IS-LM

Paul Krugman in praise of John Hicks and IS-LM:

Who You Gonna Bet On, Yet Again: Today’s FT has a piece on famous financial managers having a bad year; among them are John Paulson and Bill Gross. Regular readers may recall that back in 2010 Business Week ran an article contrasting my views with Paulson’s, with the tone of the article clearly conveying the message that we should trust the billionaire, not the silly academic. You might also recall that I was highly critical of Pimco’s assertions that the end of quantitative easing would lead to a spike in interest rates.

Now, the point of this post isn’t to gloat — OK, it’s not mainly to gloat. Instead, what I want to point out is that there has been a simple principle to getting things mostly right in the Lesser Depression — namely, remember your Hicks.

The basic IS-LM model, with its possibility of a liquidity trap, has been a very good guide in these troubled times. And there’s a reason for that: as I wrote long ago, in a piece from the 1990s, IS-LM is basic economics applied to a world in which in addition to production of goods there is both money and a bond market. Aside from the assumption of sticky prices — which is overwhelmingly obvious and supported by strong evidence — it’s your basic, minimal, compelling model. It should come as no surprise that it gets at a lot of what’s going on. Yet people don’t know this model — which is to say, they don’t have any simple framework for thinking about how money, interest rates, and the real economy interact.

Which people am I talking about? Money managers, obviously; they may know a lot about individual markets and companies, they may have lots of experience, but now that we’re talking about macro issues of a kind not seen since the 1930s, those talents are a lot less relevant than usual. Pimco used to have Paul McCulley, who was very good on the macro, but with him gone, they seem to be making up theories on the fly. And whatever model Paulson is using, it’s not IS-LM.

But economists also don’t know this stuff. We’re living in a dark age of macroeconomics, in which much of the profession has turned its back on past knowledge.... The point, again, is that getting this crisis right isn’t mostly about being super-smart or insightful — it’s about knowing and being willing to apply basic analysis that everyone making pronouncements on macro should have learned in freshman year. It’s sad, and disturbing, how few people are able or willing to do that.

Tyler Cowen opposed (in 2005):

Six reasons why I don’t like IS-LM analysis:

1. It suggests that you can shift one curve without the other moving as well.  In other words, it assumes that excess demands in the goods market are independent from excess demands in the money market.
2. The IS curve — which involves investment demand — uses the real rate of interest, r.  The LM curve — which involves money demand — uses the nominal rate of interest, i.  These two curves are then put on the same graph.  I have been told many times this can be done without contradiction; at best this is true only in the shortest of runs, when prices are not changing.
3. Everything in the model is flows, but stocks matter too.  No person in the model considers his or her intertemporal budget position.  You don’t have to believe in Barro’s Ricardian debt-equivalence theorem to be worried by this.
4. Coordination problems — which should be at the center of macro — are obscured by the aggregate apparatus.
5. The IS curve, drawn from investment demand, uses the long-term rate of interest.  The LM curve, drawn from money demand, uses short-term rates of interest.  Yet the relative movements of short and long rates remain a significant puzzle and do not follow the predicted relationship.
6. You see the curves — which remind you of supply and demand curves — and you wish to start manipulating them in the same manner.

My (significant) concession: The model does fairly well predicting many economic phenomena in the short run.  But you could do better reading Arthur Marget on sophisticated versions of the quantity theory of money.  I hope to explore this point in more detail soon.

Note that a macroeconomic model that "does fairly well predicting many economic phenomena in the short run" beats every single other macroeconomic model hands down.

And note that Tyler Cowen is the only--I say the only--living person I am aware of who finds Arthur Marget comprehensible.