IS-LM is bad economics no matter what Krugman says


"There is nothing in the post-General Theory writings of Keynes that suggests him considering Hicks’s IS-LM anywhere near a faithful rendering of his thought. In Keynes’s canonical statement of the essence of his theory in the 1937 QJE-article there is nothing to even suggest that Keynes would have thought the existence of a Keynes-Hicks-IS-LM-theory anything but pure nonsense. So of course there can’t be any “vindication for the whole enterprise of Keynes/Hicks macroeconomic theory” – simply because “Keynes/Hicks” never existed..." (see rest here)

Comments

  1. Well I have a much more positive view of ISLM. The problem is not with the interaction per se of a an IS equilibrium and an LM equilibrium, but the way it's done in the mainstream. You can have an IS with the marginalist negative relation between investment and interest rate, and an LM that allows for endogenous money. For more see this post http://nakedkeynesianism.blogspot.com/2011/02/islm-what-is-it-good-for.html

    ReplyDelete
    Replies
    1. I meant an IS without the negative relation between I and r.

      Delete
    2. Matias is right, I think.

      My preference is for an upward-sloping IS curve (because the marginal propensity to consume plus invest may be greater than one).

      The LM can have any slope, depending on what the central bank is doing. In Canada, the LM curve is:
      horizontal in the very short run (6 weeks, when it targets a nominal interest rate)
      vertical in the medium run (maybe a few months, when they sort of target the output gap)
      horizontal with the inflation rate on the vertical axis in the long run (2 years, when they target 2% inflation).

      Delete
    3. The ISLM is stock-flow inconsistent. When the interest rate rises the interest income on bonds rises too, thus giving rise to higher levels of aggregate demand (as Godley and Lavoie showed in their book "Monetary Economics"). Thus, if the interest rate rises it can have non-linear effects on aggregate demand.

      This can be quite important. Consider, for example, the failed monetarist experiment in Britain under Thatcher. When the central bank tried to restrict the money supply interest rates broke the 20% barrier -- and the money supply/inflation continued to grow faster and faster. One component was the 20% then being paid on savings accounts which was then spent into the economy. A person with 100,000 pounds in savings was getting 20,000 (nominal) pounds in interest income which they would rush to spend because of the inflation.

      The ISLM is completely unfixable framework simply because it is stock-flow inconsistent. It needs to be dropped. (Also, if you introduce endogenous money it becomes rather meaningless, but I won't go into this here...).

      Delete
    4. By the way, I should also add that the mainstream has -- at the "upper-levels" -- accepted a flat LM-curve in line with the Taylor Rule, although the flat LM-curve is then thought to shift because central bankers adhere to the Taylor Rule (in fantasy-land, but whatever...). The rest of the profession, as is typical, has failed to get the memo.

      "The main change [from the ISLM model] is that it replaces the assumption that the central bank targets the money supply with an assumption that it follows a simple interest rate rule. Because of the new approach’s many advantages over IS-LM-AS, variants of it have surely been developed by many instructors. Yet to my knowledge it is not used as the main approach in any intermediate macroeconomics text." (Romer, D. 'Keynesian Macroeconomics without the LM Curve'. p154)

      The whole approach is broken and confused. The ISLM makes a teacher's life easier and allows for nice assignments to be handed out in class (derive this, derive that). But it is bad economics.

      Delete
    5. Hi Phillip:
      Congrats on graduation! In all fairness, there is nothing stock flow inconsistent in the ISLM. Note that if you have an exogenous rate of interest, the stock of money adjusts to the needs of the economy, i.e. the flow of income. Wynne's model had an IS (based on a multiplier) and endogenous money (and that can be an MP, which is a version of an LM), with the whole stock flow accounts. So does the Fair model, but Fair makes additional assumptions that Wynne didn't do.

      Delete
    6. Yes, Matias. But it doesn't and cannot take account of income flows coming from interest repayments. When interest rates rise it is assumed that this has linear effects on aggregate demand/income (i.e. AD falls due to a fall in investment). However, higher interest rates also mean a higher flow of income to savers.

      Delete
    7. Again that's not necessary. Sure thing the neoclassical story implicit in Hicks does, but one can discard that, and should.

      Delete
    8. But if you discard it the model doesn't work because if you raise the LM-curve it does not have linear effects on the IS-curve. The heart of the model is that shifts in the LM-curve -- no matter what shape it is -- has a linear effect on the IS-curve.

      Delete
  2. Also, arguably chapter 18 of the GT is kind of a non-mathematical representation of an ISLM, by the way, with all the marginalist problems.

    ReplyDelete
  3. Matias took the words out of my mouth. There are real problems with IS-LM, which are connected to the elements it shares with the marginalist theory of distribution. But these elements are present to some degree in the GT--as Matias notes, it's right there in ch. 18. Go have a look. As guide to sensible macroeconomic policy, the IS-LM model certainly overestimates the interest-elasticity of investment (which obviously depends heavily on expectations, as Keynes noted), but it provides a sensible rationale for countercyclical demand management policies.

