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A Parable of Macroeconomics
Tom Cunningham
tom.cunningham@gmail.com
July 6, 2017
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1. This is a parable intended to explain the basic idea of macroeco-
nomics: why we have recessions, and how we can get rid of them.
2. The starting point is that modern societies are specialised, so that
each person exchanges their labour for the products of the rest
of the world, using money as a medium of exchange. The big
puzzle of macroeconomics is why the web of exchange sometimes
abruptly shrinks, leaving empty factories, fallow fields, and un-
employed workers (i.e., all of which are reflected as lower GDP)
without any tangible cause. The most accepted theory is that it’s
the fault of the slowness with which prices and wages change. The
parable tries to show how this sluggishness in prices can cause the
network of exchange to shrink, i.e. a recession. It also tries to ex-
plain the logic behind interventions in the economy (monetary and
fiscal policy) intended to smooth out recessions.
3. After the parable I state a simple formal model, to make explicit the
assumptions being used. Finally I discuss a list of related economic
issues, and how the basic story can be used to make sense of them.
SETUP
4. Imagine a village with ten identical households, each of which starts
off as self-sufficient: each grows their own wheat, herds their own
sheep, raises their own tomatoes, etc.. However each household
gradually discovers that they can become better off by specialising:
if, for example, your household were to concentrate entirely on
growing wheat, then you could grow it very efficiently, and then
exchange that wheat for vegetables and meat, and whatever else
you need.
5. So suppose the village organises a market every Saturday where
everyone brings the thing they produce: the farmer sells her wheat,
the shepherd sells her sheep, the market gardener sells his tomatoes.
6. And suppose that on Saturday mornings each farmer brings 10
sacks of their crops to the market, and at the end of each Saturday
they bring home 1 sack of their own crop, and the 9 sacks of the
others’ crops that they’ve bought in exchange.
7. And finally suppose that they use sea shells as a form of money.
Each farmer owns 10 shells, and over the course of a Saturday
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they use these shells to buy others’ vegetables, and receive shells
in return for their own, so that at the end of the day each farmer
returns home with 10 shells. Suppose that the price of all vegetables
is the same, 1 shell per sack of vegetables. The price of crops will
naturally be proportional to the number of shells in circulation: if
there were 10 times as many shells in circulation, then the price
would be 10 shells per sack.
RECESSIONS
8. Suppose that one Saturday morning every farmer decides they
would prefer to buy fewer crops (and thus save more shells) than
usual. This could be for any reason: because each expects a harsh
winter, or because each is saving for a wedding. Each farmer will
therefore arrive to the market with the intention to buy fewer goods,
and save more shells, than usual.
9. Now, it is possible for any one farmer to return home with more
shells than they arrived with, but it is not possible for every farmer
to return home with more shells than they arrived with, because
there are only a fixed number of shells available.
10. If all of the farmers arrive with a higher demand for shells than
usual, then they will all spend less on vegetables than usual, and in
turn every farmer will notice that they are selling fewer vegetables
than usual. If the farmer wants more shells, they will have to cut
their prices, to get rid of their surplus crops and collect more shells.
In turn the lower prices will tempt each farmer to spend more of
their shells, because it’s cheaper to buy the other guys’ goods. The
price must keep dropping as long as each farmer has more of their
own vegetables than others’, until eventually it drops far enough
that each farmer returns home, as usual, with 10 shells and 10 sacks
of crops, one of each type of vegetable. When everyone has a desire
to spend less, this will cause only a decrease in the prices of goods,
but the total exchange of goods will not be affected.
STICKY PRICES
11. Now suppose instead that the farmers were not able to change their
prices: for example, if each farmer has already advertised their price
(one shell per sack) and they feel obliged not to cut the price. Then
each farmer will buy less, and therefore each farmer will sell less,
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and so at the end of Saturday each farmer will return home with
more of their own vegetables, and less of others’ vegetables. There
will be less overall exchange, and the farmers will be all worse off:
the children of the carrot farmer will have to eat carrot soup for
breakfast, carrot cake for lunch, and carrot pie for dinner. When
prices cannot change then a fall in the desire to spend causes a
fall in the amount of goods exchanged, making everyone worse off.
