Recently in Economics--Teaching Category

[The price of oil] has plummeted nearly 40% in just three months, from about $147 a barrel in July to below $83 on Friday, with no obvious bottom in sight. If that sounds good, you are probably a driver who winces these days at filling your gas tank. But the downward spiral could mean trouble for oil-rich countries and for the environment.

Of course I have tried to accomplish some things on my summer break as well. In addition to doing a little research, I sat down and knocked out another Mathematica demonstration. You can download it from the Wolfram demonstrations website.

This one was actually pretty easy to do. It's a neat way of looking at how the coefficients of the cubic total cost function affect the average and marginal cost curves. If you use it in class, let me know!

Gas prices are up. So is Amtrak ridership. (Macomb Journal)

If there is any good news about $4 per gallon gasoline, it is that ridership on Amtrak is booming.

...

Ridership on the Illinois Zephyr and Carl Sandburg routes was up 41.4 percent in fiscal 2007, compared to fiscal 2006. Ridership on Illinois state-subsidized routes increased another 180,823 passengers during the first two-thirds of fiscal year 2008, to a total of 670,605.

When I ride the Illinois Zephyr or the Carl Sandburg, it is typically packed. Last time I rode, there were just a handful of empty seats.

I enjoy riding the rails. It's faster than driving, and without the hassle of driving. We don't drive to Chicago anymore if we can avoid it. Take the train!

UPDATE: Stephen Karlson has much more.

And now for something completely different...

One type of post that gets people talking is when I discuss the teaching of economics. So a few posts back, I pointed out that the NY Times confused "demand" and "quantity demanded". The Times wrote:

An open letter signed recently by more than 100 economists said the proposed tax holiday would do little to reduce gas prices. In part, that is because a fall in prices would lead to more demand, which would cause prices to return to their earlier level. The result would be that overseas oil-producing governments would get money now flowing to the United States government in gas taxes.

And I said:

The whole sentence about demand is the sort of circular statement that we caution our students not to make but that newspapers print all the time. Not only is it a terrible misstatement of demand vs quantity demanded, it's not even consistent with the claim (advanced by Krugman among many) that supply is fixed.

John Whitehead pointed out something similar in another story. After taking a little heat in the comments, he links back to me approvingly.

Why the heat? Well, I have to admit that when an economics professor starts to pontificate on demand vs quantity demanded, it tends to border on the pedantic. I know it does. I can't stand it, but I do it anyway. Why? Because the misunderstanding often leads to circular reasoning as it did here. You argue that prices fall, which causes demand to rise, which causes prices to rise and you're back to where you started.

Every principles of economics textbook seems to have a homework question devoted to identifying and critiquing that sort of circular reasoning--often from a real-life example like this.

So we've got a a real problem with the terminology here. It's made worse by the fact that the principles textbook terminology has absolutely zero chance of catching on in the wider world. Face it, journalists are not going to use demand and quantity demanded correctly in an Econ 101 sense. Not going to happen. But we need to figure out how to educate them to avoid making hideous errors even if they don't use Econ 101 terms.

I have addressed this before.... Digging into the archives for Polley's greatest hits of November 2005:

Stephen Karlson (Cold Spring Shops) links to Phil Miller's (Market Power) post and mine on a common media mistake. Karlson adds this,

...the source of the confusion in many observers' minds might be in the terminology of introductory economics (and nowhere else in economics) itself.

Much of the discipline refers to the act of drawing a new demand or supply curve as a "change in demand (or supply)," sometimes calling that an "increase" or "decrease" in demand or supply. A new choice along the same demand or supply curve goes by the cumbersome locution "change in quantity demanded (or supplied.)" Bleah. I recommend the use of the term "shift" to describe the drawing of a new curve, and I'm continually reinforcing "left shift" and "right shift" as "increase" and "decrease" have the potential for mischief on the supply curve. A new choice along the same curve is a "movement along."

I agree. Bleah. He is absolutely right that this terminology is only an issue at the introductory level. Why, you ask? Long story. At more advanced levels, the mathematics forces you to keep track of what is going on without resorting to these labels. That's part of it. We (those of us who teach this) also just tend to obsess over making sure students shift the right curve. These labels, properly used, do force you to be clear about what you're doing. But I agree with Karlson that there has got to be a better way.

Unfortunately, "shift" is not likely to catch on with journalists either. That only makes sense if you're thinking of the curve, and most of their readers aren't thinking that way. So I'm still puzzling over this one. Your suggestions, and any discussion on the topic, are very welcome.

Anyway, back to the article at hand, it is true that the writer confuses demand and quantity demanded. But the greater sin is that the passage was not even consistent with the main critique of the tax holiday. And I don't think that these errors are unrelated. Sloppiness begets sloppiness. Once you introduce that circular logic, the next step is more likely to go off-track. If anything, that's why professors need to continue to instill some professional discipline in the use of language to describe supply and demand.

We just need to come up with something that resonates better with journalists.

I posted this as a comment at Angry Bear.

The real question is this: How much would gas prices need to fall in order to induce consumers to buy up whatever additional production would be optimally squeezed out of the refineries if the gas tax temporarily went away?

When you think about it that way for a little bit, it becomes easier to see that the answer is probably greater than zero, but not much.

Jabberwonk posts the open letter signed by a number of economists opposing the gas tax holiday. Here's the key paragraph.

