How to Teach Macroeconomics After the Great Recession, Explains Olivier Blanchard

“Where is the General Theory of the 21st Century?” is an interview series in which we ask top economists a very important question: “Why haven’t economists come up with a new General Theory after the Great Recession?” We want to know how macroeconomic academia has evolved since the Great Recession, and why the responses from macroeconomists since 2008 are different from their counterparts in the 1930s.

In this interview, we talked to Olivier Blanchard, the C. Fred Bergsten Senior Fellow of the Peterson Institute for International Economics and formerly the economic counselor and director of the Research Department at the International Monetary Fund.

Blanchard further explains the role of empirical research on DSGE models, how to teach undergraduates macro after the Great Recession, and his research on hysteresis.

This is Part II of our conversation with Olivier Blanchard. In Part I, Blanchard discussed his view on the role of DSGE models in modern Macroeconomics and policymaking.

Q: EconReporter
B: Olivier Blanchard

The interview has been edited for length and clarity. All mistakes are ours.

More Empirical Integrations Into DSGE?

Q: What is the role of empirical work in the development of DSGE models? Is it possible to have a bigger role for empirical models to be in the DSGE model?

B: The current approach is to use calibration rather than estimation for most of the coefficients. Then we do Bayesian estimation to estimate the remaining parameters and the system as a whole.

I think the evidence from the vast body of econometric work should be used much more. For example, in order to specify the consumption function, we should do it by using all kinds of information—single equation estimation, natural experiments, case studies, or anything else. Then, use all these pieces to characterize a consumption function which can then be put in the DSGE model.

Once this is done, we want to make sure that the DSGE replicates the VAR representation of the data. If the dynamics of the DSGE are close to those of the VAR, the job is done.

If not, one has to go back to the drawing board and see why the DSGE model is not replicating the VAR dynamics.

But this is a completely different exercise, which involves building on the work of hundreds of people who do partial equilibrium estimation.
This is not done at this point and DSGEs are largely operating within an intellectual silo with less than enough interaction with the rest of the empirical work going on in macro.

Q: Is the way to build a model which you have just mentioned too ideal to be possible?
Or is it just macroeconomists not working fast enough to make significant progress in macroeconomics?

B: I think there is a lot of progress. If, say, we look at the NBER working papers, there are five or six macroeconomics papers coming out every week and they are all extremely interesting.

What happens is that this new research has not been fed into the DSGE models. The DSGE models live in their own universe. They do not build on the very good works that are happening in macroeconomics in the recent years. 

So, it is not that we don’t have enough good research. It is that there are not enough coordination and integration of the results.

Q: Are there any other ways to speed up the progress in coordinating and integrating the research? Maybe the IMF Annual Research Conference “Macroeconomics after the Great Recession” you co-hosted this year is one of those efforts to further the coordination?

B: Yes. There is another project by David Vines, professor at Oxford University.

He—together with other researchers—is trying to build an alternative DSGE. It will be microfounded, but will also be based on more realistic consumption functions, investment behavior, asset demand. It is building on the works that are done by others. And there are other projects at work also. I hope some of them will be successful.

‘I Would Use This Model to Explain Macroeconomics to My Mum’

Q: In another one of your notes, “How to teach intermediate Macro after the crisis”, you have mentioned an IS-LM-Phillips Curve model. Is this a kind of toy model you have just mentioned? Are you confident that more students will learn about this?

B: Actually, I have done just that in my own textbook. If I have to teach undergraduate students, I don’t want to teach them 200 models, right?

The students are not ready to use Matlab or any complicated programming, so we cannot teach the DSGEs yet. We must teach them with the toy models.

If I have to teach undergrads or to explain something to my mother or to my friends, I think using an ISLM with two interest rates plus a Phillips Curve is the best way to talk about most of the issues that are relevant today.

Q: Actually, I am a student of the 5th edition of your textbook “Macroeconomics”, and I have to say after reading your notes, I sensed that the new editions are vastly different from the old ones.

B: Yes, it’s different. As you may know, the 5th edition was published before the crisis and the 7th edition is published this year, so there are several major changes.

The first change is that I have introduced a financial sector in the basic model. Traditionally, the ISLM only has one interest rate, which is the rate set by the central bank. It is the same rate in the LM and the IS curve. That’s clearly not right.

A lot of what happened in the financial crisis is that even if the central bank lowered the policy rate, the rate relevant to investment decisions turned out to be a very different and much higher rate.

So, I think it is very important to have two rates, one determined by the central bank, and another which is relevant for people and firms when they borrow. This is a way to introduce the financial system.