Next week the prices will change, and they will all fall, and the
amount of goods exchanged will bounce back, but in the meantime
there is a slump in the quantity of goods exchanged, and all of the
farmers will be unnecessarily worse off.
12. The observation that prices change slowly, and this causes un-
necessary fluctuations in exchange, is the core dogma of orthodox
macroeconomics.
ANTI-RECESSION POLICY
13. The mayor of the village is distressed: she sees that the carrot
farmer’s children are sick of eating carrots, and the shepherd has a
barn full of rotting mutton. She sees that everyone could be better
off, but the system of exchange is not working as it normally does.
What can she do to prevent so much waste? Ideally she would find
some way of allowing people to drop their prices, or to force the
prices down. However the problem would also be solved if she could
somehow persuade every farmer to spend more money, because the
stickiness of prices has turned the situation into a tragedy of the
commons: each farmer is spending as much as they would like to,
but if all the farmers were to spend more then they would also all
sell more, and this would make them all better off. So the task of
fighting recessions is often described as persuading people to spend
more money.
14. monetary policy. Because the problem is that the old level of
prices is too high for today’s demand, an elegant solution is to
simply change today’s demand to make the old prices the correct
prices. This the mayor does by collecting shells from the beach,
stamping them with her official mark, and handing them to each
farmer as they arrive on Saturday morning.1 If prices were not
1Newly created money is not usually given away, instead it is used to buy bonds, but the effect is
similar, and the profit made from creating new money is usually quite small relative to other taxes.
4
sticky then increasing the amount of money would simply cause an
exactly proportional increase in prices: if, for example, the mayor
doubled the number of shells in circulation, then prices would dou-
ble. However because prices are slow to change, giving each farmer
more shells will make it relatively more attractive for each farmer
to spend. If the Mayor is able to choose just the correct amount
of shells, then farmers will spend enough to return to the original
state, in which each farmer returns home with one sack of each
type of vegetable, and everyone is made better off.2
15. As we said, monetary policy can be thought of as changing the
market conditions, so that the fixed level of prices becomes the
price level at which a healthy level of exchange takes place. Thus
as mayor you could instruct the head of the village Mint to follow
this policy: from week to week, increase or decrease the quantity of
shells necessary to keep the average level of prices stable. This pol-
icy should offset any fluctuations of demand, and should keep the
level of exchange at an efficient level. This is roughly the doctrine
of modern central banks: they try to managethe money supply so
that the average price level remains constant, or more commonly,
so that it slowly grows at a predictable rate, e.g., a 2% rate of
inflation.
16. fiscal policy. An alternative solution to the problem is for the
mayor to stand by the village gates on a Saturday morning, and
as each farmer passes, confiscate some amount of shells from each
one. The Mayor then uses the confiscated shells to buy vegetables
off the farmers which she distributes to the town. As a farmer you
end up with the same number of shells, because for every shell you
lose in taxation, the government pays you a shell for your produce.
But instead of returning home with your unsold produce, it is now
owned by the mayor, who then distributes it for free.3 This policy
(fiscal policy) is usually regarded as a less efficient way of countering
out recessions than monetary policy, because the distribution of
vegetables is now determined by the mayor, instead of the farmers
themselves.4
2Note that farmers are still not saving any more, their net savings are zero.
3Note, this is equivalent to balanced-budget fiscal policy. In fact it is more common to use deficit-
financed spending, in which you borrow shells off each farmer, to buy food now, and repay the shells
later, by taxing the farmers in the future.