There are several reasons for this opposition. First, research shows that waiving the gas tax would generate major profits for oil companies rather than significantly lowering prices for consumers. Second, it would encourage people to keep buying costly imported oil and do nothing to encourage conservation. Third, a tax holiday would provide very little relief to families feeling squeezed. Fourth, the gas tax suspension would threaten to increase the already record deficit in the coming year and reduce the amount of money going into the highway trust fund that maintains our infrastructure.

Read closely all of the reasons behind why so many economists oppose the gas tax holiday.

Now look at how the NY Times summarizes it.

An open letter signed recently by more than 100 economists said the proposed tax holiday would do little to reduce gas prices. In part, that is because a fall in prices would lead to more demand, which would cause prices to return to their earlier level. The result would be that overseas oil-producing governments would get money now flowing to the United States government in gas taxes.

The whole sentence about demand is the sort of circular statement that we caution our students not to make but that newspapers print all the time. Not only is it a terrible misstatement of demand vs quantity demanded, it's not even consistent with the claim (advanced by Krugman among many) that supply is fixed.

The Times' statement that oil producing countries would get some of the gain is only true insofar as gasoline production (and therefore oil consumption) would actually increase. As I have pointed out, that effect is likely to be small though positive. I wouldn't call it my main objection to the tax holiday. The open letter is careful to say that "it would encourage people to keep buying costly imported oil and do nothing to encourage conservation," in effect implying that it spending on oil could stay the same as the "fixed supply" adherents would suggest.

Students writing term papers often rephrase the words in an article that they cite, and occasionally the rephrasing ends up changing the economic meaning of the passage (sometimes with comic results). I see this all the time. If I had a nickel for every time I said to myself while grading, "That's not what that article really meant, was it?" I'd have a pretty big collection of nickels. Likewise when I read the Times article, I immediately said, "That can't be what was written in that open letter, can it? No economist would say it that way." Indeed, they did not.

I suppose the Times could say that the paragraph in question was not a summary of the letter but their own analysis. But that would be just as bad, wouldn't it?

Bottom line: Members of the media sometimes have trouble quoting economists correctly because we don't always fill in all the blanks. The media (and students writing term papers) want to fill in those blanks, and sometimes they get it quite wrong. Understanding that people want to fill in those blanks (and understanding the ways that they are tempted to do so) goes a long way toward making you a better communicator of economic ideas.

We've been tough on the "McCain-Clinton gas tax holiday". We economists, that is. Seems there's not one of us who thinks it's a good idea. It's just plain bad public policy. The actual effect will be small. A family that goes through two tanks of gas a week might see a difference of maybe a couple dollars a week under the best case scenario (full explanation here). If you want to give working families some relief there are certainly better ways to do so. A check for $50 for every family with less than $50,000 income would be better targeted, subject to less uncertainty, and would have a larger effect. Just about any economist would tell you this.

Ah, but what do they know.

“Well I’ll tell you what, I’m not going to put my lot in with economists,” -- Hillary Clinton

And...

“When the federal government, through the Fed and the Treasury gave $30 billion in a bailout to Bear Stearns I didn’t hear anybody jump up and say, ‘That’s not going according to the market, that’s rewarding irresponsible behavior.’ We’ve got to get out of this mindset, where somehow, elite opinion is always on the side of doing things that really disadvantage the vast majority of Americans.”

The market reference is strange. You see, I think many economists did have reservations about what happened with Bear Stearns, although many of us ultimately feel that it was necessary to prevent even further catastrophe--one which might have had a pretty sizable impact on "the vast majority of Americans." Rather than take that chance, the Fed decided to put its own credibility up as collateral--no small decision, that.

So suddenly Senator Clinton has all this concern for markets? Is she implying that her gas tax holiday should be supported by economists because it removes the tax that is somehow distorting the free market?

No, more likely it was just a convenient sound bite. But I do see one very troubling problem in this exchange and it's going to have me thinking for a while. These quotes by Senator Clinton show that economists have not done a very good job of explaining what we really know objectively and scientifically to be true. Though my previous post (as well as posts on other blogs) pointed out some caveats, the basic thrust of tax incidence theory is not in question. The questions deal with specific issues such as whether summer production quantities have been set and how costly it would be to change them. That's an objective scientific question. Once we know the answer to it, we know whether the market price of gas would go down by roughly half of the tax cut (as econometric research suggests) or not at all (if quantities are already set).

The level of economic literacy in this country is so low that few people know that this is a point of near 100% agreement among economists. But correct though it may be, it is a counterintuitive result. People expect that the tax cut would drop the price one-for-one. People will believe a politician who tells them that this tax cut will help them. In fact, other policies would help them more, but because this one is believable and strikes an emotional chord, they'll remember it at the ballot box.

To add insult to injury, the same politician can discredit the economists on this point of near 100% agreement and mountains of objective evidence by pointing to a more controversial and unsettled issue where our pronouncements seem to favor the "elites" for reasons that are hard to explain in a hundred words or less, hard to draw on a blackboard, and are based on more recent scholarship.

It's sort of like saying that the meteorologist who sees clouds, hears thunder, and predicts rain should not be believed because he's on the wrong side of the global warming issue for your tastes. That would be ridiculous and should be called out as such. The level of economic understanding necessary for good citizenship is a level that would enable a person to see that connection.

True economic literacy does require some understanding of the concept of elasticity.

In my intermediate macroeconomics course, the final project is a simulation of an FOMC meeting where members of the class play the roles of Fed officials. They did exceptionally well. The presentations and discussion were excellent.

My class voted 9 to 7 to cut by another quarter point. (The 7 wanting to hold rates steady)

As far as I can remember, my class has never been wrong, and also as far as I can remember, when the class predicts dissent, there usually, if not always, is (though never as much in the real vote).

