How Do We Fix Econ 102?

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One objective of these weekly newsletters is to demonstrate how useful price theory can be in explaining what we observe in the world. Ideally, someone with no background or formal education in economics can subscribe to the newsletter and gain insight into current events or learn how price theory might help us answer general questions, such as why women’s clothes tend to cost more than men’s. It is also our hope that some of our posts might find their way into classrooms as supplemental reading. Judging by some of our statistics about incoming traffic, we seem to have had some success in that regard.

But the newsletter is also helpful to me as a teacher. Writing the newsletter helps me to think about how I want to teach particular material. The newsletter also provides a venue for us to write about how one might improve teaching using a price theoretic approach. Brian and I have each written in the past about the shortcomings of Econ 101 (see here and here, for example). Although we’ve spent considerable time discussing what is wrong with Econ 101 and how to improve it, there is arguably a bigger problem with what we might call Econ 102, or the introductory course in macroeconomics. What this course needs is more price theoretic foundations.

What is Wrong with Econ 102?

I often see academics lament the fact that Econ 101 lacks any sort of reference to state-of-the-art research. These academics often argue that we, as economists, owe it to our students to recreate the course to reflect things that we have learned and are learning at the frontier of economic research. In reality, however, this is easier said than done. Anyone teaching an introductory course knows that the vast majority of students have never even seen supply and demand. How can you teach them the state-of-the-art stuff when they don’t know the basics? The answer is often that you simply cannot do it. However, I would argue that a better answer is that you should not even try it. In my opinion, it is much better to really emphasize the basics of price theory so that students have a firm foundation upon which to build their knowledge.

As a result of this position, people often ask if I’m being hypocritical when I critique Econ 102 as being completely detached from modern macroeconomics. This question, however, misunderstands my critique.

Most Econ 102 textbooks are awful, but often in their own unique way. Some of these textbooks are entirely centered around an Old Keynesian-style national income approach to macroeconomics. In these books, the focus is mostly on aggregate accounting identities. Developing an understanding of these identities is important. It is important to understand that gross domestic product (GDP) can be calculated as the sum of four components of spending in the economy (consumption, investment, government purchases, and net exports). It is important to understand how to calculate national savings and the balance of payments. Unfortunately, however, this approach to macroeconomics often leads students to reason from accounting identities, which one should never do. This accounting approach often gives students the impression that one can assign causation to individual components of the accounting identity. Students are led to make errors like claiming that policymakers can increase GDP by increasing government purchases or reducing the trade deficit. In reality, consumption, investment, government purchases, and net exports are jointly-determined equilibrium outcomes based on relative prices. Policies designed to boost government purchases or net exports will therefore have an effect on the consumption and investment components, which potentially limits any predictive power from the accounting identity.

Modern introductory macroeconomics textbooks also tend to be a random mix of topics that are not always consistent with one another. It is not uncommon to find a chapter on money and inflation that discusses the Quantity Theory of Money followed by a chapter on business cycles that suggests that inflation is caused by output or employment gaps. There is no doubt that some New Keynesians and some Old Monetarists might be able to thread that needle, but they are unlikely to do so in the same way and this juxtaposition is often confusing for students.

Introductory macroeconomics has also failed to do a good job incorporating insights from modern macroeconomics. Some people misunderstand me when I make this point. This is not the claim that the introductory courses need to incorporate state-of-the-art insights. Instead, what I am arguing is that introductory macro has failed to adequately incorporate the role of microeconomic decision-making and the role of expectations in any serious way. To the extent that these things are incorporated, they are done with what might be described as hand-waving.

How To Fix Econ 102

It should come as no surprise to anyone who has read this newsletter that I think the way to improve Econ 102 is to incorporate more price theoretic foundations. Although that terminology should be no surprise to regular readers of the newsletter, the careful reader will note that I am making a distinction between price theoretic foundations and microeconomic foundations.

The reason that I am distinguishing between microeconomic foundations and price theoretic foundations of macroeconomics is that microeconomic foundations have turned out to be a mixed bag. The entire New Keynesian paradigm in macroeconomics seems like a way to simply reverse engineer some things that certain people believed to be true or useful. This model has microeconomic foundations in the sense that it has optimizing agents making economic decisions. However, the model is riddled with ad hoc assumptions that render the microeconomic decision-making relatively banal.

Microeconomic foundations are done well when they take seriously particular constraints and information and knowledge problems. In short, microeconomic foundations are done well when they are price theoretic foundations.

Thus, although the New Keynesian model is a workhorse of modern macroeconomics, I think it would be an error to try to make introductory macroeconomics just a graphical representation of New Keynesianism. Furthermore, doing so ignores the entire point of price theoretical foundations in the first place. Macroeconomic models should be consistent with microeconomic behavior. Otherwise, policy errors can potentially have disastrous consequences.

So what are we to do?

In recent years, I have been redesigning my introductory macroeconomics course to be based on price theoretic foundations. I generally start with simple two-period models of consumption, saving, and investment that I learned from Jack Hirshleifer’s Investment, Interest, and Capital. That book is written on a much higher level than an introductory course, but one can simplify the examples and provide proper price theoretic foundations for these types of decisions in ways that are easy for students to understand. In fact, I have written up my lecture notes in the style of a book that I provide to my students as a free .pdf so that they have something digestible for an introductory course. That foundation can then provide a proper jumping off point for other topics like economic growth and money.

When discussing money, I tend to spend a lot of time talking about why money exists, what emerges as money, and the price theoretic foundations of the quantity theory of money. We then spend time on the costs of inflation — not only the inflation tax, but other costs that I’ve previous written about (see here and here, for example).

I also talk about banking in ways that I have written about here at Economic Forces. Why do banks exist? What purpose do they serve? How can we understand fractional reserve banking? What are the incentives of banks and is there a role for policy?

This discussion of money and banking leads naturally into a discussion of central banks. What do central banks do? Where did they come from? Why do they exist? This is also an opportune time to bring in price theoretic concepts and discuss whether money is a natural monopoly.

This then leads into a discussion of monetary policy. What is monetary policy? How is it conducted? What is monetary policy trying to achieve? How do central bankers think about monetary policy and how do they communicate to the public? This allows me to talk about concepts like the Phillips Curve and the natural rate of unemployment.

Following this discussion of money, I conclude with a discussion of fiscal policy and government debt.

Throughout this entire process, there is an emphasis on price theory. The questions that are asked are macroeconomic questions. However, the answers that are provided are grounded in price theory.

I find that this approach has a lot to offer students. This approach helps students to learn how to think about these macroeconomic questions in a systematic way — and a way that is broadly consistent with their previous experience in microeconomics. It dispenses with reasoning from accounting identities and gives people a framework for thinking about the world when they are presented with bad arguments.

I would encourage others to do the same. Let’s have a price theoretic approach to Econ 102.