4There may be other reasons for the mayor to put on a regular feast, but here we are just interested
5
17. It is very important to keep in mind that these stimulative policies
only make sense when prices are fixed. If we assume prices are flex-
ible, as is done in classical economic analysis, then neither fiscal nor
monetary policy make any sense at all. Printing money will only
increase prices, it will not increase exchange. Taxing in order to
spend will just change who controls the distribution of vegetables,
it will not increase the overall amount of vegetables exchanged.5 If
we assume that in the long-run all prices adjust to their equilibrium
levels, then these policies will only work temporarily, while prices
are stuck at their old levels.
IN A NUTSHELL
18. The overall level of prices reflects how much people value money
relative to goods and services. When that tradeoff changes, for ex-
ample when people have a lower desire to spend today, then the
equilibrium level of prices will change, but there should be little ef-
fect on the amount exchanged. However if prices are fixed then a
fall in the desire to spend will cause a contraction in the volume
of goods and services exchanged, leaving everyone worse off. The
volume of exchange can be reinflated either by printing and dis-
tributing more money, or by the Government enforcing exchange
through tax and spending.
19. More precisely: why did I have a job at Starbucks in 2007, but no job
in 2009? The answer is that everyone stopped spending money, yet
prices and wages remained the same instead of falling. So, many
previously profitable jobs became unprofitable, i.e., people were will-
ing to buy fewer cups of coffee at the 2007 price. Then why didn’t
Starbucks just cut their prices and wages, to sell the same amount
of coffee, instead of laying off workers and closing stores? This
remains a fundamental puzzle, some theories, discussed below, are
(i) because the effect on Starbucks’ profit is small, even though the
effect on employment may be large; (ii) because Starbucks doesn’t
want to cut their prices or wages without other firms cutting theirs
at the same time; and (iii) firms are particularly reluctant to cut
wages because it has a bad effect on morale.
THE STICKINESS OF PRICES
in tools to fight a recession.
5Or if it does, not in a beneficial way (discussed below).
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20. The slowness of prices to change is the single essential ingredient
of the mainstream of macroeconomic theory since the middle of
the 20th century (often called “Keynesian” or “new Keynesian”,
though the idea was explained at least as early as Hume). From
here on, when I say “price” I mean both prices and wages, because
a wage is just a price for labour. The general belief by economists
in the sluggishness of prices, usually called price stickiness, is based
on two observations (a third observation is that if prices are sticky,
this could explain why we have unemployment).
21. The first observation is simply that most prices and wages change
very gradually over time, whereas supply and demand can change
rapidly. The wholesale prices of oil and wheat fluctuate a great
deal from day to day, but this is not the norm, most prices are
extremely stable. Think of the prices of a pack of spaghetti, a
pizza from a restaurant, the price of a telephone connection, the
price of a t-shirt, or the wage needed to hire a dish-washer: these
prices mostly remain the same month to month, even from year to
year, despite changes in supply and demand for each good. The
reason why prices and wages move so slowly remains a subject of
argument.
22. The second observation is a pattern in historical economic data:
recessions (i.e. periods of low GDP and high unemployment) tend
to occur at the same time that prices are falling, and booms tends to
occur at the same time that prices are rising (i.e., during periods of
inflation). This empirical relationship is called the Phillips curve,
after a paper by A.W. Phillips in 1953, and it is what the story
above predicts: when people are trying to spend less then prices
will tend to fall, but won’t fall instantaneously, so there will be a
period of low exchange and falling prices. Likewise when there is
an overall increase in spending the amount of goods exchanged will
be temporarily higher than usual, and over that period prices will
be rising to catch up.6
APPLIED TO THE US RECESSION OF 2007-09
6In the 1970s many developed countries had a period of “stagflation”: simultaneous high inflation
and high unemployment, which is not predicted by the Phillips curve. This is usually interpreted as
being due to an increase in inflation expectations: if people are expecting prices to increase by 15%,
then a fall in demand may cause prices to increase by only 10% instead. The Phillips curve can be
reinterpreted as a good description of the difference between actual and expected inflation.