It's an unscientific indicator, to be sure. But it is very rewarding to see the students take it so seriously and really learn about how the Fed works.

The real meeting, of course, is tomorrow. More on that later.

This all started with my post on how a computer demonstration allowed me to illustrate a certain technical feature of the Solow model that would otherwise require a lot more setup time. The (unstated) implication being that it allowed me to get to the "good stuff" sooner.

That's a little ironic because both John Palmer and Gavin Kennedy clearly want to focus on the other important institutional aspects of growth. Kennedy wants more attention to a careful and correct reading of Adam Smith (I can't disagree with that), and Palmer wants to focus on reducing transaction costs a la Coase. No doubt that others could come up with entirely reasonable things to add to that list, and no doubt many of those additions are things that, given enough time in the semester, would be beneficial to cover in class.

Yet I think that both John and Gavin overstate the objection to the Solow model (and presumably other models) as just a mathematical exercise--math for math's sake. As John puts it, "Yes the models are a great seive for filtering the students and putting them through the hoops." But in his later post he writes:

Second, the basics of economic growth are extremely important: consumption uses scarce resources that cannot then be available for producing capital goods; saving allows investment, which means more will be available for consumption in the future. We all (I hope) teach something like this in our intro courses when we show that saving today shifts the production possibilities frontier outward for the future.

We agree! And there's probably no better way to quickly and coherently communicate this than a simple undergraduate treatment of the Solow model. You have the most simple dynamics possible. You can talk about investment and depreciation. You can talk about stocks and flows. You can talk about capital seeking a high rate of return. You can talk about the tradeoff inherent in the consumption/saving decision. It's all there in a convenient package that can be covered in one class period.

And really, the Solow model as typically presented at the undergraduate level is not much of a math problem. It reduces to a couple lines of algebra. One does not have to do the full-blown differential equations version.

Perhaps this would be a good time to lay out the way that I approach growth in an intermediate macro course. It is based on the presentation in Steve Williamson's text, but I add my own twist.

1. Overview of growth experiences across the world. Evolution of average world GDP since the industrial revolution. Demonstration of gapminder.org website. Parente and Prescott stylized facts.
2. Malthusian pre-industrial revolution scenario. No growth. Mercantilism.
3. Industrial revolution. Economies begin to accumulate physical capital in a serious way. Solow model is introduced. Growth accounting. Solow model can explain how high marginal product of capital attracts investment. Solow model can't explain why countries take off or why sustained growth occurs. Convergence happens among wealthy countries with similar institutions but no worldwide convergence. Finish with Alwyn Young analysis of TFP in Asia before the financial crisis, which leads directly to...
4. Modern growth. Robert Lucas and Paul Romer style models (sketch... little math). "It's not factor accumulation, it's 'A'" a la Easterly and Levine. Endogenous TFP. Discussion (institutional issues are raised).

It's not particularly math heavy, though there are some opportunities for the motivated student to show off a little. If anyone had the impression that I dwell on the Solow model, I'll clear that up now. But it is a very important part of the context of the whole discussion (not to mention the only way I know to introduce growth accounting). Plus, while the Parente and Prescott approach is not exactly the Solow model, it is of that lineage.

There are so many interesting things to talk about when the time of the semester comes around to discuss growth theories. The simple algebra of an undergraduate version of the Solow model is one of the boring parts, but it is, I believe, necessary. Not as a filtering device (it is a rather coarse filter), but as a way of showing the "measure of our ignorance" (as the Solow residual is sometimes renamed) before moving on to (attempt to) lift the veil of that ignorance.

So anyway, I think we should have more and better presentation tools for streamlining the presentation of the Solow model to make the mechanics clearer and to better allow us to communicate how it revolutionized thinking about growth and how it ultimately showed us that there is so much we don't know without getting our students bogged down in the technical details.

That's what started this whole discussion anyway.

See also: Mike Moffatt (whose comments on the Coase theorem I will take up at a later time), Gabriel Mihalache (who agrees with me while maybe overdoing the case for analytical precision--at least if we're mainly talking about undergraduate pedagogy--but that is to be expected of a soon to be first year Ph.D. student [been there, done that]), and YouNotSneaky (who agrees with me for essentially the right reasons).

John Palmer asks this question in response to yesterday's post.

My response was:

Same reason we teach the Ricardian model of comparative advantage.

Even though it oversimplifies reality to nearly the point of absurdity, it contains many useful insights that are vital to understanding more sophisticated models and policy discussions.

It introduces a way of organizing one's thinking about the topic at hand. (Growth accounting, in Solow's case... a very important concept.)

It is a touchstone in the literature for an entire field. One cannot be considered to be educated in that field without an understanding of it.

It can be augmented and extended fairly easily to obtain more interesting and potentially useful results.

Despite all that, we know that it is a bit too simple to be the only tool in our arsenal. Indeed, to use it as the only tool in our arsenal would be dangerous.

Would not each of these statement apply to the Ricardian model as well as the Solow model? (Readers are invited to suggest others.)

John responds:

Recently a colleague asked me if I teach anything about growth in my intro course. I replied that I teach nothing explicit about growth theories, but I do teach the Coase theorem and the importance of property rights and transaction costs in understanding exchange and growth.

In contrast, Ricardian comparative advantage lies at the heart of exchange; some would argue it is the only argument we have in favour of free trade. It is indeed based on heroic assumptions, but in many instances these assumptions do not detract from the usefulness of the concept. And at least comparative advantage depends on such basic concepts as opportunity costs and relative prices.

