Krugman and DeLong mount a chivalrous defense of IS-LM

I’ve posted a bunch of critiques of IS-LM, but naturally Tyler Cowen’s criticism (which I agree with) got more attention.  Brad DeLong had this to say:

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.

Both DeLong and Krugman insist that macro needs to start with simple models.  I agree.  And that those models must at a minimum include money, bonds and output.  Here I don’t entirely agree.  I think a model with money and goods, plus sticky prices, can get at many of the key features of the business cycle.  BTW, I am not envisioning a model with constant velocity; I agree that would be almost entirely useless.  But I’m willing to provisionally go along with the three market minimum for reasons that DeLong lays out here:

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.

A quantity theoretic monetary model need not be the mechanical quantity theory.  So I see DeLong making a pragmatic argument here.  He’s saying that thinking in quantity theoretic terms is likely to lead us astray.  We know that V might change, but we are likely to forget that problem when thinking about policy options at the zero bound.  Fair enough.  But this criticism applies equally to IS-LM, which is also likely to lead one astray, especially at the zero bound.

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.  And IS-LM proponents underestimated the importance of monetary stimulus in late 2008, because they thought the IS-LM model told them that monetary policy is ineffective at the zero bound.  Brad DeLong himself was one of those IS-LM proponents who underestimated the importance of monetary stimulus in late 2008.  Now he’s bashing the Fed almost every day. 

Some IS-LM defenders argue that there is nothing wrong with the IS-LM approach; it’s just that the model is misused by its supporters.  After all, there has to be some sort of general equilibrium in the goods, money, and bond markets.  The markets all interact with each other.  And the IS and LM lines merely depict that general equilibrium.  Yes, but a model that general would be pretty useless.  IS-LM proponents also tend to argue that the IS curve is downward sloping.  Nick Rowe recently argued that it is upward sloping.  I think Nick’s right, at least if we use the yield on T-securities as “the interest rate,” and use a time frame that is relevant for business cycle analysis (a few months or years.)  The problem is that most Keynesians identify changes in monetary policy by changes in interest rates, and hence misidentify monetary shocks.

So has Nick “fixed” the problem with IS-LM?  Not really, because it’s a mistake to think of their being a “true” IS-LM model, untainted by the misuse of its adherents.  Models aren’t out there in some Platonic realm, they are tools created by humans.  The value of any model is instrumental, not intrinsic.  If IS-LM is misused by almost everyone, then ipso facto, it’s not a good model.

Paul Krugman makes an anti-elitist argument in favor of IS-LM:

Here’s the problem: Macro I (that’s 14.451 in MIT lingo) is a quarter course, which is supposed to cover the “workhorse” models of the field – the standard approaches that everyone is supposed to know, the models that underlie discussion at, say, the Fed, Treasury, and the IMF. In particular, it is supposed to provide an overview of such items as the IS-LM model of monetary and fiscal policy, the AS-AD approach to short-run versus long-run analysis, and so on. By the standards of modern macro theory, this is crude and simplistic stuff, so you might think that any trained macroeconomist could teach it. But it turns out that that isn’t true.

.   .   .

Now you might say, if this stuff is so out of fashion, shouldn’t it be dropped from the curriculum? But the funny thing is that while old-fashioned macro has increasingly been pushed out of graduate programs- it takes up only a few pages in either the Blanchard-Fischer or Romer textbooks that I am assigning, and none at all in many other tracts – out there in the real world it continues to be the main basis for serious discussion. After 25 years of rational expectations, equilibrium business cycles, growth and new growth, and so on, when the talk turns to Greenspan’s next move, or the prospects for EMU, or the risks to the Brazilian rescue plan, it is always informed – explicitly or implicitly – by something not too different from the old-fashioned macro that I am supposed to teach in February.

I think Krugman’s right that real world policymakers use IS-LM to frame the issues.  And to me that’s precisely the problem.  The policymakers understand the basic IS-LM model, but not its weaknesses.  They think there is “a” fiscal multiplier, ignoring monetary policy feedback.  They think that low rates mean easy money.  That’s why when I started arguing that money became ultra-contractionary in late 2008 I was regarded as something of a kook.  Policymakers also tend to assume the Fed is out of ammo at zero rates.  Where does this crazy idea come from?  Krugman constantly like to praise Hick’s 1937 model, but in that paper Hicks said that the liquidity trap was the only revolutionary idea in the entire General Theory.  The rest was putting already understood concepts (i.e. money demand depends on interest rates, or wages and prices are sticky) into a different language.  There’s no question that the liquidity trap view comes from IS-LM, even its supporters admit that.  And the liquidity trap view that is out there in the real world is the main reason we are letting central banks off the hook, the reason Obama thinks the Fed has “shot its wad.” 

We don’t need policymakers that rely on IS-LM; we need policymakers that rely on cutting edge macro.  Who rely on arguments for why level targeting is an extremely powerful tool at the zero bound.  Those should be the standard model, if we insist on teaching our policymakers a standard model.  We need useful models, not models that fulfill our urge map out a 3 market general equilibrium framework.

Here Krugman trashes Tyler Cowen:

Brad DeLong comes down hard on Tyler Cowen over his attempt to critique the IS-LM model — but not hard enough.

.  .  .

In macro — or at least macro that tries to get at monetary and fiscal issues — what you need, at minimum, is to understand an economy in which there are three goods: money, bonds, and economic output.

.  .  .

There’s something about macro that seems to invite this sort of thing: more even than the rest of economics, macro seems afflicted with people who mistake confusion for insight, who think their own failure to understand basic ideas reflects a failure of those ideas rather than their own limitations.

Tyler shouldn’t feel too bad about this.  After all, Krugman doesn’t identify a single flaw in Tyler’s critique.  The post is just a string of personal insults.  And recall that Michael Woodford creates models without money, so he’s also “confused.”  And of course Milton Friedman was no fan of IS-LM—so he’s another guy who just doesn’t get it. 

I favor an ad hoc approach to models–use the simplest model that gets at the issues you are interested in.  Start with a simple economy with money and goods, no bonds.  The supply and demand for money determines the price level and/or NGDP.  That’s most of human history.  Add wage price stickiness and you get demand-side business cycles.  Add interest rates and you get . . . well it’s not clear what you get.  Interest rates almost certainly have an influence on the demand for money.  Do they play a major role in the transmission mechanism between money and aggregate demand?  Hard to say.  Short term Treasury yields probably don’t have much impact.  Other asset prices might, but then there is generally no zero bound for other asset prices.  On the other hand monetary policy often operates through purchase of short term T-securities.  Bottom line, it’s complicated.

Now let’s add another asset, NGDP futures contracts.  Now the modeling process gets much easier.  We model monetary policy as changes in the price of NGDP futures contracts (accomplished through central bank purchases of financial assets in order of safety and liquidity, as much as it takes.)  Then we have a Philips Curve or SRAS curve to translate NGDP shocks in fluctuations in real output.  Since NGDP futures prices are monetary policy, fiscal policy is 100% classical.

Some will object that we don’t have NGDP futures contracts, so we are currently forced to stop at the money/bonds/goods stage of human progress.  Not so, we can construct a pseudo-NGDP futures price by modeling expected NGDP as a function of lots of variables (past NGDP, current asset prices, TIPS spreads, consensus forecast of economists, etc.)  That pseudo-NGDP futures price is available to Fed officials in real time.  They can peg it if they want to.  The policy has flaws related to the circularity problem (which NGDP index futures convertibility does not have), but it’s workable. 

