- Email: [email protected]
Teaching macroeconomics through flowcharts
International Review of Economics Education 14 (2013) 86–93
Contents lists available at ScienceDirect
International Review of Economics Education journal homepage: www.elsevier.com/locate/iree
Teaching macroeconomics through flowcharts Yaniv Reingewertz Department of Economics, George Washington University, 215 G Street NW, Washington, DC 20052, United States
A R T I C L E I N F O
A B S T R A C T
Article history: Available online 14 October 2013
Flowcharts are an invaluable tool for explaining complex mechanisms. They are used in Biology, Chemistry and many other disciplines as a teaching tool, as well as in research. However, flowcharts are hardly used in economics. This paper suggests that flowcharts could supplement graphs and algebra in the teaching of economics, especially in undergraduate courses. In order to demonstrate their effectiveness the paper presents a series of flowcharts that describe the IS-LM/AD-AS model. These flowcharts could be used in various undergraduate courses in macroeconomics, as a supplement to the standard IS-LM and AD-AS graphs. ß 2013 Elsevier Ltd. All rights reserved.
JEL classification: A22 E10 Keywords: Economics education Teaching of economics Flowchart Macroeconomics
1. Introduction One of the major challenges in the teaching of economics is explaining complex models in a clear and comprehensible manner. For example, even the simplest macroeconomic models, such as the ISLM model, might be too complex for undergraduates (Romer, 2000). This paper suggests that flowcharts could help with this task. The literature on economic education suggests many methods to improve the learning process. In particular, the use of computers is highly emphasized (Cox, 1974). Millerd and Robertson (1987) and Khandker and Wehrs (1990) suggest computer simulations, and Agarwal and Day (1998) suggest using the internet. Other tools include games (Fels, 1993), video games (Lawson and Lawson, 2010) and experiments (Wells, 1991). However, to the best of my knowledge the use of flowcharts was never explicitly suggested. Flowcharts are a very useful tool for conveying ideas. They are used to describe different mechanisms of action in many academic disciplines, such as biology, chemistry and computer science. For example, the Krebs cycle, which describes the way food is converted to energy within the human body, is usually presented in the form of a flowchart (Berg et al., 2002). Several studies show that
E-mail address: [email protected]. 1477-3880/$ – see front matter ß 2013 Elsevier Ltd. All rights reserved. http://dx.doi.org/10.1016/j.iree.2013.10.004
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flowcharts help in the learning process (Kammann, 1975; Brooke and Duncan, 1980). Flowcharts help in visualizing mechanisms, since they outlay the steps which constitute the mechanism. Macroeconomic processes could also be explained through flowcharts. However, the use of flowcharts in the teaching of economics is very rare, with the exception of the circular flow of income (Mankiw, 2012a,b) and occasional flowcharts in macroeconomics textbooks. For example, Dornbusch et al. (2010) present only one flowchart in their book (Fig. 4.2, p. 89). I suggest a series of flowcharts that describe the IS-LM/AD-AS model that is commonly taught in macroeconomics courses. The flowcharts are used to analyze short term dynamics in a closed economy.1 These flowcharts could be used in various undergraduate courses in macroeconomics, as a supplement to the IS-LM and the AD-AS graphs. Currently, macroeconomic textbooks, such as Barro (1997), Blanchard (2010), Dornbusch et al. (2010), Romer (2011)and Mankiw (2012a,b) mainly use graphs in order to explain macroeconomic models. Another tool for describing the models is algebra, which is presented mainly in graduate courses. Graphs are an invaluable tool for explaining the material. However, relying solely on graphs is problematic because of at least three reasons. Firstly, some undergraduate students might not understand graphs very well (Cohn et al., 2001). This is especially true for students lacking the necessary mathematical or analytical ability. Secondly, a graph can only present a relation between two variables. However, macroeconomics entails many complex interactions and transmission mechanisms between more than two variables. Using a series of graphs is one solution, which might be confusing. Therefore, the use of graphs might withhold information from the students and make the learning process more demanding. Finally, graphs focus on the equilibrium in the different markets, and can be very implicit regarding the dynamics which bring the equilibrium into place. Flowcharts resolve the three issues discussed above. Firstly, contrary to graphs, flowcharts enable the presentation