Homa Note: Mankiw – a Harvard prof – is probably the foremost econ teacher these days. Evidence: he got an author’s advance of over $1 million for his textbook …
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Excerpted from NY Times, “That Freshman Course Won’t Be Quite the Same”, Mankiw, May 24, 2009
Despite the enormity of recent events, the principles of economics are largely unchanged. Students still need to learn about the gains from trade, supply and demand, the efficiency properties of market outcomes, and so on. These topics will remain the bread and butter of introductory economics courses.
Nonetheless, the teaching of basic economics will need to change in some subtle ways in response to recent events. Here are four:
THE ROLE OF FINANCIAL INSTITUTIONS
Students have always learned that the purpose of the financial system is to direct the resources of savers, who have extra funds they are willing to lend, to investors, who have projects that need financing.
The economy’s financial institutions — banks and insurance companies are part of a system [that is largely taken for granted] and quickly fade into the background
The current crisis, however, has found these financial institutions at the center of the action.
Financial institutions are like the stagehands who work behind the scenes at the theater. If they are there doing their jobs well, the audience can easily forget their presence. But if they fail to show up for work one day, their absence is very apparent, because the show can’t go on.
THE EFFECTS OF LEVERAGE
The economic crisis arose because some financial institutions had, in effect, invested in housing by holding mortgage-backed securities. When housing prices fell by about 20 percent nationwide, these institutions found themselves nearly insolvent.
[The] important question: “If housing prices have fallen only 20 percent, why did the banks lose almost 100 percent of their money?”
The answer was leverage, the use of borrowed money to amplify gains and, in this case, losses.
Economists have yet to figure out what combination of mass delusion and perverse incentives led banks to undertake so much leverage. But there is no doubt that its effects have played a central role in the crisis.
THE LIMITS OF MONETARY POLICY
The textbook answer to recessions is simple: When the economy suffers from high unemployment and reduced capacity utilization, the central bank can cut interest rates and stimulate the demand for goods and services.
When businesses see higher demand, they hire more workers to meet it.
But, what would happen if the central bank cut interest rates all the way to zero and it still wasn’t enough to get the economy going again?
Now, with the Federal Reserve’s target interest rate at zero to 0.25 percent, that question is pressing.
The Fed is acting with the conviction that it has other tools to put the economy back on track. These include buying a much broader range of financial assets than it typically includes in its portfolio.
Economists are far from certain how well these tools work.
THE CHALLENGE OF FORECASTING
It is fair to say that this crisis caught most economists flat-footed.
In the eyes of some people, this forecasting failure is an indictment of the profession. But that is the wrong interpretation.
In one way, the current downturn is typical: Most economic slumps take us by surprise. Fluctuations in economic activity are largely unpredictable.
Yet this is no reason for embarrassment. Some things are just hard to predict. [The vest an economist can do is] assess risks and to be ready for surprises.
Full article:
http://www.economics.harvard.edu/faculty/mankiw/files/That%20Freshman%20Course.pdf
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