Of course you’ve probably noticed that this is also my model.  I think it’s also in the tradition of Milton Friedman, although obviously it differs in certain respects.  Friedman thought it was more useful to take a partial equilibrium approach to macro.  By doing so he was able to avoid the mistakes of those who looked at the Depression from an IS-LM perspective.  He was interested in how monetary policy determined NGDP, and then used a separate Phillips Curve approach with a natural rate to explain output fluctuations, to partition NGDP into RGDP and P.  He viewed interest rate movements as a sort of epiphenomenon.  Monetary policy affected rates in a complex way, which made interest rates an unreliable indicator of the stance of monetary policy.

Of course the indicator Friedman choose, M2, also turned out to be somewhat unreliable, which is why I replaced it with NGDP futures.  Expected NGDP (or something similar that incorporates the Fed’s dual mandate–like the Taylor Rule) is the goal of monetary policy.  There’s quite a bit of slack between changes in M2 and changes in expected NGDP.  In contrast, changes in the price of NGDP futures contracts ought to track changes in expected NGDP (the policy goal) pretty closely.  I find the NGDP perspective to be much more useful than the interest rate perspective. 

BTW, I think this might have been what Tyler Cowen had in mind here (first Tyler, then Brad):

“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 want all 5000 of my readers to Google “Scott Sumner nominal GDP perspective” 100 times.  Each time, please link to my blog if it appears on the list.

I think DeLong and Krugman need to lighten up a bit.  They are defending the IS-LM model like it’s some sort of bride whose virginity has been challenged.  Models are only valuable if they are useful.  We critics are convinced that other approaches are much more useful.  Contrary to DeLong, there is nothing “tribal” about all this.  I’ve discarded the old monetarist preference for M2 targeting, and accepted the Krugman argument that temporary monetary injections are ineffective at the zero bound.  I’m not tribal, I’m eclectic.  When we see people use models in ways that we think are wrong, indeed that we think helped cause the Great Recession, we are naturally going to be critical of those models.  Especially if we find alternative approaches that seem more fruitful—like viewing monetary policy through the lens of changes in NGDP expectations, and viewing fiscal policy in essentially classical terms (except where a bizarrely perverse central bank allows fiscal decisions to alter its inflation or NGDP target.) 

PS.  Yes, I do understand that the strongest criticism of my approach is that we do live in a world with bizarrely perverse central banks.  We’ll fight that issue another day.


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73 Responses to “Krugman and DeLong mount a chivalrous defense of IS-LM”

  1. Gravatar of Kevin Donoghue Kevin Donoghue
    6. October 2011 at 08:11

    “We don’t need policymakers that rely on IS-LM; we need policymakers that rely on cutting edge macro.”

    Two words and I hope I spell ‘em right: Narayana Kocherlakota.

    Be careful what you wish for….

  2. Gravatar of Kevin Donoghue Kevin Donoghue
    6. October 2011 at 08:17

    BTW Scott, you might like to know that Hicks, rather late in life, came to the conclusion that Keynes got the idea of a liquidity trap from Marshall. I’ll tell you about it some other time. Now please excuse me for reproducing a little homily I’ve posted elsewhere:

    IS/LM means different things to different people. With many, many models it’s possible to group together two or more equations representing the supply and demand for money, show that they imply a relationship between the return on some asset and income or consumption, and call that relationship an LM curve. Similarly one can often generate something not entirely unlike an IS curve from the other equations in the model. Some writers like to do this, either in order to help students to get their bearings or to encourage them to take the older literature seriously. Some writers like to do the opposite.

    Really, I think we should have a rule that says you don’t say ‘the’ IS/LM model is good or bad, fashionable or unfashionable, deep or superficial, until you have provided your readers with a link to tell them just what you mean by ‘the’ IS/LM model in the present context.

  3. Gravatar of marcus nunes marcus nunes
    6. October 2011 at 08:24

    Scott
    Krugman´s and DeLong´s intransigent defense of ISLM is mostly due to the fact that that´s the easiest way to get their preferred “Liquidity Trap” result.
    http://thefaintofheart.wordpress.com/2011/10/05/it%C2%B4s-baaack-part-ii-defending-islm/

  4. Gravatar of dtoh dtoh
    6. October 2011 at 08:33

    Scott,
    You get around a lot of the model problems especially velocity if you adopt equity reserve ratios as a policy tool. An equivalent way of thinking about this is that effectively it would give the Fed the power to tell banks that they are required to hold assets (excluding Fed deposits, cash, etc.) equal to for example 17x of their equity. Want a more expansionary monetary policy…raise it to 18x.

    If the Fed had this tool, there would be no more discussion about liquidity traps, velocity, etc. Plus the Fed wouldn’t take any heat for “printing money” with open market operations, asset purchases.

    The problem with the current monetary tools is that they are liking pushing on very long flexible levers…. nothing much happens except you get a big drop in velocity.

  5. Gravatar of Benjamin Cole Benjamin Cole
    6. October 2011 at 08:41

    Excellent blogging.

    It comes back down to the basics: The Fed needs to announce it is targeting 7 percent nominal GDP, and release a photo of Bernanke with his hand on the lever of a printing press. The caption: “You think I can’t do it? Just watch.”

    No more fancy-dancing, no more fine-tuning. Just a direct frontal assault on the deflationary recession we are in. We can worry about inflation later.

    Far more important than inflation is growth, prosperity, innovation, commercial freedoms.

  6. Gravatar of Scott Sumner Scott Sumner
    6. October 2011 at 08:50

    Kevin#1, I should have said “cutting edge demand-side models” as I was focusing on the “how to” question regarding stimulus.

    Kevin#2, That’s a fair point, but I don’t think my post suffers form that problem. I made it very clear they are different versions of IS-LM, and noted that the problem was those who relied on a misleading version. I pointed out the specific flaws I objected to, such as the assumption that low rates means easy money, and pointed to versions like Nick Rowe’s, which are not subject to that objection. So I don’t think I oversimplified. We can hardly even talk without making some generalizations about categories (Austrian, NK, monetarist, MMT, etc) which frequently do oversimplify a bit.

    Marcus, That may well be right.

    dtoh, I’m not quite sure how you get around problems of velocity. Couldn’t a change in the equity reserve ratio result in either a change in equity, or a change in assets? But I certainly agree that the current tools are inadequate, which is why I support NGDP futures targeting. My plan would also eliminate talk of liquidity traps.

  7. Gravatar of Scott Sumner Scott Sumner
    6. October 2011 at 08:52

    Ben, Yes, I like to think of other approaches (interest rates, M2, etc) as beating around the bush, whereas NGDP expectations gets right to the heart of the matter.

  8. Gravatar of Morgan Warstler Morgan Warstler
    6. October 2011 at 08:57

    Finally in the post script, Sumner steels himself for a real argument…. another day.

    Us perverts look forward to it.

  9. Gravatar of dtoh dtoh
    6. October 2011 at 09:01

    Scott,
    Exactly the questions I expected because they are the obvious practical questions…. but they are easy to get around.

    1) To avoid changes in equity, you simply require that the banks hold assets equal to (e.g.) 17x the maximum equity they have had in the last 12 months. Then there is no benefit to the bank in reducing equity…. it doesn’t change the amount of assets they need to hold.

