IS-LM is quite the rage this week. Perhaps I will come back with some further observations another time, IS-LM being a perpetual object of argumentation among monetary theorists and macroeconomists, but here are some of my own, mostly critical, observations about that old standby of Keynesian economics.
Everyone recognizes that, in its original Hicksian form, IS-LM is a static one-period model, which sharply limits its practical application unless it is augmented to give it some dynamic features. But augmenting it in the standard fashion doesn’t address, much less fix, its basic deficiency. What is the nature of a static one-period equilibrium in which there is positive investment and saving and a rate of interest? The model doesn’t have a coherent intuitive economic interpretation even in its one-period form. Merely adding some dynamics doesn’t address the disconnect between the model and basic economic concepts.
For example, does anyone outside of Cambridge England actually think of the rate of interest as the price of holding money? In the IS-LM model, the rate of interest is determined by the demand for money and a fixed supply of money (though in more up-to-date versions the interest rate is chosen by monetary authority). The demand for money depends on income, so investment spending and consumption spending do affect the interest rate by way of their influence on the demand for money. Now it’s true that there are bonds in the IS-LM model, otherwise there would be no way to measure the cost of holding money, but the presence of bonds doesn’t fix the underlying problem. Even though a bond market is included, it can be kept in the background out of sight inasmuch as you only have to solve for equilibrium in two of the markets in a three-good system to find the equilibrium for the third market as well (Walras’s Law).
The trouble is that the bond market, reflecting the supply of and the demand for loanable funds, is an epiphenomenon. There is a mismatch between the money market (demand for and supply of a stock) and the market for loanable funds (demand for and supply of a flow). In the real world, interest rates are not equilibrating the supply of and demand for loanable funds; interest rates emerge out of the process of evaluating all durable assets, which are nothing but claims to either fixed or variable future cash flows of various durations and risk characteristics. The structure of interest rates and risk and liquidity factors must adjust to bring about equilibrium between the demand for and the fixed supply of the current stock of physical assets. The interest rates on the subset of financial assets that we call bonds are determined as part of the process of valuing all durable assets, the valuation of bonds being constrained by the valuations placed on the entire range of durable assets. One of the good things about Milton Friedman’s 1956 restatement of the quantity theory of money was his explicit recognition that interest rates are determined not in a narrow subset of markets for fixed income financial assets, but in the complete spectrum of interrelated markets for long-lived physical and financial assets.
One way to handle this would have been to make explicit the consumption/investment tradeoff by defining a purchase price (for consumption) and a rental or hire price for current use of the output as an input in producing units of output for the next period. The rental price over the purchase price represents a real interest rate and allows in an obvious way for both expected inflation and a consistent distinction between the real and the nominal interest rate. (In the General Theory, Keynes explicitly rejected that distinction, based on reasoning implicitly assuming the existence of a liquidity trap, but in fact, using a comparative-statics approach, you can derive an effect on the interest rate in IS-LM from expected inflation when there is no liquidity trap. And if you start from full employment equilibrium, the comparative-statics exercise increases the interest rate by as much as expected inflation. Allyn Cottrell showed this in a paper some years ago, “Keynes and the Keynesians on the Fisher Effect,” Scottish Journal of Political Economy 41:416-33, 1994.
The conditions of factor-market equilibrium and money-market equilibrium can then be used to derive an equilibrium time path for the economy with the Keynesian spending (consumption and investment) functions suppressed instead of a meaningless bond market which can be discarded. Earl Thompson developed such a model nearly 40 years ago, but never published it. The 1977 version of his working paper deriving and applying the model is available here. He also modeled the monetary sector in a way that can be made consistent either with the competitive nature of a modern banking system or with the fixed money-supply approach of the General Theory.
Earl’s paper is tough to follow in a number of places, which may have something to do with its lack of influence. His earlier papers were not always written in the most accessible style, as he tended to leave out too many steps in his argument that were obvious to him, but not so obvious to his readers. To achieve a level of aggregation comparable to IS-LM requires some heroic assumptions, and making them explicit, as Earl did, underscored the unrealistic nature of his model, a characteristic that Hicks’s matter-of-fact presentation of IS-LM tended to obscure in his presentation. Also carrying out the analysis in terms of spending functions imparts a certain appearance of realism that is lacking from characterizing factor-market equilibrium in terms of a single labor input and the rental rate for using the single output as in input into its own production. That is probably why IS-LM, for all its faults, remains popular with people with a moderate degree of economic sophistication when trying to get a handle on economic policy. The fact that, despite its many shortcomings, some recognized some not, so many economists and policy makers are stilling using it is a sad commentary on the deplorable lack of progress made by macroeconomics over the past 40 years than on the virtues of IS-LM, a lack of progress for which both Keynesians and non-Keynesians alike can take the blame in roughly equal shares.