of many variables, hence many macroeconomic relations. Secondly, flowcharts might be more easily understood than graphs, at least at the undergraduate’s level. Lastly, flowcharts are better in describing dynamic processes and the convergence toward equilibrium. Flowcharts also have shortcomings. Firstly, like any other model, flowcharts are also a partial representation of reality. This means that the less important economic interactions are not presented within the flowchart. Secondly, flowcharts do not explicitly describe the equilibrium point, only the convergence to it. 2. A macroeconomic flowchart This paper describes how flowcharts could be used in the teaching of economics. The paper presents a series of flowcharts describing the IS-LM/AD-AS model. We will first construct a flowchart for the IS-LM model, and then move to the IS-LM/AD-AS model in a closed economy. In order to manifest the usefulness of flowcharts under different modeling assumptions we will also present a flowchart without the LM curve, a-la Romer (2000). The macroeconomics flowcharts are constructed in the following way. They consist of a series of boxes, connected with arrows. Every box represents a different macroeconomic variable. Boxes containing economic variables which are part of the same market have the same color.2 The arrows that connect between the boxes mark the direction of the causal link between the variables. These arrows can point to each direction, as well as to two directions simultaneously. Arrows take one of two colors – green, indicating a positive correlation between the variables, or red indicating a negative correlation.3 For example, since an increase in output (Y) would cause an increase in private consumption (C), there would be a green arrow pointing from Y to C. The flowchart is built in a hierarchical manner, starting with Y and ending with Y (which is the same). This is done in order to facilitate the order of the mechanisms. In addition, the exposition of the flowchart could be done in steps, one box at a time, until the entire flowchart is being presented. Note that in reality there is no
1 2 3
The flowcharts could also be modified to describe open economies. These colors are not essential to the explanation and could be omitted in a class presentation. In addition, a plus or a minus sign accompanies each arrow.
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natural starting point and the dynamics are circular. Therefore, an increase in Y (at the bottom) is influencing other variables through the Y in the beginning of the flowchart. 2.1. The IS-LM model First let us describe the IS-LM model with the help of a flowchart. In this model the IS curve describes the goods market, i.e., the link between aggregate demand and the interest rate. The LM curve describes the money market – the relation between money supply and money demand that determines the interest rate. This model is presented in Fig. 1, in the form of a flowchart. The flowchart ascribes different colors to the different markets. The goods market is assigned the color blue. Variables describing the money market (i.e. the LM curve) are colored in gray. Output (or aggregate demand) is colored in light blue. The dynamic behavior of the IS-LM model is described by the arrows connecting the variables. The IS-LM model is often used to analyze the effect of monetary policy and fiscal policy. The flowchart makes it easy to see the main dynamics in this framework. The flowchart is also useful in analyzing other macroeconomic situations, such as changes in the marginal propensity to consume etc. We will start with monetary policy. The central bank (described by the box ‘‘monetary policy’’) can increase the money supply, leading to a decline in the real interest rate (r). When the interest rate declines, investments increase and there is an increase in aggregate demand (Y). This is the main effect of an increase in the money supply, but an increase in Y is influencing other variables as well (see the arrow connecting Y at the bottom of the flowchart to Y at the beginning of the flowchart). An increase in Y is leading to a higher interest rate (through the demand for money), lower investments and lower aggregate demand (Y). Therefore, the initial increase in Y is being partially offset by this increase in the interest rate. A new equilibrium is achieved, with higher Y and lower interest rate compared to the original state. We now turn to fiscal policy, assuming a positive shock to government spending. In this case, the increase in government spending increases aggregate demand (Y). An increase in Y increases personal consumption and therefore increases aggregate demand once again. This positive feedback mechanism is known as the fiscal multiplier. However, an increase in Y also has a secondary effect
Fig. 1. The IS-LM flowchart.
