Paul Krugman Blogs from an Undisclosed Location Somewhere in China
links for 2009-05-16

MV = Y, P = Y/Q, S = I

Paul Krugman writes:

Forgotten snark - Paul Krugman Blog - Brad DeLong catches a footnote in a decade-old paper by Olivier Blanchard:

Paul Krugman recently wondered how many macroeconomists still believe in the IS-LM model. The answer is probably that most do, but many of them probably do not know it well enough to tell.

I actually have no memory of saying that. But I was worrying about the state of macro a decade ago. Here’s a short piece I wrote back then. Even then, it was obvious that the Great Forgetting was underway; only economists of a certain age knew how to think about what remain the essential insights of macro.

It is remarkable: if you ask, every macroeconomist says they believe in the quantity theory of money: MV = PY. Yet remarkably few can come up with a theory of the determinants of V--they seem to know less than Fisher and Wicksell, for whom discoursing on the determinants of monetary velocity V was not a problem.

Krugman a decade ago:

From <>:

There's something about macro: young economists, trained to regard IS-LM and all that with contempt if they even know what it is, find themselves turning to it after a few years in Washington or New York... if Hicks hadn't invented IS-LM in 1937, we would end up inventing it all over again.... Afficionados know that much of what we now think of as Keynesian economics actually comes from John Hicks, whose 1937 article "Mr. Keynes and the classics" introduced the IS-LM model, a concise statement of an argument that may or may not have been what Keynes meant to say, but has certainly ended up defining what the world thinks he said. But how did Hicks come up with that concise statement? To answer that question we need only look at... Value and Capital....

Value and Capital may be thought of as an extended answer to the question, "How do we think coherently about the interrelationships among markets?... How does the whole system fit together?"... [I]t helps to think about the simplest case in which something more than supply and demand curves becomes necessary: a three good economy. Let us simply call the goods X, Y, and Z - and let Z be the "numeraire", the good in terms of which prices are measured.

Now equilibrium in a three-good model can be represented by drawing curves that indicate combinations of prices for which each of the three markets is in equilibrium.... [Plot] the prices of X and Y, both in terms of Z... on the axes.... Although there are three curves, Walras' Law (if all markets but one are in equilibrium, that market is in equilibrium too) tells us that they have a common intersection, which defines equilibrium prices for the economy as a whole.... This diagram is simply standard, uncontroversial [general equilibrium] microeconomics. What does it have to do with macro?...

[T]hinking coherently about macro-type issues, such as the interest rate and the price level... require[s] consideration of the supply and demand for goods, so that it could be used to discuss the price level; the supply and demand for bonds, so that it could be used to discuss the interest rate; and, of course, the supply and demand for money. What, then, could be more natural than to think of goods in general, bonds, and money as if they were the three goods.... Put the price of goods - aka the general price level - on [the horizontal] axis, and the [inverse of the] price of bonds... on the other [vertical axis]... [and] we have... Patinkin's flexible-price version of IS-LM.

If you try to read pre-Keynesian monetary theory, or for that matter talk about such matters either with modern laymen or with modern graduate students who haven't seen this... you quickly realize that this seemingly trivial formulation is actually a powerful tool for clarifying thought, precisely because it is a general-equilibrium framework.... Here are some of the things it suddenly makes clear:

  1. What determines interest rates? Before Keynes-Hicks... there has seemed to be a conflict between the idea that the interest rate adjusts to make savings and investment equal [in financial markets, "loanable funds"], and that it is determined by the choice between bonds and money[, "liquidity preference"]. Which is it? The answer, of course--but it is only "of course" once you've approached the issue the right way--is both: we're talking general equilibrium here, and the interest rate and price level are jointly determined in both markets.

  2. How can an investment boom cause inflation (and an investment slump cause deflation)? Before Keynes this was a subject of vast confusion, with all sorts of murky stuff about "lengthening periods of production", "forced saving", and so on. But once you are thinking three-good general equilibrium, it becomes a simple matter. When investment (or consumer) demand is high... [people] are... trying to shift from bonds to goods.... both the bond-market and goods-market equilibrium schedules... shift; and the result is both inflation and a rise in the interest rate.

  3. How can we distinguish between monetary and fiscal policy? Well, in a fiscal expansion the government sells bonds and buys goods.... In a monetary expansion it buys bonds and "sells" newly printed money, shifting the bonds and money (but not goods) schedules....

Of course, this is all still a theory of "money, interest, and prices" (Patinkin's title), not "employment, interest, and money" (Keynes'). To make the transition we must introduce some kind of price-stickiness, so that incipient deflation is at least partly translated into output decline.... But the basic form of the analysis still comes from the idea of a three-good general-equilibrium model in which the three goods are "goods in general", bonds, and money....

But step back from the controversies, and put yourself in the position of someone who must reach a judgement about the likely impact of a change in monetary policy, or an investment slump, or a fiscal expansion. It would be cumbersome to try, every time, to write out an intertemporal-maximization framework, with microfoundations for money and price behavior, and try to map that into the limited data available.... [T]hat is why old-fashioned macro, which is basically about that model, remains so useful a tool for practical policy analysis.