7
23. Here is a simplified story, transposed from the village market, to
the US economy in 2007.
24. Think of a typical American family in 2007, who earns $4,000 per
month.7 The national average savings rate was around 0%, mean-
ing that families spent their entire income. The low desire to save
was probably due to the prices of houses, which had been increas-
ing at 10% per year, and since most families owned houses, this
seems to have reflected optimism about the future in some sense.
However in mid 2006 house prices stopped rising, i.e. the optimism
started to peter out, and in during 2007 people started to cut back
spending, and therefore increase saving.
25. Many people cut back their spending by about 5% by, for example,
deciding not to buy a new house, not buying a new car, to less often
buy a coffee on the way to work, or to not buy a new laptop. Thus,
at the existing level of prices and wages, there was less demand for
goods and services, and people started losing jobs (the construction
worker, the car manufacturer, the coffee maker, and the laptop
seller).
26. The original level of employment and output could be restored if
both wages and prices fell in response to reflect the lower demand
for goods and services relative to money; the lower level of prices
and wages would cause people to spend more money, restoring the
balance. However prices and wages did not fall, they remained
quite flat. So employment (and hence GDP) fell by 5% between
summer 2007 and summer 2009.
27. Remember that GDP is principally a measure of the value of goods
and services produced for exchange. So when GDP falls it means
that the extent of exchange has contracted: it means that many
people are at home, cooking themselves meals, entertaining them-
selves, and polishing their own nails, insteadof entering into the
huge network of exchange; likewise office buildings, roads, factories
and telephone lines all suddenly became unused.
28. The following policies were used to try to restore employment and
output:
7In 2007 there were 100 million households in the US, with average income of $150,000, median
income of $50,000. http://research.stlouisfed.org/fred2/series/USARGDPC
8
(a) the Federal reserve increased its lending of money, from $1Tn
to $2Tn ($10,000 per household)
(b) the Federal government rebated around $1Tn of taxes in 2008
and 2009 to households ($10,000 per household)8
(c) the Federal government spent around $500Bn in 2008 and 2009
on new projects ($5,000 per household, although at the same
time state and local spending decreased by about the same
amount)
(d) finally, the Federal government has been spending around
$100Bn extra in unemployment benefits per year since 2008
($1,000 per household per year)
29. In fact, despite these policies, employment and GDP have only
recovered very slowly towards to their previous levels. Some say
this is because the policies were not effective; others say that the
recession would have been worse without them.
8Sounds suspiciously large.
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A FORMAL MODEL
Here I will briefly describe a mathematical version of the parable.
The model is not necessary for understanding the parable, but it helps
in making clear a set of assumptions sufficient to produce the behaviour
described. In brief, suppose an economy has farmers who are identical
except for producing differentiated goods, who have a desire to hold
real money balances, and who price their goods competitively, but the
sellers must commit to prices in advance. Then an exogenous increase
in the demand for money will cause the volume of exchange to fall, a
Pareto-dominated outcome. The efficient equilibrium can be restored by
increasing the money supply.
In more detail: suppose there are two farmers, i ∈ {b, g}, who are
each able to produce x̄ sacks of beef and grain each per week respectively.
They also both hold money, mi, and I represent their preferences with
Ui =
!
j∈{b,g} ln(x
j
i)+γ ln(
mi
p
), where xji represents farmer i’s consumption
of good j, and p is the overall price level, p = 12
!
