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Does the IS Curve Slope Upwards?

In the standard three-commodity Hicks 1937 macro model--a model with the liquid cash money stock, the bond stock, and spending on currently-produced goods and services as its three commodities--we draw a graph with the interest rate (the inverse of the price of bonds in terms of money) on the vertical axis and the rate of spending in terms of money on the horizontal axis. We then draw the money-spending equilibrium as an upward-sloping "LM" curve--with a higher interest rate people want to shift from holding cash to spending on currently-produced goods and services. We then draw the bonds-spending equilibrium as a downward-sloping "IS" curve--with a higher interest rate businesses do not issue as many bonds, and so spenders feel short of wealth and cut back on spending to try to build up their asset stocks. (And by the adding-up constraints the money-bond equilibrium takes care of itself.)

We understand this model.

Cochrane has a twist on this model. Cochrane's model has the standard "LM" curve built off of the money demand function and the money-spending equilibrium condition. It has an "IS" curve built off of a bonds-spending equilibrium condition. But its "IS" curve is not downward but upward sloping: A higher interest rate lowers the attractiveness of the fixed stock of government debt. Spenders then try to dump their government bonds in order to purchase more of currently-produced goods and services instead. And so the higher the interest rate, the higher is the flow of spending needed to maintain bonds-spending equilibrium.

In this model contractionary monetary policy--i.e., the Federal Reserve increasing interest rates--is expansionary as higher interest rates induce wealth holders to dump their bonds and spend more on currently-produced goods and services instead. And in this model the economy is very volatile: small shocks either to the money demand curve or to interest rate spreads produce huge shifts in this equilibrium. Thus by playing with this model Cochrane can get small changes to have huge effects--after all, when both curves slope upwards any shift in one curve will move the economy's equilibrium a very long way. But can it be the rigfht model? We have not, after all, gotten Lesser Depressions and near-hyperinflations every decade...

Now Paul Krugman and Noah Smith are also both very disturbed by Cochrane's model.

Paul: If you come at the current Lesser Depression from my angle, there’s no great mystery... a clear line of descent with only moderate modification running from Hicks 1937 to liquidity-trap models of Japan (pdf) to models that add in debt/deleveraging. The situation we’re in seems fully comprehensible. But at Chicago and elsewhere in the freshwater universe they’re playing Calvinball (and what a good coinage that was from Mike Konczal). All kinds of novel and implausible effects — effects that weren’t in any of the models they were using before the crisis — are invoked to explain why we’re in a sustained slump; strange to say, all of these newly invented models just happen to imply the need for tax cuts and a shrunken welfare state.

But I don’t think it’s just political bias: part of what’s happening, I’m sure, is intellectual embarrassment. These people come from a movement that declared, with great arrogance, that Keynesian economics was dead – then failed to produce a workable alternative, and now finds itself in what is very recognizably a Keynesian world.... Anyway, it’s a sight to behold.


Noahpinion: John Cochrane's Sum of All Right-Wing Assumptions: [D]on't expect to get Exciting New Results using only the Same Old Stuff.... Simplifying your model past the point of full determinacy doesn’t remove the need to make additional assumptions about economic relationships; it just makes those assumptions implicit.... Cochrane... left out all of the things that monetarists and Keynesians believe makes stimulus and quantitative easing effective... the conclusion that countercyclical policy doesn’t work is going to follow pretty naturally from the assumption that countercyclical policy doesn’t work.

[Cochrane's] particular sequence of events relies on three assumptions.... Higher taxes would... increase deficits.... Increased deficits are structural.... Bond investors will not believe that the U.S. will be able to reduce spending... and will thus abandon U.S. Treasury bonds.

[Cochrane]... implies that the Bush tax cuts raised our trend per-capita growth by 0.36%... the Johnson and Reagan tax cuts raised our trend growth far more... the Clinton tax increases significantly decreased our trend growth. Unsurprisingly (to me, anyway), a long-term plot of U.S. output doesn’t show any of these things.... Cochrane’s “dynamic Laffer curve” analysis is not supported by any evidence presented here (or any evidence of which I am aware).

Cochrane’s second assumption is that stimulus deficits are structural... basically political in nature.... Finally, we have the notion that these permanently higher deficits will lead to capital flight... a posited decrease in the stochastic discount factor.... But... long-term interest-rates [should] spike as soon as (or actually well before) the higher deficits are announced. As many, many people have pointed out, nothing like this has yet happened....

[T]he “Sum of All Right-Wing Fears” scenario is really just a “Sum of All Standard Right-Wing Assumptions.” Tax increases decrease revenue. Democrats are addicted to deficits. Bond vigilantes are ready to abandon U.S. Treasuries...