Home > The Economy, Uncategorized > Why was the IS/LM model developed in the first place (and how to use it)?

Why was the IS/LM model developed in the first place (and how to use it)?

from Merijn Knibbe

The IS/LM model is the talk of the town, at the moment: the big boys are at it. But they should do a better job, as they do not seem to grasp the historical setting of the model – and I mean this in two ways.

As I understand the model it’s all about investments – or, to be more precise, about expenditures that require either saving or borrowing.  Think about houses, cars, business equipment and the like. The kind of things which you don’t buy every day. Which means that the expenditure can be postponed. Which means that (one of the aspects of the model) there can be a ‘liquidity trap’ – sometimes, people just do not want to borrow or to use their savings to buy a new car or to build a new house or to invest in business equipment, even when interest rates are close to zero. There can be many reasons for this kind of behavior. They (households, or firms) may already be overburdened by debts (Western world except Germany, post 2000). Or there may be a glut of houses in the market (USA, 2008). Or they may be unduly, or duly, pessimistic about the future (Europe, october 2011 – but lets go to Munich). Or they might expect that prices of houses will fall even more, in the future (Netherlands, 2011). Or productivity may rise much more than expected (the Great Depression). Whatever. In any case: in each of these cases the interest rate does not work as the price which makes markets for savings and investments clear. By the way – whoever told you the fairytale that business investments are primarily driven by the interest rate and not by the level of demand, utilization of the stock of existing capital and available cash?

The question is: why did economists develop this idea, in the thirties of the 20th century? Why did classwical economics not suffice anymore? In my view, there is a clear answer (see graph): in the thirties investments were not anymore what they used to be:

1. Post 1860 (or sometime during the end of the nineteenth century) the rate of investment started to increase, easily doubling in most countries in the period up to 1929 (including consumer durables, think of the Ford-revolution, but private cars are not even included). This meant that investments, the most volatile of all kind of expenditures, could fall deeper than ever before. Yes, it’s that simple.
2. Economic historians have figured out that entrepreneurs are often very fast to invest in mayor new technologies – but that it often takes decades before these investments show up as mayor improvements in average productivity, due to all kind of private and public learning curve effects. Remember – Henry Ford had to build some private railways (railways!)…
3. Combined, this caused productivity in the thirties to keep improving – despite the disastrous decline in the investment rate. This is the same thing as the ‘high marginal productivity of capital’ which bothered Keynes so much. To state this otherwise – even when demand and production increased, investments would not increase while unemployment would not fall, or only a little.
4. Point 1 and 3 taken together mean that unemployment would not only react less vigorously to increasing consumer or export demand while investments also would increase much less than before – but also that consumer or export demand had to increase much more than before to make up for the gap… and even more so because rapidly increasing productivity meant that the gap between potential and real GDP was increasing all the time, maybe with as much as 5% a year.

This clearly shows in the graph, which is for the Netherlands but which is indicative for many other countries (least so for the USA where the investment rate increased earlier while the post war investment boom was smaller). Clearly, investments were very low for an unusually long time – the problem which was more or less denied by classical economists (save, save, save!) but which inspired Keynes: the long run had become longer – and saving made it even longer.

What does this mean for the present situation? It might pay off to define investements (the “I” of IS/LM) better and to distinguish between households and firms. And we should include debts in the analysis of the model: does an ever increasing burden of debt make households more prone to postpone mayor investments (yes)? And the analysis really has to take history into account: is productivity increasing as fast as in the thirties (no). Debt relieve may, at the moment, be as or more important than low interest rates. And we have to define the price level better: it has to include house price deflation or inflation in one way or another.

Ooops – the investment rate in China is even higher than the investment rate in the western world around 1929, while productivity rises faster…

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Categories: The Economy, Uncategorized
  1. October 6, 2011 at 1:56 pm

    Sir John Hicks was the inventor of the IS-LM model.

    I later convinced him that it was all wrong and had nothing to do with Keynes. In an article published in the JOURNAL OF PoST KEYNESIAN ECONOMICS, vol. 3 Winter 1980-81, entitled “ISLM: an Explanation”, Hicks renounces the ISLM model as nonsense and explains why he foolishly did it in 1937 for, what he thought at the time, was an explanation of Keynes’s General Theory.

