Why I do not like the IS-LM model

1. It fudges the distinction between real and nominal interest rates, so it can put the two curves on the same graph.  Every time you write down an IS-LM model you should hear a clock start ticking in your head.  The longer the clock ticks, you more you need to worry about this problem because the more that a) the price level may change, or b) expectations about future price level changes will start to matter.

2. It fudges the distinction between short-term interest rates (for the money market curve) and long-term interest rates (a determinant of investment).  They’re not the same!  Don’t assume they are the same, just to squash the two curves onto the same graph.

3. It leads you to think that the distinction between non-interest bearing currency and short-term interest-bearing securities is a critical wedge for the economy.  It also implies that if all currency paid interest (a minor change, most likely, macroeconomically speaking), the economy would behave in a totally screwy way.  It probably wouldn’t.

3b. The model leads you to believe that interest rates are more important than they probably are.

3c. For a while it treats “money” as the non-interest-bearing security, and then for a while it treats money as the transactions media behind AD, something closer to M2.

4. It overemphasizes flows and under-emphasizes stocks of wealth.  The quantity theory approach, as wielded by Fisher and Friedman, does not induce individuals to make this same judgment.  For one thing, this distinction really matters when you’re trying to predict the macro effects of “window breaking.”  The flows perspective will usually be more optimistic than a perspective which recognizes both stocks and flows.

5. Those aggregate curves are not invariant with respect to expectations, including expectations of government policy.  You don’t have to believe in an extreme version of the Lucas critique to worry about this one.  Those curves are conditional and the ceteris paribus assumption is not to be taken lightly here.

6. In the LM curve, what is the embedded reaction function of the Fed?  Good luck with that one.  Pondering this issue leads you to conclude that the whole model was written for an economy fundamentally different than ours.

7. The most important points, for instance about the significance of AD, one can derive from a quantity theory or nominal gdp perspective (for the latter, see my Principles text with Alex).

Why take on all that extra baggage?

Here is why Scott Sumner does not like IS-LM.  After writing this post, I remember I had an earlier 2005 post on why I do not like IS-LM; I didn’t like it back then either.

Addendum: For a few sources, here is Roubini on IS-LM.  Here is Wikipedia.


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