IS-LM is not a useful model

I have to admit that I have rarely used the IS-LM model since I became interested in economics. Instead, I find the AD-AS model much more useful. Of course, this does not mean that there is a major theoretical flaw in the IS-LM model. Rather, I think that the inferences that economists make by looking at the model are wrong, and that the model leads both economists and students to “reasoning from a price change.” To be more precise, it leads them to assume that changes in the interest rate are a good indicator of the monetary policy stance.[1]Sumner, Scott. A Critique of Interest Rate–Oriented Monetary Economics. Working Paper, Mercatus Center at George Mason University, November 23rd, … Continue reading But that’s not true. For example, interest rates fell in late 2007 due to the weakening economy, and monetary policy was certainly not expansionary. It is true that a shift in IS could cause this, but I suspect most economists either ignored or failed to see it.

Nor do I find it reasonable to assume that increased savings result in lower demand and output. Whether an increase in hoarding is accommodated by the central bank seems to me a more accurate perspective. [2]Rowe, Nick. The paradox of thrift vs the paradox of hoarding. Worthwile Canadian Initiative, October 01st, 2010. … Continue reading However, when looking at monetary policy through the lens of interest rates, it seems clear that this will hardly be seen. However, when looking at monetary policy through the lens of interest rates, it seems clear that this will hardly be seen. Accordingly, when the propensity to save decreases, the central bank has to reduce the money supply. But the increased desire to save does not affect demand, so there is no reason for an inflation-targeting central bank to reduce the money supply.

Let’s start with interest rates. Theoretically, a doubling of the money supply would almost immediately double the price level. But that’s not the case in the real world – mostly because of sticky wages and prices, although there are other factors. If the price level is not doubling, another variable must double to equate the increasing supply. That variable is the (nominal) interest rates, and they are not sticky – they quickly move the equilibrium rate at which money supply and demand equated. In this example, a fall in the interest rate may be a sign of wage and price stickiness rather than the stance of monetary policy. It need not have an essential role in nominal aggregates.

Someone might say, “But Kursad, the IS-LM model is not about nominal aggregates; it’s about real GDP.” I agree; we can’t get real effects with a perfect wage and price elasticity model. But in the case of wage and price stickiness, we can still get the same kinds of real effects, even if interest rates do not play an essential role: it is possible in the SRAS model. Consequently, a sustained increase in the money supply will proportionally raise the price level, or NGDP. The nominal expense ratio also increases, but to a lesser extent. But I don’t see anything necessary for short-term interest rates to fall in this process. If current rates are held constant, real interest rates will fall as expected inflation increases. Or nominal rates may rise at the same rate as expected inflation, and real rates remain constant. In this case, the opportunity cost of holding cash increases rapidly. We can get real effects when we consider nominal expenditures to rise and wages/prices are sticky. Or suppose nominal rates are falling. I think this would be the case that the IS-LM model would most easily explain. But I don’t understand exactly why it matters whether interest rates fall when the expected future NGDP rises. This puts upward pressure on existing AD and NGDP, and this is true for any commodity. So why are we focusing on interest rates? My conclusion from these scenarios is that monetary policy determines the growth rate in NGDP, which determines the level of nominal interest rates. Interest rates, then, do not determine the stance of monetary policy, because they are not a cause, but rather a result.

But none of this is why I choose not to use IS-LM. Actually, I have purely pragmatic reasons. Basically, I think it’s hard to apply the IS-LM model to the real world, and we have better alternatives instead. I saw this more clearly when I read this passage by Robert King[3]King, Robert G. 1993. “Will the New Keynesian Macroeconomics Resurrect the IS-LM Model?” Journal of Economic Perspectives, 7 (1): 67-82.DOI: 10.1257/jep.7.1.67:

“If changes in the money stock are persistent, then they lead to persistent changes in aggregate demand. With a rational expectations investment function of the neoclassical form, persistent changes in demand for final output lead to quantitatively major shifts in the investment demand schedule at given real interest rates. These effects are generally sufficiently important that real interest rates actually rise with a monetary expansion rather than fall: the IS curve effect outweighs the direct LM curve effect. Further, if persistent changes in the money stock are only gradually translated into price or wage increases, then there are very large additional expected inflation effects on nominal interest rates.”