I wholeheartedly agree with the emphasis on the Coase theorem--which may be one of the most important ideas in economics. And yes, the Ricardian model is where we show off our propensity to make opportunity cost and relative prices the cornerstone of the entire edifice of our theory. The Solow model does not give opportunity cost and relative prices the same central role. Indeed, they play almost no role (unless you count the rental rate being the marginal product of capital, but one could overlook that if one is not careful).

But the successors of the Solow model do give prices that role. And so again I go back to my assertion that Solow's model provides the basic framework for thinking about the problem of growth accounting, for taking a measure of our ignorance, and for laying the foundation for half-a-century of research. Not a bad record.

And let's be honest. Any model that can get our attention and cause us to take stock of the measure of our ignorance about a problem as deadly serious as economic growth and development is very much worth teaching.

Gabriel M. also comments.

Office hours today: A student had a question about the golden rule saving rate in the Solow growth model. No problem. Bring up the Mathematica demonstration on the Solow model. Use the sliders to show how changing the saving rate causes consumption on the balanced growth path to rise or fall. The concept was effectively communicated faster than I could have stood up, found a dry erase marker, and started to sketch out the model on the whiteboard in my office.

If you teach the Solow model, you really should check it out.

A student sends me this piece by Dani Rodrik.

How does globalization reshape wealth and opportunity around the world? Is it mainly a force for good, enabling poor nations to lift themselves up from poverty by taking part in global markets? Or does it create vast opportunities only for a small minority?

To answer these questions, look no farther than soccer. Ever since European clubs loosened restrictions on the number of foreign players, the game has become truly global.

Read the whole thing.

Via Newmark's Door comes this from the Richmond Fed "Why I Want To Be An Economist". Read it. Many of us have had students who would tell similar stories.

Ruminating on this post by Gabriel Mihalache reminded me of this. It's Preston McAfee's introductory econ text. Since I'm teaching MBA microeconomics this summer, I need to make a note to put this on the list of suggested supplements.

Gabriel has noted some other free books and notes out there as well. The variety of what's out there for economics is truly amazing. McAfee's text is fine for a principles course at Cal Tech but probably too advanced for principles courses at most places. However, one could put it on the reading list as an optional supplement for more advanced courses, as I intend to do.

Students occasionally ask what economics book they should read for pleasure. If you're an econ professor, you know what I mean. Greg Mankiw tells us of a recent conversation he had...

Student: Professor Mankiw, if you could recommend just one book, what book would it be?

[Mankiw]: Am I allowed to recommend my favorite textbook?

Student: No. Textbooks are disallowed.

[Mankiw]: In that case, I'll suggest Milton Friedman's Capitalism and Freedom.

Student: That's funny. That's the same answer I got when I asked this question of Professor Summers.

Capitalism and Freedom is a book that I have recommended as well. As I described previously on this blog, that book was and still is a favorite of mine.

By the time I read Capitalism and Freedom, I had already made up my mind to go to grad school and be an academic economist. So it was not a life changing event in that sense. However, by the time I put the book down I knew that I had made the right choice for me. I remember that one of my thoughts after reading it for the first time* was, "Wow, that's how to make an economic argument." Maybe that's why economists across the spectrum from Mankiw to Summers and undoubtedly many more in-between recommend the book to students.

*It is indeed a shame that I will never again read it for the first time and capture that exact feeling again. I am reminded of an episode of "Classic Albums" on VH1Classic in which one of the members of Pink Floyd (probably David Gilmour, but I don't recall for sure) waxed philosophical about what it must have been like for someone to bring home Dark Side of the Moon, turn out the lights, put on the headphones, and listen to it for the first time--and that since he was so involved with brining it into being he never had that experience for himself. I can't help but wonder if Milton Friedman had a similar experience with Capitalism and Freedom.

I mentioned these once before. Now, I'm starting to contribute to the library of demonstrations. My first contribution is a simple Keynesian IS-LM model. I chose this for my first attempt as it was easy to code and could be widely used in classroom presentations. Granted, I don't make the IS-LM the centerpiece of my class, but it does have some value and students should know what it is.

If you teach macroeconomics, you might want to try it out. It requires the Mathematica version 6 player (free download). Here's a link to the demonstration. Here's a link to all the economics demonstrations. And this is what the interface of my IS-LM demonstration looks like...

Please let me know if you find it useful. I hope to do some more of these in the near future.

The college had a bulletin board contest for the various student organizations. The Economic Student Association took 3rd place (the cash prize will help pay for our trip to St. Louis we're planning). The Finance Club took 1st, but I really shouldn't complain since one of the items on their bulletin board was a sign advertising my talk to their club earlier this week.

Also this week, I heard from a former WIU student now studying for her Ph.D. in economics that she has passed both her comprehensive exams...with a "high pass" in macro. Since I taught both her macro classes in our M.A. program, I am delighted to hear that news. She did both her B.A. and M.A. at WIU.

Another former student of mine recently returned from a semester at Oxford. Still another student is in the running for a very prestigious award. Hopefully he'll find out about that soon.

Not to mention that I have some really bright students this semester as well. Could be one of my best groups yet (compared to any place I've been). We've got some really good econ majors, and some good finance majors getting a minor in econ (a very good and increasingly popular combination here).

Flyers like this one have been seen on campus.

It shouldn't be hard to come up with 45 minutes worth of things to talk about.

Today's howler is from CNN/Money:

Gasoline is one of those items that some economists consider "inelastic," that is, people will buy it no matter what the cost. But the recent drop in demand puts that into question, and suggest people will cut out unnecessary trips if they are too expensive.

