the grand unified theory

A Sad Story — I Mean, AS-AD Story (Wonkish) by Krugman

As it happens, I’ve thought about this issue quite a lot; it comes up with each revision of Krugman/Wells, where we have to ask whether AS-AD belongs in the exposition. The problem is not that the “real” model is DSGE (New Keynesian theory with intertemporal optimization yada yada); in practice, when it comes to thinking about macro policy Robert Waldmann has it right:

most have gone all the way back to an IS curve (real interest and output) assuming AS doesn’t matter and with the LM curve replaced with something like a Taylor rule. AS if anything, is an adaptive expectations augmented Phillips curve which matters only because of real interest rates, the monetary authority’s response to inflation and debt deflation/inflation.

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Second — and this plays a surprisingly big role in my own pedagogical thinking — we do want, somewhere along the way, to get across the notion of the self-correcting economy, the notion that in the long run, we may all be dead, but that we also have a tendency to return to full employment via price flexibility. Or to put it differently, you do want somehow to make clear the notion (which even fairly Keynesian guys like me share) that money is neutral in the long run. That’s a relatively easy case to make in AS-AD; it raises all kinds of expositional problems if you replace the AD curve with a Taylor rule, which is, as I said, essentially a model of Bernanke’s mind. 

So there is a place for AS-AD, although it’s an awkward one, and the transition to IS curve plus Taylor rule plus Phillips curve, which is the model you really want to use for America right now, is a moment that fills me with dread every time we take it on in a new edition.