When I read this, everything actually became clearer. Everything can be interpreted with IS/LM model; still, that doesn’t make it useful. If it’s not intuitively obvious, most people can misunderstand it; and if most people misinterpret it, it’s useless.

While the example I give most of the time relates to the Great Recession, there are many other examples as well. Similar things happened in 1920-21 and 1929-30. In both cases, monetary policy was extremely tight, but if you interpreted it in terms of interest rates, you would think that monetary policy was “appropriate.” Similar situations apply for 1929, 1937, and 2008. However, the IS-LM is not a useful model when thinking about these shocks and seems to mislead most economists.

Between 1926-29, gold reserve rates were increasing at about 2.5% per year. Between October 1929 and 1930, this ratio rose to 9% as central banks increased demand for gold. This naturally changed the future path of NGDP, thus leading to a fall in stock and asset prices. Keynesians saw nominal interest rates fall during this period and assumed that the problem was not monetary policy. I see precisely this kind of reasoning as a bad interpretation of the IS-LM model. Someone might say, “if the problem is not with the model but with the interpreters, you can’t blame the model.” However, I am not blaming IS-LM or claiming it has a theoretical flaw. Rather, I question how useful a model could be that many of the leading economists of the time misinterpreted. If you misdiagnose the disease, your prescription will be useless.

It must be admitted that the IS-LM model works quite well in Great Moderation. However, this seems to me more related to the Taylor Rule. However, the model is not that useful in times when inflation expectations change rapidly. It is more difficult to predict the real interest rate during these periods; For this reason, it is much easier to think that the monetary policy is expansionary in periods such as 1929, 1937, and 2007 when it is actually tight. In a scenario where the Wicksellian equilibrium rate falls more than the policy rate, IS-LM would be misleading. Likewise, traditional monetarism will fail to interpret these periods. Consider a driver who drives well on a straight road, but is more prone to crashes when there are many intersections. This is exactly how I see IS-LM.

All right, so what’s my solution? I prefer to use a more useful and simple model. I prefer to rely on AD/AS, where output changes depending on supply and demand shocks. I believe the interest rate transmission mechanism is confusing and misleading. The AD curve is a rectangular hyperbola (simply NGDP, or nominal expenditures) AS is merely a function that represents short-run output. And finally, OL is a vertical curve that shows the long-run output, i.e., the optimal level of the economy. Since nominal wage stickiness is the underlying assumption of this model, the “Optimal level” will vary depending on the type of wage stickiness and will require us to define nominal shocks in terms of wage stickiness. We could actually add GDP-linked bonds to this model. It would be much easier to model this way, but as we don’t have such a thing for now, we have to make do with what we have.[4]Prasad, Pradyumna. Why you should issue GDP linked bonds, Bretton Goods Substack, July 20th, 2021. https://brettongoods.substack.com/p/why-you-should-issue-gdp-linked-bonds. An unexpected change in AD/NGDP/NE creates a change in hours worked as wages are sticky. The output will returns to OL when wages are fully adjusted. The simple implication of the model is that NGDP shocks affect both production and inflation. I think this model, the “musical chairs”[5]Sumner, Scott. Money and output (The musical chairs model), The Money Illusion Blog, April 06th, 2013. https://www.themoneyillusion.com/money-and-output-the-musical-chairs-model/ interpretation, is much more useful than the interest rate-oriented approach.

P.S. I didn’t originally think of the AD curve as a hyperbola, but as I said here, after seeing Sumner’s model, I decided to tweak it a bit. I think Sumner’s framework has been much more useful.

References

References
1
Sumner, Scott. A Critique of Interest Rate–Oriented Monetary Economics. Working Paper, Mercatus Center at George Mason University, November 23rd, 2020. https://www.mercatus.org/system/files/sumner-critique-interest-rate-mercatus-working-paper-v1.pdf.
2 Rowe, Nick. The paradox of thrift vs the paradox of hoarding. Worthwile Canadian Initiative, October 01st, 2010. https://worthwhile.typepad.com/worthwhile_canadian_initi/2010/10/the-paradox-of-thrift-vs-the-paradox-of-hoarding.html
3 King, Robert G. 1993. “Will the New Keynesian Macroeconomics Resurrect the IS-LM Model?” Journal of Economic Perspectives, 7 (1): 67-82.DOI: 10.1257/jep.7.1.67
4 Prasad, Pradyumna. Why you should issue GDP linked bonds, Bretton Goods Substack, July 20th, 2021. https://brettongoods.substack.com/p/why-you-should-issue-gdp-linked-bonds
5 Sumner, Scott. Money and output (The musical chairs model), The Money Illusion Blog, April 06th, 2013. https://www.themoneyillusion.com/money-and-output-the-musical-chairs-model/