    2) You allow the Fed to set the equity reserve ratio by asset class (e.g. government securities, small business loans, mortgages, etc) and you allow the Fed to set negative as well as positive ratios. So if you are afraid the banks will shift all their assets from mortgages to T-Bills, you just put a negative ratio on Mortgages and a very high positive ratio on T-bills.

  10. Gravatar of W. Peden W. Peden
    6. October 2011 at 09:32

    Fascinating stuff. All this model discussion relates quite a bit to my masters course.

    Off topic: QE2 has begun in the UK-

    http://www.bbc.co.uk/news/business-15196078

    - which was always likely, given the squeeze on AD from record cuts in government spending. In fact, I would have liked a combination of the two: when the Emergency Budget was introduced in the dark days of mid-2010, the BoE should have cried havoc and let slip the dogs of QE.

    It will be interesting to see if the FTSE gets back above 6000 within the next six months.

  11. Gravatar of Victor Victor
    6. October 2011 at 09:43

    There is no stagnation.

    Similar thoughts on fiscal policy from Mankiw & Weinzierl http://www.brookings.edu/~/media/Files/Programs/ES/BPEA/2011_spring_bpea_papers/2011a_bpea_mankiw.pdf

    “This policy might be interpreted, for example, as the central bank
    targeting a higher level of nominal GDP growth. With this monetary policy
    in place, fiscal policy remains classically determined.”

  12. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    6. October 2011 at 09:44

    This is your best blogpost ever, Scott. It’s the essence of Sumnerianism.

  13. Gravatar of Becky Hargrove Becky Hargrove
    6. October 2011 at 09:54

    Some good thoughts here on economics education in general.

  14. Gravatar of Michael Michael
    6. October 2011 at 10:05

    Sad how really smart people with a lot to say can beat up on each other about a model. IS-LM is a very useful model for teaching a lot of basic concepts around how central banks and business cycles work. Like all good models, the truth is in the assumptions. I haven’t seen a lot of empirical work that supports quantity theory’s usefulness in the short-term, but I’m still a graduate student, so it’s possible I’m not looking in the right places.

  15. Gravatar of Josh Josh
    6. October 2011 at 11:30

    “I think DeLong and Krugman need to lighten up a bit. They are defending the IS-LM model like it’s some sort of bride whose virginity has been challenged. ”

    This is probably the best thing i’ve ever read

  16. Gravatar of Thomas Summers Thomas Summers
    6. October 2011 at 11:52

    @ Dr. Sumner, Wouldn’t you want to avoid actually issuing NGDP futures contracts, because of the circularity problem created by having futures contracts in the target variable? I think Bernanke and Woodford had a paper on this. It seems like you would have to use RGDP futures contracts and a TIPS spread (or other future inflation measurement). Then you could say something like NGDP = i + RGDP and still be able to achieve any arbitrary level of NGDP so long as there is no interaction between i and RGDP and there isn’t a liquidity trap. Then your target would be able to avoid both the circularity problem and solution multiplicity, but this slightly different than an explicit contract in NGDP, which under your target would seem to be a case of the circularity problem.

  17. Gravatar of DanC DanC
    6. October 2011 at 12:18

    I hated IS-LM, not to mention it was taught by the worst teacher I ever had.

    It felt inadequate at the time, and it remains a poor tool.

  18. Gravatar of marcus nunes marcus nunes
    6. October 2011 at 12:42

    Scott
    Send Blanchard some post links and papers. He says there´s not much difference between inflation targeting and NGDP targeting and that adopting an NGDP target wouldn´t make a “gigantic difference”! The good thing is that the NGDPT idea has begun to circulate in the policy making bodies.
    http://thefaintofheart.wordpress.com/2011/10/06/clueless-in-washington/

  19. Gravatar of Jeff Jeff
    6. October 2011 at 12:49

    LS-IM fundamentally lacks the time element in the for of a d/dt component (which matters a ton – demand not meeting supply – how does it work? d/dt). There are similar relationships between the quantities as well. The terms are not independent quantities but interdependent variables.

    It’s NOT just a matter of adding in addition LINEAR terms but adding in essential DERIVATIVE terms that account for the size of MARGINAL differences in key parameters.

    It’s literally akin to making a model of a mechanical system that has no springs and no mass but only friction. Zero inertia and zero snap-back. It’s hardly surprising that 2008 was a surprise. These are essential features that the model said could not exist!

  20. Gravatar of Liberal Roman Liberal Roman
    6. October 2011 at 13:11

    OT: This impresses even me. From Occupy Wall Street:

    http://modeledbehavior.com/2011/10/06/in-which-i-am-won-over-by-occupy-wall-street/

  21. Gravatar of Joe Joe
    6. October 2011 at 13:57

    Professor Sumner,

    Is your skepticism of the importance of interest rates for the monetary transmission mechanism based on “a hunch” or is it based on economic evidence you’ve read in academic papers over the years? For example, since you’re both right wingers, what exactly causes you and Mankiw to see the importance of interest rate differently? Is it just “a feeling” or empirical evidence?

    Personally, I interpret the Keynesian interest rate mechanism as nothing more than the hot potato process going through the bond markets.

    Joe

  22. Gravatar of Doc Merlin Doc Merlin
    6. October 2011 at 14:03

    Nonsense. Interest rates matter a lot if prices and wages are sticky!

    If prices are sticky and the rate is held down too much it lowers investment quantity supplied like a price ceiling.

    If prices are sticky and the rate is held up too high it lowers investment quantity demanded like a price floor.

  23. Gravatar of Andrew C. Andrew C.
    6. October 2011 at 15:56

    If we live in a pure money-goods universe, how does a central bank expand the money supply? They could buy goods, but then they’re basically conducting fiscal policy. They could do helicopter drops, but that’s also basically fiscal policy (think tax credits). I don’t see how you can introduce monetary policy without also introducing bonds, or at least some kind of financial asset.

  24. Gravatar of Scott Sumner Scott Sumner
    6. October 2011 at 16:25

    dtoh, I still don’t see how it controls NGDP.

    W. Peden, QE is better than nothing, but depreciation of the pound or an explicit NGDP target would have been far better.

    Victor, Great minds think alike.

    Patrick, Wow! That’s a nice compliment.

    Thanks Becky.

    Michael, You said;

    “Sad how really smart people with a lot to say can beat up on each other about a model.”

    I agree. You’d think someone who won a Nobel Prize might be a little less rude to us mere mortals.

    Josh. Thanks.

    Thomas, My 1989 paper avoids that problem in exactly the way they suggest. The price of NGDP futures is fixed by the government, and the market forecasts the instrument setting expected to hit that target. That’s exactly what their 1997 paper suggests.

    DanC, Yup.

    Marcus, Which Blanchard? The blogger?

    Jeff, Good points.

    Liberal Roman, Matt Yglesias was at the protest?

    Joe, It comes from looking at lots of empirical evidence, and the realization (from my research on the Depression) that there are no “long and variable lags.” That makes the procyclicality of interest rates very revealing.

    Doc Merlin, I don’t follow that argument.

    Andrew. Monetary policy has been around for a long time, long before bonds. Kings used to debase coins to earn seignorage. That’s “policy.” The essence of monetary economics is studying the impact of a change in the quantity of money on its value. That’s been something that’s been well understood for as long as we’ve had money.