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Fig. 2. The IS-LM flowchart, with taxes.
of increasing the interest rate through the demand for money. Investments decrease as a result of the increase in the real interest rate and Y decreases. The new short run equilibrium will therefore be at a higher level of interest rate and a higher level of output. Fig. 2 introduces taxes into the analysis. If the increase in government spending is being financed by taxes then it will lead to a decrease in private spending, leading to a decrease in aggregate demand. If we do not assume Ricardian Equivalence then the fiscal multiplier is still positive. This is because the decrease in private spending due to taxes is smaller than the initial increase in government spending, because the marginal propensity to consume is less than 1. However, the fiscal multiplier in this case might be relatively small. Government spending could also be financed by debt. In this case we need to discuss the assumption of Ricardian Equivalence. If individuals follow the Ricardian Equivalence principle then an increase in long term debt will be interpreted as a future tax increase. Therefore, rational individuals would cut their current consumption levels. Since government spending increases but private consumption decreases, the net effect on the level of output cannot be determined. The Keynesian framework usually assumes that the individuals are not Ricardian, i.e., they base their consumption decision on current income, which is not affected by the level of debt. Therefore, in the Keynesian model private consumption increases as a result of the increase in the level of output. 2.2. AD-AS in a closed economy The IS-LM model assumes exogenous prices. In order to loosen this assumption we turn to the ADAS model (Fig. 3). We will analyze the case of ‘‘sticky prices’’, but the flowchart is also appropriate for discussing flexible prices. The AD-AS (or IS-LM/AD-AS) model is more complete than the IS-LM, and is the full macroeconomic model as being taught in many undergraduate courses. The flowchart is presented using five colors. Blue represents the goods market. Pink represents taxes. Gray represents the LM curve. Brown represents the prices, and light blue represents output. We can analyze the effects of monetary policy and fiscal policy with the help of the AD-AS flowchart. We will begin with monetary policy. The effect of monetary policy on output is better explained through the AD-AS model, since prices are now endogenous. Similarly to Fig. 2 an expansionary monetary policy (i.e., an increase in money supply) leads to an increase in Y. However,
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Fig. 3. AD/AS in a closed economy.
an increase in Y leads to a price increase (inflation), which leads to a reduction in the real money supply and to an increase in the real interest rate. The final result of an expansionary monetary policy is an increase in the level of output which is smaller than it was under the IS-LM framework. We now turn to fiscal policy. An increase in government spending is leading to an increase in aggregate demand (Y), private consumption, and then aggregate demand once again. This is the fiscal multiplier. However, now there are two offsetting channels which lead to an increase in the real interest rate. Firstly, as before, the increase in the demand for liquidity leads to an increase in the interest rate. Secondly, an increase in Y leads to an increase in prices, leading to an increase in the real interest rate. Therefore, fiscal policy is also less effective when prices are not fixed. Making prices endogenous enables us to discuss the differences between the Keynesian model and the neoclassical model. When output increases prices increase as well. However, according to the New-Keynesian theory prices are ‘‘sticky’’, i.e. they do not fully adjust to the changes in production costs. Therefore, the effect of the increase in the interest rate on aggregate demand would not fully restore aggregate demand to its original point. Neoclassical models, however, would argue that the increase in output and wages lead to a price increase which is large enough to fully offset the increase in the level of output, through the interest rate channel. These two points of view could be clearly discussed through the flowchart. 2.3. AD-AS in a closed economy, without the LM curve The LM curve represents the equilibrium in the money market. Discussing the money market is useful if we assume that the central bank is keeping the supply of liquidity constant and the equilibrium in the money market determines the interest rate. However, modern central bankers tend to use the interest rate, and not the money supply, as their primary policy tool. This is why in recent years some claim that the use of the LM curve is outdated (Romer, 2000; Guest, 2003; Turner, 2006). For this reason we present Fig. 4, which contains a flowchart similar to the one presented in Fig. 3, only without the LM curve. This model is named AD-IA instead of AD-AS (Romer, 2000). The main advantages of this flowchart are twofold. Firstly, the flowchart is more realistic, since it better describes the operation of the central bank. Secondly, the flowchart is now less complex.
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Fig. 4. AD/AS in a closed economy, without the LM curve.