Indicators of A Good Monetary Policy

There has been a heated debate lately about whether inflation is transitory or not. I think I caught this discussion a little late, but for various reasons, it took me quite a while to finalize this post, and I see no reason not to share it now. Note that most of the post was written almost two months ago, and I only made a few additions to it due to a few posts shared recently.

While the US economy is recovering from the recession, we have seen the CPI grown by 0.6%, 0.9%, and 0.5% in the last three months. We’ve seen many pundits seem extremely concerned about persistent inflation. However, we also had many convincing data to think that inflation was transitory and not worry about it. Despite the many dramatic changes experienced during the pandemic, market and consumer expectations remained quite moderate. The unemployment rate is 5.2%, indicating that the economy still needs to make necessary improvements to reach full employment. It is reasonable and realistic to predict that aggregate demand will decrease (due to the decrease in government support) in 2022, but will reach normal levels once the supply bottleneck is over.

Source: Yes, Inflation is Transitory, Apricitas- An Econ Blog. Graph created by @JosephPolitano

The Fed’s new framework, FAIT, requires short-term above-trend inflation to offset periods of below-trend inflation and maintain a sustainable 2% inflation. However, the Fed has communication problems in explaining its new framework to the public, which created uncertainty about the future path of monetary policy. Moreover, it seems that many pundits still haven’t internalized and understood FAIT. Calls for tightening and doomsday scenarios started flying around as PCE inflation caught the pre-March 2020 trend. In fact, these concerns stem from fundamental confusion: pundits simply do not realize that the inflation we are experiencing is due to the supply shocks from the pandemic.

First of all, I think it’s essential to understand what “transitory inflation” means. According to the generally accepted definition, what we mean by temporary inflation is that inflation, which is higher than the trend, will return to normal level soon. But this seems too obscure to me, and I believe we can make a better definition. It is clear that the Fed is capable of “stopping” both supply-side and demand-side inflation and returning it to normal levels. So the main debate should not be whether the Fed can fix the problem or have something to do, but whether more or less AD would be helpful. The Fed has always had this capability, and we have enough examples not to doubt it. Therefore, whether inflation is transitory depends entirely on what the Fed does in the future. It would be more useful to think of transitory inflation as returning inflation to normal levels without triggering higher unemployment than the current rate. Indeed, this is very similar to the difference between a cold and the flu. If you only have a cold, you can regain your health in a short time if you drink herbal tea, keep yourself warm and rest. But if you have, for example, the flu or pharyngitis, you will have to take antibiotics, and you will suffer from a high fever for a while.

Joey Politano has a fascinating post exactly about that. In here, Joey says:

“In 2007, 2015, and 2018 the Federal Reserve preemptively tightened policy out of misplaced fear of oncoming inflation, only to reverse course later and loosen monetary policy in order to support the economy. If the Federal Reserve does not learn from these prior experiences and stick to their new commitment to create policy-driven transitory inflation they will deal irreparable damage to both their credibility and to the economy. Today’s inflation is transitory, and policymakers should not react to it by pre-emptively tightening monetary policy.”

The Fed is learning from its past mistakes. That’s why we got FAIT last year. It’s not ideal, but it’s a good step in the right direction, and Powell has given us a pretty reasonable policy so far. That’s exactly why the Fed should not make the same mistake.