    I understand that there is a fiscal aspect to all monetary policy. OMPs extinguish public debt, and thus mean that government goods are paid for via an inflation tax, rather that debt, (and hence future ordinary taxes.) But the effect of high powered money on the price level has little or nothing to do with how it’s injected into the economy. The king could debase coins and give them away, or buy bars of silver and put them in the castle, or buy bonds if they existed. In any case, you’d get inflation.

  25. Gravatar of Scott Sumner Scott Sumner
    6. October 2011 at 16:37

    Marcus, I just saw the link–excellent video by Blanchard–I was impressed.

  26. Gravatar of Liberal Roman Liberal Roman
    6. October 2011 at 16:46

    OT again (sorry): It’s 10/6/2011, 5:44 PM. I have officially had it with the Obama administration. You can count me in the ‘strongly disapprove’ column.

    http://www.msnbc.msn.com/id/44806723/ns/us_news-crime_and_courts/t/calif-pot-dispensaries-told-feds-shut-down?gt1=43001#.To5K4rKHSXk

  27. Gravatar of dtoh dtoh
    6. October 2011 at 16:51

    Scott,
    Same way as the Fed would do it now but more directly. Essentially, other than pronouncements, the Fed has 3 tools: a) the discount rate, b) the rate of IOR and c) open market operations. They all work the same way though which is by driving asset prices up (or down if they are trying to contract NDGP). The problem with these is that they don’t work well because they operate indirectly through banks, and if banks just decide to sit on cash or increase their deposits with the Fed nothing happens except a decrease in velocity.

    If on the other hand you can command the banks to increase specific asset holdings, you have a very direct lever by which to push up asset prices. Setting equity reserve ratios gives the Fed this lever.

    Two other quick points. First, you need to distinguish between policy (e.g. setting an NGDP target) and the tools to achieve the policy (e.g. setting an equity reserve ratio or setting the rate of IOR). Second, with an equity reserve ratio what you are controlling is the asset to equity ratio of the banks (you’re just expressing it with the numerator and denominator reversed when you talk about an equity reserve ratio).

  28. Gravatar of Morgan Warstler Morgan Warstler
    6. October 2011 at 16:52

    Liberal Roman,

    State rights, baby!

  29. Gravatar of Doc Merlin Doc Merlin
    6. October 2011 at 17:30

    “Doc Merlin, I don’t follow that argument.”

    Hrm, let me reword it. If prices are sticky but interest rates are not then in the short run, the fed forcibly changing interest rates just changes nominal rates without changing real rates.
    However, since prices are sticky this doesn’t mean inflation increases, so the only other option is that the interest rates changed without the supply and demand equilibrium in capital markets changing.

    This is in effect a market distortion similar to a price ceiling or floor, but only if prices are sticky. This is is a macro, AD-AS, way of describing the price distortions from monetary policy that Hayek used to talk about.

  30. Gravatar of Liberal Roman Liberal Roman
    6. October 2011 at 19:47

    You know what sucks the most Morgan. If you press Obama on this, he’ll just shrug his shoulders and say “Well, that’s what the DEA and the IRS decided was the best way to go. I am just implementing the opinion of the experts.”

    The man is not a leader. He is a technocrat.

  31. Gravatar of Mark A. Sadowski Mark A. Sadowski
    6. October 2011 at 19:50

    Scott wrote:
    “We critics are convinced that other approaches are much more useful. Contrary to DeLong, there is nothing “tribal” about all this. I’ve discarded the old monetarist preference for M2 targeting, and accepted the Krugman argument that temporary monetary injections are ineffective at the zero bound. I’m not tribal, I’m eclectic. When we see people use models in ways that we think are wrong, indeed that we think helped cause the Great Recession, we are naturally going to be critical of those models. Especially if we find alternative approaches that seem more fruitful—like viewing monetary policy through the lens of changes in NGDP expectations, and viewing fiscal policy in essentially classical terms (except where a bizarrely perverse central bank allows fiscal decisions to alter its inflation or NGDP target.)”

    Don’t we always discard the old ways when the new ways are better?

    I for one, hope so.

    By the way, my old ways are melting away in face of personal success. Success!

  32. Gravatar of Krugman and DeLong mount a chivalrous defense of IS-LM « Economics Info Krugman and DeLong mount a chivalrous defense of IS-LM « Economics Info
    6. October 2011 at 20:02

    [...] Source [...]

  33. Gravatar of Morgan Warstler Morgan Warstler
    6. October 2011 at 20:06

    The DeKrugman brigade has finally found a demand!

    http://cannonfire.blogspot.com/2011/10/ows-heres-message-youve-all-been.html

    God I love America! Is this a great country or what?

    Just a couple more months Scott, and and it will be time to start the slow arc that finishes Nov. 2012.

    (tingles all over)

  34. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    6. October 2011 at 20:54

    Scott, here’s a line you might find useful, courtesy of DeLong when he was flirting with a version of neo-Monetarism–We’re all Monetarists now and all Monetarists are Keynesians:

    http://www.j-bradford-delong.net/movable_type/2004_archives/000393.html

    w’…what Friedman and Schwartz (1963) would call a “neutral” hands-off monetary policy during the Great Depression–one that kept the nominal money stock fixed–would have been condemned by pre-World War II over-investment theorists as extraordinarily interventionist. Indeed, it would have been. Between 1929 and 1933 the Federal Reserve raised the monetary base by 15% while the nominal money stock shrunk by a third. The position of Friedman and Schwartz (1963) is that the Federal Reserve should have injected reserves into the banking system much, much faster. Sometimes to be “in neutral” requires that you push the pedal through the floor.’

  35. Gravatar of Wadolowski Wadolowski
    7. October 2011 at 02:49

    (out of context comment)

    It’s so nice to hear that Olivier Blanchard is clearly in support of your view about NGDP targeting.

    http://www.economist.com/blogs/freeexchange/2011/10/olivier-blanchard-fiscal-policy

    (And many thanks to Ryan Avent (who probably made this iterview) for the question about NGDP)

  36. Gravatar of Rien Huizer Rien Huizer
    7. October 2011 at 02:53

    Scott,

    My fingers are numb from Googlying but I am afraid you will need to recruit Shane Warne to do your dirty work. As to your blog prescriptions, I believe it is time to try this in earnest, and coordinated across the US, Europe, Japan and the UK. When Mervyn King starts to utter dark and shapeless thoughts things may be really gloomy and ready for a wrong’un..

  37. Gravatar of Rien Huizer Rien Huizer
    7. October 2011 at 02:54

    W,. Peden,

    Talk to Mervyn!

  38. Gravatar of Lewis Lewis
    7. October 2011 at 04:28

    unrelated, but are you gonna comment on this? http://www.bloomberg.com/news/2011-10-07/pound-climbs-most-in-week-as-asset-purchase-plans-spurs-economy-optimism.html
    “Pound Climbs Most in Week as Asset-Purchase Plans Spurs Economy Optimism”
    i know that stimulus can raise long-term interest rates by boosting NGDP growth expectations, but has it ever strengthened the currency? is this misreporting?

  39. Gravatar of Ken Hirsh Ken Hirsh
    7. October 2011 at 05:39

    “I favor an ad hoc approach to models–use the simplest model that gets at the issues you are interested in. Start with a simple economy with money and goods, no bonds. The supply and demand for money determines the price level and/or NGDP. That’s most of human history. Add wage price stickiness and you get demand-side business cycles. Add interest rates and you get . . . well it’s not clear what you get.”

    This is fantastic. Thanks.