j∈{b,j} pj. The game has
three stages: first, both farmers simultaneously choose the price of their
own good (pj) – and I assume that prices are set competitively (i.e., prices
clear markets based on submitted demand and supply schedules); second,
the demand for money (γ) is realised; finally, both farmers simultaneously
choose how much to buy from the other farmer at the posted price. The
farmers’ budget constraints will be (for j ̸= i, and with m0 being the
money endowment of both farmers):
income = expenditure
initial money + money earned = final money + money spent
m0 + x
i
jp
i = mi + x
j
i p
j
If both farmers maximise their utility then the marginal benefit of holding
a good ( 1
xji
) will equal its marginal cost (γ p
j
mi
), so each farmer has a
demand function,
xji =
mi
γpj
=
xijp
j + m0
(1 + γ) pj
with a marginal propensity to consume from income of 11+γ . For a given
pi, pj, equilibrium is shown on the diagram. The symmetric equilibrium
(with xgb = x
b
g, p
b = pg, m = m0), will have x
g
b = x
b
g =
m0
γp
, i.e. for a
given price level, output will be increasing in the supply of money, and
decreasing in the demand for money (γ).
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✻
✲
xbg
xgb
✟✟
✟✟
✟✟
✟✟
✟✟
xgb(x
b
g)
✁
✁
✁
✁
✁
✁
✁
✁
✁✁
xbg(x
g
b)
Figure 1: Output Determined by Demand
Suppose first that prices are flexible (equivalently, suppose that γ is
as expected). A Pareto-optimal equilibrium would be for each farmer
to have identical consumption baskets, i.e., xgb = x
b
g =
x̄
2 . In this case
prices must be p = 2m0
γx̄
, implying that if there is an exogenous change
in money supply or money demand (m0 or γ), then prices will move to
exactly offset the change, and restore efficiency.
Alternatively suppose that γ changes after prices are set. When prices
are below their efficient level we are now in a prisoner’s dilemma: both
farmers would be made better off if they could agree to spend more
money, but it is not in either farmer’s own interest to spend more. Mon-
etary policy, through changing m0, can return the economy to the efficient
level of exchange.
You could think of fiscal policy as working by confiscating money and
buying goods, which are then handed out; in the budget constraint your
money will be unchanged, but xji and x
i
j will both exogenously increase
by the same amount.
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NOTES & EXTENSIONS
1. Making sense of macroeconomic arguments. When discussing
macroeconomic issues in this framework it is extremely important
to be clear about the distinction between the “short-run” and “long
run”, which are used to refer to the model in which prices are
fixed, and the model in which prices are free to adjust. The ef-
fects of a policy will often be completely different in the short-run
and the long-run, and confusing these two issues is a large reason
why macroeconomic policy discussion can be so confusing. Here
are some common issues explained with reference to the parable of
the vegetable farmers.
(a) “job creation” – why should we want to create jobs? Isn’t it
better if we can work less, rather than more, everything else
equal? In the long run the number of jobs simply reflects the
amount of work done for exchange (rather than for yourself),
and is determined by the returns to specialization. However
in the short-run employment can fall because of a lack of de-
mand, and so during a recession the quantity of jobs has a
different significance: it now indicates the progress in recov-
ering from a slump in demand. Work isn’t desirable in itself,
but the amount of work done is an indicator of the health of
the economy, so that is why it makes sense, in some circum-
stances, to create jobs.
(b) encouraging consumption – during recessions economists
often talk about a lack of consumer spending. In the long-run
we might be concerned that people are spending too much or
too little, for their own sake, but in the short-run consumer
spending has another significance, as explained in the parable:
if every farmer could be persuaded to some more vegetables
at the market, then everyone would be better off, because
they would be exchanging more. It is for this reason that
Governments and central banks want to encourage consumer
spending, though these reasons apply only during a recession.
(c) bad news causing unemployment – when we talk about
why there is unemployment we often accept that it can be
caused by a negative event: e.g. by a fall in the stock market
or house prices, because of the hurricane, or caused by a re-
cession in another country. However this explanation is very
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superficial: why should bad news cause us all to work less?