It is inevitable that “how should a good monetary policy be” arises from all these. In my view, good monetary policy triggers higher employment, leads to a steady increase in nominal wages and income, increases investment and productivity, stabilizes financial and macroeconomic variables, and lowers inequality. But I’m not sure how reasonable it is to target inflation or employment to achieve these. Congress gave the Fed a dual mandate, which can be summarized as maximum employment and stable prices. However, I think that indexing monetary policy to inflation or employment may fail to achieve the above. Of course, it can still do all of these, but I’m not sure that each of them can be reached at an ideal level. Maximum employment is not clearly defined, and we do not have a clear sense of how many jobs can be created by monetary stimulus without destabilizing prices. This does not mean that maximum employment or price stability can be ignored; the Fed should certainly strive to achieve the dual mandate. Rather, it looks like the Fed needs a more precise model to achieve it.

If high inflation is an indicator of excessive AD, then it is more reasonable to focus on NGDP rather than inflation. Similarly, I think the best way to reach maximum employment is to aim for steady growth in NGDP. What could be the definition of maximum employment other than a period when NGDP growth is stable over a long period, and the unemployment rate remains relatively constant over the years? Consequently, in order to achieve dual mandate, the Fed should not target both for monetary policy. The outcomes of a good monetary policy are likewise indicators of whether a monetary policy is good or not.

(4) Joey Politano🐇🚴🌱🕊️ on Twitter: “Now that’s some good tea https://t.co/AwNAxr3OcH” / Twitter

A Personal Note

First of all, I have to say that this post will be radically different from other posts on my blog. I’ve never written a personal post here before. Of course, there were texts where I shared my personal feelings, but I shared this in Turkish on Medium and did it (dare to say) more poetically. This post will be purely an attempt to write my thoughts in a monologue. Writing down my thoughts, feelings, and things about my past in this way, maybe it will add a different perspective to me. Writing this post came to my mind after reading Joshua’s last post and these posts by Claudia Sahm. So it would be appropriate for me to thank them.

To be honest, I’ve been an introvert my entire life. Anyone who spends 10 seconds with me has no way of not realizing it. I have many hypotheses about why I am the way I am, but I have no idea which one is correct. As Josh mentioned, “the vast majority of humans are naturally extroverted in personality.” So, I have an introverted personality for a reason. My ideas about the source of this focus on a few things: a) my nurture, b) the process I went through in building my own identity, c) Asperger’s.

Not surprisingly, I often tell people I have Asperger’s syndrome. But that’s not all. I’ll go back a bit because I think I can understand some things better from the retrospective. When I was born, I was seriously suspected of having cerebral palsy. Because which child cannot just sit or walk until 1.5 years old? Frankly, although I can’t remember those times, I can get an idea based on what’s been told to me. I know that thanks to the extraordinary effort of my parents, I made several years of progress in a few months, and then I was able to walk. And it was said that I had “differences” that were just beginning to be noticed during this period. That seemed normal to me, at least until I met other kids my age. For example, I used to think that we had no data on what other people felt in any given circumstances or how we should treat people. Or that other children read dozens of books when they were younger, on a subject they were just as interested in (say, dinosaurs). Or that we have built these capabilities from the very beginning through basic scientific observation. But I learned that’s not true. Maybe that’s why I’m not very good at emotions, and the only thing I think I do really well is to connect and explain almost everything about the world and emotions to basic economic principles or concepts.

I’ll give an anecdote so you can grasp what I’m talking about. On the first day of primary school, I felt pretty “strange.” I knew how to read before, but I had no writing experience. Unfamiliar and uncertain things always make me incredibly anxious, and I didn’t know what to do. I remember the teacher asking has anyone has a pen. I remember the teacher asking, “Does anyone have a pencil?” Even though I had exactly the pen he wanted, I shouted, “I have,” pointing to something else. The girl in front of me, which I later thought was a really nice person, looked at me angrily and said, “that’s not the pen.” Seems like a simple social interaction so far, right? Actually, it is, but I wouldn’t have said that if you had asked me back then. I didn’t understand why someone was angry with me, why they were offended, or why a question was asked to me. I wouldn’t know what to say in any dialogue and I couldn’t make inferences about how anything I said made the other person feel. I simply couldn’t connect with other people’s feelings and didn’t know how to do social interactions.

