I spent my last few days grading scripts of undergraduate students. Two of the papers I teach use popular contemporary textbooks written by prominent writers in the field, including more than one Nobel laureates. Some of the more difficult topics in these textbooks, and also the ones where the students are most prone to making mistakes in exams, include among other things, an analysis of determination of the rate of interest from an interaction of a demand for money function with an exogenously given stock of money supplied by the central bank.
It has been nearly two decades that bulk of macroeconomists and policymakers arrived at a consensus to conduct monetary policy by directly administering the rate of interest. The other alternative, of conducting monetary policy by controlling the level of monetary aggregates, critically depended for its success on the existence of a stable demand function for money – a matter of considerable debate in the discipline. Direct administration of the rate of interest bypasses all these contentious issues, and hence, is a lot more reliable policy instrument. Most of the contemporary literature on monetary policy attributes this idea to this oft-quoted 1993 paper by John Taylor, though the history of such a policy prescription goes at least as far back as Wicksell in 1907. A very successful implementation of such direct administration of the rate of interest by the Swedish Riksbank in the 1930s is reported, among others, by Jonung and Woodford. A series of studies by Clarida, Galí & Gertler showed that the monetary policy followed by the US Federal Reserve during the Volcker & Greenspan era actually involved a direct administration of the rate of interest. In fact, with the exception of the German Bundesbank, central banks in almost all major developed countries around the world are reported to be targeting the rate of interest rather than the level of monetary aggregates.
The pertinent question which arises, therefore, is why major textbooks, especially macroeconomics textbooks, still persist with using money markets, with a stable demand function for money, as the primary tool for analyzing monetary policy. As someone teaching macroeconomics to the undergraduate students over the years, I have personally witnessed the students struggling with the rather complicated (and I dare add, far-fetched) concept of demand functions and exogenously given supply of money leading to a change in the rate of interest. The textbook explanation of this varies from one textbook to another: from the simplistic demand-supply equilibrium to more evolved fairy tales involving portfolio imbalance, the bond markets, liquidity preference schedule etc. The serious problems with all these explanations are now well-known in the literature. What does it say about the academic integrity of our profession that we gloss over all these serious problems and continue to teach these models to generation after generation of students? Especially when, at the stage of evaluation, we note that this is an area where the students are most prone to making mistakes (a fact admitted even by some of the authors of these textbooks), perhaps because we ourselves are not convinced with what we teach?
Sure enough, there is no lack of pedagogical alternative. These issues have been raised by several prominent people in the discipline, including by Taylor himself, as well as a series of other contributions (see for instance, these contributions by David Colander, David Romer and Paul Turner) – all these contributions offer pedagogical alternatives. At the post-graduate level, there are at least two popular textbooks, by Michael Woodford and Jordí Galí, which dispenses with the discussion on money markets altogether in favor of interest rate rules. I myself have dabbled with a (slightly) more complex pedagogical alternative in a contribution included in a forthcoming edited collection from OUP. Why do we still continue to teach the complicated money market analysis to the undergraduate students nearly two decades since there was an apparent consensus in the profession against these models? Why do even latest editions of popular textbooks written by Nobel laureates persist with obsolete complicated models to the agony of teachers and students? There exists few excuses for doing so, except blaming it on the conservative and arrogant nature of our professional field itself.
