Minsky Meets Wicksell: Using the Wicksellian Model to Understand the Twenty-First Century Business Cycle

Abstract

The recent turmoil in US financial markets presents undergraduate macroeconomics instructors with an opportunity to link dry textbook presentations to exciting and important real world events. Speculative excess and panic in financial markets, vulnerability of the banking system, widening credit spreads, the Fed’s difficulty in managing long-term risky interest rates, and its use of unconventional open market operations are topics that have been discussed extensively in the financial press. Unfortunately, the IS-LM model that is still the centerpiece of most Intermediate Macroeconomics and Money and Banking textbooks is not well-suited for an analysis of such topics. IS-LM takes the money supply rather than the interest rate as the target for monetary policy and makes no distinction between short and long, risk-free and risky interest rates. The Romer (2000) model, variants of which have appeared in some recent textbooks (e.g. Taylor, 2003; Frank and Bernanke, 2004; DeLong and Olney, 2006), rectifies the first of these problems but at great expense. By assuming that the Federal Reserve controls the key interest rate, the Romer model has monetary policy directly affecting investment, thereby abstracting entirely from the banking and financial sector. Thus a great virtue of the IS-LM framework, its depiction of monetary policy as a tool that acts through the financial system, is lost. On two counts we would submit that the loss is unacceptable.