    ReplyDelete
  4. Assessing the claim that Keynes had "sort of" an IS-LM model in GT is difficult partly because in his 1937 paper Hicks actually elaborates four different models:

    1) "Classical": M = k*I I = C(i) I = S(i,Y)
    2) Keynes' "special" theory: M = L(i) I = C(i) I = S(Y)
    3) Keynes' "general" theory: M = L(Y, i) I = C(i) I = S(Y)
    4) The "generalized general" theory: M = L(Y, i) I =C(i) I = S(i, Y)

    It is obvious from the way Krugman draws his IS-LM curves that he is thinking in terms of model number 4 - and that is not even by Hicks considered a Keynes model (modells 2) and 3)). It's basically a loanable funds model, that belongs in the "classical" camp and which you find reproduced in most neoclassical textbooks! Hicksian IS-LM? Maybe. Keynes? I think not.

    ReplyDelete
    Replies
    1. Hi Lars, I think we all agree that the neoclassical synthesis version of Keynes (which you are correct, maintains a natural rate of interest, and is a Loanable Funds theory) is not what Keynes intended. He was clear that he wanted to get rid of the natural rate. He was, in my view, less successful than he wanted. And as Franklin says below chapter 19, with flexible wages, is quite different from Hicks.

      Delete
  5. Matias and Dr. Mongiovi all share my position. I found this post on real world economics blog and hoped to generate some discussion, which it inevitably did. With the same reasons that I have a negative view of the notion of long-run disequilibrium-negating an understanding of an unemployment trend line - I have a positive view of the IS-LM model used correctly as a means to construct aggregate demand management policies and highlight the essence of a monetary theory of production.

    ReplyDelete
  6. hi, this is franklin serrano

    Keynes wrote a letter to Hicks in which he
    said that he had "next to nothing by way of criticism"
    apart from saying that investment should depend on future expected income rather than current income.
    In my view most people do not take into account that in Hicks paper money wages are given. the difference between Keynes and ISLM only stand out when they are flexible. As gary says chap 18 is just like hicks paper. But chap 19 is very different from modigliani 1944.

    ReplyDelete
  7. hi

    do you have further references where we can read more about the IS-LM model variations that are being commented here?

    Thanks in advance,

    Gabriel

    ReplyDelete
    Replies
    1. I'm being a bit disingenuous here. For me any model in which the IS equilibration is done by income (effective demand) rather than interest rate (Loanable Funds) and has monetary side is an ISLM. I prefer models in which the LM is represented by an exogenous rate of interest, and the Investment function is dependent on income and not the rate of interest (get rid of the marginalist theory of distribution). Bortis as suggested by David is a great intro to these models. Read also Franklin Serrano's stuff on the super-multiplier.

      Delete
  8. Keynes and the Classics: Notes on the
    Monetary Theory of Production
    by Heinrich Bortis

    http://cas.umkc.edu/econ/economics/faculty/Lee/courses/602/readings/structure1.pdf

    ReplyDelete
  9. This is by far the most important keynesian article since ISLM

    http://www.jstor.org/pss/1837124

    ReplyDelete
  10. The argument that IS/LM should be dumped because that is not what Keynes thought (or the position by Hicks forty years later) is argument by fatwa. The truth is not contained at Keynes general theory or any other bible. The only questions that is relevant are does the IS/LM give reliable answers? Can we identify the situations when we should use it? Is that a good framework to start teaching students? I find the answer to all those three questions is yes. Now is that the end all of macroeconomics? Of course not. But no model is.

    "O"

    ReplyDelete
  11. If only things were as easy as that. Of course labeling things are not the most important preoccupation in science - BUT etiquettes/labels do matter. If e.g. people call themselves New Keynesians and you can't find anything essential resembling the thoughts of Keynes in the models and theories these economists come up with - are you then really not entitled to criticize them for using a confusing misnomer that signals things that simply are not there? And if people say that they try to vindicate a Keynes-Hicks theory with models that arguable have very little to do with Keynes and that Hicks later retracted from, are you not entitled to be sceptical and criticize the whole idea of vindicating something that really never was there. If people want to use and defend the early Hicks's models of 1937 I think I wouldn't react so strongly. But when perpetuating the false idea of there really having existed Hicksian IS-LM-models that got hold of the essence of Keynes's thoughts I do react.

    ReplyDelete
    Replies
    1. Well here I think there is a distinction of what Keynes intended to do and what he achieved. I think you are quite correct that Hicks models do not get Keynes' intentions. But I do think that the ISLM is a reasonable representation of some ideas in ch. 18, in particular because Keynes was unable to shed some of his neoclassical ideas, particularly the marginalist notion of the Marginal Efficiency of Capital. But certainly one should discard those interpretations as flawed.

      Delete

Post a Comment

Popular posts from this blog

A brief note on Venezuela and the turn to the right in Latin America

A few brief comments on Brexit and the postmortem of the European Union