Think about the analogy of a single farm: if something bad
happens to a farmer (a barn burns down, or the price of his
crops falls), then why would the farmer work less? In most
cases it seems more plausible that they will work more. Yet
looking at history we do see that unemployment in a country
often follows bad news. This connection can be explained by
the model of sticky prices: if bad news causes people to spend
less money, and if the price level doesn’t adjust immediately,
then the amount of exchange will fall, and there will be less
employment. And indeed, in this parable, in the long-run bad
news will often cause people to work more.
2. Monetary policy: In real life monetary policy does not con-
sist of just giving away money. Instead the central bank usually
buys things with the newly created money. Generally they buy
Government-issued bonds, and for this reason monetary policy is
often described as raising or lowering interest rates, instead of as
increasing or decreasing the amount of money, but the two actions
are equivalent: when the central bank issues more money they use
it to buy government bonds, buying bonds raisestheir price, which
is the same thing as lowering the interest rate on those bonds (and
in lowering the interest rate on government debt, in turn this tends
to lower the interest rate on all debt). In the model of the farm-
ers you could say this: the mayor stands by the gate on Saturday
morning, and offers to lend each farmer 10 shells, which they must
pay back next week, at some interest rate. The farmers are happy
to take extra shells, if the interest rate is sufficiently low, and then
because they now have more shells on hand, they will become rela-
tively more inclined to spend shells, and this will tend to push the
economy back towards greater exchange.9
3. Sticky inflation & downward nominal rigidities: Since the
rise in unemployment in 2007 and 2008, many countries have had
high unemployment stay high for a long time, yet inflation has
not fallen as would be predicted by the Phillips curve. We would
normally expect the high unemployment to reflect low demand,
and therefore falling prices.10 A common explanation is that this is
9Note that the farmers should be glad to borrow the shells at a positive interest rate because they
get utility directly from holding the money.
10Or, if inflation is sticky, then a fall in the inflation rate, i.e. disinflation.
13
due to prices and wages (especially wages) being particularly slow
to drop in nominal terms. I.e., people are very resistant to selling
their goods, or their labour, at a lower nominal price than they had
previously been selling it. There is strong evidence for this effect
in the labour market, in the high density of zero-change in wages.
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4. Taxation: For the mayor to raise money to pay for public services
she has to impose a tax. She can either demand that each farmer
pay a certain amount of money (a poll tax), or she can demand that
they pay an amount proportional to the value of the vegetables they
sell or buy (an income tax, or a consumption tax). If she uses an
income tax then, from each farmer’s point of view, exchange is now
less attractive: if the tax is 50% then, for every sack of carrots that
I grow, I will receive only half a sack of cabbages, or half a sack
of lettuces, etc.. So now each farmer will tend to do relatively less
exchange, and become relatively more self sufficient.12
This effect of taxes can readily be seen in everyday life: suppose
that I would be happy to pay someone $10 to make me a sandwich
at lunchtime, and there is someone who would be happy to work
making sandwiches if they can sell them for $10. However every
time that we make this transaction we have to set aside $3 for the
tax collector. This discouragement will tend to decrease the amount
of exchange done, so that I may make my own sandwiches in the
morning, and the sandwich-maker stays at home instead. In this
way higher taxes tend to lower the overall extent of specialization
and exchange.
5. Price Setting. In the story I did not specify how prices are set,
and in the model I assumed that prices are set competitively. This
implies that each farmer has an enormous incentive to change their
prices. Instead it may be more reasonable to think that they set
their prices monopolistically, so that a small change in price has
a small effect on sales.13 Think about what this implies for the
11Note that this argument only makes sense for sticky inflation, not for sticky prices. See for example
Fuhrer, Olivei and Tootell (2011), and an IMF paper on disinflations during persistent large output
gaps.
12In fact, in the perfectly symmetric framework here, an increase in taxes will increase exchange, be-
cause farmers have to sell more vegetables to pay the tax, but the volume of exchange will nevertheless
be lower than the efficient level (which would be achieved with a lump sum tax).
