Saturday, 29 March 2014

Rediscovering IS-LM

At Pieria, I attempt to show how Paul Krugman's favourite economic model can give important insights in an endogenous money framework:
"This post was sparked by recent conversations with people who have opposing views of how money creation works. Some people think that classical models such as IS-LM don't work with endogenous money theory, therefore the models need to be discarded: others think that there's nothing wrong with the model and the problem is endogenous money theory. Personally I think that simple models like IS-LM can be powerful tools to explain aspects of the working of a market economy, and it behooves us therefore to find ways of adapting them to work with an endogenous fiat money system.So this is my attempt..... "
Read on here.


  1. Hi Francis,

    Very good post.

    Even if ISLM is seen to be cumbersome when set next to full scale dynamic financial system modelling, we can probably learn from the way in which different people do attempt to interpret it. There is a challenge in attempting to decipher its awkwardness. It is also interesting to see how some who believe in it as a useful tool have gradually been evolving their interpretation of it. So on that basis, I’ve never dismissed it as useless. If it is a gadget as Hicks described, it’s an intriguing gadget.

    A few quick comments/observations:

    The anchor for the whole thing in my view is that the money supply is fixed. But I think it’s a mistake to associate that with the gold standard – which many people do. I see no reason to single out the gold standard as to whether money supply is fixed or variable. As far as I know, banks making loans credited deposit accounts then too. Gold was just a constraint. It wasn’t prohibition on double entry bookkeeping.

    Interpreting the money supply as fixed involves just that – freezing it while attempting to analyze all other dimensions.

    As I said elsewhere, the idea of M being the base is a pretty specific assumption. But the interesting thing about ISLM is that the assumptions are a moveable feast. There are no laws of exactly what certain pieces of it must refer to. In that regard, I don’t believe the real/nominal rules are set in stone either.

    As I also said, I’d be concerned about the general treatment of IS as being reflective of credit creation. It’s very reasonable to assume that there’s credit creation and destruction going on, but it’s also reasonable to assume that the velocity of money is volatile. I’d be flexible on that. That said, the sliding IS curve viewed as a credit machine fits nicely with an unchanged monetary base I guess.

    All that said, the Keynesian multiplier makes no direct assumptions about the creation of credit, does it? It actually could work in theory as if money was fixed and credit was fixed and velocity of money just got cranked up.

    Anyway, that sort of goes against the thrust of your post, but only at the margin. I would interpret it as a strongly correlated credit creation effect as you described – but something that is really going on in the background to what ISLM says more directly. However, it is a very good thing to be bring out as an inextricably associated financial system effect.

    I get a bit lost starting to think about changes in the base, QE, etc. as those relate to this interpretation of the model. Given the underlying debates and disagreements about how the base relates to broad money, that adjustment gets pretty complicated. And of course, I’d much rather interpret the credit creation process as the leveraging of buoyant and growing bank capital positions than a growing monetary base.

    - Still looking for bank capital in some nook or cranny of ISLM, but haven’t seen it yet :) 

    BTW, doesn’t Krugman show IS and LM intersecting below the zero bound as indicative of a liquidity trap? If so, isn’t he using nominal interest rates? (Maybe I’m not recalling that correctly).

    Finally, Krugman has been resorting selectively to ISMP over the past year – where the interest rate is the policy rate. ISMP started with David Romer, I believe, here:

    One question:

    How does ISLM show that falling interest rates are deflationary?