Making Macro Dynamic

On Monday I covered Chapter 8 of Cowen and Tabarrok, “Saving, Investment, and the Financial System,” which I used as a springboard for a lengthy discussion of the financial crisis of 2008.  The chapter has an able discussion of the suppy and demand for loanable funds and uses the analogy of financial institutions as a bridge between savers and the firms, entrepreneurs and households who borrow funds.  I’ve used this analogy myself in class for years.  It works fairly well, but it can leave one with the impression that the financial secure is inert, that getting things right in this sector is a matter of engineering — sort of like building a solid bridge for the interstate highway system.  As we all know, however, the financial sector is very dynamic — it seeks out opportunities rather than passively allowing traffic to flow from one side of the river to the other.  I’m especially fond of Figure 8.11, which shows the financial bridge broken by insecure property rights, politicized lending, government banks, interest rate controls, inflation and bank failures/panics.  The Figure might work even better if the green arrow showing the flow of money simply disappeared into the abyss, rather than reemerging into the accounts of firms, entrepreneurs and household on the other side.

Yesterday I began Chapter 12, “Business Fluctuations and the Dynamic Aggregate Demand-Aggregate Supply Model.”  Teaching this chapter has been challenging because up to this point I’ve taught only the more static version of the AD-AS Model.  I’m used to a graph with the price index on the vertical axis, real GDP on the horizontal axis and AD, SRAS, and LRAS curves interacting.  This approach illuminates a lot but it has a major shortcoming.  Acknowledging that the long-run aggregate supply curve keeps shifting out over time and drawing in multiple LRAS curves makes the graph very busy and risks getting students lost.  Instead, the convenient convention is to freeze the LRAS in place and discuss how AD and SRAS dance around it — but occasionally reminding the audience (and yourself) that the LRAS curve is, indeed, chugging outward.  C & T’s alternative approach is to look only at changes in aggregate supply and demand.  The inflation rate goes on the vertical axis and the real GDP growth rate goes on the horizontal axis.  They integrate two earlier chapters seemlessly in explaining that the long-run growth curve is determined by the Solow growth rate (from Chapter 7), while linking changes in aggregate demand to the quantity theory of money (from Chapter 11).   Next they show how both the Real Business Cycle Model and the New Keynesian Model behave within this framework.  Bravo!   I got about halfway through the chapter yesterday and — from the looks on their faces, questions they asked and responses to my questions — my students seem to have a pretty clear grasp.  Friday’s quiz will tell me if this reading is correct.