As I try to tell my students, a good or service is not elastic or inelastic--the demand for or the supply of it is. Second, inelastic demand doesn't mean that people will buy it no matter what the cost--budget constraints ensure that eventually the curve slopes back to the left as you go up higher in price. Third, if you want to get really pedantic, it's not a drop in demand, but a drop in the quantity demanded as this is a change induced by higher prices (caused by increased input costs which reduced the supply). Fourth, one should consider short-run vs. long run demand for gasoline since it takes a while for habits to change.

When I read that I had flashbacks to grading exams.

No wait, I did not grade any exams this term that packed this many errors into two sentences. My students are better than that.

Yes, I've been quiet the last few days. It has been final exam week, and on Wednesday it almost required a shovel to get down to the desktop. Things are better now, and I hope to be rejuvenated after the weekend. In the morning, I will be at the Commencement ceremony. As I often do, I will be leading the graduate students (MA Econ) across the stage and handing each of them their diploma cover as we smile for the camera (the actual diploma will be in the mail after grades are in).

Then, after the ceremony, we're going to St. Louis to see Wicked (for the 2nd time).

Have a good weekend!

I figure I've logged about 1600 miles of driving in the last 11 days. That cuts into the time available for blogging. Things should improve now for a while at least.

Yesterday, I was in Chicago with my students competing in the 7th District College Fed Challenge. Three time defending national champion Northwestern University won again. Although the University of Chicago certainly gave them a run for their money. We faced U of C in the first round and thus didn't advance. Even so, the value of the program as a learning experience for our students is tremendous.

Fredric Mishkin spoke yesterday about the risk management approach to monetary policy decisions. This was the basis for the lead off question in the final round Q and A session at the Fed Challenge. By the way, all of the final round teams (in addition to our team), were unanimously in favor of holding rates constant at this point in time. The competition is real-time. Therefore having it so soon after the last meeting does sort of predispose one to holding steady. However, there was a lot of discussion and debate by all the teams about what the outlook is going forward.

As for that outlook, Tim Duy is concerned.

...One has to imagine that the Fed must be feeling a little uneasy about pulling the trigger on another 25bp last Wednesday given Friday’s employment report. Still, they likely take comfort in the belief that they drew a line in the sand with the statement, declaring a balanced risk outlook.

But can they stick to that line during a scary four months? Can they look through to that period of “moderate growth” that they keep predicting? I would like to believe they are ready to stick to their guns, but recent history is not on my side.

...

Can the Fed resist that pressure to keep cutting even if they are confident that the medium term risks are really balanced? If the “risk management” faction at the Fed continues to hold power, it seems like more rates cuts are likely, especially if there is any hint of further softening in employment or investment. That is what recent history tells us.

Standing in the way of additional cuts, however, is these new-found inflation concerns that appeared in the last statement. Declining core-inflation has been cited as a justification for Fed easing based upon decreasing estimates of the neutral Fed funds rate. I would only like to suggest that the recent history of core-PCE is not all that comforting. Looking a three-month inflation trends on an annualized basis:

I detect something of an upward trend in the past four months, on the order of 50bp – perhaps it is too early to be lowering estimates of the neutral rate? Personally, I wouldn’t break out the champagne on the inflation story just yet. It appears, however, that Fed Chairman Ben Bernanke and Governor Frederick Mishkin – the power couple in the “risk management” regime – already popped the cork.

The chart is from Duy's post at Economist's View.

This is precisely a point that was made by my students as well as most of the other teams at the Fed Challenge yesterday. This is a concern going forward. There is a very real risk that any further easing could have nasty repercussions for intermediate to long term inflation expectations. And if the Fed is going to be facing a real inflation problem in a year or two, when the economy is still trying to right itself from the subprime debacle, that's not going to be good for growth either.

See also this article by Bloomberg's John Berry.

Tim Schilling has moved from the Chicago Fed to the Powell Center for Economic Literacy. Thus his blog had to move as well. You can now find it at http://www.valuingeconomics.blogspot.com/. In his latest posts, he finds economic ideas in the Meredith Willson musical The Music Man... everything from elasticity and externalities to the roles of government and the entrepreneur. If you teach economics, put Schilling's blog in your feed reader.

I intended to post last night, but lack of sleep got the better of me. Anyway, the reason that I was away from the computer yesterday is that two other economics faculty and I took a group of econ majors, graduate students, and other interested folks up to the Chicago Board of Trade yesterday to watch what happened on the floor when the Fed announcement came out. Astute readers will recall this post from a few weeks ago:

Note to self: WIU economics faculty and students usually make a trip up to Chicago to see the Board of Trade every year. I am one of the faculty who works on scheduling and arranging the trip. I must do what I can to see if we can get up there on an FOMC day this fall.

The blog is great for keeping some of those notes to self in writing so they can be remembered and acted upon.

Let me also say that I am very happy to be part of a department that places such value on these kinds of experiences for students.

Last spring we saw the Board of Trade on a day where there was considerable activity in the grain markets, but the financial markets were absolutely dead. There were just a few people milling around checking the computer screens, reading the newspaper, and so forth.

Contrast that with yesterday. In the gallery there was a map showing what instruments are traded in each pit. It appeared that the most activity was in the bond futures and options, particularly the 10 year, but a bit of activity in the 2 and 5 year as well. There were some people in what the map showed was the fed funds pit, but the activity was not frantic. My guess is that a lot of that activity is electronic. There was some activity in the Dow futures, more on that later.