If the financial system is in good shape, the two rates tend to be close; if it is not, the two rates can be quite different.

The second change is in the LM curve. The old LM curve was derived on the assumption that the central bank chooses the money supply, and then the interest rate is determined by the market.

It is clearly not true. Nowadays, the central banks choose the rate. So, that’s how we should think about the LM curve, which is at the rate chosen by the central bank.

The third change is that I have given up on Aggregate Supply and Demand model (ASAD). It is because ASAD was quite complicated. It is not great from the point of view of being a toy model. 

Also, ASAD is misleading as it has the very strong message that even if no economic policy is implemented, the economy will return to the equilibrium all by itself.

As I have written in the 5th edition, if there was an adverse shock in the ASAD model, the price level would decrease, then real money supply would increase, this lowered the interest rate, which would have pushed the economy right back to its potential output level.

This mechanism is more or less irrelevant now. Economies do not return to health all by themselves, central banks do not keep the nominal money supply constant.

The figure is an illustration of a reversed example which starts with a positive shock to demand. The figure is from “Macroeconomics: A European perspective” by Olivier Blanchard, Alessia Amighini, Francesco Giavazzi.

So I gave up on AS. Instead, I use the Phillips Curve as a description of the supply side. It gives a much more realistic description of what happens.

What Does Blanchard Think About FTPL?

Q: In my previous interview, John Cochrane mentioned that he thought that the Fiscal Theory of the Price Level (FTPL) may be the missing link in the New Keynesian model. What do you think about the FTPL’s prospects of being incorporated into mainstream models?

B: I don’t believe it. It would take a long time to explain, but I don’t find FTPL to be an attractive theory of determination of the price level.

I believe however that the issue of the fiscal dominance of monetary policy is an important one. There are many countries where fiscal policy determines monetary policy. If the ministry of finance is very powerful, it can force the central bank to monetize their bonds. But this is a very different story from John’s fiscal theory of the price level.

Hysteresis and Where to Find It

Q: Federal Reserve Chair Janet Yellen, in her recent speech “Macroeconomic Research After the Crisis”, suggested four research topics macro researchers should work on. One of them—the problem of hysteresis—is a research topic you have been working on in recent years.
Are there any more things which macroeconomists can do on this topic? Will there be a chance that economists will accept this as a “fact” soon?

Explainer—What is Hysteresis?

Hysteresis refers to the hypothesis that recessions may have permanent effects on the level of output relative to trend.

In a recent paper  “Inflation and Activity – Two Explorations and their Monetary Policy Implications”, Blanchard, Larry Summers and Eugenio Cerutti presented a strong case for the existence of hysteresis. Based on the data from 1960 for 23 advanced economies, the authors found that two-thirds of the recessions in the dataset are followed by lower output relative to the pre-recession trend, and almost one-half of those are followed not only by lower output but also by lower output growth relative to the pre-recession trend. The authors suggested this result could have important implications for monetary policy.

In her speech “Macroeconomic Research After the Crisis”, Janet Yellen said that if we assume that hysteresis is, in fact, present, it may imply there are possibilities that policymakers can temporarily run a “high-pressure economy” to reverse the adverse supply-side effects caused by hysteresis. 

For example, Yellen postulated that running a “high-pressure economy” may result in a tight labor market and draw potential workers who would otherwise sit on the sidelines into the labor force, and lead to a more efficient job market.

B: For the moment, it is just a hypothesis. Therefore, I think the way policymakers should deal with it is to assume it’s true, say, with a probability of 20%, but not with 100% probability, and then decide what should the policy be. For the moment, that’s what they should do.

In terms of academic research, I am actually doing more research on this topic. I think when we look at topics like this, we should look at the micro evidence.

There are interesting works on how, for example, long-term unemployed people drop out of the labor force. There is also some very interesting research on what happens to research and development during the recessions. But I don’t think we will ever be sure.

I hope that I can convince a few more people that it is important. Maybe, I can get the 20% to become 50%, in a few years’ time.

Q: Why are economists so hard to convince that there is hysteresis? I think it is very intuitive to laymen to believe that unemployment has long-term effects on the economy.

B: Let’s say, for example, people commit suicide as the result of being unemployed, that’s hysteresis, right? We know in fact some people commit suicide, so it clearly is the case, right?

But the important question for macroeconomists is how quantitatively important that is. One suicide is one big individual tragedy. Yet if it is just one, it doesn’t matter from the macroeconomics point of view, right?

So, the important thing is to show how big the effect is. How reliable is it? What type is it? Is it the case that they only exist in recessions? Or they also exist in booms? Is it asymmetrical? All these are the things that we don’t know.