Here is David Glasner:
Scott is totally right, of course, to point out that the fall in interest rates and the increase in the real quantity of money do not contradict the “money hypothesis.” However, he is also being selective and unfair in making that criticism, because, in two slides following almost immediately after the one to which Scott takes such offense, Foote actually explains that the simple IS-LM analysis presented in the previous slide requires modification to take into account expected deflation, because the demand for money depends on the nominal rate of interest while the amount of investment spending depends on the real rate of interest, and shows how to do the modification. Here are the slides:
. . .
Thus, expected deflation raises the real rate of interest thereby shifting the IS curve to the left while leaving the LM curve where it was. Expected deflation therefore explains a fall in both nominal and real income as well as in the nominal rate of interest; it also explains an increase in the real rate of interest. Scott seems to be emotionally committed to the notion that the IS-LM model must lead to a misunderstanding of the effects of monetary policy, holding Foote up as an example of this confusion on the basis of the first of the slides, but Foote actually shows that IS-LM can be tweaked to accommodate a correct understanding of the dominant role of monetary policy in the Great Depression.
Was I really so unfair? Did I actually accuse Foote of not understanding that tight money can reduce nominal rates. You be the judge:
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.
It sure looks like I’m suggesting that Foote “correctly” understood the distinction between the impact of monetary policy on real rates and nominal rates. I’m not sure where David got the idea I was being critical of Foote. Then David simply ignored my observation that switching from nominal to real interest rates in no way rescues the IS-LM model. Tight money can also reduce real interest rates. Ex ante real rates did fall during the 1930s. So IS-LM cannot be “tweaked to accommodate a correct understanding” of the role of money Depression. It’s rotten to the core.
The Great Depression was triggered by a deflationary scramble for gold associated with the uncoordinated restoration of the gold standard by the major European countries in the late 1920s, especially France and its insane central bank. On top of this, the Federal Reserve, succumbing to political pressure to stop “excessive” stock-market speculation, raised its discount rate to a near record 6.5% in early 1929, greatly amplifying the pressure on gold reserves, thereby driving up the value of gold, and causing expectations of the future price level to start dropping. It was thus a rise (both actual and expected) in the value of gold, not a reduction in the money supply, which was the source of the monetary shock that produced the Great Depression. The shock was administered without a reduction in the money supply, so there was no shift in the LM curve. IS-LM is not necessarily the best model with which to describe this monetary shock, but the basic story can be expressed in terms of the IS-LM model.
I agree that the best way to visualize the Great Contraction is through a large increase in the demand for monetary gold. But I’m confused by David’s claim that this would not shift the LM curve. Gold was the medium of account. Unless I’m mistaken, an increase in the demand for gold would certainly be expected to shift the LM curve to the left, wouldn’t it? (But then IS-LM is not my forte, so please tell me if I am wrong.)
PS. In case you think I cherry-picked a quote, here’s the opening to my post, where I describe the quality of Foote’s PP slides:
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.
If I’m going to be accused of being unfair to someone, at least give me the satisfaction of trashing their work! My post had no criticism of Foote at all. Just some criticism of ideas he listed on one slide as things other people have claimed might have caused the Depression. I never assumed that was his view, and indeed he himself criticized some of those arguments in later slides.
PPS. And how does David know I am “emotionally committed” to the view that IS-LM is worthless? Perhaps I have rational reasons for holding that view. I’ve claimed that monetary policy can shift the IS curve, or else one has to assume the IS curve is upward sloping (Nick Rowe’s view.) I haven’t seen anyone rebut that view, emotionally or unemotionally.