When you do economics and apply it to the real world, you start with the simplest possible model. Does that help you understand enough of the real world to satisfy you? If not, you complicate it by adding the most important thing that you had left out. Does that help you understand enough of the real world to satisfy you? If so, you use that model--and then when you want to go further you complicate it in its turn.
But at each stage in the process, you absorb the valid insights from your current model before you go on to complicate things further.
In monetary economics the simplest model is the bare two-good one-period quantity theory of money model:
- There is a peculiar commodity called "money".
- Total economy-wide spending is roughly proportional to it.
There are lots of valid insights to be gained from this model. But does it help us understand the real world today enough to satisfy us? No: the money stock is very large, but the flow of spending is not.
So we complicate the model:
- The incentive to spend money is lower when the short-term safe nominal interest rate is low.
- For each counterfactual level of the money stock there is a curve, with total spending on the horizontal axis and the short-term safe nominal interest rate on the vertical axis, that tells us how the level of spending varies with counterfactual variations in the short-term safe nominal interest rate.
- We call this family of curves--one for each counterfactual level of the money stock--the LM equation.
- But this is not a complete model: we need to figure out what the short-term safe nominal interest rate is. So we add a bond market to our model and look at its equilibrium level of asset prices to pin down the interest rate.
- We call that pinning-down the interest rate the IS equation.
- That is the IS-LM model.
IT is a three-good one-period model.
Now after we have extracted the insights from IS-LM, we can go on to complicate things further if we do not think that we have enough of the story. Such complications take the form of a deeper look at the bond market and its interactions with spending than simply supply of bonds = demand for bonds. We add credit channels, accelerators, variations in expectations--all kinds of things.
But we do that only after we have assimilated all the valid insights from IS-LM. The one-good one-period macro model simply has output: that is not terribly useful. The two-good one-period mechanical quantity theory has money and output. The three-good one-period IS-LM model has money, output, and bonds. We need to understand it before we move on.
Yet some have a deep aversion--an aversion I can only classify as "tribal", as a mark of social identity rather than analysis--to gaining insights from the three-good general-equilibrium macro model.
Tyler Cowen complains:
(1) [IS-LM] fudges the distinction between real and nominal interest rates, so it can put the two curves on the same graph. Every time you write down an IS-LM model you should hear a clock start ticking in your head. The longer the clock ticks, you more you need to worry about this problem because the more that a) the price level may change, or b) expectations about future price level changes will start to matter.
(2) It fudges the distinction between short-term interest rates (for the money market curve) and long-term interest rates (a determinant of investment). They’re not the same! Don’t assume they are the same, just to squash the two curves onto the same graph.
(3) It leads you to think that the distinction between non-interest bearing currency and short-term interest-bearing securities is a critical wedge for the economy. It also implies that if all currency paid interest (a minor change, most likely, macroeconomically speaking), the economy would behave in a totally screwy way. It probably wouldn’t.
(3b) The model leads you to believe that interest rates are more important than they probably are.
(3c) For a while it treats “money” as the non-interest-bearing security, and then for a while it treats money as the transactions media behind AD, something closer to M2.
(4) It overemphasizes flows and under-emphasizes stocks of wealth. The quantity theory approach, as wielded by Fisher and Friedman, does not induce individuals to make this same judgment. For one thing, this distinction really matters when you’re trying to predict the macro effects of “window breaking.” The flows perspective will usually be more optimistic than a perspective which recognizes both stocks and flows.
(5) Those aggregate curves are not invariant with respect to expectations, including expectations of government policy. You don’t have to believe in an extreme version of the Lucas critique to worry about this one. Those curves are conditional and the ceteris paribus assumption is not to be taken lightly here.
(6) In the LM curve, what is the embedded reaction function of the Fed? Good luck with that one. Pondering this issue leads you to conclude that the whole model was written for an economy fundamentally different than ours.
But what is Tyler's solution. He says that it is to go backward:
The most important points [gained from IS-LM], for instance about the significance of AD, one can derive from a quantity theory… perspective…
But the mechanical quantity theory is simply wrong for us today: the Fed has tripled the monetary base since 2007, and yet the flow of nominal spending has not tripled: not at all. IS-LM at least starts you thinking about the issues around the concept that has been called the "liquidity trap" which the mechanical quantity theory does not.
And he says that it is to go elsewhere:
The most important points… one can derive from a… nominal gdp perspective…
What is this "nominal GDP perspective"? The Google reports that as of this writing the phrase "nominal GDP perspective" appears only once on the internet--in Tyler's post. I think he might mean the (nominal form of the) national income identity:
Y = C + I + G + NX
That is the not-terribly-usful one-good model.
He might mean the more complicated version in which consumption C, investment I, and net exports NX depend on the level of spending Y and in which investment I and net exports NX depend on the interest rate i:
Y = C(Y) + I(Y, i) + G + NX(Y, i)
but that is simply an alternative, Wicksellian, two-good model--one in which the two goods are output and bonds rather than output and money. And it is not complete: there is some story about how the Federal Reserve sets interest rates that needs to be added. And when we do that we are back at IS-LM. Tyler's suggestions seem to me to be movements backward, in the wrong direction.
The right thing for Tyler to have said, from my perspective at least, would have been that IS-LM does not provide us with enough insights to satisfy us, and here is a slightly more complicated model--a four-good or a three-good two-period model--that actually helps us think coherently about (some of) the issues of nominal versus real interest rates, short-term versus long-term interest rates, safe versus risky interest rates, moral hazard and adverse selection in the bond market, non-interest bearing and interest bearing assets, liquidity and means of payment, flows and stocks, expectations, government reaction functions, and so forth. (The IS-LM framework--at least when you draw it with the short-term safe nominal interest rate on the vertical axis--loads all of these issues into the IS equation in a non-transparent way, and that is not satisfactory.)
But that is not what he does.
For when you do try to move further than IS-LM, you need to make a judgment about what is the most important complication that you would like to introduce. (My next step right now is usually to complicate things by breaking the IS equation up into two: a national-income identity and an adverse-selection in the bond market equation). And I know of no way to get to a better model that tackles any of these issues without using Hicks's IS-LM as a stepping-stone to get there.