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October 07, 2005

Marginal Revolution: Six reasons why I don't like IS-LM analysis

Tyler Cowen gives six reasons that he does not like the Hicks-Hansen IS-LM way of thinking about short-run macroeconomics. I think that a seventh reason is more important:

The "LM" part of the analysis assumes that the money stock remains fixed as elements of the economic environment and economic policy change. No central bank in the world acts to offset changes in the money multiplier and holds the money stock fixed as elements of the economic environment and economic policy change. Some central banks' responses can be modeled as (temporarily) fixing (short-term, nominal) interest rates. Other central banks' responses need to be modeled as following some kind of reaction function, in which interest rates are a function of expected future inflation and unemployment. No central banks act as the "LM" part of the analsysi assumes they do.

Here are Tyler's six reasons:

Marginal Revolution: Six reasons why I don't like IS-LM analysis :

  1. It suggests that you can shift one curve without the other moving as well. In other words, it assumes that excess demands in the goods market are independent from excess demands in the money market.
  2. The IS curve -- which involves investment demand -- uses the real rate of interest, r. The LM curve -- which involves money demand -- uses the nominal rate of interest, i. These two curves are then put on the same graph. I have been told many times this can be done without contradiction; at best this is true only in the shortest of runs, when prices are not changing.
  3. Everything in the model is flows, but stocks matter too. No person in the model considers his or her intertemporal budget position. You don't have to believe in Barro's Ricardian debt-equivalence theorem to be worried by this.
  4. Coordination problems -- which should be at the center of macro -- are obscured by the aggregate apparatus.
  5. The IS curve, drawn from investment demand, uses the long-term rate of interest. The LM curve, drawn from money demand, uses short-term rates of interest. Yet the relative movements of short and long rates remain a significant puzzle and do not follow the predicted relationship.
  6. You see the curves -- which remind you of supply and demand curves -- and you wish to start manipulating them in the same manner. See #1.

Posted by DeLong at October 7, 2005 01:14 PM