    I convinced him that it was not. Hicks then recognized that economics was embeded in historical time and relationships that held in the past need not hold in the future and admiitted in the article that of the ISLM “I have become dissartisfied with it”.

    Finally on reading my paper on the fallacy of rational expectations and the uncertain future modelled as a nonergodic stochastic process, Hicks wrote to me: “I have just been reading your RE [rational expectations] paper….I like it very miuch…You have now rationalized my suspicions andshown me that I missed a chance of labeling my own point of view as nonergodic. One needs a name like that to ram a point home”.

  2. shivz
    October 6, 2011 at 4:19 pm

    Merijn,

    You say, “Clearly, investments were very low for an unusually long time – the problem which was more or less denied by classical economists (save, save, save!)…”.

    Please be advised that for the “classical economists”, like Smith and Mill, ‘saving’ was nothing but an act whereby capitalists employ their, or their fellow capialists’, surpluses productively, i.e., transferring the power of consumption embedded in their surplus “to the labourers to whom they give employment”, as JS Mill said.

    Their savers were not people like you and me (for whom, ‘saving’ is paying our mortgage each and every month, or purchasing financial assets, or hoarding), but capialists, employers of labour, who employed their profits, the fruit of production, for further increasing their, and total, wealth (in their times, the likes of you and me were net consumers, if you will).

    Your nameless “classical economists” apparently have other ideas about saving and investment, but I wonder what these have to do with classical economics.

    • merijnknibbe
      October 6, 2011 at 5:15 pm

      Shivz,

      I should probably have written: “the classical economists of the day” or “proto-neoclassicals”. What I meant were economists who stuck to the next idea:

      “In the beautiful free world of classical economics, no human intervention is required to lead the capital markets to equilibrium as well. If the economy does not follow the last assumption and shows a mismatch in savings and investments, the classical economists provide the evergreen solution – do nothing, it is temporary and will correct itself. If savings exceed investment, the interest rates fall and the market achieves equilibrium again”.

      In this world view, the low rate of investment characteristic of the thirties could be ‘çured’ by more saving instead of more spending.

      http://www.buzzle.com/articles/classical-economics-vs-keynesian-economics.html

      I did not have Smith and Mill in mind, but twentieth century economists (not a particular one).

  3. Dave Taylor
    October 6, 2011 at 4:46 pm

    I’m pleased to see your response, Paul. As a developer of programs which did something – rather than mathematical proofs – it was obvious to me when I read Keynes that he was talking about the dynamic continuity of economics, and how to steer it away from shipwreck.

    Merijn, house prices will have to fall relative to incomes much further than they have done, because our young people and those going through bad times simply can’t afford them. Here we’re reverting to Rachmanite rents paid by the Government. But surely, if housing is an investment, the debt secured on them should be going up and down with the market value, as in all the other buying and selling of title to other people’s property in the stock markets? That won’t work, of course, unless the gamblers had an income, but given that they could go and do something useful.

  4. shivz
    October 6, 2011 at 5:44 pm

    Merijn,

    Thanks for the clarification.
    What classical economics really is, and whether “the beautiful free world of classical economics” (if ever existed) is relevant thereto, is another matter.

  5. October 6, 2011 at 7:17 pm

    Shivz, the beautiful free world of classical economics can not exist in our real world. The classical system requires decision makers to KNOW the future. In the Walrasian system onceadam and Eve came out of the garden of eden, they had to provide demand and supply equations and execute contracts not only for Day1 (spot market) but forward market demand and supply equations and excecute contracts on Day 1 for every day in the future till the end of time .. They could do so because of the assumption of the ORDERING AXIOM.

    When 19th nd 20th century economists entered probability events into the system; the ergodic axiom played the same role as the ordering axiom.

