Download Modern Principles, Macroeconomics

FAQ: Cowen/Tabarrok -- Modern Principles: Macroeconomics: The Macro
Model
1) Most textbooks teach a New Keynesian approach to business fluctuations, a few teach a real
business cycle approach. Modern Principles covers both of these approaches. Why?
We offer a balanced approach to New Keynesian and RBC theories of business fluctuations because we
think that economies are subject to both aggregate demand shocks and to real shocks. It's not a case of
one or the other. Indeed, for the student of Modern Principles there really aren't two models but rather
a single, unified model, the dynamic AD-AS model. The dynamic AD-AS model is used to analyze
aggregate demand shocks and real shocks. (The idea of two models is more explanatory for the
instructor who is used to thinking of things in this way than it is for the student, who does not approach
the material with prejudgment.)
Aggregate demand shocks are analyzed with shifts in the aggregate demand curve. Real shocks are
analyzed with shifts in the Solow growth curve. The basics are that simple but once the basics are
mastered it's easy to analyze different combinations of aggregate demand shocks and real shocks, real
shocks that create aggregate demand shocks, aggregate demand shocks that create real shocks, and so
forth.
2) Does an analysis of real shocks add to an analysis of aggregate demand shocks?
Absolutely. In our view, a key problem with many textbooks is that they make fiscal and monetary
policy look too easy. In the standard P,Y model the economy can always be restored to full employment
by shifting the right curves. If only this were true! Not only are there lags and uncertainties, as some
textbooks discuss, but in some cases there is no way for either fiscal or monetary policy to return
growth to its normal level. Few people think that fiscal or monetary policy could much increase the long
run growth rate so why are so many people certain that fiscal and monetary policy can increase the
short run growth rate? After all, the long run rate is nothing more than a succession of short run rates!
In other words, sometimes the economy is dealt a bad hand and neither fiscal nor monetary policy can
turn a bad hand into a straight flush.
Of course, sometimes monetary and fiscal policy can work! Only Modern Principles provides a balanced
discussion of both of these cases.
3) Why do you model business fluctuations in inflation, growth-rate space rather than in P, Y space?
Working in inflation, growth-rate space has a number of advantages. First, by keeping the focus on
growth rates, Modern Principles unifies growth theory and business fluctuations. Long run growth rates
are explained with growth theory and short run fluctuations in the growth rate are explained with
dynamic AD-AS. Thus, there is no more switching between growth rates and GDP levels! Students see
that growth theory and business fluctuations are closely related enterprises and not disjoint fields of
thought.
It also makes sense to work in inflation rates. Again, this creates unification across chapters. Every
principles text has a chapter on inflation but when it comes to business fluctuations many textbooks
abandon inflation to work in price levels. Inconsistency across chapters makes it more difficult for the
student to learn. Modern Principles builds on what students have already learned.
In addition, it's inflation rates and growth rates which are discussed in the media. Many students come
to class with an intuitive understanding of what an inflation rate is but how many students understand
the concept of a price level? Similarly, many students come to class with an intuitive understanding that
in a recession the growth rate turns negative but how many students know the approximate value of
U.S. GDP? In short, modeling business fluctuations in inflation, growth-rate space builds on what
students already know, creates consistency across chapters, and teaches macroeconomics as a unified
whole.
4) How does the dynamic AD-AS compare with the P, Y model?
The dynamic AD-AS model in inflation, growth-rate space should quickly feel familiar to anyone who has
used the AD-AS model in P, Y space because the models are quite similar. Here are a few differences.
In the old principles, a shift in monetary policy is a one-time shift in the money supply. In the Modern
Principles a shift in monetary policy is a shift in the money growth rate. The latter seems a more natural
interpretation of monetary policy and is consistent, for example, with setting a lower interest rate for
several periods.
In terms of the diagram the analysis is very similar. In the figure below, we show the old principles on
the left and Modern Principles on the right. On the left an increase in M shifts the AD curve out and the
equilibrium moves from a to point b in the short run. In the long run, prices increase even further and
we return to the long-run potential output of 10 trillion at point c. Notice that in moving to the long-run
equilibrium the growth rate increases and then decreases and there is a temporary burst of inflation.
In the Modern Principles on the right, an increase in the growth rate of the money supply M shifts the
AD curve out and the equilibrium moves from a to point b in the short run. At point b the inflation rate
and the growth rate have increased. In the long run, the inflation rate increases even further and we
return to the potential growth rate or what we call the "Solow Growth Rate" of 3% at point c.
As noted, the old principles analyzes an increase in the money supply while Modern Principles analyzes a
shift in the growth rate of the money supply. Suppose we wanted to look at a one-time increase in the
money supply using the Modern Principles diagram. What would that look like? In Modern Principles
we could do that by shifting the AD curve out in the short run and then returning it to the same position
as it started in the long run (so we would have a burst of inflation but in the long run the inflation rate
would return to the same level). In fact, this is essentially the analysis that we use for a shift in fiscal
policy. Which brings us to our next question.
5) Why does the AD curve shift out and then back when analyzing fiscal policy?
In analyzing monetary policy it seems more natural to analyze a change in M , the money growth rate.
But for analyzing fiscal policy it seems more natural to analyze a one-time shift in the level of, say,
government purchases which means that the growth rate of v, v , increases temporarily. Thus, in the
case of fiscal policy the AD curve shifts out and then returns to its previous level. The easy way to
remember this is that in the long run inflation is a monetary phenomena so if M doesn't change then
inflation doesn't change either, in the long run.
Notice that the final results of a change in fiscal policy are the same as in the Y,P framework, only the
curve shift is slightly different. The following figure shows the old principles on the left and Modern
Principles on the right. In both cases, an increase in government purchases increases the growth rate in
the short run but in the old principles the emphasis is that the price level increases permanently. In
Modern Principles the emphasis is that the inflation rate returns to its normal level after a temporary
increase.
6) Why use arrows for growth rates?
We think that dots are hard to see and arrows are a more intuitive way for students to remember
growth rates.