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Critique of IS/LM model--Please provide reading sources

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Prashanth Perumal posted on Sat, Dec 19 2009 5:08 AM

Any Austrian source material which explains what the IS/LM model is all about, and then critiques the model, if available, please do share it here.

I am very much confused with this Keynesian model.

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If you're confused with the model, it might be worth trying to understand it first, then go looking for critiques.

I know Reisman has one in his Capitalism.

There's a critique of Keynesianism that begins on page 863 [913 of 1100] and the IS-LM critique begins on page 879 [929 of 1100].

I suppose the whole chapter is worth reading.

Austrians do it a priori

Irish Liberty Forum 

 

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MatthewWilliam:
If you're confused with the model, it might be worth trying to understand it first, then go looking for critiques.

Well, yeah!

So, if you could clarify what Mankiw says about the IS/LM model. Here's what Mankiw(in the book 'Macroeconomics', page no: 285) says:

"For example, suppose Congress were to raise taxes.What effect should this policy
have on the economy? According to the IS–LM model, the answer depends
on how the Fed responds to the tax increase.
Figure 11-4 shows three of the many possible outcomes. In panel (a), the Fed
holds the money supply constant. The tax increase shifts the IS curve to the left.
Income falls (because higher taxes reduce consumer spending), and the interest
rate falls (because lower income reduces the demand for money). The fall in income
indicates that the tax hike causes a recession.
"

My doubts:

Why does a tax cause the IS curve to shift to the left? Is it because if the government hadn't taxed income, the money would have gone into savings(and thereby into investment)?

Neither do I understand how lower income leads to reduced demand for money.

Please clarify!

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Only after-tax income can be used for consumpton. So, by increasing federal taxes on income, you are reducing the amount of money people have left over to spend on goods and services. The point is not that if the government hadn't taxed income the money would have went into savings. quite the opposite. By taxing the income the government is taking money out of circulation that would have been spent on goods and services. This why the IS curve shifts left.

Does that make sense?

Now, of course, government typically doesn't tax people's incomes just to stick the money in a vault somewhere. The government will most likely spend the money, which will shift the IS curve to the right. See how the IS curve would be pulled in two different directions there? Taxes shifting the IS curve to the left, spending shifting it to the right?

But you are being implicitly asked to ignore this ambiguity in this question. The point here is only to consider the economic impact of the tax increase, not the increase in government spending. Does that help?

If none of this makes sense, let me know and I will try to help if I am around (I am traveling all of next week). I tutor during the school year so I enjoy this kind of thing. :P

 Also, if you are interested in a really good discussion of IS-LM, I would recommend McElroy's intermediate textbook. Its more mathematical than Mankiw, but it sv ery simple math (just solving linear equations like in high school algebra). For me, it really helped make the undelying assumptions of IS-LM clear when i was in school. Plus, its now available for free on-line. Check out this chapter especially:

http://legacy.ncsu.edu/classes/ec348001/E_Chpt3.pdf

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Also, if you are interested in a really good discussion of IS-LM, I would recommend McElroy's intermediate textbook. Its more mathematical than Mankiw, but it sv ery simple math (just solving linear equations like in high school algebra). For me, it really helped make the undelying assumptions of IS-LM clear when i was in school. Plus, its now available for free on-line. Check out this chapter especially:

http://legacy.ncsu.edu/classes/ec348001/E_Chpt3.pdf

 

I confess this is the first time I've read what the IS equation is. And it's total baloney according to the principles of this site.

Let me quote from the excellent link you gave, then refute it:

"If government spending rises, this increases equilibrium income since every dollar spent
is also a dollar received by someone else. This leads, in turn, to an increase in people's
planned consumption spending"

Nope, that's wrong.  Indeed every dollar spent by the gov't is a dollar received by someone else. But it does not follow that this increases equilibrium income, because every dollar spent by the gov't WAS TAKEN AWAY FROM SOMEBODY FIRST.

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Student:
If none of this makes sense, let me know and I will try to help if I am around (I am traveling all of next week). I tutor during the school year so I enjoy this kind of thing. :P

Thanks. I seem to be getting all that you say. So, get ready for some more joy.

Why is it the market for loanable funds and the market for real money balances taken to be different markets, when in the real world both are actually the same(if I am right)?

