The IS-LM Framework – Part 7

I am now using Friday’s blog space to provide draft versions of the Modern Monetary Theory textbook that I am writing with my colleague and friend Randy Wray. We expect to complete the text during 2013 (to be ready in draft form for second semester teaching). Comments are always welcome. Remember this is a textbook aimed at undergraduate students and so the writing will be different from my usual blog free-for-all. Note also that the text I post is just the work I am doing by way of the first draft so the material posted will not represent the complete text. Further it will change once the two of us have edited it.

Previous Parts to this Chapter:

Chapter 16 – The IS-LM Framework


16.7 Why we do not use the IS-LM framework


Expectations and Time

Consider the role of the investment function in the derivation of the IS curve. Investment is said to be dependent on the interest rate (cost of funds) and, perhaps, output (via the accelerator affect).

While the IS-LM approach of John Hicks tried to represent, what he saw as the key elements of Keynes’ General Theory, it clearly left out issues relating to uncertainty and probability that Keynes saw as being crucial in the way long-term expectations were formed. Chapter 12 of the General Theory was devoted to this topic.

In the General Theory (1936: 149-50), Keynes wrote:

The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory, the goodwill of a patent medicine, an Atlantic liner, a building in the City of London amounts to little and sometimes to nothing; or even five years hence.

Thus the decision to invest is dependent on the “state of long-term expectation”, which is ignored in the static IS-LM approach.

Investment, among other key economic decisions, is a forward-looking process, where firms form guesses about what the state of aggregate demand will be in the years to come.

It is necessarily such because the process of creating new capital stock is lengthy and involves a number of separate decisions – type of product to produce, nature of capital required to produce it, design, access supply and ordering, and quantum – are all separated in time.

The investment spending today is the result of decisions taken in some past periods about what the state of the world will be today and into the future. Investment spending is not a tap that is turned on or off when current interest rates change.

The psychological factors that are crucial for comprehending the decision to consume (marginal propensity to consume); the decision to invest (Marginal efficiency of capital); and the determination of the labour market bargain (implicit in the IS-LM approach) are abstracted from in the derivation of the equilibrium – what are essentially dynamic process with complex feedback loops are frozen in time by the need to derivate static IS and LM curves.

The failure to include the crucial role of expectations and historical time means that IS-LM framework is reduced to presenting a general equilibrium static solution that has little place in a dynamic system where uncertainty is a key driver in economic decision-making.

The last word in this Chapter will go to the original architect of the IS-LM approach, John Hicks, who reflected on his creation and the way it had been subsequently used in a 1981 article in the Journal of Post Keynesian Economics:

I accordingly conclude that the only way in which IS-LM analysis usefully survives—as anything more than a classroom gadget, to be superseded, later on, by something better—is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of equilibrium methods, is not inappropriate. I have deliberately interpreted the equilibrium concept, to be used in such analysis, in a very stringent manner (some would say a pedantic manner) not because I want to tell the applied economist, who uses such methods, that he is in fact committing himself to anything which must appear to him to be so ridiculous, but because I want to ask him to try to assure himself that the divergences between reality and the theoretical model, which he is using to explain it, are no more than divergences which he is entitled to overlook. I am quite prepared to believe that there are cases where he is entitled to overlook them. But the issue is one which needs to be faced in each case.

When one turns to questions of policy, looking toward the future instead of the past, the use of equilibrium methods is still more suspect. For one cannot prescribe policy without considering at least the possibility that policy may be changed. There can be no change of policy if everything is to go on as expected—if the economy is to remain in what (however approximately) may be regarded as its existing equilibrium. It may be hoped that, after the change in policy, the economy will somehow, at some time in the future, settle into what may be regarded, in the same sense, as a new equilibrium; but there must necessarily be a stage before that equilibrium is reached. There must always be a problem of traverse. For the study of a traverse, one has to have recourse to sequential methods of one kind or another.

[Reference: Hicks, J. (1981) ‘IS-LM: “An Explanation”’, Journal of Post Keynesian Economics, 3(2)(Winter, 1980-1981), 139-154]



Saturday Quiz

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