I continued to experience such things in the following years. I remember very well being a rather ostracized child in elementary school. It doesn’t have to be for a specific reason; we all know how kids are. However, even though I could make friends after meeting people on rare occasions, I couldn’t maintain these relations. I guess that’s why I started burying myself in areas of my interest because I wasn’t very successful socially. Specifically, these were epic fantasy fiction, Medieval European History, Medieval Latin, and basic economics. I had read an incredible amount of articles and books, especially on Medieval History. I was told by a history professor that I had reached the level of a doctoral candidate while I was still in secondary school. While Asperger’s had an incredibly negative impact on me socially, it was instead a blessing academically. My ability to understand and interpret things was relatively advanced to most people my age, but it only made me feel worse. My perspective on the world and human relations has always been a bit pessimistic, but I guess it’s all about my nature. I mean, if you’re 13 but have much “older” than your peers, you shouldn’t expect them to keep up with you.

But at 14, I became convinced that I had to follow another strategy. Honestly, Marcus Aurelius influenced me a lot and may have triggered me to follow such a strategy. This strategy was as follows:

I believe that we have built our character or identity for as long as I can remember. This means that there is no objective or deterministic “meaning of life,” we construct our own meaning and design our own reality. There is no personality given to us; we can import from outside or produce from inside. In this way, we each construct our own meaning and shape our lives. Actually, I think this applies to everything. It doesn’t matter if almost everything is “constructed” because we built them for certain functional features and designed them so that we can replace them when their functionality is gone.

Let’s get back to personality. Doing this ultimately means that it takes a lot of time and effort. After designing the mechanisms based on basic economics principles, I established the general equation of what and how I would react and practiced observing for years. I observed how people treated a waiter in a restaurant, what the median behavior was, and which behaviors were more effective. For example, there is a difference in behavior and outcome between shouting at a waiter and thanking him. After observing both, I decided that the second was more effective and the long-term effects are more satisfying, and it’s been my custom to thank people ever since. I kept a notebook to keep these equations and observations collectively. I chose social behaviors that would provide me with the maximum benefit at the least cost among social behavior patterns and social rules, or sometimes I used my synthesis. My empathy skill is still not very strong, but I have seen that it has developed more as I observe. At least I can predict, albeit mechanically, how people are feeling.

My purpose in doing all this was to design my own personality in the most effective way possible and take advantage of my personality while forming my plans and life purpose. But later on, I had to learn that life is not so mechanical. I was diagnosed with anxiety disorder and OCD at 16, and the framework I created has been shaken in many ways. I started having tremors due to random triggers, tended to be more socially unstable, and days were going to hell for me. I won’t go into the details of this here, but the next three years with them were utterly devastating for me. I had trouble with everything in every possible way; I was hopeless and had no interest in the world and living in it.

I got through this process in several ways. While receiving medical/psychiatric help, I thought about how I could explain and what I could do about this problem. My method was to interpret my depression and changes in my mood through economic concepts. After observing myself, I realized that I could go through some periods pretty severely, but if I do the right behavior, I could recover quickly(let’s say V-shape), or my recovery could be extended with different kinds of behavior. 1921-22, the Great Depression, Great Moderation, the Volcker era, and the 2008 Crisis were perfect examples for me in this respect. I experienced all of them for my emotional state.

However, these patterns were following each other, and I was going through the same cycle all over again. But at some point, I discovered a difference with the business cycle. My boom and bust periods were more likely to follow a “particular” pattern. For example, I feel better in the spring and worse in the fall, with one(actually two at the moment) exception for the last ten years of my life. After discovering that it’s a cycle, I started thinking about how to recover most effectively, and I’ve found something that works. I was aware that we tend to be more melancholic in the fall for evolutionary reasons. Our ancestors, who spent more time in caves when the weather was worse, were more prone to hunger and sadness. But how would that affect my recovery? Well, it can be put into a normative structure: acceptance. I’ve learned to accept that I’m not okay. I admitted that I was(and still am) struggling. I can cry as much as I want, I can be sad, and yes, time passes while I do this. But losing a few months or years is no big deal. It’s always good to recover as quickly as possible, but sometimes we just have to accept that we’re not okay and give it a try over time.

After accepting this, I realized that I was more successful in social interactions. The time I spent at 3H Movement and Students for Liberty contributed a lot to me in this regard. I used to think that taking responsibility would drive me crazy with anxiety, and I wouldn’t do anything. However, I’ve learned that taking responsibility sometimes makes me feel good. I met many talented people, I managed to be more comfortable in social interactions, and I started to get better every day; most importantly, I learned my limits – there were times when I was burnout, and I saw how much responsibility I could potentially take and what I was most effective in doing. All this has helped me tremendously; I guess I have to say I’m grateful.

