+3 votes
asked ago in General Economics Questions by (1.8k points)
I am keenly aware that since, say, 1997 one disagrees with Paul Krugman at one's grave intellectual peril...


I am not as confident as Paul Krugman is that "the past decade has been a huge validation for textbook macroeconomics", and am somewhat puzzled at his insistence that it has been. After all, a large component of what Krugman calls "good old-fashioned macro" was that expectations were, if not rational, adaptive.Thus John Maynard Keynes's <https://www.marxists.org/reference/subject/economics/keynes/general-theory/ch12.htm> "speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done..." had no place in "old-fashioned macro". And it is not as though this was a flaw and could be quickly, coherently, and satisfactorily patched.

The integration of behavioral finance and macro is still not done—which is why I am such a booster <https://www.project-syndicate.org/commentary/crisis-of-beliefs-and-the-2008-crash-by-j--bradford-delong-2018-10> of **Nicola Gennaioli and Andrei Shleifer** (2018): _A Crisis of Beliefs: Investor Psychology and Financial Fragility_ <https://books.google.com/books?isbn=0691184925>. (That, and Andrei is my friend.) They are at least looking in the right direction.

Cf.: **Paul Krugman**: _What Do We Actually Know About the Economy?_ <https://www.nytimes.com/2018/09/16/opinion/what-do-we-actually-know-about-the-economy-wonkish.html>: "n an important sense the past decade has been a huge validation for textbook macroeconomics.... IS-LM... is the simplest model you can write down of how interest rates and output are jointly determined, and is how most practicing macroeconomists actually think about short-run economic fluctuations.... The overall story... is one of overwhelming predictive success. Basic, old-fashioned macroeconomics didn’t fail in the crisis–it worked extremely well.... But, you say, we didn’t see the Great Recession coming.... That’s... a problem with financial economics.... Where are the examples of microeconomic theory providing strong, counterintuitive, successful predictions on the same order as the success of IS-LM macroeconomics after 2008?..."
commented ago by (250 points)
edited ago by
Although I generally hesitate to put much stock in IS-LM dynamics, as it's fudamentally a static model, I think with very little modification it does a reasonably good job of capturing mechanisms relevant to policy. The IS curve and Taylor rules are pretty well understood relationships, for instance. I also can't think of a better way to introduce the concept of general equilibrium to undergrads, which may just be a failure of imagination on my part. That being said, the most blatant deviation from IS-LM I can see is the missing deflation issue. A textbook IS-LM model with a ZLB produces an upward-sloping region of the AD curve which can result in a death spiral of deflation and unemployment. That thankfully didn't materialize, even in Europe.

Research that aims to capture the spirit of IS-LM, including the litany of OLG papers by Gauti Eggertsson, are dynamic models that AFAIK don't fix the inflation problem. The best attempt I've seen to capture sticky inflation in these sorts of models is in the Ravn and Sterk HANK+DMP model (which seems to be going nowhere in publication?) which allows for ZLB and non-ZLB recessions with limited or no deflation due to reduction of the real interest rate arising from precautionary saving. I'm of a mixed opinion on whether that channel would be empirically large enough or of the proper sign in a deep recession.

1 Answer

+1 vote
answered ago by (610 points)
This seems like more of a comment than a question :-)

In any case, I agree that the "integration of behavioral finance and macro is still not done". That's not my area at all, but sounds like a fascinating intersection for future research.
commented ago by (1.8k points)

But there is no "more a comment than a question" button on this site...