Is the IS-LM model basically a short-run model? Is that why an increase in the money supply affects nominal interest rate in the model while in the long run real interest rate reasserts itself? Does this have any similarity with the Austrian Business Cycle theory in which savers reassert their actual time preference after credit expansion temporarily holds nominal interest rates down?

I am sorry if I made no sense!

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Student replied on Sun, Dec 20 2009 11:14 AM

Prashanth Perumal:

Student:
If none of this makes sense, let me know and I will try to help if I am around (I am traveling all of next week). I tutor during the school year so I enjoy this kind of thing. :P

Thanks. I seem to be getting all that you say. So, get ready for some more joy.

Why is it the market for loanable funds and the market for real money balances taken to be different markets, when in the real world both are actually the same(if I am right)?

Is the IS-LM model basically a short-run model? Is that why an increase in the money supply affects nominal interest rate in the model while in the long run real interest rate reasserts itself? Does this have any similarity with the Austrian Business Cycle theory in which savers reassert their actual time preference after credit expansion temporarily holds nominal interest rates down?

I am sorry if I made no sense!

I think I see what you're saying. ;) Here's how I understand it.

The loanable funds market is where the supply of savings gets translated into investment, right? Well, the supply of savings can be an odd birg to deal with. I think most people on this board would agree that the supply of savings is partly determined by the time preferences of individuals. However, the level of a person's income also substantially influences how much a person saves. This should also seem obvious to people on this board because I may have a very low time preference (i may place a lot of emphasis on future consumption), but if I only earn $1 per day, my level of savings may not be very high. In fact, the actual value of my savings may well be lower than someone else who has a higher time preference than me, but a greater amount of income.

Why does this make things difficult to model? Well, by saying that savings is dependent on income, we are essentially saying that the model is indeterminate. We can say what the interest rate will be for any given level of income (in other words, we can draw the IS curve), but we can't say what determines the interest rate. So the neo-Keynesians (led by Hicks and Hansen) solved this problem by introducing the money market. In some sense, you can say that the interest rate is determined in this market by people's liquidity preferences, but that is more or less a simplifying explaination. In reality, you can't solve for the interest rate without solving for equilibrium in both markets, so they both actually determine the interest rate.

Hopefully this makes some sense. :P Some additional reading may help. There is a great essay on IS-LM on the New School's History of Economic Though Website:
http://homepage.newschool.edu/het//essays/keynes/hickshansen.htm

I am also a big fan of wikipedia, so try the section on "excessive" savings in the article on Keynesian Economics here:
http://en.wikipedia.org/wiki/Keynesian_economics#Excessive_saving

Now, like you might imagine, there are some problems with taking the approach. As Hicks himself would later admit, there is a problem combining saving-investment decisions, which are being made on a "flow" constraint (savings and investment are flows), and the money demand decision, which are being made on a stock constraint (the amount of money available is a stock). Also, the interest rate that clears the loanable funds market is a REAL interest rate, while the interest rate that clears the money market is a NOMINAL interest rate and these two will only be equal in the short run when prices are less flexible.

So you could reasonably ask (and many economists have) why IS-LM is useful at all. Some would say that it isn't (in Barro's macro textbook it akes up only a small chapter at the end, in Romer's Advanced Macro textbook, it takes up even less space, in Sargent's advanced macro textbook I don't think its included at all). But others would say that it is a great simplification for guiding one's intuition. Here is Paul Krugman in defense of IS-LM (though the model he presents here is not IS-LM, you can kinda read around it to get his defense of old-school macroecon):
http://www.pkarchive.org/theory/islm.html

Hope all of this helps :)

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Student replied on Sun, Dec 20 2009 11:46 AM

Smiling Dave,

The great thing about McElroy's textbook is that he breaks everything about IS-LM/AD-AS analysis into parts to make it easier for the reader to understand if they are williing. Chapter 3 is merely the outlining of the Keynesian Model for Aggregate Demand, it is only intended to outline th parts of model and how they work. If you want to see the full model applied to Fiscal Policy, you should flip to Chapter 5 (particuarly relevant text quoted below).