We got up to the gallery shortly before 1:15 as traders were quietly waiting for the announcement. I was looking at the bond options area when I heard a noticeable rise in volume from the floor. That's when I turned to the big CNBC monitor in the corner and saw that the announcement had come out and that it was 50 basis points. Within seconds, the pace of activity had increased from relative calm to a rather brisk pace. Yet it was controlled rather than frantic. I would guess that every trader on that floor had a game plan for this possibility that they had thought out ahead of time. They were executing that game plan rather than simply reacting. Had the decision been for 25 basis points, the game plan would have been different, but it would have been similarly executed.

Casual observation: There was some media coverage on the floor. I could see the cameras but from my vantage point I could not see the reporters. It looked like CNBC cut to their camera on the floor a couple times while we were there, and when it did the volume level on the floor seemed to rise. (Playing to the camera?)

Prices of various instruments were posting up to the big digital boards on the wall. Green numbers under the 2 year note futures, red numbers for the 10 year futures reflecting the movements taking place on Wall Street as the short term prices rose (yields fell) and the news was mildly negative for the longer term bonds. As someone who takes an interest in this and teaches it, I have to say that it was quite a sight to see those the hand signals in the pit and look up and see the numbers on the board go red and green as the traders digested the information.

Another way that the trading in Chicago mirrored that on Wall Street was in the Dow futures. Again, we could see on the digital price board that the DJIA was heading upward while all of this was going on. It was up about 170 points at the point when I started to notice what was going on with the futures. Every few minutes there was a little outburst of activity in the futures. As the Dow climbed, the futures kept pace. The September contract expires on Friday, and of course other months prices rose in lock step (this is where you can illustrate the law of iterated expectations).

All told, it was a great day for the students to see economics and finance in action. Before the announcement, we even got to go down to the trading floor briefly as a guest of a trader who knew one of our students. Also that morning, before going to the CBOT, we visited a consulting firm. That gave our students a chance to see more about how economics is used in the "real world". Now I'm working on a handout and presentation as a "debriefing" for the students to reinforce what they learned. I think the title of the presentation will be "What happened while you were watching and why?".

We also got to meet up with a student of ours who just finished an internship in Chicago and leaves next week for a study abroad term at Oxford. Did I tell you that our students can compete with the best?

Later, some thoughts on the rate decision itself.

Brad DeLong is teaching American economic history. I'm scheduled to teach it next year, and I feel his pain when he says that his eyes are bigger than his stomach.

The canonical course on American economic history spends:

* one week on the Spanish conquest

* one week on Amerindians

* one week on colonial settlement

* one week on the American Revolution

* one week on Alexander Hamilton

* one week on agriculture in the Old Northwest

* one week on New England manufactures

* one week on slavery

* one week on the Civil War

* one week on the Gilded Age

* one week on Populism

* one week on Progressivism

* one week on immigration

* one week on the Roaring Twenties

* one week on the Great Crash and the Great Depression

* one week on the New Deal

And we have overshot the end of the semester by three weeks.

He goes on to say that he wants to make room for post WWII history by getting to 1865 by the fourth week. Wow. I think you could buy a little time by spending just one day rather than a full week on the pre-colonial period and on Hamilton. Due to my location, I would switch out agriculture in the Old Northwest for agriculture in the Midwest, put it later in the semester (together with the railroads). Make Populism and Progressivism a day each instead of a week each. Similarly for immigration and the 1920s--make them a day instead of a week.

But even at that, you've only crammed that syllabus into the proper length of the semester. You haven't made room for post WWII.

This is going to require some serious contemplation.

Bryan Caplan had some fun at lunch recently...

At a recent GMU lunch, two economists sparred over the optimal quantity of cash to keep in one's wallet. Economist A holds very little cash, on the grounds that you can pay for virtually everything with credit cards. Economist B holds lots of cash, on the grounds that the foregone interest is virtually nothing, and his time is very valuable.

Whose side do you take, and why? Value of time and foregone interest calculations are welcome.

P.S. Please don't repeat the textbook model of money demand. I'm asking for a concrete solution, not a general framework. :-)

Greg Mankiw defends the textbook model:

For example, suppose that the GMU economist spends $10 per day in cash, takes 10 minutes to go get cash out of his ATM, has a value of time equal to $60 an hour, and earns 5 percent annual interest on balances held at his bank. From this information, the Baumol-Tobin model yields a very specific prediction: The prof should take out $1200 from his bank three times a year and hold an average of $600 in his wallet....

Most people hold much less money on average and go to the ATM much more often than the model predicts for their parameter values. This is a puzzle. It is also a great example to work through in an intermediate macro class. You can generate a good classroom discussion about why the model fails to match behavior.

He then gives two examples (neither of which he finds compelling). My answer to Caplan is that personally, I'm with "Economist A". I don't carry a lot of cash, but that's mainly because I use very little of the stuff and have extremely convenient access to an ATM on campus (which charges no fees as I am a customer of the bank that owns the ATM).

Mankiw's puzzle, however, is not really a puzzle to me. The problem for the model is that the value of time tends to be overestimated in examples like this. Perhaps I can bill my time at $60/hour, but that does not mean that I will at all times and in all places behave as if my time is literally worth $1/minute.

