ISI Faculty Resource Center

At the recent meetings of the American Economic Association four famous economists addressed the topic of whether and how the financial crisis should change the way we teach.  Some dilemmas and pedagogical choices are unchanged by the crisis: Should we emphasize business cycles or economic growth?  Should the basic model be “Keynesian” or should it start from the frictionless baseline?  If anything, the crisis seems to have resurrected interest in short-run fluctuations and in Keynes . . . and in criticisms of Keynes.

Where the standard presentation of introductory macroeconomics fails students most is in its treatment of finance.  I know this will come as a shock to those who believe that economics is about money and money-getting, but the enormous majority of economists (and of economics courses) ignore entirely the financial sector (banks, stock prices, the Dow Jones, can you balance my checkbook).  In part, this is because finance is terribly complicated, once you get past the first couple of concepts. 

A more important reason is that, if one starts from the frictionless baseline, finance is irrelevant.  Banks work perfectly and financial crises can’t exist.  If oranges and orthopedic doctors are allocated perfectly efficiently in the deus ex machina of frictionless markets, introducing financial intermediaries is at best a distraction and at worst an ideological ploy to introduce government regulators or epistemological questions about the unknowability of the future and the uncertainty of promises.

Still, we cannot explain October 2008 (and our students’ current dismal employment prospects) without holding our noses and allowing for a little complexity.  Einstein is cited in this context: if  everything should be made as simple as possible, but no simpler, we have to look for two or three concepts that we can introduce to our students in ways they will enjoy and understand.

Here follow three suggestions for concepts that must be added to the standard presentation of a Principles of Macroeconomics course.  The focus is on the inexperienced student who will probably not go on in the economics major.

The first obvious addition we must make is the concept of risk premia: lenders will charge different interest rates to borrowers of different riskiness.  Sure, we don’t want to try to model five hundred interest rates (prime, mortgage, commercial, credit card, etc.); but we can at least make a distinction between safe and risky borrowers and safe and risky rates.  Students may very well be familiar with the concept of a FICO credit score.

The second obvious addition is the concept of leverage.  It can be illustrated with a very simple numerical example (I used one here).  Borrowing to buy stocks (or houses) multiplies your earnings on the way up, but it also multiplies your losses on the way down.

The third simple addition is the (hotly debated) topic of whether monetary policymakers should be concerned with financial stability (perhaps in addition to, perhaps as a direct corollary of, its concern with price and output stability).  Should banks/bankers/depositors/customers be rescued if the financial system collapses?  What are ways of doing so that avoid moral hazard?

Discussing these topics will make an already-packed course even fuller, but it will help students to understand what happened in 2008, or at least begin to understand the concepts in play.

Tags: Economics, Education, Economic thought, Public Policy, Fiscal Policy, US Federal Reserve