  40. Gravatar of Britmouse Britmouse
    7. October 2011 at 07:02

    @Lewis

    The pound fell from USD $1.55 to $1.53 in the minutes after the QE announcement but has since risen to $1.56. I’ve no idea what is driving that.

    The 5y breakeven rate ticked up quite sharply, and is now back at a much more healthy level than it was for most of September, but still forecasting sub-2% CPI (UK “linkers” track the RPI inflation measure, which is up to 1% above CPI):

    http://www.bloomberg.com/apps/quote?ticker=UKGGBE05:IND

  41. Gravatar of tim tim
    7. October 2011 at 08:20

    hi scott
    would it be possible for you to do a post explaining how monetary stimulus works through friedmans original money demand equation and then reconciling it with your views on monetary policy based on future expectations? i think it would really clarify the differences between monetarism and market monetarism. .
    also i remember reading friedman’s article “comment on the critics” which tried to explain monetarism through the is/lm framework.
    tim

  42. Gravatar of J Mann J Mann
    7. October 2011 at 09:02

    Either Krugman’s google-fu is weak or he’s being disingenuous.

    No one curious about Tyler’s point would google for ‘”nominal gdp perspective”‘, they would google for someling like ‘”nominal gdp” vs is/lm’ or just ‘”nominal gdp”‘, then read those links and try to identify more relevant terms.

  43. Gravatar of flow5 flow5
    7. October 2011 at 09:12

    “It led modern Keynesians to assume that money was easy in 2008″

    Duped again. Actually, monetarists have yet to describe, in monetarists terms, what happened. And Bernanke continues to cite inflationary indexes that are not representative (bragging about his inflation targeting success).

    IS=LM The equation ought to be thrown out of all text books. Both sides have major errors.

    “and accepted the Krugman argument that temporary monetary injections are ineffective at the zero bound”

    Krugman’s wrong. He’s probably never even traded futures contracts, options, etc. It pays to live in the real world.

  44. Gravatar of StatsGuy StatsGuy
    7. October 2011 at 09:24

    Please add one major issue to Tyler Cowen’s list (pet peeve):

    Failure to separate risk-component of interest rate from the time-component of the interest rate.

    This has become one of the dominant features of international finance markets – manifested either as Credit Default Swaps, or as risk-spreads for bonds. Risk aversion is not constant – it responds to the nominal money supply due to fixed debt loads and non-linear utility.

  45. Gravatar of Andrew C. Andrew C.
    7. October 2011 at 10:32

    Scott, in reply to your comment:

    “Andrew. Monetary policy has been around for a long time, long before bonds…

    [T]he effect of high powered money on the price level has little or nothing to do with how it’s injected into the economy. The king could debase coins and give them away, or buy bars of silver and put them in the castle, or buy bonds if they existed. In any case, you’d get inflation.”

    I was imagining a world where the ONLY means for people to save is to hold money. That would exclude the existence of bars of silver or gold. In that universe, it seems to me, the distinction between monetary and fiscal policy disappears.

    If we allow the existence of durable assets that people can reasonably hoard like silver or gold, you could write down a version of the IS-LM model where “asset price” replaces the interest rate. So liquidity preference would be an upward sloping function of the asset price for given level of Y. This would create a downward sloping LM curve in asset prices. Meanwhile, you’d have an upward sloping IS curve corresponding to higher aggregate demand for higher asset prices. Would you object to that version of IS-LM?

    I guess the key difference is that with bonds when you hit 0 interest, money becomes every bit as good, if not a better way to store value. Thus the liquidity trap. Whereas there’s no maximum price on silver bars.

  46. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    7. October 2011 at 13:24

    Eric Falkenstein weighs in:

    http://falkenblog.blogspot.com/2011/10/is-lm-is-ignored-for-reason.html

    ‘Here’s a tip. When a new paradigm is introduced, and it generates many honors, books, and large-scale-collaberative models, and then after 40 years is found uninteresting by young graduate students who don’t have a dog in the fight, this is a sign it has been a good-faith mistake. Best to move on. All the IS-LM model predicts is that with massive fiscal or monetary stimulus there will be a short run effect, but you don’t need the IS-LM for that (eg, WW3 will increase output). And like any short run stimulus, that shouldn’t be the focus of economists, any more than a psychologist should recommend drinking beer to get over your problems (you’ll feel better in an hour!).’

  47. Gravatar of Mark A. Sadowski Mark A. Sadowski
    7. October 2011 at 21:27

    I happen to agree with Krugman.

    The following video is well worth a listen to:

    http://www.youtube.com/watch?feature=player_embedded&v=cKujuu6SpYA

    Get it?

  48. Gravatar of bm bm
    8. October 2011 at 01:54

    I have read your blog almost since the beginning and intuit that you’re onto something. Yet when I have to think through an economic problem I use IS-LM. At least I know what it is – I can write down the equations and shift the curves around.

    But I can’t remember you ever having written down your model. Unless you write down the equations I really don’t know what to do with it.

  49. Gravatar of anon anon
    8. October 2011 at 07:03

    Good news: Brad De Long is finally endorsing NGDP targeting! So much for the “liquidity trap” view.

    “Let me be the first to say that I really, really wish the Federal Reserve would pull a Paul Volcker–would change its operating procedures–and announce that it will buy as many risky and long-duration assets for cash as it needs to in order to push market expectations of nominal GDP five years hence back to its pre-2008 trend level of $18 trillion/year.”

  50. Gravatar of Kevin Donoghue Kevin Donoghue
    8. October 2011 at 07:34

    Krugman returns to the subject in the light of the many responses he has received:

    http://krugman.blogs.nytimes.com/2011/10/08/ah-yes-lm-wonkish/

    Almost the very first textbook I ever had was Macroeconomics by Robert L. Crouch. AFAICR it took a very sound approach, constructing a four-sector GE model (commodities, bonds, money and labour) with IS/LM left unmentioned until quite late in the book. Having seen how much confusion there is about the model I think maybe that’s the best way to teach it.

  51. Gravatar of The big IS/LM debate – DeLong comes under heavy shelling « The Market Monetarist The big IS/LM debate – DeLong comes under heavy shelling « The Market Monetarist
    8. October 2011 at 09:43

    [...] Scott Sumner, Nick Rowe and David Glasner all weigh in on the debate. [...]

  52. Gravatar of Pat Pat
    8. October 2011 at 10:25

    “Krugman trashes Tyler Cowen[...] Krugman doesn’t identify a single flaw [...] The post is just a string of personal insults. And [...] Michael Woodford[...]‘s also ‘confused.’ And of course Milton Friedman[...]’s another guy who just doesn’t get it.”

    Two things: First, Krugman writes in response to Delong, who identifies at least the following “single flaw[s]” with Cowen’s approach: (1) monetary quantity theory is inconsistent with present circumstances, (2) “nominal GDP perspective” is unclear, and (3) each objection Cowen levels is supposedly a rap against IS/LM’s over-simplicity… but each proffered alternative is more, not less, simplistic. One could probably add that Cowen’s probably overstating distinctions between long- and short-term interest rates and real and nominal rates, or at least that they seem less pressing when we’re against the zero bound with no inflation in sight. Cowen also repeats several times that IS/LM “leads” one to mistaken conclusions; I have no idea if that tendency is real, nor if Cowen had specific misled commentators in mind when he wrote that, but suffice to say I suspect at least it may be chimerical.