In fact, I have roughly formed my “life purpose” in this process. To be sure, it’s not something specific and mechanical. I always wanted to be an academic and acted accordingly, but my primary motivation was not just to be an academic. I don’t want to be an economist just because I love economics.

I should mention a few things at this point. First of all, I think this poem from Wheel of Time, one of my two favorite fantasy series, coincides with my view of life:

“Life is a dream — that knows no shade.

Life is a dream — of pain and woe.

A dream from which — we pray to wake.

A dream from which — we wake and go.

Who would sleep — when the new dawn waits?

Who would sleep — when the sweet winds blow?

A dream must end — when the new day comes.

This dream from which — we wake and go.”

And these passages from Malazan was an inspiration for me:

“Why, without a sense of humour, you are blind to so much in the world. To human nature. To the absurdity of so much that we say and do.

“Children are dying.”

Lull nodded. “That’s a succinct summary of humankind, I’d say. Who needs tomes and volumes of history? Children are dying. The injustices of the world hide in those three words.””

I see life as a dream, but it’s more of a lucid dream. We will eventually wake up from this dream, but if we can control the dream, why not transform it into a better place before we wake up? After all, “Who would sleep — when the new dawn waits?”

I know my strengths and weaknesses. With each passing day, I can experience what I am good at and what I am bad at. Doing what I’m good at may not be enough to make the world a better place, but that doesn’t matter. If I’m doing what I’m best at and contributing to social change, maybe one day I can contribute to making the world a better place, even if I don’t see it in my lifetime. There are things I want to leave to the world from me.

When I read Harry Potter at I was 7, Dumbledore’s life seemed too relatable to me for some reason. Let’s ignore the irony that a book character is the only person to understand how he touches people’s lives and what he’s going through. But later, when I grew up, I put it in a theoretical way, which led me to adopt Hayek’s theory of social change.

According to Hayek’s theory, scholars develop ideas; intellectuals adopt and spread them, ideas become values as they spread, and politicians act according to widely shared values. I think this theory applies to economics as well. To contribute to the advancement of social changes, ideas must be developed in this sense at the first step. I am relatively better at researching and generating ideas, and I believe this is the only way I can contribute to this process.

I’ve been struggling for a few months now(both physically and mentally), I guess I’ve been going downhill since April. It’s all about me and I’ve made myself this way, but it will pass. We may not be feeling well, sometimes we may be doing the wrong things, sometimes we may be unstable, there may be times when we are not ourselves, sometimes we may act wrong even though we wouldn’t normally act that way. It’s okay, because we’re humanbeings. We will stumble and fall, but we will get up and keep walking. And we will know that every time we fall, it will pass. I’ll be fine. It’s gonna be alright.

Joachim Wtewael, The Adoration of the Shepherds, 1598

Random thoughts on economics

  1. I think most people understand the supply and demand less than we think. That’s because supply and demand are more confusing and complex than what is taught in mainstream EC101 lectures today. Maybe you don’t think so, but I do. Suppose we asked students who have already taken EC101&102:

“Oil prices fell. For this reason, people will probably buy more gas(as if something is cheaper, people will likely buy more.) (True/False).”

What do you think will be the response of many students? Most students would say “true” because “The demand curve slopes downwards; so the quantity demanded increases as the price falls.” But is it so? When I took EC101, I had the opportunity to observe many students. Almost all of them pass the course at the end of the semester without knowing more than they knew before. That’s why student essays consist of an endless cycle like “prices fall, demand increases; prices increase, supply increases.”

To be honest, I think economics is taught the wrong way. Have you looked at the introductory chapters of the best-selling textbooks? In the textbook next to me, all I see are meaningless examples such as “After an unexpected hail squall, the supply of crops decreases and prices increase,” “Unexpected high interest in Dean Martin concert driving up prices.” Students knew this even before taking the EC101. Do you know someone who has never studied economics and has never heard of the phrase “supply and demand sets the price”? And what most of the students know exactly at the end of the semester is nothing more than that. Basic econ courses should teach students intuition and interpretation, instead, they learn nothing but memorizing things like the “5 factors that shift the demand curve.” “If price increases, supply increases; when demand decreases, price increases; when X happens, the supply curve shifts to the left/right.” And it goes on like this.