The interpretation of the flowchart is almost unchanged compared to Fig. 3, and the effect of fiscal policy is analyzed in the same way. However, monetary policy is now described differently. The central bank is determining the interest rate based on a Taylor rule, i.e. it is affected by prices and the level of output. A decrease in the level of output would encourage the central bank to lower the interest rate (hence the positive link between output and interest rate). The price level is also positively linked with the interest rate. A demand shock would increase the price and cause the central bank to increase the interest rate. In addition, a supply shock could also increase the price level and therefore lead to an increase in the interest rate. Therefore, the effects of prices and output on the interest rate are unchanged compared to Fig. 3, and the only difference is the exact mechanism. 3. Class application This section will provide an example as to how flowcharts might be presented in class, together with the standard graphs. We will focus on the effect of fiscal policy in an IS-LM model. The analysis will be demonstrated using Fig. 1, which presents a flowchart, alongside with Fig. 5, which presents the IS-LM graph. In Fig. 5 we can see the IS-LM model in the form of a graph, where the equilibrium is maintained in point A. A positive shock to government spending causes the IS curve to shift to the right. The new equilibrium is achieved at a higher output and a higher interest rate (point B). However, the convergence toward equilibrium is not illustrated in the graph. We now turn to Fig. 1 which would allow the students to see how an increase in government spending leads to the new equilibrium. As can be seen in Fig. 1, an increase in government spending increases aggregate demand (Y). This is achieved through a direct effect, since Y = C + G + I, but also through the effect of Y on personal consumption which in turn increases output. However, an increase in Y also increases the demand for liquidity, which in turn leads to an increase in the interest rate. Investments decrease as a result of the increase in the real interest rate and Y decreases somewhat. The new short run equilibrium will therefore be at a higher level of interest rate and a higher level of output.
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Fig. 5. The IS-LM graph – the effect of fiscal policy.
We can now return to Fig. 5, note that the equilibrium shifted from A to B, and discuss the fact that output is adversely affected by the increase in the real interest rate, which was caused by the initial increase in the output. This is captured by the slope of the LM curve. The fact that the LM curve has a slope larger than zero implies that monetary policy is crowding out the increase in output, as explained by the flowchart. 4. Discussion This paper suggested that flowcharts could be used as a supplementary teaching tool in macroeconomics courses. The paper demonstrated this tool by analyzing the IS-LM/AD-AS model through flowcharts. Flowcharts are much more explicit than graphs in describing the mechanisms of macroeconomic models. Macroeconomic processes could be modeled as a chain of event, as one macroeconomic variable is affecting the next. Flowcharts help in visualizing this chain of events, making the learning process easier. More research is needed in order to test the effectiveness of flowcharts for teaching of macroeconomics. Future research is also needed in order to develop and implement flowcharts in other fields in economics. Acknowledgements I would like to thank Oren Levintal, Herman Stekler, Daniel Spiro and Fahkri Hasanov for inspiring discussions. Any remaining errors are the responsibility of the author. References Agarwal, R., Day, A.E., 1998. The impact of the internet on economic education. Journal of Economic Education 29 (2) 99–110. Barro, R., 1997. Macroeconomics, 5th ed. The MIT Press. Berg, J.M., Tymoczko, J.L., Stryer, L., 2002. Biochemistry, 5th ed. Freeman. Blanchard, O., 2010. Macroeconomics, 5th ed. Prentice Hall. Brooke, L.B., Duncan, K.D., 1980. Experimental studies of flowchart use at different stages of program debugging. Ergonomics 23 (11) 1057–1091. Cohn, E., Cohn, S., Balch, D.C., Bradley, J., 2001. Do graphs promote learning in principles of economics? Journal of Economic Education 32 (4) 299–310.
