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Most of us macro teachers work with some sort of new Keynesian model. This is roughly the AS/AD model, with an upward sloping SRAS curve.

We teach the model by repeatedly lying to our students. I’ll give a couple examples:

1. We argue that the Keynesian model superseded a “classical model” that had a vertical AS curve, and assumed flexible wages and prices. In fact, no such classical model existed prior to 1975. Instead, the old Keynesian model replaced something closer to the modern new Keynesian model. The model of Fisher/Hawtrey/Cassel and many other interwar economists featured sticky prices, short-run non-neutrality of money, and a self-correcting mechanism that brought us back to the natural rate on the long run. In Fisher’s case there was even a Phillips Curve.

The textbook story is a good pedagogical device. But it’s not true. It’s not even close to being true.

2. We explain that inflation can be produced by fiscal stimulus, supply shocks, and/or monetary stimulus. Then we talk about the Great Inflation mostly by referring to two shocks. The first was the huge fiscal stimulus of the 1960s, when LBJ ran up huge deficits to finance the Vietnam War and the Great Society without raising taxes. Except that this never happened. Then in the 1970s OPEC jacked up oil prices twice, and this caused the high inflation of the 1970s and early 1980s as the SRAS curve shifted to the left. Another lie, as SRAS was shifting to the right during the 1970s. The folly of the oil shock theory was illustrated in the 2000s when oil soared from $20 to $147, and core inflation barely budged. People were actually surprised by that fact!

If oil shocks are going to raise inflation, they should lower RGDP. Yet even during the worst of the oil shock period (mid-1973 to mid-1981) RGDP rose by 2.6% per annum. So the inflation was almost all monetary, even if you generously assume RGDP growth would have been 3.6% in the absence of the oil shocks. In fact, growth slowed sharply after 1973 for reasons mostly unrelated to oil; the rapid improvement in products like jet airliners and home appliances came to a screeching halt. We shifted toward a slower growing service economy. We couldn’t even average 3.6% growth in the 1990s, when oil got cheap and the computer revolution took off.

Are these lies justified? It’s nice to give students some real world examples of fiscal shocks and supply shocks. But what if the message they take from this exercise is that monetary explanations of inflation and NGDP determination are “just a theory,” just as evolution or global warming are “just a theory.” What if the public doesn’t realize that the Fed drives the nominal economy? Might that lead to less effective public policies? Might that have contributed in some small way to the fiasco of 2008?

I think our students can handle the truth. Why don’t we stop lying?”

PS. If you are wondering why the LBJ story is a lie, recall that the huge budget deficits began under Reagan, and were associated with a big fall in inflation.

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This entry was posted on February 23rd, 2013 and is filed under Misc., Monetary History, Monetary Policy. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



