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IS-LM Watch: In the Country of the One-Eyed, the Self-Blinded Man Is in Bad Shape, or Something Department

So I am sitting here peacefully at my office desk, when across my screen flow the words of Scott Sumner, who writes:

The IS-LM model led economic historians to argue money was easy in 1929-30, because rates fell sharply.  It led modern Keynesians to assume that money was easy in 2008, because rates fell sharply...

Well, I would say that not just "modern Keynesians" but a lot of people believed that monetary policy was expansionary in 2008.

They believed so not just because (safe) nominal (and real) interest rates were falling, but because the money supply was expanding. Indeed, since 2007 the Federal Reserve has tripled the monetary base:

FRED Graph  St Louis Fed 1

This episode of monetary expansion is surely the largest monetary expansion in the United States in a long, long time:

FRED Graph  St Louis Fed 2

If expanding the monetary base to three times its previous size is not "expansionary", what could possibly be?

And I see that Scott Sumner is joined by Matt Rognlie, who writes:

historically low inflation expectations and below-potential output are prima facie evidence that real interest rates are too high. That’s what every macro model tells us is associated with contractionary policy by the Fed.... [T]he fundamental, overriding dilemma is getting the price (in this case, the interest rate) right.... [O]nce we recognize that the fundamental problem is monetary, the issues become much clearer. The Fed’s failure to use all the tools at its disposal--in particular, its failure to make a conditional commitment like the one proposed by Chicago Fed President Charles Evans--is by far the most serious failure of economic policy today…

"Wait a minute!" you say. "The ten-year nominal Treasury bond rate has fallen 325 basis points since 2007. The three-month Treasury bill rate has fallen by 500 basis points since 2007. And this is not a case in which apparently low nominal interest rates are really high real interest rates because of expected deflation: expected inflation has fallen by only about a third as much as nominal interest rates have fallen. The real interest rate on ten-year Treasury bonds has fallen from 2.5% per annum in 2007 to zero today:

FRED Graph  St Louis Fed 3

"And Matt wants us to believe that this pushing-up of the present value of a real dollar of cash flow ten years in the future by more than one-quarter--this more than doubling of the present value of a real dollar of cash flow thirty years in the future--this tripling of the monetary base--is contractionary? What is going on here?!"

What Sumner (and Rognlie) should say, I think--in order to avoid confusing readers who try to wrap their minds around the idea that a large monetary expansion is contractionary--is that monetary policy was expansionary but the expansion was not large enough to cope with the macroeconomic problem.

But for some reason they don't want to say this.

They want to say that the expansion of the monetary base and the money stock was contractionary. They want to say that an easing of the difficulty people have borrowing cash is restrictive of people's access to money. They want want to say that a loosening of the conditions required for something to be a positive NPV investment project is a tightening of those conditions. They are taking words that had clear meanings--expanding the monetary base, easing the difficulty of borrowing, loosening required conditions for investment to be profitable--and claiming that they mean the opposite because these policy moves were not large enough to prevent the steep fall in nominal GDP.

I think both of their arguments would become much, much easier and clearer and coherent--and, I think, stronger--if they would only allow themselves to draw an IS-LM diagram.


The financial crisis--the collapse of trust in the competence of bankers, the impairment of the capital of banks, the loss of housing values, the reduction in risk tolerance--was a massive shock that pushed the IS curve far to the left. Had the Federal Reserve kept "monetary conditions" unchanged--had it engaged in contractionary open market operations and shrunk the money stock in order to keep interest rates at their 2007 levels--we would have had another Great Depression. Fortunately, the Federal Reserve did not do that. It expanded the monetary base and the money supply, and kept on expanding even after the short-term safe nominal interest rate had hit the zero nominal lower bound. But these expansionary policies--while they greatly moderated the size of the Lesser Depression--were not enough to offset the negative IS shock of the financial crisis.

The problem is that we need much more monetary expansion (or fiscal expansion, or something) than we have, given the damage done by the financial crisis. We need to push the real interest rate substantially below zero to get the economy back to full employment. We need enough monetary expansion to drive expectations of inflation up so that the relevant interest rate once again matches the supply of to the demand for the flow-of-funds through financial markets at full employment.

The IS-LM framework has the virtue of not forcing you to say things like the things Rognlie and Sumner do: that the Lesser Depression struck in late 2008 because monetary policy turned contractionary, and because the Federal Reserve tightened. That simply leads--in my view at least--to a lot of confusion.