Friday, October 7, 2011

Good and Bad Arguments against IS-LM

Start with the bad, i.e. Tyler Cowan:
1. It fudges the distinction between real and nominal interest rates, so it can put the two curves on the same graph.  Every time you write down an IS-LM model you should hear a clock start ticking in your head.  The longer the clock ticks, you more you need to worry about this problem because the more that a) the price level may change, or b) expectations about future price level changes will start to matter.
Weird.  There’s no price level in the model.  Obviously IS-LM is a theory about real interest rates, and real everything else.  If you had an expanded theory with price level changes, the IS-LM part of it would use real  magnitudes.  What’s the criticism?
2. It fudges the distinction between short-term interest rates (for the money market curve) and long-term interest rates (a determinant of investment).  They’re not the same!  Don’t assume they are the same, just to squash the two curves onto the same graph.
The yield curve requires another dimension but doesn’t change the logic.  This is an add-on to IS-LM, not a flaw.
3. It leads you to think that the distinction between non-interest bearing currency and short-term interest-bearing securities is a critical wedge for the economy.  It also implies that if all currency paid interest (a minor change, most likely, macroeconomically speaking), the economy would behave in a totally screwy way.  It probably wouldn’t.
Hey Tyler, all IS-LM requires is that money earn less.  If it earned more, the economy would be screwy indeed.
3b. The model leads you to believe that interest rates are more important than they probably are.
That depends on the slopes of the curves, doesn’t it?  This is not a criticism of the model per se.  (Besides, there isn’t a 3a.)
3c. For a while it treats “money” as the non-interest-bearing security, and then for a while it treats money as the transactions media behind AD, something closer to M2.
The whole point of the LM curve is that money is both of these at the same time: transactions demand and liquidity preference, remember?
4. It overemphasizes flows and under-emphasizes stocks of wealth.  The quantity theory approach, as wielded by Fisher and Friedman, does not induce individuals to make this same judgment.  For one thing, this distinction really matters when you’re trying to predict the macro effects of “window breaking.”  The flows perspective will usually be more optimistic than a perspective which recognizes both stocks and flows.
This is a valid criticism, but again, how would the addition of stocks alter the IS-LM logic regarding flows?  Incidentally, the broken windows thing works like this: assuming your broken windows are capital stock, and that a reduction in it raises its marginal product, your IS curve shifts out.  If you have heterogeneous capital, and the loss of one part of it reduces the marginal productivity of the rest, your IS curve could shift in, at least temporarily.  Obviously, if you add in wealth effects you will depress investment via the effective demand channel, but that’s something that IS-LM is not built to handle.  You can’t solder with a screw driver, and this is not an argument against screw drivers.
5. Those aggregate curves are not invariant with respect to expectations, including expectations of government policy.  You don’t have to believe in an extreme version of the Lucas critique to worry about this one.  Those curves are conditional and the ceteris paribus assumption is not to be taken lightly here.
Yes, the position and shape of the curves depend on all sorts of things.  And?
6. In the LM curve, what is the embedded reaction function of the Fed?  Good luck with that one.  Pondering this issue leads you to conclude that the whole model was written for an economy fundamentally different than ours.
There is no reaction function and that’s perfectly fine with me.  You can ask, what would happen if the Fed had this particular reaction function, but that’s not the same as making that function an assumed part of the model you use for other purposes.  Models should inform policies, not assume them.  (And empirically, do we think that central bank decisions are so predictable?)
7. The most important points, for instance about the significance of AD, one can derive from a quantity theory or nominal gdp perspective (for the latter, see my Principles text with Alex).
MV=PY?  All the relationships between interest rates and income are in the background.  The Keynesian Cross?  How does that express liquidity preference?

So much for the darts that don’t stick—what are some that do?

1. The LM curve assumes a fixed money supply.  This would be dubious if it were just a matter of portraying an irrational and nonexistent central bank reaction function, keep the money supply constant at all times!  It’s worse than that, because most money is created endogenously through the provision of credit.  The IS curve would have us imagine that different levels of investment are open to the economy, but somehow they don’t correspond to different levels of the money supply on the LM side of things.  This is a big, big problem.

2. The model abstracts from default risk, but in doing so it ignores connections between interest rates and real income.  (It also introduces a channel through which changes in the price level can alter the relationship between real variables.)  In other words, incorporating default is not just adding on something new, it’s taking account of logical connections between the variables you are already modeling.  Omitting default is not always a consequential flaw, but when it is it really is.

Incidentally, my criticisms are not competitive with Hicks and the Post Keynesians, who argue that IS-LM  does not capture the core of what JMK had to say.  This is correct, but a different matter.

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