This well known Keynesian macro economic model is used by Paul Krugman to explain 'the Liquidity Trap' but he admits that the economic model could be all wrong. Its still worth examining, because of its popularity in topical macroeconomic discussions and debates. There is a heated albeit wonkish debate between Steve Keene and Paul Krugman about it.
We begin with an intuitive explanation rather than thread together an academic, jargon laden exposition. Later we will add provisos, gotchas and include more academic arguments.
Basic IS-LM Curve
The curve has two parts, a 'goods, services, production' part called IS (investment savings) and a monetary, bonds, cash part called LM (liquidity money).
They are treated as kinda separate although in reality that is not the case. An equilibrium point is where the two lines cross giving us a GDP and interest rate values.
1) IS Curve (goods market)
Loneable funds viewpoint - Look at the IS ( investment / savings) line where the amount of investment in goods & services decreases as the interest rate increases. If a bank is offering higher interest rates we will save more and invest less. If the interest rate is low we will save less and invest more because we can make more money from growth-aimed investment than we can get from savings interest.
2) LM Curve (money market)
Liquidity preference viewpoint - Look at the LM (liquidity preference money supply) line. Money in bonds and treasuries is illiquid because its stuck there for the time period of the bond (short or long). Money in cash is liquid because we can invest or spend it immediately. When the GDP is high there are more transactions and the demand for money (cash) is high, so it costs more.
3) Combined IS and LM Curves
This gives us the two opposite sloping lines on the ISLM model. They cross at an equilibrium point where the IS curve crosses the LM curve, which results in an equilibrium interest rate and its corresponding GDP.
4) The Liquidity Trap using this Model
If a central bank (or the FED) increases the real money supply by printing money, then there will be more money in the system. More money available *should* be less expensive to borrow it by simple supply and demand logic. When there is more of something (money) it is cheaper to borrow. BUT if the interest rate is already zero bound (ZIRP), then the cost of borrowing money cannot be any less and increasing the supply of money does not change its cost. This is the liquidity trap which neutralizes central bank attempts to stimulate an economy. Its limited by the central bank rule or regulation that disallows negative interest rates. So increasing the money supply will not make people borrow more or save more because there is no gain for them to do so.
The liquidity trap in the ISLM model:
The demand for money stays constant even if the IS curve is shifted to the right by increasing money supply. The red line crosses the IS curve at zero interest rate regardless of money supply. There is 'low or zero money demand elasticity' with respect to the interest rate - because the rate is bound at zero. Then changes in the money supply has no effect on interest rates and thus investment borrowing is not encouraged - they are already as low as the FED or central bank will allow.
Alternative Non Keynesian Model of Credit Deadlock
The Keynesian ISLM model above was proposed by J. R. Hicks and is still keenly debated and used today even though, as Krugman admits, it could be all wrong.
A non Keynesian theory from Hawtrey, Sandiland explains the lack of growth through investment as banks too cautious to lend and investors too cautious to borrow. Entrepreneurial pessimism to borrow because of perceived lack of adequate returns and banks wary to lend because of regulatory capital requirements and recent impaired loan losses suffered in the crises of 2008.
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Lets Get More Geeky
1) The IS (goods and investment) and LM (money markets) curves are not in reality separate entities. A change in either can produce a change in the other.
2) The ISLM is an *equilibrium* model. But, the presence of economic uncertainty is essential in deciding how much liquidity is needed. If investment success was entirely certain and known then there would be no need of liquidity since exact sums would be invested or saved. (BUT, see the deflationary reason to hold cash)
3) Deflation provides another reason for liquidity apart from purely transactional reasons. If there is real deflation, the real value of cash increases over time, but our ISLM model is zero bound.
4) Total spending = consumer spending + planned private investment + government purchases + net exports) equals an economy's total output (equivalent to real income, Y, or GDP).
5) IS-LM model is used to study the short term run when prices are held or sticky.
6) No price inflation and is taken into consideration.
7) For the IS curve: the real level of GDP is Y and then:
Y = C(Y-T(Y)) + I(r) + G + NX(Y)
C is consumption, T is tax, I is interest rate, G is exogenous government spending, NX is net exports.
8) For the LM curve: M/P = L(Y, i)
M/P is the real money supply, L is the real demand for money which depends on the interest rate i, and Y the level of real income.
We all believed in the Phillips Curve in the late 60s. But just because a model explains a particular phenomenon happening at a certain time gives it no special merit. What you leave out may be more important than what you put in.
ReplyDeleteI'm confused: Are investors immune to the zero interest rate policy? I mean, why is the LM curve kinked, and the IS curve not kinked?
ReplyDeleteThe IS-LM model doesn't account for future expectations. When do austerity measures change expectations and persuade investors to buy bonds? I understand that this is a possibility, but when does it become real?
ReplyDeleteUsing ISLM model to understand the economy is crazy. ISLM assumes fiscal and monetary policy to be independent of each other. If you believe that, you are lost to explain the sovereign debt crisis in Europe. Unbelievable!
ReplyDeleteOne thing that I don't get about graphs like the ones you have is extent to which the curves are real or not; so far as i can tell, they are invented - that is there is no data on actual interest rates or demand or anything like that.
ReplyDeleteI understand this might be useful in many ways, but for general discussion it is odd to have these theoretical constructs, which might , or might not be reality
Like many of you, I've been struggling to understand; went to the library, looked under islm in the not very good card catalog, and found several books; can recommend John B Smith's Economics, if you don't mind the left wing moralizing (I have the 2003 edition, and table 17, "The cost of various Risk-reducing regulations", about the cost of gov't regs, seems outdated and partisan, notwithstanding it was a good piece and I thank you.
I understand much more now than I did before. Thanks once again.
However, to the point, Prof Taylor presents whole chapters of what seem like totally theoretical arguments, for instance, the most basic of economic concepts - the law of supply and demand, that when the price goes down, people buy more - doesn't seem to have any data.
In other sciences, even seemingly obvious ideas have data; I don't understand how economists can teach students the law of supply and demand without at least a ref to a review of real world studies on the subject.