Scott Sumner on IS-LM

by on October 6, 2011 at 3:09 pm in Economics | Permalink

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.

There are many excellent parts, read the whole thing, I won’t excerpt the best part.  And also there is this:

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.

Cahal October 6, 2011 at 4:25 pm

‘Add wage price stickiness and you get demand-side business cycles.’

You get demand side cycles without this. In fact, sticky prices/wages make them less severe.

Tom Powers October 6, 2011 at 5:32 pm

How?

Cahal October 6, 2011 at 6:09 pm

By keeping demand buyoant. If they were more flexible we’d have severe deflation and it would turn into a spiral.

anon October 6, 2011 at 7:02 pm

I’m pretty sure that this is wrong. Without wage or price stickiness, the price level would adjust instantly to changes in AD (i.e. money supply and demand for money balances), so there would be no adjustment in output.

Cahal October 7, 2011 at 3:26 am

Nominal ages would go down which would hit demand. If prices go down at the same time then you have a deflationary spiral. If they don’t then you redistribute from wages to profits, but it won’t be invested because demand will go down.

bbartlog October 6, 2011 at 4:46 pm

The only actual claim Sumner makes for his simple models in your excerpt is the prediction of demand-side business cycles, and on that front I believe he’s simply making shit up. The rest is not even wrong. I suppose I should read the whole article but really, if this excerpt is supposed to be one of the *good* parts, why bother? Anyway, if you want to look at models over ‘most of human history’, then I think you will need one set of models for the agricultural/hard-money/pre-fractional-reserve banking part of history, and an entirely different set for the industrial/fiat-money/fractional-reserve-banking era of the last two hundred years or so.

Jeff R. October 6, 2011 at 5:33 pm

I am skeptical about the claim that ‘most of human history’ (by which he’s implicitly only talking about the part after the invention of money itself) was free of lending at interest. Generally speaking, priests do not take the trouble to make rules against things that nobody is doing, after all.

Doc Merlin October 6, 2011 at 5:58 pm

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 supply like a price ceiling.

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

Doc Merlin October 6, 2011 at 6:04 pm

Supply/demand should be quantity supplied and quantity demanded in my statement.

Cahal October 6, 2011 at 6:11 pm

There is no investment supply as investment creates its own savings. There is no question of I being constrained by S, so rates should be as low as possible.

Doc Merlin October 6, 2011 at 6:53 pm

No.
Investment Supply is just a relation between interest rate and how much risk you are willing to accept at that rate. There /is/ a relation.

Cahal October 7, 2011 at 3:27 am

Banks extend loans and create deposits in the process. This is an empirically verified fact – there is no supply side limitation to investment.

Doc Merlin October 7, 2011 at 5:22 am

This is to Cahal:

“Banks extend loans and create deposits in the process. This is an empirically verified fact – there is no supply side limitation to investment.”

I can see from this statement that you must be an MMTer.
Ok, let me explain why your sentence is wrong.
By increasing their liabilities and reserves they increase their holdings of risk. This risk preference is what restricts supply of loanable funds.

I am NOT arguing that quantity supplied of credit is fixed. I am arguing that supply curve for loanable funds is upwards sloping because of loaning out funds has risk (which is a cost).

Cahal October 7, 2011 at 6:30 am

Ah, OK, misunderstanding.

(I’m not an MMter btw).

Cahal October 7, 2011 at 10:26 am

Btw, I still stand by the idea that long & short term interest rates should be as low as possible. If interest rates are higher it forces people into more speculative and riskier investments, whereas when they are lower it produces more sustainable outcomes.

Elliot Rosewater October 6, 2011 at 6:58 pm

Other than Becker-Posner, are there any good resources on the internet about how economic thought has affected law. I am currently writing a personal statement and want to draw out some parallels between my undergraduate education and law.

Any help would be greatly appreciated.

anon October 6, 2011 at 7:06 pm

David Friedman’s “Law’s Order” is quite good and freely available on the net. He also has essays on his website discussing “Legal systems very different from ours”.

Guy in the Veal Calf Office October 6, 2011 at 9:34 pm

I’d start with Unspeakable Ethics, Unnatural Law by Arthur Leff before you dive into Law & Economics. Academic law professors are more similar to typical social science professors than to practicing lawyers, so any Law & Economics type will be more economic professor than lawyer.

Outside of academia, those two do not play well together, economists’ ceteris paribus make no sense in a practicing lawyer’s mutatis mutandis world (or, if I may coin my own ablative absolute, nusquam paribus world). You could talk to a transfer pricing expert to see what professional law & economics looks like.

Thoma Hawk October 6, 2011 at 11:31 pm

Interest rates matter? Ya think?

Short term interest rates are a major input in the determination of the admissibility of projects. Lower the short term interest rate, and more short term projects magically become admissible. Long term projects can become admissible sooner if long term rates aren’t expected to rise enough to negate the NPV. Even if you believe that expectations for long term interest rates will rise, it changes the composition of long and short term projects in the current period. It robs the future for the present.

That would be OK if the future weren’t just a day away.

Dynamic efficiency conditions are also violated, i.e. total utility is lower than if nondistorting interest rates were used to value projects. The social welfare function implicit in the monetary policy decision creates a redistribution between suppliers of labor and capital for the projects. The identity of the winners.and losers is not immediately discernible, particularly when resources are mobile between project classes. When there are labor and capital frictions, the least mobile inputs bear the heaviest cost of unemployment. Moreover, the increase in short term projects results in shorter duration labor and capital contracts. These contracts will reprice at lower wages when interest rates rise or face higher unemployment.

So the monetary stimulus is costly in ways that are hard to measure, which is why its a politically costless maneuver.

But expected cash flows of projects are not set in stone either. If lower interest rate policies proceed from common expectations of weak AD, expected CF will be lower and fewer new projects would be admissible than we would hope the policy would create.

Lowering interest rates is nothing but borrowing from the future. The net impact on social welfare depends crucially on the weight one applies on the utility of the expected winners and losers.

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