Teaching Intermediate Macroeconomics using the 3-Equation Model

Much teaching of intermediate macroeconomics uses the IS-LM-AS or ADAS approach. This is far removed both from the practice of interest rate setting, inflation-targeting central banks and from the models that are taught in graduate courses. Modern monetary macroeconomics is based on what is increasingly known as the 3-equation New Keynesian model: IS curve, Phillips curve and interest ratebased monetary policy rule (IS-PC-MR). This is the basic analytical structure of Michael Woodford’s book Interest and Prices published in 2003 and, for example, of the widely cited paper “The New Keynesian Science of Monetary Policy” by Clarida et al. published in the Journal of Economic Literature in 1999. A recent graduate textbook treatment is Gali (2008). Much of this literature is inaccessible to undergraduates and non-specialists. Our aim is to show how this divide can be bridged in a way that retains the tractability and policy-friendliness of the old approach yet fits the institutional realities of contemporary policy-making and opens the way to the more advanced literature. Our contribution is to develop a version of the 3-equation model that can be taught to undergraduate students and can be deployed to analyze a broad range of policy issues, including the recent credit/banking crisis and the oil and commodities price shock.1 It can be taught using diagrams and minimal algebra. The IS diagram is placed vertically above the Phillips diagram, with the monetary rule shown in the latter along with the Phillips curves. We believe that our IS-PC-MR graphical analysis is particularly useful for explaining the optimizing behaviour of the central bank. Users can see and remember readily where the key relationships come from and are therefore able to vary the assumptions about the behaviour of the policymaker or the private sector. In order to use the model, it is necessary to think about the economics behind the processes of adjustment. One of the reasons IS-LM -AS got a bad name is that it too frequently became an exercise in mechanical curveshifting: students were often unable to explain the economic processes involved in moving from one equilibrium to another. In the framework presented here, in order to work through the adjustment process, the student has to engage in the same forward-looking thinking as the policy-maker. The model we propose for teaching purposes is New Keynesian in its 3-equation structure and its modelling of a forward-looking optimizing central bank. A significant problem for most students in the more formal versions of the New Keynesian model is the assumption that both households (in the IS equation) and price-setting