The world's three smallest macro models
By Scott Sumner
In a comment over at TheMoneyIllusion, Britonomist pleaded for a transmission mechanism:
I’m sympathetic to market-monetarists, I’d love to be able to believe that problems like low aggregate demand can easily be solved using monetary policy alone even at the ZLB, rather than having to rely on politicians to enact policy to drive growth.
But when I see so many other economists and experts in finance point out again and again the unreality of assumptions used in many monetarist models, the extreme importance of banking and bank money & how banking is absolutely central to determining the broad money supply – I have absolutely nothing to counter them. I can mention vague ideas about alternative ways to boost broad money via portfolio-re-balancing, they can counter with all kinds of technical discussion to show this would never be enough, and because I’ve still yet to see a tractable model of the actual transmission from market monetarists, I’m completely unable to make a case for MM. If I at least had an explicit model of the transmission mechanism (taking actual economic reality into account, rather than just assuming the monetary policy = giving everyone more M directly) I could vouch for you guys properly, which is why I keep asking for one here.
What is wrong with this model? Don’t get me started … but actually there are three main objections that macroeconomists are likely to raise:
1. What happened to the interest rate? For most purposes we will want at the minimum a theory of employment, interest, and money; that means a model with bonds as well as money and goods, which means IS-LM. (See my note “There’s something about macro”).
2. More fundamentally, the quasi-static approach here is at best a crude approximation to a dynamic model in which behavior results from plans that are based on expectations about the future.
3. Finally, the output effects of money come from the assumption of price rigidity. Where does that come from? (Overwhelming empirical evidence, that’s where – but why?).
All these objections help to set the agenda for the last six decades of research.
But if you are one of those people to whom macroeconomics always sounds like witchcraft, who is hung up on Say’s Law, who cannot even comprehend how a shortfall of aggregate demand is possible – then the world’s smallest macro model is a good place to start on the road to enlightenment.
Meanwhile, Nick provided an even smaller model. Nick also discussed the absence of a financial sector in his model:
It’s got nothing to do with “too much saving”. There is no saving in this model. It’s a one-period model, dammit. Everything gets consumed during the period, then they die and time ends.
It’s got nothing to do with the real interest rate being wrong. There is no interest rate in this model. It’s a one-period model, dammit.
Yes, the essence of the business cycle is monetary shocks and sticky prices. Here’s a third “model”, also lacking interest rates: The Fed determines the value of base money by adjusting its quantity. Shocks to the value of base money change all nominal aggregates in the economy, since money is the medium of account. The explanation? Supply and demand. And once you change nominal total labor compensation, hours worked will change if nominal hourly wages are sticky. And when hours worked changes, output changes. That’s it, monetary shocks and sticky wages. No need to bring in the financial sector.
If you want to add the financial sector, that’s fine. But it won’t help you understand 2008-09. The Fed caused NGDP and nominal total labor compensation to fall about 8% below trend, nominal wages were sticky, and hours worked fell about 8% below trend.
That’s all. Everything else is a footnote.