Commenter Joseph sent me an excellent set of PP slides by a professor at Harvard named Chris Foote. He has a very clear derivation of the AD curve from the IS-LM model. This slide caught my attention.
The “spending hypothesis” obviously cannot explain the Great Depression. In 1987 we saw an equally big stock market crash, and GDP kept booming. (And don’t bother trying to concoct excuses about how things were different in 1987—I’ve swatted them all down 100 times.)
An investment backlash? Does that mean people switch from investment goods to consumer goods? If so, why did consumption also fall?
Hoover actually favored public works projects, so fiscal policy explains nothing until at least 1932, when he raised taxes. Was there a Great Depression in 2013? I don’t think so. And yet we had “savage” austerity in 2013.
OK, so it was tight money. We’ve known that for 50 years, ever since Friedman and Schwartz. What interests me is the suggestion that the “money hypothesis” is contradicted by various stylized facts. Interest rates fell. The real quantity of money rose. In fact, these two stylized facts are exactly what you’d expect from tight money. The fact that they seem to contradict the tight money hypothesis does not reflect poorly on the tight money hypothesis, but rather the IS-LM model that says tight money leads to a smaller level of real cash balances and a higher level of interest rates.
To see the absurdity of IS-LM, just consider a monetary policy shock that no one could question—hyperinflation. Wheelbarrows full of billion mark currency notes. Can we all agree that that would be “easy money?” Good. We also know that hyperinflation leads to extremely high interest rates and extremely low real cash balances, just the opposite of the prediction of the IS-LM model. In contrast, Milton Friedman would tell you that really tight money leads to low interest rates and large real cash balances, exactly what we do see.
Note the very last comment on the slide, about the significance of deflation. The rest of the PP slides develop this idea further, and correctly show that while tight money might raise real interest rates, it could lower nominal rates through the Fisher effect. Thus it could shift the IS curve. That helps, but it seems to suggest that the IS-LM model can be rescued by switching the argument from nominal to real interest rates. Alas, that won’t work. The Fisher effect is only one of the ways that monetary shocks impact interest rates. Tight money also reduces expected future real GDP, and this also shifts the IS curve. So it isn’t just nominal interest rates that fall, real rates also fell during the 1930s, as expected future real GDP plunged. The IS-LM model is useless, and should be discarded. The fact that it is used to derive the AD curve probably explains why I can’t seem to understand how Keynesians use the concept of AD; they are basing it on ideas that make no sense to me.
Here’s a simpler model. AD is a hyperbola (a given level of NGDP). This model does not assume NGDP targeting, just as the current AD model does not assume money supply targeting. Changes in NGDP are caused by monetary policy. The P/Y split for changes in NGDP is determined by the slopes of the SRAS and LRAS curves. The LRAS curve is vertical. Interest rates? Yeah, they fluctuate a lot.
BTW, the PP slides end up with an excellent Greg Mankiw post from December 2008. Mankiw recommends the Fed commit to a price level 30% higher in 10 years time. Had they done so the recession would certainly have been much milder.
On the other hand if Mankiw had been head of the Fed in December 2008 they would have done almost exactly what they did under Bernanke, not what Mankiw recommended in 2008. Mankiw’s policy views are pretty similar to Bernanke’s views. Unfortunately there is also the formidable “FedBorg.” Had Mankiw been in charge, it would have been Bernanke who wrote the blog post suggesting the Fed should commit to a 30% higher price level in 10 years. We are all just puppets, filling out the roles determined for us by blind fate.
Off topic: Ramesh Ponnuru is right, I see lots of interest in NGDPLT among conservatives.
I have a post on AD over at Econlog, for those not burned out on the issue.
Just to show you that MMs don’t agree on everything, David Beckworth has a excellent post arguing against the Great Stagnation hypothesis. Marcus Nunes is also skeptical. In contrast, I accept the Great Stagnation hypothesis. Fortunately it doesn’t matter for our monetary policy views, as we all favor targeting NGDP and ignoring RGDP.