    Anyway, it’s not a very telling blow against Krugman that he links to Delong rather than reiterate each point individually. And, for the record, Krugman’s post is a pretty good explication of point (3), above, although perhaps not in good Lincoln-Douglas format that points out where, precisely, Cowen is wrong.

    Delong concludes from this that Cowen’s demonstrated aversion to IS/LM isn’t really about his objections, on the terms he’s picked for them, but is rather due to “tribal” loyalties. (Delong’s word, btw.) After all, if one follows the logic down this road, one starts to think the New Deal had something going for it and maybe the government does occasionally have a market-correcting role to play. One of the two tribes in America today knows very well what they think about that, thank you very much, and they’re quite insistent that interest rates need to rise and deficits fall. Now, perhaps one could infer from this that Delong’s is so mad about that tribe that he’s imagining its tribesmen where they aren’t really. Fair enough, but Cowen doesn’t get to make that plea on his own behalf, and I think you’re confused to make it on his account.

    Second, this is what passes for a “trash[ing],” “a string of personal insults”? The strongest language in Krugman’s post is the word “simple” in his caption (a reference to an old Amish song, if I’m not mistaken) and the following summation: “macro seems afflicted with people who mistake confusion for insight, who think their own failure to understand basic ideas reflects a failure of those ideas rather than their own limitations.” Oh, and the word “silly.”

    Heavens. Do pass the smelling salts. And seriously, if Krugman writing so much honestly gets your hackles up, I think Delong’s point about tribalism is, well, so much the stronger.

  53. Gravatar of Kevin Donoghue Kevin Donoghue
    8. October 2011 at 11:15

    Mankiw supports Krugman. Textbook millionaires of the world unite, you have nothing to lose but your royalties! If you’re downloading his freebie book chapter, be warned it’s a 5.8Mb PDF file.

    http://gregmankiw.blogspot.com/2011/10/krugman-on-is-lm.html

  54. Gravatar of Scott Sumner Scott Sumner
    8. October 2011 at 15:45

    Liberal Roman, Obama’s war on drugs might be the worst thing he’s done. And we know he doesn’t even believe in it. And he doesn’t have to do it, the voters in California disagree with him. It’s a disgrace.

    dtoh, I don’t agree that monetary policy works through banks. I think it works by changing the value of the medium of account, base money.

    Doc Merlin, You said;

    “Hrm, let me reword it. If prices are sticky but interest rates are not then in the short run, the fed forcibly changing interest rates just changes nominal rates without changing real rates.”

    Not true, sticky prices doesn’t prevent OMPs from changing expected inflation. But even if expected inflation didn’t change, a change in nominal rates will lead to a change in real rates.

    Mark, Congratulations.

    Morgan, Don’t be surprised if Perry’s not elected President.

    Patrick, That’s a good find. But if the Fed had really done that, they might well have needed less base money, as most of the base injections were in response to the banking panics, and the monetary base actually declined in the first year of the Depression.

    Wadolowski, Yes, a good question from Avent.

    Rien, Yes, that’s worrisome.

    Lewis, Very good question, and I have to plead ignorance. I’ve always suspected that a suitably expansionary monetary stimulus might be able to appreciate a currency, by leading to faster growth expectations, just as it can lead to higher short term rates. But I’ve never had much confidence in that hunch, so I don’t talk about it. It’s something we need to keep an eye on.

    Thanks Ken,

    Britmouse, Thanks for that info. Now I’m glad I never put forth that hypothesis.

    Tim, Actually, I have talked a lot about how monetary policy works through all sorts of asset prices–stocks, commodities, real estate, exchange rates, etc. That’s also Friedman’s view.

    Did Friedman argue that monetary stimulus shifted the IS curve?

    J Mann, I agree, but it was DeLong, not Krugman.

    Flow5, Krugman’s right; if you inject money then withdraw it not much happens.

    Statsguy, Very good point. People used to tell me the TIPS spreads overestimated deflation fears in late 2008, because there was a rush for liquidity. I responded; “A rush for liquidity? An even better reason for easy money.”

    Andrew, I have two problems with your comment.

    First, people keep telling me that I can’t ignore the role of banks, and then I do, and people say even though there are no banks, silver is durable so there are quasi-interest rates. Maybe so, but that doesn’t disprove my argument that one can ignore the role of banks and bonds and just focus on physical goods. There is no zero bound for silver bars. Plus, assume every good was very perishable, like bananas. It would still be true that if you doubled the quantity of the medium of exchange, the price level in terms of than media would double. The hot potato effect.

    Second, I don’t like the attempt to find a pure monetary policy untainted by fiscal implications. I agree that a helicopter drop is a fiscal operation too. But so is an open market purchase of government bonds, as you are reducing the national debt, and hence future tax obligations.

    But these objections are trivial compared to my third point. We have natural experiments that show the difference between a helicopter drop and an OMP is trivial. I did a post comparing Australia and Canada. Both have similar monetary bases, but (prior to 2008) Australia had something like 1/10th the national debt that Canada had. That means Canada could have doubled its monetary base through an OMP, and still had a vastly larger net debt than Australia. Suppose Australia doubled its base via a helicopter drop at the same time Canada did through an OMP. Does anyone seriously doubt that both countries would have seen their price levels roughly double? (Remember neither was in a liquidity trap.)

    People who go on about helicopter drops don’t seem to know the stylized facts about monetary bases, the price level, and national debts. The stylized facts are that the base matters a lot, and the size of the national debt matters very little.

    Regarding the zero bound, I don’t think anyone denies that if it’s expected to last forever, the money supply must be redefined to include public debt. The base is then all cash plus reserves plus public debt. I’m not holding my breath for that to ever happen. If it’s not expected to happen, then one can still target a path of prices or NGDP.

    Patrick, I agree with his conclusion, but the argument didn’t exactly blow me away.

    more to come . . .

  55. Gravatar of Scott Sumner Scott Sumner
    8. October 2011 at 16:18

    Mark, Yes, but he was a bit late in jumping on the AF bandwagon, wasn’t he?

    bm, My model is the AS/AD model, with the AD being a rectangular hyperbola. A shift in AD is monetary policy, by my definition. There’s obviously more, but that’s the basic model.

    anon, Actually, he’s been doing that for at least a few months, but thanks for the link.

    Kevin, I don’t have much to say about that, other than it was more polite than his previous post, as he was disagreeing with his fellow Keynesians.

    Pat, I’m always amused when Krugman supporters can’t even recognize an insult. Then you won’t mind if I insult you by saying you don’t even understand the most basic aspects of human interaction. You don’t understand that saying a distinguished economist fails to understand basic ideas is an insult.

    That’s fine if Krugman wants to be that way, but then he’s also the one who whines about how nasty the GOP rhetoric is.

    You said;

    “Delong concludes from this that Cowen’s demonstrated aversion to IS/LM isn’t really about his objections, on the terms he’s picked for them, but is rather due to “tribal” loyalties.”

    That’s right, if one distinguished economist disagrees with another, the other guy can’t be sincere, it must be “tribal.” But of course! And it goes without saying that all the Keynesians who don’t like IS-LM and who are now coming out of the woodwork . . . well I don’t know what’s wrong with them–maybe some sort of psychological problem, perhaps they need therapy.