Consider the example that circulated a while back about how Bill Gates wouldn't even bother to pick up a $100 bill off the ground because he makes more money in the time that it would take him to bend over and pick it up. (A clever rendition of that story, complete with a chart, can be found here.) But there's something about the example that doesn't wash. Does Bill Gates literally get paid by the second? No. As clever as this example is, it is not literally true that Bill Gates would forgo the fraction of his income that could be attributed to 4 seconds out of his day when he bends over to pick up a $100 bill. The amount he would forgo might even be more, and is probably often less. Using the value of time as an explanation only makes sense if there is truly something given up. Think about it this way, would Bill Gates be more likely to stop and pick up a $100 bill on his way into an office building for a meeting or on his way out? On his way in, his mind is focused and he doesn't want anything interfering with getting to the meeting. On his way out, he may have a bit of "slack time" (unless he's late for the next meeting). The point is that the true opportunity cost of Bill Gates' time is not uniform throughout the day.

Or how about this one... A lot of people don't bother to pick up pennies. Is it because the value of their time is more than the value of the money that is picked up? Perhaps it is sometimes. But it seems more likely (and more in tune with my own experience) that you just don't want to carry a penny around, or maybe because you suffer disutility from bending over. The value of time matters, but it doesn't have to do all the heavy lifting in this example.

The fact of the matter is that most of us have a bit of "slack time" built into our day by accident or design. Suppose that it takes me 50 minutes to eat lunch and that I like to get to class 5 minutes early. If I'm passing by the ATM on my way to get lunch and it's 60 minutes until my class starts, the time that it takes me to get cash comes out of the 5 minute buffer that I have in my schedule. That's time that I would spend checking my e-mail, looking at my notes, or enjoying the view out my window while I get my thoughts in order. It's a low opportunity cost window of time--small enough to just be counted as the time equivalent of loose change. Those fleeting moments don't aggregate very well into billable $60/hour blocks.

Viewed that way, the puzzle disappears. Personally, ideas tend to come to me in low opportunity cost moments of time, so paradoxically, I value those moments highly. Discuss.

Robert Frank brings up a problem he wrote about two years ago and goes on to compare learning economics to learning a foreign language. Here's part of the article. Read the whole thing.

In a recent paper, Paul J. Ferraro and Laura O. Taylor, economists at Georgia State University, suggest a more troubling possibility — that introductory economics instructors may not have mastered some of the basic concepts themselves. When the researchers described an activity and asked a sample of 199 professional economists to identify its opportunity cost, only one in five answered correctly.

The good news is that an approach that has revolutionized the teaching of foreign languages promises similar gains in economics and other disciplines. I took four years of Spanish in high school, only to have difficulty making myself understood when traveling in Spain. In those days, most language courses focused on arcane grammatical details, the functional equivalent of the technical material that often bedevils introductory economics students. Today, the best language programs try to mimic the organic process by which children learn their native language.

My first exposure to the new approach came during my Peace Corps training for teaching math and science in rural Nepal. All the things we learned to say were grammatically correct, but we were never taught any formal grammatical rules. Starting from scratch, we had to be able to teach, in Nepali, just 13 weeks later. Our linguistic skills were fairly basic, but virtually all of us made it.

Of course, it’s not easy taking this approach consistently in an economics textbook. Ben S. Bernanke and I have tried in our own textbook, but given what the marketplace is willing to accept, we have not yet gotten all the way there.

Just as a few simple sentence patterns enable small children to express an amazing variety of thoughts, a few basic principles do much of the lifting in economics. If someone focuses on only these principles and applies them repeatedly in examples drawn from familiar contexts, they can be mastered easily in a single semester.

The form in which ideas are conveyed is important. Perhaps because our species evolved as storytellers, the human brain is innately receptive to information in narrative form. Years ago, I stumbled upon an assignment that plays directly to this strength.

Twice during the semester, I ask students to pose an interesting question based on something they have personally observed or experienced. In no more than 500 words, they must then use basic economic principles to answer it. I call it the “economic naturalist” assignment, in the spirit of field biologists who use Darwinian principles to interpret the traits and behavior of living things.

Here's his column from two years ago and my response. Economic naturalism is harder to do for macro (current conditions excepted), but macro principles could use a fresh approach as well. Something for the "to do" list.

So many good Dilbert comic strips deal with opportunity costs within the firm. Saturday's made me laugh. Non-economists probably laughed at the punch line. I laughed at the set-up.

David Leonhardt explains why records are made to be broken and why one must always adjust for inflation. (NY Times)

The S.& P. 500, which is a much better measure than the Dow, closed yesterday at 1,549, just 1.4 percent higher than the peak it reached in March 2000. Think about what that means. While the price of nearly everything has risen over the least seven years — while the price of bread has increased almost one-third, for instance — stocks have barely budged. They have only marginally outperformed cash sitting in a bureau drawer. So if we are going to talk about a stock market record, we should be doing the same for a whole lot of other things: Loaves of Bread Surge to New Highs

Max sounds his "barbaric yawp" over at the TPM Cafe.

Let's look at a few of his positions.

1. Supply and demand, 1. This celebrated and most basic economic model while in principle multidimensional in practice obscures anything interesting that affects market conditions. It bespeaks militant, ideologically-based reductionism. A good illustration is the minimum wage debate. In the usual S&D model, a MW can only reduce employment. Nothing else is logically possible.

We've been over this before. I am reminded of the old quote by Thomas Carlyle that I first heard when I was taking principles of economics, "Teach a parrot the terms 'supply and demand' and you've got an economist." Max's concern that the supply and demand model is taken to a reductionist extreme is nothing new. Unfortunately.

In principle it is multidimensional, but general equilibrium theory is hard to put into the format of a sound bite or an op-ed. The blog medium maybe does a little better at conveying the message because it allows for a more extended and thoughtful discussion.