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Cox, S.R., 1974. Computer-assisted instruction and student performance in macroeconomics. Journal of Economic Education 6 (1) 29–37. Dornbusch, R., Fisher, S., Startz, R., 2010. Macroeconomics, 11th ed. Mcgraw-Hill/Irvin Publishers. Fels, R., 1993. This is what I do, and I like it. Journal of Economic Education 24 (4) 365–370. Guest, R., 2003. Modifying the Taylor-Romer model of macroeconomic stabilisation for teaching purposes. International Review of Economics Education 2 (1) 58–68. Kammann, R., 1975. The comprehensibility of written paragraph and the flowchart alternative. Human Factors 17 (2) 183–191. Khandker, A.W., Wehrs, W.E., 1990. Integrated microcomputer graphics and simulation in open-economy macroeconomics. Journal of Economic Education 21 (2) 167–180. Lawson, C.L., Lawson, L.L., 2010. Adventures in learning: creating role playing video games to teach and learn economics. International Review of Economics Education 9 (1) 93–110. Mankiw, G., 2012a. Principles of Macroeconomics, 6th ed. South-Western Cengage Learning. Mankiw, G., 2012b. Principles of Economics, 6th ed. South-Western Cengage Learning. Millerd, F.W., Robertson, A.R., 1987. Computer simulations as an integral part of intermediate macroeconomics. Journal of Economic Education 18 (3) 269–286. Romer, D., 2000. Keynesian macroeconomics without the LM curve. Journal of Economic Perspectives 14 (2) 149–169. Romer, D., 2011. Advanced Macroeconomics, 4th ed. Mcgraw-Hill. Turner, P., 2006. Teaching undergraduate macroeconomics with the Taylor-Romer Model. International Review of Economics Education 5 (1) 73–82. Wells, D.A., 1991. Laboratory experiments for undergraduate instruction in economics. Journal of Economic Education 22 (3) 293–300.
Contents lists available at ScienceDirect
International Review of Economics Education journal homepage: www.elsevier.com/locate/iree
Teaching macroeconomics through flowcharts Yaniv Reingewertz Department of Economics, George Washington University, 215 G Street NW, Washington, DC 20052, United States
A R T I C L E I N F O
A B S T R A C T
Article history: Available online 14 October 2013
Flowcharts are an invaluable tool for explaining complex mechanisms. They are used in Biology, Chemistry and many other disciplines as a teaching tool, as well as in research. However, flowcharts are hardly used in economics. This paper suggests that flowcharts could supplement graphs and algebra in the teaching of economics, especially in undergraduate courses. In order to demonstrate their effectiveness the paper presents a series of flowcharts that describe the IS-LM/AD-AS model. These flowcharts could be used in various undergraduate courses in macroeconomics, as a supplement to the standard IS-LM and AD-AS graphs. ß 2013 Elsevier Ltd. All rights reserved.
JEL classification: A22 E10 Keywords: Economics education Teaching of economics Flowchart Macroeconomics
1. Introduction One of the major challenges in the teaching of economics is explaining complex models in a clear and comprehensible manner. For example, even the simplest macroeconomic models, such as the ISLM model, might be too complex for undergraduates (Romer, 2000). This paper suggests that flowcharts could help with this task. The literature on economic education suggests many methods to improve the learning process. In particular, the use of computers is highly emphasized (Cox, 1974). Millerd and Robertson (1987) and Khandker and Wehrs (1990) suggest computer simulations, and Agarwal and Day (1998) suggest using the internet. Other tools include games (Fels, 1993), video games (Lawson and Lawson, 2010) and experiments (Wells, 1991). However, to the best of my knowledge the use of flowcharts was never explicitly suggested. Flowcharts are a very useful tool for conveying ideas. They are used to describe different mechanisms of action in many academic disciplines, such as biology, chemistry and computer science. For example, the Krebs cycle, which describes the way food is converted to energy within the human body, is usually presented in the form of a flowchart (Berg et al., 2002). Several studies show that
E-mail address: [email protected]. 1477-3880/$ – see front matter ß 2013 Elsevier Ltd. All rights reserved. http://dx.doi.org/10.1016/j.iree.2013.10.004
Y. Reingewertz / International Review of Economics Education 14 (2013) 86–93
87
flowcharts help in the learning process (Kammann, 1975; Brooke and Duncan, 1980). Flowcharts help in visualizing mechanisms, since they outlay the steps which constitute the mechanism. Macroeconomic processes could also be explained through flowcharts. However, the use of flowcharts in the teaching of economics is very rare, with the exception of the circular flow of income (Mankiw, 2012a,b) and occasional flowcharts in macroeconomics textbooks. For example, Dornbusch et al. (2010) present only one flowchart in their book (Fig. 4.2, p. 89). I suggest a series of flowcharts that describe the IS-LM/AD-AS model that is commonly taught in macroeconomics courses. The flowcharts are used to analyze short term dynamics in a closed economy.1 These flowcharts could be used in various undergraduate courses in macroeconomics, as a supplement to the IS-LM and the AD-AS graphs. Currently, macroeconomic textbooks, such as Barro (1997), Blanchard (2010), Dornbusch et al. (2010), Romer (2011)and Mankiw (2012a,b) mainly use graphs in order to explain macroeconomic models. Another tool for describing the models is algebra, which is presented mainly in graduate courses. Graphs are an invaluable tool for explaining the material. However, relying solely on graphs is problematic because of at least three