13Blanchard & Kiyotaki (1987, AER) “Monopolistic Competition and the Effects of Aggregate De-
mand”
14
village: each farmer now has an incentive to raise their price above
the competitive level, therefore the extent of exchange will shrink.
The carrot farmer’s family will tend to eat somewhat more carrots
than everyone else, and the beef farmer’s family will eat relatively
more steak; i.e., the effect of monopoly is to retard trade and have
a less efficient distribution of goods.14 Now consider the effect of
prices being temporarily above their equilibrium level: sellers will
only have a weak incentive to cut prices, because although a cut
will increase sales, profits will not be much affected in the neigh-
borhood of the optimum.15
Second, suppose that everyone else’s price is stuck at the old level,
but you have the chance to adjust your price to reflect new condi-
tions. Will you adjust it to the new equilibrium price? If you are in
partial competition with other firms, then you only need to lower
your price a little to bring in many more customers (i.e., prices
are strategic complements). This fact is another reason that prices
may adjust very slowly to their new equilibrium levels.
6. Why have money at all? Why don’t the farmers just barter
instead? The usual argument for the existence of money is that
it allows us to make indirect trades: suppose the potato farmer
wants beans, the bean farmer wants garlic, and the garlic farmer
wants potatoes. No pair of these farmers can make an exchange
which directly makes both of them better off, they have to barter
and accumulate vegetables that they will use later to exchange for
vegetables that they want. However if we introduce money then
each can directly make a trade, without accumulating goods that
they would only want to resell later. In the model I described
above barter would in fact work, this is due to the assumption that
the situation is perfectly symmetric: in general barter is much less
efficient than using money.
7. International effects: Suppose there are two villages, one which
uses shells, one which uses pebbles. We assume that prices are
slow to adjust in both villages, but that the exchange rate between
shells and pebbles can adjust immediately, and also that trade is
14The effect of monopoly power is clear in everyday life. Suppose that everything was priced at its
marginal cost: software and music would be free, branded computers would be sold for the price of
no-name computers, and shops in the middle of the cities would sell things for the same price you
would pay way out on the outskirts of town.
15In other words, the welfare loss is first-order, but the gains from changing prices are second-order.
15
balanced in the long-run. Suppose extra shells are handed out.
It then becomes relatively less attractive to hold shells due to ex-
pected inflation, so citizens of both villages will be less inclined to
hold shells, causing more shell-expenditure, and lowering the value
of shells relative to stones (the exchange rate). Thus expenditure in
the pebble village will also decrease because it has become relatively
more attractive to buy shell-denominated goods. Thus expansion-
ary monetary policy in one country tends to lower expenditure in
other countries; but expansionary fiscal policy in one country will
tend to raise expenditure in other countries.
8. Monetary union: Suppose there are two villages with the same
currency, but a fall in demand occurs in only one of them. In this
case monetary policy cannot be as effective in counteracting the
fluctuations in demand, because stimulating the depressed village
has the side-effect of over-stimulating the other village.
9. Debt-deflation: In general the model implies that when there
is a recession it would be best if all wages and prices could fall.
However a change in prices could also have a second effect: if the
farmers have been lending money between themselves, then a fall
in the price level will make the lenders richer, and the borrowers
poorer. (...)16
10. Stagflation and expectations. As discussed above, the basic
theory predicts that booms will be times of high inflation, and
recessions will be times of low inflation. In the 1970s andearly 80s
many countries experienced “stagflation”: high inflation and high
unemployment at the same time. A common diagnosis is that in
the early 1970s many central banks increased their money supply,
to boost employment and output. If their output had been below
the natural level, this would have kept prices constant. However
output was not below its natural level (or, alternatively, too much
money was introduced due to political pressure). Thus the extra
money caused inflation. As this continued for some time consumers
and firms came to expect inflation, so that the natural level of
output could only be achieved if prices kept rising at the same
rate. In the early 1980s, having diagnosed the problem in this way,
central banks cut the rate of growth of money supply – which was
16See Krugman & Eggertson (2010) “Debt, Deleveraging & the Liquidity Trap.”
