess supply" in China is a non-sequitur, but it's not in the US, tight money or loose money. That's a difference that I find concerning.

I have the same question: Is there a savings glut? In my two masters-level macroeconomics courses I never saw a model that began to address my question. There are macro models with the word "savings" sure enough, but my question is more like this:

I saved during my working career. Now in retirement I have a nestegg which (supplemented by Social Security) seems sufficient to carry me through. But I am far from alone. I am a member of a baby-boom generation, so I guess many others like me are now sitting back assuming that no more productive labor will be required of us. But how far can that go? What fraction F of a population can expect to be trading their dollars saved in 1980 for support services produced in 2020 by the remaining fraction (F-1)? As I say, I never noticed a macro model which seemed to me to get at this question.

Henry writes:

Scott said:

"Henry. I don't agree about the fiscal stimulus, it was not very large, and other countries also did fiscal stimulus:"


There were two packages of spending dispersed over a period of two years.

October 2008, the Economic Security Strategy (ESS) $10.4 billion (0.85% of 2008 GDP)

February 2009, the Nation Building and Jobs Plan (NBJP) $42 billion (3.36 % of 2009 GDP)

The quantum and rate of spending were high by any standards. (And remember the US stimulus was to be spent over several years.)

You don't think this is a high rate of spending?

Alexander Hamilton writes:

Henry, You're explanation is essentially: "this country performed well because of one pet policy I support" the only person who does economics like that is Ha-Joon Chang. And no Australias stimulus wasn't particularly big for a G20 country. Fiscal policy is irrelevant.

Henry writes:


I hazard to guess its size was unprecedented in Australia as a one off stimulus package.

And I suppose the fact that Australia suffered no recession is not important to note.

And of course no ideological bias has intruded into your assessment of my comments. :-)

Scott, Thank you for your correction, which was:

Many of the macro models basically apply to currency areas, such as the USA, or the eurozone.
I will add that such currency areas represent super-states in my view — just another manifestation of state. Being created by member states, currency areas must in some way owe their organizational survival to the ability of those member states to apply coercion. This understanding of "state" refers to the distinction of the economic means vs. the political means, as I am sure you must already know.

Alexander Hamilton writes:

Henry, I think the government can spend as much or as little as it deems optimal given its mandate from the electorate to do so. I've never really understood why people try to divide the debate about fiscal stimulus down ideological lines or why people of the left defend countercyclical fiscal policy so virulently. Hacking away at public spending during a boom doesn't seem like a policy progressives would be particularly happy with.

Henry writes:

Alexander or is it Alexander Hamilton,

(I'm not sure how to address you as I note your name is the same as that of the first treasury secretary of the commonwealth of the US. :-) )

"....why people of the left defend countercyclical fiscal policy so virulently"

Probably because people of the right attack countercyclical fiscal policy virulently.

George Selgin writes:

"Rayward, Deflation is caused by tight money, not globalization."

But Scott, equating deflation with tight money is forgetting possibility of rightward shifts of AS--that's the error of inflation targeting!

Jim Glass writes:


Commentary and exchanges about Sumner v Blanchard among the young & future economists at the very good r/badeconomics.

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