reasons. Firstly, some undergraduate students might not understand graphs very well (Cohn et al., 2001). This is especially true for students lacking the necessary mathematical or analytical ability. Secondly, a graph can only present a relation between two variables. However, macroeconomics entails many complex interactions and transmission mechanisms between more than two variables. Using a series of graphs is one solution, which might be confusing. Therefore, the use of graphs might withhold information from the students and make the learning process more demanding. Finally, graphs focus on the equilibrium in the different markets, and can be very implicit regarding the dynamics which bring the equilibrium into place. Flowcharts resolve the three issues discussed above. Firstly, contrary to graphs, flowcharts enable the presentation of many variables, hence many macroeconomic relations. Secondly, flowcharts might be more easily understood than graphs, at least at the undergraduate’s level. Lastly, flowcharts are better in describing dynamic processes and the convergence toward equilibrium. Flowcharts also have shortcomings. Firstly, like any other model, flowcharts are also a partial representation of reality. This means that the less important economic interactions are not presented within the flowchart. Secondly, flowcharts do not explicitly describe the equilibrium point, only the convergence to it. 2. A macroeconomic flowchart This paper describes how flowcharts could be used in the teaching of economics. The paper presents a series of flowcharts describing the IS-LM/AD-AS model. We will first construct a flowchart for the IS-LM model, and then move to the IS-LM/AD-AS model in a closed economy. In order to manifest the usefulness of flowcharts under different modeling assumptions we will also present a flowchart without the LM curve, a-la Romer (2000). The macroeconomics flowcharts are constructed in the following way. They consist of a series of boxes, connected with arrows. Every box represents a different macroeconomic variable. Boxes containing economic variables which are part of the same market have the same color.2 The arrows that connect between the boxes mark the direction of the causal link between the variables. These arrows can point to each direction, as well as to two directions simultaneously. Arrows take one of two colors – green, indicating a positive correlation between the variables, or red indicating a negative correlation.3 For example, since an increase in output (Y) would cause an increase in private consumption (C), there would be a green arrow pointing from Y to C. The flowchart is built in a hierarchical manner, starting with Y and ending with Y (which is the same). This is done in order to facilitate the order of the mechanisms. In addition, the exposition of the flowchart could be done in steps, one box at a time, until the entire flowchart is being presented. Note that in reality there is no
1 2 3
The flowcharts could also be modified to describe open economies. These colors are not essential to the explanation and could be omitted in a class presentation. In addition, a plus or a minus sign accompanies each arrow.
88
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natural starting point and the dynamics are circular. Therefore, an increase in Y (at the bottom) is influencing other variables through the Y in the beginning of the flowchart. 2.1. The IS-LM model First let us describe the IS-LM model with the help of a flowchart. In this model the IS curve describes the goods market, i.e., the link between aggregate demand and the interest rate. The LM curve describes the money market – the relation between money supply and money demand that determines the interest rate. This model is presented in Fig. 1, in the form of a flowchart. The flowchart ascribes different colors to the different markets. The goods market is assigned the color blue. Variables describing the money market (i.e. the LM curve) are colored in gray. Output (or aggregate demand) is colored in light blue. The dynamic behavior of the IS-LM model is described by the arrows connecting the variables. The IS-LM model is often used to analyze the effect of monetary policy and fiscal policy. The flowchart makes it easy to see the main dynamics in this framework. The flowchart is also useful in analyzing other macroeconomic situations, such as changes in the marginal propensity to consume etc. We will start with monetary policy. The central bank (described by the box ‘‘monetary policy’’) can increase the money supply, leading to a decline in the real interest rate (r). When the interest rate declines, investments increase and there is an increase in aggregate demand (Y). This is the main effect of an increase in the money supply, but an increase in Y is influencing other variables as well (see the arrow connecting Y at the bottom of the flowchart to Y at the beginning of the flowchart). An increase in Y is leading to a higher interest rate (through the demand for money), lower investments and lower aggregate demand (Y). Therefore, the initial increase in Y is being partially offset by this increase in the interest rate. A new equilibrium is achieved, with higher Y and lower interest rate compared to the original state. We now turn to fiscal policy, assuming a positive shock to government spending. In this case, the increase in government spending increases aggregate demand (Y). An increase in Y increases personal consumption and therefore increases aggregate demand once again. This positive feedback mechanism is known as the fiscal multiplier. However, an increase in Y also has a secondary effect
Fig. 1. The IS-LM flowchart.