16
the equivalent of cutting the money supply in the world without
inflation. This caused spending to fall (relative to expectations),
and so prices were stuck at a higher than natural level, and so GDP
fell.
RELATED LITERATURE
1. I’m not aware of another simple model which has the same features
as this parable:
(1) there is a clear distinction between long-run and short-run out-
comes
(2) you don’t need to distinguish between firms and consumers, or
wages & prices
(3) it emphasises that a recession is a fall in the volume of goods &
services exchanged, and exchange only makes sense because of spe-
cialization (in a representative agent model, it’s difficult to think of
the intuition of why output falls with sticky prices)
(4) unlike the IS-LM it’s all done at the individual level, and budget
constraints are explicit (& so it’s somewhat easier to think about
welfare implications17)
(5) it emphasises that there are certain things that most macroe-
conomists believe happen, but they disagree over why (the stickiness
of prices, & the causes of changes in money demand)
Finally, a similar story is also good for explaining trade models:
e.g., the Ricardian, Heckscher-Ohlin, & increasing-returns models
of trade can be explained with stories about farmers trading their
products in a village market.
2. Hume (1742) “Of the Balance of Trade”
http://www.econlib.org/library/LFBooks/Hume/hmMPL28.html#b53
3. Blanchard & Kiyotaki (1987, AER) “Monopolistic Competition and
the Effects of Aggregate Demand”
Famous simple model to show you can get short-run effects of ag-
gregate demand with monopolistic competition plus sticky prices
(because of monopolistic competition there is an externality from
aggregate demand, even when prices are flexible (everyone would
be better off if we all reduced our prices)).
17Of course welfare implications depend on assumptions about the cause of price stickiness, and the
cause of the demand shift, but it’s still much easier to interpret than ISLM.
17
4. Joan and Richard Sweeney (1978, JMCB) "Monetary Theory and
the Great Capitol Hill Baby-Sitting Co-op Crisis."
A story about the breakdown of exchange of babysitting services, be-
cause .
Often discussed by Krugman: http://www.slate.com/articles/business/the_dismal_scie
5. Blanchard & Fischer (1989) “Lectures in Macroeconomics”
pp 376-380 has a “yeoman-farmer” model
6. Krugman (1999) “World’s Smallest Macro Model”
http://web.mit.edu/krugman/www/MINIMAC.html
He also says it maps pretty well onto the baby-sitting coop parable.
7. Krugman (1999) “There’s Something About Macro”
http://web.mit.edu/krugman/www/islm.html
8. Romer, (2000), “Keynesian Macroeconomics without the LM curve”
Replace fixed money supply with a Taylor rule (IS-MP model)
9. Benassy (2007, EL) “ISLM and the Multiplier: a dynamic GE
model”
He shows you can get basic ISLM predictions with (a) sticky prices,
and (b) overlapping generations, to prevent ricardian equivalence.
(In particular, with Ricardian equivalence, it is difficult to get a
multiplier bigger than 1.)
10. DeLong (2010) “Mr. Hicks and "Mr Keynes and the ’Classics’: A
Suggested Interpretation"”
http://seekingalpha.com/article/210956-mr-hicks-and-mr-keynes-and-
the-classics-a-suggested-interpretation
Says ISLM is a combination of Fisher, Wicksell, Kahn.
11. Kimball (2012) “the deep magic of money”
http://blog.supplysideliberal.com/post/31655212753/the-deep-magic-
of-money-and-the-deeper-magic-of-the
12. Sumner (2013) “Money & Inflation Part 3 (the Quantity theory of
money & the great inflation)”
http://www.themoneyillusion.com/?p=20216
Good explanation of how supply & demand for money determine
the price level when there’s fiat money, & the effect of monetary
policy in the long run.
18