My main caution about the supply and demand model in its simplest form is that it assumes homogeneous goods (or factors of production--to use the minimum wage example) and perfect competition. When the basic model is used in cases where those conditions are not satisfied, there is potential for mischief.

2. S&D, 2. The outcome in an S&D model in principle has no inherently attractive qualities, in and of itself, since it depends on the distribution of ability to pay. If Oliver Twist has no money to buy a crust of bread, his zero allotment is "efficient." The lack of any normative foundation is typically glossed over.

Or as I like to say, "No normative judgments, please; we're economists." Deirdre McCloskey as chided the profession with variations of that phrase as well, so that's where I picked that up. Max is right up to a point. The supply and demand model is value free in and of itself, but it can shed light on the effects of imposing alternative policies, and policies are generally based on some set of values or norms. It is true that economists often shy away from doing the latter. There are good reasons for being circumspect about recommending one policy over another, and indeed there is some value in specializing in the positive analysis. But we live in a political world, and our models can deal with that if we let them. There is no reason to suppress the normative discussion. The normative questions are the interesting ones--if we give up on those, our students will lose interest.

3. GDP. Add up all the Qs in the S&D models over the year ("final goods and services") and you get GDP. Solemn assurances that GDP is not synonymous with economic welfare fall easily by the wayside. More GDP (and less leisure time, less environmental quality, a less sustainable economic future) is always better. If terrorists knock down the Empire State Building, GDP could go up. More! Better! Comrade Stalin would approve.

See the broken windows fallacy.

7. Capital fundamentalism. As with reductionism of the S&D model, growth modeling zeroes in on private capital accumulation, even though a) other factors are demonstrably important and beg for attention; and b) private capital accumulation may be a consequence of other factors, rather than a cause and appropriate object for policy. Out of an obsession with this premise, the International Monetary Fund has screwed up a lot of countries too weak to ignore its advice.

Other factors are always important. If a model is simple enough to use, it necessarily leaves out many other factors. Those two fundamental facts are at the heart of more than just this criticism. In some research that a student of mine conducted we found that the relationships between growth, capital and other factors can be notoriously hard to identify. Yet, I think it is important to try. And yes, my confidence interval around theoretical growth models has increased once I started reading more of the empirical papers. Does that make me heterodox? Nah, probably not. But I know enough to know that some fundamental questions haven't been answered yet, and thus a little modesty is in order.

9. The unnatural rate of unemployment. Economists used to say it was 6.0, maybe 5.5. Lower would give rise to ruinous inflation. The huge social benefits of another couple of percentage points less unemployment were -- are -- implicitly discounted. Current rate is 4.5. 'Nuff said.

I think I know what he's getting at here. While I also am no fan of the natural rate concept of the old days, I come at it from a different angle. Max's statement here suggests that the social benefits to having a 4.5% unemployment rate were feasible back when economists thought the natural rate was 6%--and without the inflation we all feared back then. I'm not sure about that. The productivity gains of the 1990s did allow for lower unemployment and lower inflation.

When inflation and unemployment came down together in the 1990s, the Friedman-Phelps version of the natural rate gave way to the NAIRU (non-accelerating inflation rate of unemployment). It was not without its skeptics. Estimating the NAIRU is like finding your way around the room in the dark when someone keeps moving the furniture. It is easier to identify what it was in the past based on your experience, but there is no guarantee that it hasn't changed. Again, in what seems to be a common theme here, that would lead me to exercise caution in using the NAIRU to guide policy. Yet, the practical advantages in doing so carry a lot of weight, and so you use your past experience and hope that the furniture hasn't moved too much. And that means that occasionally you'll stub your toe.

But what mechanism would allow the policymaker to systematically do better?

10. "Power? You want the political science dept." Power looms over economic transactions, except in economic theory. Workers do not hire capitalists. Consumers do not choose merchants. Shareholders do not choose managers. Voters do not choose elected officials.

I have wrestled with this problem in my own models. It becomes difficult to produce clear predictions when you allow variations in power (e.g. bargaining power) to enter the model. It is similar to allowing preference shifts. Suddenly you can explain everything--and therefore you can explain nothing. Yet acknowledging the role of power (of various kinds) makes for a compelling narrative sometimes. It's something of a shame that it often needs to be excised from published research. It gives the impression that we don't care about it. That would, at least in my case, be a wrong impression. Yet at the same time, I believe it is appropriate to keep those power considerations separate from the rest of it, lest we end up with a model where anything goes.

I guess that makes me orthodox. Ultimately, I line up on the neoclassical free-market team more often than not, but I never stop asking many of the questions that Max does. And so I temper my free-market analysis with thoughts like: perfect competition is hard to find, rent-seeking in politics influences outcomes, real time estimates of the NAIRU should have a decent confidence interval, not all $1 transactions have the same social value, and power does matter even if it is hard to measure or even describe.

In some circumstances, those considerations are more important than others. But much of the time, they don't radically alter the main story that incentives matter--a story that the orthodoxy mostly gets right.

UPDATE: Max links back. Robert Waldmann also responds. Other blogs covering the topic include Greg Mankiw, Angry Bear and Cafe Hayek.

I learned today that one of our alumni is now Deputy Minister of Finance for Economy and Integration in Paraguay. One of my thesis students from this past year is in the Ministry of Finance in Mozambique. He and I are working on a paper together.

Both came here on a Fulbright Fellowship. Over the years, WIU has attracted many Fulbright students from around the world. They add to the intellectual vitality of the department, and it is rewarding to see them do well.