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Fig. 2. The IS-LM flowchart, with taxes.
of increasing the interest rate through the demand for money. Investments decrease as a result of the increase in the real interest rate and Y decreases. The new short run equilibrium will therefore be at a higher level of interest rate and a higher level of output. Fig. 2 introduces taxes into the analysis. If the increase in government spending is being financed by taxes then it will lead to a decrease in private spending, leading to a decrease in aggregate demand. If we do not assume Ricardian Equivalence then the fiscal multiplier is still positive. This is because the decrease in private spending due to taxes is smaller than the initial increase in government spending, because the marginal propensity to consume is less than 1. However, the fiscal multiplier in this case might be relatively small. Government spending could also be financed by debt. In this case we need to discuss the assumption of Ricardian Equivalence. If individuals follow the Ricardian Equivalence principle then an increase in long term debt will be interpreted as a future tax increase. Therefore, rational individuals would cut their current consumption levels. Since government spending increases but private consumption decreases, the net effect on the level of output cannot be determined. The Keynesian framework usually assumes that the individuals are not Ricardian, i.e., they base their consumption decision on current income, which is not affected by the level of debt. Therefore, in the Keynesian model private consumption increases as a result of the increase in the level of output. 2.2. AD-AS in a closed economy The IS-LM model assumes exogenous prices. In order to loosen this assumption we turn to the ADAS model (Fig. 3). We will analyze the case of ‘‘sticky prices’’, but the flowchart is also appropriate for discussing flexible prices. The AD-AS (or IS-LM/AD-AS) model is more complete than the IS-LM, and is the full macroeconomic model as being taught in many undergraduate courses. The flowchart is presented using five colors. Blue represents the goods market. Pink represents taxes. Gray represents the LM curve. Brown represents the prices, and light blue represents output. We can analyze the effects of monetary policy and fiscal policy with the help of the AD-AS flowchart. We will begin with monetary policy. The effect of monetary policy on output is better explained through the AD-AS model, since prices are now endogenous. Similarly to Fig. 2 an expansionary monetary policy (i.e., an increase in money supply) leads to an increase in Y. However,
90
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Fig. 3. AD/AS in a closed economy.
an increase in Y leads to a price increase (inflation), which leads to a reduction in the real money supply and to an increase in the real interest rate. The final result of an expansionary monetary policy is an increase in the level of output which is smaller than it was under the IS-LM framework. We now turn to fiscal policy. An increase in government spending is leading to an increase in aggregate demand (Y), private consumption, and then aggregate demand once again. This is the fiscal multiplier. However, now there are two offsetting channels which lead to an increase in the real interest rate. Firstly, as before, the increase in the demand for liquidity leads to an increase in the interest rate. Secondly, an increase in Y leads to an increase in prices, leading to an increase in the real interest rate. Therefore, fiscal policy is also less effective when prices are not fixed. Making prices endogenous enables us to discuss the differences between the Keynesian model and the neoclassical model. When output increases prices increase as well. However, according to the New-Keynesian theory prices are ‘‘sticky’’, i.e. they do not fully adjust to the changes in production costs. Therefore, the effect of the increase in the interest rate on aggregate demand would not fully restore aggregate demand to its original point. Neoclassical models, however, would argue that the increase in output and wages lead to a price increase which is large enough to fully offset the increase in the level of output, through the interest rate channel. These two points of view could be clearly discussed through the flowchart. 2.3. AD-AS in a closed economy, without the LM curve The LM curve represents the equilibrium in the money market. Discussing the money market is useful if we assume that the central bank is keeping the supply of liquidity constant and the equilibrium in the money market determines the interest rate. However, modern central bankers tend to use the interest rate, and not the money supply, as their primary policy tool. This is why in recent years some claim that the use of the LM curve is outdated (Romer, 2000; Guest, 2003; Turner, 2006). For this reason we present Fig. 4, which contains a flowchart similar to the one presented in Fig. 3, only without the LM curve. This model is named AD-IA instead of AD-AS (Romer, 2000). The main advantages of this flowchart are twofold. Firstly, the flowchart is more realistic, since it better describes the operation of the central bank. Secondly, the flowchart is now less complex.
