“It´s baaack”, Part II – Defending ISLM

Suddenly a discussion on IS-LM mushroomed. Tyler Cowen had a post yesterday on “Why I do not like ISLM. His last point (#7) is:

The most important points, for instance about the significance of AD, one can derive from a quantity theory or nominal gdp perspective.

Brad DeLong counterattacks:

But the mechanical quantity theory is simply wrong for us today: the Fed has tripled the monetary base since 2007, and yet the flow of nominal spending has not tripled: not at all. IS-LM at least starts you thinking about the issues around the concept that has been called the “liquidity trap” which the mechanical quantity theory does not.

Hum, DeLong “forgets” to consider the behavior of the money multiplier. As the graphs show, the rise in the base has been completely offset by the drop in the money (MZM) multiplier since NGDP “dropped through the floor” in mid 2008. And ever since early 2007 the demand for money (inverse of MZM velocity) has risen significantly! So tell me Professor Delong how, in that situation, could the “flow in nominal spending have tripled”?

And Krugman reinforces DeLong:

As Brad says, the right way to do economics is usually to start with the simplest model that can get at the essential features of whatever you are trying to understand. In macro — or at least macro that tries to get at monetary and fiscal issues — what you need, at minimum, is to understand an economy in which there are three goods: money, bonds, and economic output. What would a three-good model with these things in it look like? A full-employment version of IS-LM. Add in some form of price stickiness and what you have is Hicks/Keynes. There’s nothing arbitrary about it.

The title of this post is a reference to Krugman´s 1998 article on the “Liquidity Trap” that, according to him, was afflicting Japan. So it´s easy to see his and DeLong´s motivation for “peddling” the ISLM model. In Delong´s quote above, he leaves no doubt about that.

Long ago Scott Sumner in answer to an earlier post by DeLong, explained why he didn´t like ISLM. This passage gives his take on “liquidity traps”:

Those who read this blog know that I have had a lot to say about “liquidity traps.”  I think what most people are missing is that causation tends to run from contractionary monetary policy to low interest rates.  Low rates are not a sign of monetary policy ineffectiveness; rather they are a symptom of excessively tight monetary policy.  So far as I know, virtually every zero interest rate environment in history has occurred when central banks have run deflationary monetary policies.  The IS-LM framework leads to a sort of defeatism about the possible efficacy of monetary policy when rates are near zero.  In one sense that’s not hard to understand, after all it is deflationary policy that got us into the mess, why should we expect more from monetary policy in the future?

In contrast Krugman’s “expectations trap” approach says what really matters is credibility, one needs a policy that is expected to boost inflation (or I would say NGDP growth) expectations.  Krugman clearly understands that monetary injections expected to be permanent can be effective at zero rates, but if he thinks central bank attempts to reflate will often lack credibility, then he might regard IS-LM as a useful heuristic device.  Perhaps he is pessimistic about monetary policy effectiveness because of the way he reads history (1930s America, 1990s-2000s Japan, and right now.)  I find very little evidence in any of those three cases to support monetary policy ineffectiveness, but he probably reads the evidence differently.

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