If you need any more help with the material, please let me know and I will help if I can. :)

Fiscal policy is fundamentally about 

how we choose and pay for our public goods andservices. Let's examine this transfer process with the AD/AS model, supposing that we wish to increase the level of real government spending (+Δg0) in a fully-employed economy (y = y*). We've seen that the rise in government spending—by itself—sets off the multiplier process as rising income and consumption feed one another until leakages into saving, taxes, and imports eventually bring it to an end. The resulting rightward shift in IS and AD causes a short run increase in the real rate of interest and output/income. This analysis is correct as far as it goes, but it is incomplete in an important way— it says nothing about how this increased government spending is financed. The only options, as we saw in Chapter One, are tax-financing (+Δg0=+Δt0), deficit-financing (+Δg0=+Δb), and money-financing (+Δg0=+ΔM0,

not used in the U.S. but prevalent in countries with weak tax systems). The impact of these three choices for financing a given increase in public spending are outlined below and illustrated in Figure 5.1.


http://legacy.ncsu.edu/classes/ec348001/G_Chpt5.pdf

 

 

 

 

 

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Student:
In reality, you can't solve for the interest rate without solving for equilibrium in both markets, so they both actually determine the interest rate.

hmm.. does this mean that both time preference and liquidity preference jointly determine the interest rate? Hey, may be liquidity preference in itself is just a theory got from pulling out a part of the productivity of investment theory. Here's Hayek's take on the theory of liquidity preference:

In order to show that in fact the liquidity preference
curve cannot be regarded as independent of the productivity
of investment but merely conceals or rather
includes the productivity element, and consequently that
the demonstration that the rate of interest is completely
determined by this curve and the quantity of money does
not prove that it is independent of the productivity of
investment, we need ask only one question: Are the
amounts which people are assumed to be willing to hold
for reasons of liquidity at any given rate of interest
supposed to be independent of the amounts which th~y
can invest at that rate 1 Only if this question could
reasonably be answered in the affirmative could the
liquidity preference curve be regarded as independent df
the productivity of investment.

Remember, I told you it's just one market where interest rates are determined. So may be, liquidity preference is just one of the minor criteria, and probably just a part of the productivity of investment(or time preference of the borrower) theory, which determines interest rates.

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Student, let me tell you what I really understand about Keynesian economics. Since I'm very new to Keynesian economics, correct me wherever I am wrong.

The base of Keynesian economics is formed in the circular flow of money. If I may, for the sake of example, group society into two groups: producers and consumers. Under perfect equilibrium conditions, the products that producers make by investing money must be bought by consumers(workers who receive wages mainly) at a price that covers the cost of production, so that aggregate supply equals aggregate demand. What Keynes cited as the problem with the market economy was that aggregate demand was insufficient to buy the products at production costs(since we're assuming equilibrium conditions, there are no profits or losses).

How I understand the IS/LM model to the derivation of the aggregate demand is, pertaining to the loanable funds market, ideally, all money that is saved in the economy must be directed towards investments so that the circular flow is maintained sustainably(in the sense that products produced can be bought at cost of production prices under equilibrium conditions). Interest rates can flex to transfer savings into investments, but at very low interest rates savers decide to hoard their money rather than save it. So this affect the circular flow model, in the sense that, aggregate demand plummets. But price level does not quickly adjust to the new level of aggregate demand since prices are sticky. Citing this problem, Keynesians suggest that policies must be enacted to prop up the aggregate demand.

This ends the first episode of my understanding of Keynesian economics. Please point out the glitches.

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Prashanth,

I think that is pretty close. Somethings to note. First, I think a Keynesian would argue that the "speculative demand for money" (the desire to hoard cash as an asset) is really always there and not just when interest rates get close to zero. And changes in the demand for money matter most of the time because prices are sticky. However, over time when prices become flexible, those shifts in demand will not matter and the economy will return to full employment. Why is that? Because a decreasing price level will result in a drop in the interest rate (through LM) 

However, if interest rates are next to zero, some would argue that you may wind up in a liquidity trap. If that happens, then the interest rate cannot go any lower. So we would up in a recession regardless of sticky prices and could potentially get stuck in a deflationary spiral.

Other wise, I think that is a well articulated, ultra-simplified version of Keynesian-ism in a nut shell. :)

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Student,

Your replies were of great help. Thank you very much!Smile

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