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Fig. 4. AD/AS in a closed economy, without the LM curve.
The interpretation of the flowchart is almost unchanged compared to Fig. 3, and the effect of fiscal policy is analyzed in the same way. However, monetary policy is now described differently. The central bank is determining the interest rate based on a Taylor rule, i.e. it is affected by prices and the level of output. A decrease in the level of output would encourage the central bank to lower the interest rate (hence the positive link between output and interest rate). The price level is also positively linked with the interest rate. A demand shock would increase the price and cause the central bank to increase the interest rate. In addition, a supply shock could also increase the price level and therefore lead to an increase in the interest rate. Therefore, the effects of prices and output on the interest rate are unchanged compared to Fig. 3, and the only difference is the exact mechanism. 3. Class application This section will provide an example as to how flowcharts might be presented in class, together with the standard graphs. We will focus on the effect of fiscal policy in an IS-LM model. The analysis will be demonstrated using Fig. 1, which presents a flowchart, alongside with Fig. 5, which presents the IS-LM graph. In Fig. 5 we can see the IS-LM model in the form of a graph, where the equilibrium is maintained in point A. A positive shock to government spending causes the IS curve to shift to the right. The new equilibrium is achieved at a higher output and a higher interest rate (point B). However, the convergence toward equilibrium is not illustrated in the graph. We now turn to Fig. 1 which would allow the students to see how an increase in government spending leads to the new equilibrium. As can be seen in Fig. 1, an increase in government spending increases aggregate demand (Y). This is achieved through a direct effect, since Y = C + G + I, but also through the effect of Y on personal consumption which in turn increases output. However, an increase in Y also increases the demand for liquidity, which in turn leads to an increase in the interest rate. Investments decrease as a result of the increase in the real interest rate and Y decreases somewhat. The new short run equilibrium will therefore be at a higher level of interest rate and a higher level of output.
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Fig. 5. The IS-LM graph – the effect of fiscal policy.
We can now return to Fig. 5, note that the equilibrium shifted from A to B, and discuss the fact that output is adversely affected by the increase in the real interest rate, which was caused by the initial increase in the output. This is captured by the slope of the LM curve. The fact that the LM curve has a slope larger than zero implies that monetary policy is crowding out the increase in output, as explained by the flowchart. 4. Discussion This paper suggested that flowcharts could be used as a supplementary teaching tool in macroeconomics courses. The paper demonstrated this tool by analyzing the IS-LM/AD-AS model through flowcharts. Flowcharts are much more explicit than graphs in describing the mechanisms of macroeconomic models. Macroeconomic processes could be modeled as a chain of event, as one macroeconomic variable is affecting the next. Flowcharts help in visualizing this chain of events, making the learning process easier. More research is needed in order to test the effectiveness of flowcharts for teaching of macroeconomics. Future research is also needed in order to develop and implement flowcharts in other fields in economics. Acknowledgements I would like to thank Oren Levintal, Herman Stekler, Daniel Spiro and Fahkri Hasanov for inspiring discussions. Any remaining errors are the responsibility of the author. References Agarwal, R., Day, A.E., 1998. The impact of the internet on economic education. Journal of Economic Education 29 (2) 99–110. Barro, R., 1997. Macroeconomics, 5th ed. The MIT Press. Berg, J.M., Tymoczko, J.L., Stryer, L., 2002. Biochemistry, 5th ed. Freeman. Blanchard, O., 2010. Macroeconomics, 5th ed. Prentice Hall. Brooke, L.B., Duncan, K.D., 1980. Experimental studies of flowchart use at different stages of program debugging. Ergonomics 23 (11) 1057–1091. Cohn, E., Cohn, S., Balch, D.C., Bradley, J., 2001. Do graphs promote learning in principles of economics? Journal of Economic Education 32 (4) 299–310.
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