    You said;

    “Two things: First, Krugman writes in response to Delong, who identifies at least the following “single flaw[s]” with Cowen’s approach: (1) monetary quantity theory is inconsistent with present circumstances,”

    Please, DeLong already established a few weeks back that he doesn’t even know the difference between the modern quantity theory of money and the equation of exchange. So let’s not even go there.

    You said;

    “2) “nominal GDP perspective” is unclear,”

    Unclear to DeLong, but not unclear to anyone who reads the nearly a dozen market monetarist blogs.

    You said;

    “One could probably add that Cowen’s probably overstating distinctions between long- and short-term interest rates and real and nominal rates, or at least that they seem less pressing when we’re against the zero bound with no inflation in sight.”

    I don’t think even Krugman would agree there, he favors a 4% inflation target to lower real rates.

    You said:

    “Cowen also repeats several times that IS/LM “leads” one to mistaken conclusions; I have no idea if that tendency is real, nor if Cowen had specific misled commentators in mind when he wrote that, but suffice to say I suspect at least it may be chimerical.”

    I’ll give you an example; not a single IS-LM proponent in the entire world recognized in late 2008 that tight money in the US was a huge problem. We market monetarists did, and we’ve finally convinced the DeLong’s of the world. In early 2009 he said the Fed could do nothing at zero rates. Now he’s demanding the Fed do much more at zero rates. Where’d that idea come from?

    Kevin, Mankiw’s a Keynesian, so I’m not surprised.

  56. Gravatar of W Peden W Peden
    8. October 2011 at 17:56

    Scott Sumner,

    The explanation of low inflation during the Great Moderation was clearly oil prices. Oil prices affect the General Price of goods, and since all goods & services involve oil, all prices rise when oil prices rise.

    That’s why inflation reached 1970s levels during the 2000s… Ah.

  57. Gravatar of Andrew C. Andrew C.
    8. October 2011 at 18:24

    Scott,

    Here’s a brief response to your three points.

    1. I guess I just have a hard time modeling in my head how the hot potato effect works without writing down an IS-LM-like model. In your response to bm’s comment, you say you favor a rectangular hyperbola AD curve. I’m not 100% sure what you mean by that… I’m guessing it’s something like MV=PY -> Y=MV/P. But this confuses me because I also know that you keep insisting that MV=PY is not the quantity theory of money, it’s just an identity. And I agree with you there. What IS-LM does is provide a model for what determines V. And even after reading your blog for a long time, I’m still not entirely sure what your alternative is.

    2. I don’t disagree that all monetary policy has fiscal implications. My point in saying that any distinction disappears in (say) a banana-only economy was only to express my confusion that someone who advocates so strongly for the supremacy of monetary policy over fiscal would favor a model where fiscal and monetary policy are identical. But I now see that you did not necessarily mean a banana-only economy. But then, a banana-silver economy can be modeled with a variant of IS-LM.

    3. I confess I am not an expert on the economic evidence on this subject. And in general, I have a hard time evaluating economic evidence when it is presented to me because the world is so complicated. But I’m definitely open to the possibility that it supports your case.

    In your Canada/Australia hypothesis, my Keynesian instincts would tell me that that the helicopter drop would be more expansionary/inflationary that the OMP, since the OMP is a trade of assets, whereas the helicopter drop creates new nominal assets. But it’s hard to say.

  58. Gravatar of Dtoh Dtoh
    8. October 2011 at 20:15

    Scott
    I think you agreed earlier that a change in the base will have no effect if there is an equal and inverse change in the base velocity or multiplier. So there has to be a secondary impact on broader monetary aggregates or asset prices in order for a change in the base to have an actual impact.

    So why screw around with tools where the impact is indirect and diluted. Why do you think there is so much opposition to a more expansive monetary policy. It’s because the throttle is connected to the engine by a piece of string and no one (except maybe you) is confident to step on the gas.

    BTW – The last time I checked the only counter-parties the Fed deals with are the banks.

  59. Gravatar of Dtoh Dtoh
    8. October 2011 at 20:29

    Scott
    So here is a good thought experiment. Suppose there were no Fed Funds, only beads (or gold or a fixed amount of currency) sitting in a central clearing house. If all the Fed did was tell the banks how much assets (other than beads) to hold, everything would work fine and you would be out of the blogging business.

  60. Gravatar of Mark A. Sadowski Mark A. Sadowski
    8. October 2011 at 22:42

    Scott wrote:
    “Mark, Yes, but he was a bit late in jumping on the AF bandwagon, wasn’t he?”

    Evidently we can thank his wife for introducing him to AF. Better late than never.

  61. Gravatar of W Peden W Peden
    9. October 2011 at 02:56

    dtoh,

    “The last time I checked the only counter-parties the Fed deals with are the banks.”

    As I understand it, during operations like QE the Fed doesn’t engage with ordinary banks at all, but with intermediary dealers (either banking securities trading arms or securities brokers) who may or may not be acting on behalf of banks. These are the primary dealers-

    http://www.youtube.com/watch?v=F4KiQQJuaIQ

    http://en.wikipedia.org/wiki/Primary_dealers

  62. Gravatar of Dtoh Dtoh
    9. October 2011 at 05:23

    Peden
    Depends on the transaction. In the case of open market operations, it is the primary broker dealers (not sure of the number now…used to be 23). For deposit taking and lending it’s a broader set of institutions. By “banks”, I was referring generically to financial institutions.

  63. Gravatar of Scott Sumner Scott Sumner
    9. October 2011 at 06:42

    W. Peden. Yes, my thoughts exactly.

    Andrew. Do you need an IS-LM model to understand the impact of an increase in the supply of copper on the value of copper? Obviously not. S&D will do fine. So tell me at what stage you need the IS-LM model:

    1. More copper.
    2. More gold.
    3. More gold where gold is used as money.
    4. Gold money replaced by currency–more currency.

    I say you can use a S&D model for all four cases. At some point you see a IS-LM model becoming necessary, but I can’t tell where.

    Andrew, I agree that IS-LM can help determine V (although even there it’s easy to misuse, because it doesn’t handle expectations well.) But I’m not really interested in V, I’m interested in M*V. We have a fiat money system where under any plausible Fed target (Inflation, Taylor rule, NGDP, etc) they try to fully offset velocity shocks.

    I agree with IS-LM that velocity is positively related to nominal interest rates. But I don’t agree with IS-LM that easy money lowers nominal rates, that’s based on just one of the many channels by which monetary policy affects interest rates–the expectations channel.

    You said;

    “In your Canada/Australia hypothesis, my Keynesian instincts would tell me that that the helicopter drop would be more expansionary/inflationary that the OMP, since the OMP is a trade of assets, whereas the helicopter drop creates new nominal assets. But it’s hard to say.”

    This is the core of my disagreement with Keynesians. They see money working through a very different transmission mechanism than I do. Consider the non-liquidity trap scenario.

    1. When interest rates are positive and there is no IOR, then almost all of the base is cash held by the public. In that case the public likes to hold about 3% of GDP in cash, in places like Canada and Australia (the US is higher, because of foreign dollar hoarding.) And the key point is that the ratio isn’t really likely to change if you double the base. The public still wants to hold about 3%, and that requires NGDP to double via the hot potato effect. Rates play little or no long run role in the process. The size of the budget deficit doesn’t much matter–people want to hold about 3% of GDP as cash in a normal Anglo-Saxon economy. That’s why the base is high powered money, and debt isn’t.

