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

[PREVIOUS MATERIAL HERE IN PARTS 1 to 6]

16.7 Why we do not use the IS-LM framework

[PREVIOUS MATERIAL HERE IN PART 6]

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]

Conclusion

NEXT WEEK – COMPLETE BRITAIN AND IMF 1976 CASE STUDY AND THEN START EDITING OUR ALMOST COMPLETE FIRST DRAFT. TRYING TO GET IT FINISHED BEFORE NEXT FEBRUARY.

Saturday Quiz

The Saturday Quiz will be back again tomorrow. It will be of an appropriate order of difficulty (-:

That is enough for today!

(c) Copyright 2013 Bill Mitchell. All Rights Reserved.

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    One Response to The IS-LM Framework – Part 7

    1. CS says:

      OK I have now as a lay person spent numerous hours pouring over the IS/LM series of blogs. I feel I understand it somewhat better but struggle mainly with understanding the LM curve.

      I understand that as income increases people require more cash for transactions and so the demand for the fixed money supply goes up, pushing up the interest rate. But at the same time as the interest rate goes up people want less cash as they prefer to invest it in bonds or interest bearing accounts. So there are two opposing forces going on – like a push-me/pull you? Transactions push you to hold cash, higher rates encourage you not to? The slope of the LM curve then depends on the ratio between the sensitivity to income changes (the rise) and the sensitivity to interest rate changes (run).

      So the LM slope will be steep if income changes cause people to want a lot of cash for transactions and this isn’t offset by a large corresponding desire to hold less cash because of a higher interest rate?

      And the LM curve will be flatter if income changes causing people to want a lot of cash for transactions is offset a lot more by people wanting to hold less cash cash because of higher interest rates?

      So an LM curve is flatter when the desire to hold more cash in reponse to income changes is somehow more outweighed by the desire to hold less cash due to higher interest rates.?

      Then a totally flat LM curve with a slope at 0 means that regardless of income levels, the interest rate stays the same. Because the demand for cash is the same regardless of income levels. No one wants to lend out their cash for less than that rate…

      I find the flat and vertical LM curves hard to mentally understand – what is going on with respect to the opposing forces of sensitivity to income levels and sensitivity to interest rates with the vertical one? The vertical one means that money demand is completely income determined with infinite slope? The flat LM means demand for money it is completely interest determined?

      Hmmmmm

      If anyone can help me understand the “reality” behind the LM curves – the forces going on behind its slope and what is going on with horizontal or vertical LM curves I would be most grateful.

      I understand that MMT does not agree with the IS/LM derivation of the LM curve but I would like to understand the logic of the LM curve from the point of view of its proponents..

      I will check back on this post at a later date to see if anyone replies…

      Cheers

      PS: The IS LM model implies that fiscal policy will be more effective in a country with a flatter LM curve. What kind of country is that? A country where increases in income don’t increase the demand for cash much cause people quickly want to invest their cash with any rise in interest rate in a bond or a savings account? So a culture where you save a lot when you earn a bit more? Is that the logic? A country like Germany where you save for even in retirement for the next life? So the German government can spend a lot and interest rates won’t rise much because the German people will just save their extra income and interest rates won’t go up much and therefore private investment doesn’t get crowded out? Whereas the Greeks just want to spend money when their government spends and interest rates go up with this high demand for case, crowding out private investment. The reality behind the nature of the LM curve kind of confuses me….

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