This is an example of “reasoning from a price change,” and it’s the first thing many students learn in the intro to economics. Heck, it’s not surprising if you consider that even most professors make this fallacy all the time.

Let’s go back to the first example and take a closer look. Oil prices plunged, and oil consumption fell too. So low oil prices may also reduce oil consumption. How? Draw a supply and demand curve. What happens if the demand curve shifts to the left? When the price falls(if we only know that), there is the same chance that the quantity will increase or decrease.

Scott Sumner makes the same point in one of his posts: 

I often ask the following question to upper level econ or MBA students who have already taken principles:

Question: A survey shows that on average 100 people go to the movies when the price is $6 and 300 people go when the price is $9. Does this violate the laws of supply and demand?

Very, very few can answer this question, especially if you ask for an explanation. Even worse, I think there is a perception that there is something ‘tricky’ about this question, something unfair. In fact, it is as easy a question as you could imagine. It’s basic S&D. It’s merely asking students what happens when the demand for movies shifts. I cannot imagine a less tricky question, or a more straightforward application of the laws of supply and demand. In the evening hours the demand for movies shifts right. Price rises. Quantity supplied responds. What’s so hard about that? And yet almost no student can get it right. Our students enter EC101 knowing one of the two things they need to know about S&D, and they leave knowing one of the two things they need to know about S&D. Maybe instead of having them memorize mind-numbing lists of “5 factors that shift supply,” and “5 factors that shift demand,” we should just tell them to read something that will explain what economics is all about, something that portrays economists as detectives trying to solve the identification problem, something like Freakonomics.

If there are any other economics instructors out there I’d like to know what you think. I really don’t think we need to teach students what happens when frost hits the Florida orange crop. Perhaps we should just put supply and demand into an appendix and tell them to study it if they need to. Instead devote 100% of chapter 4 to the identification problem. Leave all the technical stuff for students majoring in economics to take in their intermediate level courses. Or maybe the identification problem is too hard, and we should simply forget about teaching supply and demand. Devote the whole course to opportunity costs, incentives, marginal analysis, etc.”

Read the whole thing, then tell me supply and demand is not complex than what’s taught in college.

2. I don’t favor the IS-LM. It’s not because I don’t understand the technical mechanism of the IS-LM model. I will not argue that the IS-LM is “theoretically or technically” flawed. Instead, I don’t think that the reasoning economists have made from the IS-LM is correct. In other words, I think the IS-LM will cause economists to misinterpret certain situations. That’s why I almost always use AS-AD instead of the IS-LM(more precisely, I prefer using several models with a partial equilibrium perspective). First, I’ll start by saying that the IS-LM is a useful and well-working model for periods like the Great Moderation. But I believe this is due to a different reason than many people think(Taylor Rule).

I think the problem with IS-LM is that most people(even most economists) seem to think they can tell the stance of monetary policy and/or changes in monetary policy by looking at changes in short-term nominal interest rates. In contrast, short-term rates are only a variable that accompanies changes in the money supply relative to the demand for money. Therefore, changes in AD are driven by expectations for future changes in NGDP.

My problem with IS-LM is that while it may seem like a useful model for periods like the Great Moderation, it doesn’t work well during periods of high inflation, when inflation expectations change rapidly. Likewise, it does not seem to be a useful model in periods such as the Great Depression and the Great Recession, where expectations fall too fast. According to economists’ interpretations of the Great Depression using the IS-LM, monetary policy was supposed to be expansionary. Likewise, in 2008, many economists said that monetary policy was expansionary after looking at interest rates and the IS-LM. But it wasn’t. Hence the IS-LM can be useful when everything is stable, but otherwise it’s not a useful model. But why would we use IS-LM in our analysis if it is a model that is only useful in stable periods? I am not in favor of using a model that can mislead economists at critical times like 1929 and 2008.