    Of course with a liquidity trap my argument must be modified. Then I follow the Krugman expectations approach–what matters is where the money supply is once you’ve exited the liquidity trap and the monetary authority again has sand under the tires. And you send those signals via an higher inflation target. Conventional OMPs are not effective if believed to be temporary at zero rates. (Although surprisingly, that’s also approximately true during normal times when rates are positive.)

    Dtoh, I agree that the monetary base isn’t a very good monetary policy tool. I favor using NGDP targets. So I don’t understand your criticism. I favor making the base endogenous, reflecting the demand for base money when NGDP expectations are on target.

    I don’t follow the beads argument.

  64. Gravatar of dtoh dtoh
    9. October 2011 at 08:37

    Scott
    Under your prescription, what are the tools the Fed uses for hitting the NDGP target other than just telling the market what the target is?

  65. Gravatar of Passing By Passing By
    9. October 2011 at 10:00

    Professor Summer–”And the liquidity trap view that is out there in the real world is the main reason we are letting central banks off the hook”

    In the real world, the people letting the Fed off the hook are the FOMC’s “inflation hawks”. Do you have any evidence that Messrs. Fisher, Hoenig, Kocherlakota, and Plosser rely on the IS-LM model? It seems most unlikely.

  66. Gravatar of Pat Pat
    9. October 2011 at 12:39

    “Pat, I’m always amused when Krugman supporters can’t even recognize an insult. Then you won’t mind if I insult you by saying you don’t even understand the most basic aspects of human interaction. You don’t understand that saying a distinguished economist fails to understand basic ideas is an insult.”

    “Please, DeLong already established a few weeks back that he doesn’t even know the difference between the modern quantity theory of money and the equation of exchange. So let’s not even go there.”

    Sigh.

    (And have no fear; I don’t mind at all.)

  67. Gravatar of Andrew C. Andrew C.
    9. October 2011 at 17:44

    Scott, I want to write a thoughtful reply, but this week is kind of crazy for me so I’m not sure when I’ll have time to write it.

    My short reply is that I see IS-LM as popping out of a S&D analysis, not as a competitor. I’ll write more later.

  68. Gravatar of Scott Sumner Scott Sumner
    10. October 2011 at 09:38

    dtoh, I’d adjust the monetary base until NGDP futures were on target. Note I say “adjust” not increase. It would probably require a smaller monetary base.

    Passing by, That’s right, but I don’t see them as the main problem (although they are certainly a problem.) I see the main problem as the rest of the FOMC, plus Obama, Larry Summers, Peter Diamond, Congress, the NYT, the WaPo, Joe Stiglitz, and the mainstream NK economists in America. I think that group is much more influential than the Fed hawks. If it was widely understood that easier money could quickly boost AD, it would have already happened.

  69. Gravatar of Andrew C. Andrew C.
    11. October 2011 at 10:04

    Scott, here are more thoughts I’ve had between studying for and taking exams:

    I realized that when I said I thought a helicopter drop would be more stimulative than an OMP, I was talking from the seat of my pants. When I actually think through what IS-LM has to say, I find it supports your position!

    In a helicopter drop, people increase their spending by the marginal propensity to consume times the amount dropped, shifting the IS curve to the right. The LM curve also shifts right. At this point, it looks like the drop is more stimulative, but that’s just one period. In the next period, IS shifts back to where it was, while LM stays in its new position… leaving the IS-LM equilibrium exactly where it would be if the fed simply did an OMP. The fiscal stimulus of the drop is just a temporary blip… and that’s taking the generous assumption that people apply the same MPC to the hel drop as they would any other income. If we were more realistic, a much smaller MPC would be applied.

    So I guess I simultaneously cede your point that it doesn’t matter how new money enters the economy, but also say that IS-LM agrees with you! More than that, it was IS-LM that convinced me you were right. With enemies like IS-LM, who needs friends? :)

    But in all seriousness, the point I’ve been trying to make, and I think the main thrust of what DeLong and Krugman have written, is why the special hatred for IS-LM? It has its flaws… its static, takes expectations as exogenous, the vertical money supply function is unrealistic, it doesn’t distinguish between long and short bonds, or any other asset for that matter. But this is the price it pays for being simple. Supply and demand is also a simple model; it’s a static partial equilibrium model that holds income, tastes, wages, prices of other goods, technology, costs of production, and expectations of future prices constant. But somehow you don’t hear rational expectation theorists complaining about it and demanding that it be taken out of intro-micro texts.

    I think the elephant in the room here is ideology. Liberals are predisposed to like Keynesian economics because it provides a justification for intervention in the economy to help people in need, while conservatives and libertarians are predisposed to dislike Keynes for just the same reason. I freely admit that I’m on the left, so I’m biased. But I think this is the biggest barrier economics has to be considered a science, even bigger than the inability run controlled experiments, which makes it worse because it gives people wiggle room to see the evidence they want to see.

  70. Gravatar of Scott Sumner Scott Sumner
    11. October 2011 at 18:31

    Andrew, You said;

    “I think the elephant in the room here is ideology. Liberals are predisposed to like Keynesian economics because it provides a justification for intervention in the economy to help people in need, while conservatives and libertarians are predisposed to dislike Keynes for just the same reason.”

    This may be true, but it suggests neither side understands the theory. Keynes did not provide any justification for helping people in need, just varying the size of the deficit over the business cycle. Even the GOP believes in spending at least 20% of GDP at the government level, so you can still have an active fiscal policy with small government. Look at Singapore.

    I’m not saying you are wrong, but it does show that both sides fail to understand the theory.

    Regarding IS-LM, I explained my objections in this post on purely pragmatic grounds. No one has actually disputed the points I made in the post–they seem to want to look for ulterior motives. There are none. I love simple models. I like AS/AD, which is also criticized by many on the right. So I’m not tribal at all. I’m a free thinker.

  71. Gravatar of James Oswald James Oswald
    13. October 2011 at 09:38

    I left a comment on DeLong’s original post pointing him in your direction, but I think he was being disingenuous. Everyone knows he reads “The Money Illusion” at least occasionally.

    Andrew C.: “I see IS-LM as popping out of a S&D analysis, not as a competitor.”
    I agree. I’ve always seen IS-LM as a S+D model for credit, but I don’t know if others see it that way. X axis is funds lent, Y axis is the real interest rate. Demand for loans is downward sloping, like any other demand curve, and supply of loans is upward sloping because people will want to lend more if they can make a larger return from it. Monetary policy shifts the supply of loans out by adding loanable funds to the market. The reason the central bank can control interest rates is because they can dump a ton of funds into a narrow market and prices are sticky enough to prevent demand from shifting simultaneously. If all prices were prefectly flexible, the only channel the central bank would have to affect nominal interest rates is by controlling inflation through the Fisher effect. Is this similar to your thinking?

  72. Gravatar of TheMoneyIllusion » Krugman and DeLong mount a chivalrous defense of IS-LM « alonbiztech TheMoneyIllusion » Krugman and DeLong mount a chivalrous defense of IS-LM « alonbiztech
    27. October 2011 at 12:52

    [...] TheMoneyIllusion » Krugman and DeLong mount a chivalrous defense of IS-LM. Share this:TwitterFacebookLinkedInLike this:LikeBe the first to like this post. [...]

  73. Gravatar of Who needs a macroeconomic model? « azmytheconomics Who needs a macroeconomic model? « azmytheconomics
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    [...] this recent IS/LM debate got me thinking, people don’t just randomly model things, they have a purpose [...]

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