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Macroeconomics: Another Reason We Really Need to Live in a Six-Dimensional Spacetime

Matt Rognlie writes:

What’s needed in a macro model?: Anyone who’s read a newspaper over the last few years has surely come across the notion of a flight to liquidity. When the economy dips, there’s an increase in demand for liquid assets that vastly outweighs whatever tiny drop you’d expect in transactions demand for money. In practice, LM probably slopes the wrong way…

Again, the problem is that Matt has not specified what interest rate he puts on the vertical axis of the IS-LM curve. We really need a model with five moving pieces:

  1. Money demand equilibrium M = L(i, PY) as a function of the level of spending and the short-term safe nominal interest rate.
  2. Flow-of-funds S = I + (G-T) as a function of the level of spending and the long-term risky real interest rate.
  3. Expected inflation to get you from the nominal to the real interest rate.
  4. A term premium as a function of expectations to get you from the short-term to the long-term real interest rate.
  5. Risk spreads to get you from the safe to the risky real interest rate.

Matt is saying that in practice shocks of type (1) and (2) as a rule come with shocks of type (5).

The right answer is that sometimes they do and sometimes they don't. Right now a more expansionary policy from the Federal Reserve would be unlikely to increase interest rates and reduce total spending. Better, I think, to say that we had a shock of type (5) which raised long-term real risky interest rates and lowered short-term safe nominal interest rates than to say that the LM curve slopes in the wrong direction.