One might argue that “the problem is not with IS-LM, but with economists misusing the model,” but I’m not making a technical objection to IS-LM anyway. Even if the IS-LM is technically a perfect model, it seems clear that economists were misinterpreting something in 2007. As I said above on supply and demand, low rates could result from a shift in the IS curve, but it’s clear that most economists didn’t think so in 2007 because they thought low rates implied expansionary monetary policy. That’s why I prefer a simple AS/AD model, where output can change depending on supply and demand shocks. And AD is equal to NGDP (determined by monetary policy), which is why I argued earlier that the concept should be called “nominal expenditure(s),” not AD. I think this model is more useful than the IS-LM model.

3. I don’t think corporate tax cuts benefit only the rich. On the contrary, it benefits everyone. Likewise, I think capital gains tax is meaningless. Wage taxes, in principle, tax current and future consumption at the same rate. On the other hand, a capital gains tax taxes future consumption at a higher rate than current consumption. What principle suggests that something like this would make sense? The new proposal will raise the rate above 50%. The highest rate in the world is 30% (Sweden), which is close to the current US top rate.

To be honest, I’d prefer to repeal income tax for both individuals and corporations(and inheritance tax) and replace it with a consumption tax. Then a VAT where the poor pay 0% would be ideal. Likewise, I’d prefer a progressive payroll tax. And a progressive property tax. And, of course, the carbon tax.

This tax system would be more efficient without requiring the high rates we have now. Perhaps one could argue that the consumption tax will be regressive, but that’s not true:

Consumption tax is almost all about being consistent over time. We can have a tax system that is more progressive but simple, useful, and efficient.

4. One of the reasons I prefer the term “nominal expenditure(s)” is because it refers to a specific amount. That’s why I think AD is actually something different from “demand.” For the same reason, I think using different models for business cycles will give more precise results. I prefer to use one model for nominal shocks and a separate model for everything else (real shocks). The second includes the natural rate of unemployment, technology shocks, taxes, etc. It will help to explain the changing factors. These are especially important when prices are flexible.

But the sticky wages/prices problem makes it impossible to explain business cycles by using only real shocks. Indeed this problem is very different from the rest of economics(which is why I think DSGE models are unreliable). The model I would prefer to use for nominal shocks would focus on explaining changes in nominal aggregates. That’s a model that focuses on employment fluctuations attributed to price and wage stickiness. The “optimal level” will vary depending on the type of wage stickiness, requiring us to define nominal shocks in terms of wage stickiness. This is why nominal expenditures are more useful than “AD”: when we talk about nominal shocks, we will ultimately focus on wage stickiness. Instead, many macro models focus on variables that do not affect the nominal optimal level.

Sticky prices, nominal shocks, and the optimal level are key variables in explaining business cycles. So when I saw Sumner’s model for a few days ago, I thought it was pretty close to the model I’ve been considering for a few years. It’s not exactly the same, but it almost is:

 When I used to teach macro, students had all kinds of trouble understanding AS/AD, partly because they assumed it was basically a supply and demand model.  Thus if I asked them to show the effect of population growth, they might shift the AD curve to the right.  In fact, population growth shifts the AS curve to the right, causing deflation (as we saw during 1870-95).

Why were students confused?  Probably because in microeconomics an increase in population really does shift demand to the right.  More consumers out shopping, etc., etc.  But aggregate demand isn’t really about demand at all; it’s about money.  More specifically, it’s about the medium of account.  In the late 1800s, gold was the medium of account, the thing in terms of which prices were measured.  Population growth didn’t cause more gold to circulate.

By removing the terms ‘demand’ and ‘supply’ from the AS/AD model, I hope to shake students out of their complacency, to show them how truly strange this model actually is.  It’s not a supply and demand model at all; it’s a model of how nominal shocks interact with sticky wages and prices to produce short run (but not long run) effects on real output.

P.S: Bill Wirtz has a new piece on global minimum corporate tax:

The conversation about global tax rules is tiresome because they deal in the age-old erroneous belief that companies actually pay taxes. Again, only three actors in a company can pay taxes: shareholders through reduced dividends, workers through receiving lower salaries, or consumers through paying higher prices. Nobody else can pay the tax; the building cannot, the carpets cannot. The fallacy of the corporate tax is, in its fundamental essence, not just that the negotiations between countries lead nowhere, but that the tax in itself is just another tax on consumers.