    Paul

  6. October 6, 2011 at 11:41 pm

    I certainly could be wrong, but it seems to me that what Lord Keynes left unsaid, may have been more important than most of the rest and, possibly, accounted for his great success as a wealth builder and investment advisor. Questions of selfish pragmatism shall be left aside, to question the unknowns and unknowables typically left out of “economics” and plutonomics alike. Yet, part of the generally unknown seems to be the fundamental, original assumptions and shibboleths in the underlying paradigm, or psychosocial matrix of notions upon which the arcane arts and quasi-sciences depend. There may be an advantage in reviewing the findings of Twainian metanomics and post-classical epistemics, where the quasi-equivalence of stupendous discoveries (such as large steel fish hooks) and nonlinear effects in the realm of political culture is considered a nonergodic given, especially where highly nonrational, primitive incentives and atavistic motivations can become as destabilizing as systemic corruption and pandemic ecocidal mania accepted as successfully normative adaptation. We might then procede with unhindered repudiation of schizoid Nashian game theory, that even Nash himself was a product of his previously undiagnosed, paranoiac delusional syndrome (severe schizophenia), clearing out the bats and cobwebs in the attic, and the slimy monsters in the moldy basement of the prevailing socioeconomic construct, i.e., The Market Economy World Game. We might then be able to thoroughly examine the roots of the various theories, analyse and conclusively evaluate them and develop a truly practical, highly effective scientific discipline that has a solid foundation, supporting a vast blossoming of great new work. Surely, none of here can doubt the potentials of such a bright future, revealed by the clearing away of the thick, dank, oily acid-Smog and dark, storm clouds of delusion tyranny and psychic constipation. Our zealous investigation of the roots and causes of the chronic global pandemic will serve as a very high turbo-colonic, resuscitating and rejeuvenating the intoxicated chrysalis of this mechanistic civilization, enabling its final metamorphosis into the phoenix butterfly so often imagined in the realms of science fiction, post-utopian fairy tales, adolescent fantasy, drug-induced transcendental euphoria, and the visions of old geezers (like me). So, I dare say, let us boldly, courageously go forth to metanomical battle and inevitable victory!

  7. October 6, 2011 at 11:43 pm

    PS: I suppose metanomics might sound too metaphysical (airy fairy, etc.). So, maybe “geonomics” or “macronomics” or “infranomics” or just realistics would be better…?

    • October 7, 2011 at 4:28 pm

      I’m sure my ‘Georgist’ friends would favour ‘geonomics’.

  8. October 7, 2011 at 10:11 pm

    Thanks Carol, but I now think geonomics is too Earthy for this species, at least for the next decade or so. And the best defense is often the best offense. So, let’s see if we can take the PAE/RWE reform movement to the next level by renaming conventional economics, OK? I suggest one or more of the following: 1) plutonomics, 2) Ponzinomics, 3) hedgenomics, and/or 4) pimphonomics (as in “pimp”+”ho”). I also recommend renaming RWE, possibly either 1) plutonomics, 2) macronomics, or 3) ecoforensics. I included “plutonomics” as an optional substitute for RWE in case we do nothing to end or rehab the plutonomy. “Macronomics” seems self-explanatory. “Ecoforensics” is included for the eventuality that we manage to exorcise and/or rehab global demonocracy (plutocracy) and its devilish rule by Randian socioeconomic darwinism & ethical dualism disguised as moral relativism, i.e., sociopathic ecocidal mania. I also recommend changing the name of the “Occupy Wall Street” protest movement to “Besiege Club Fed” which makes it more globally apt & semantically appropriate to the ideal MOSTFormula (Mission, Objectives, Strategy, Tactics) required to solve The Problem (ecocidal demonocracy). Respectfully, M

  9. Merijn Knibbe
    October 11, 2011 at 11:14 am

    The original graph can be found here:

  10. Dave Taylor
    November 17, 2011 at 3:32 pm

    Why was the IS/LM model developed in the first place? I’ve recently (on the thread about the Crash Tax) made the point that IS/LM is looked at as a static relationship whereas Keynes’s model was dynamic: more like steering a ship than a “general equilibrium” mechanisms like gravity causing waves to settle.

    Looking back through this thread, I feel it may be even more significant that Keynes was thinking in terms of Government making good shortfalls in employment by doing what the Private Sector hadn’t done because there was insufficient profit in it. Where in IS/LM is there any mention of Government: the second dimension – the parallel path – the growth of which can compensate during phases in the business cycle when saturated markets need to recover? IS/LM is, on the evidence – especially since the “contracting out” of Government services in the Thatcher years and the financially profitable but Government-indebting “Public-Private Partnership” now – a covert undermining of Keynes’s intelligent advice in favour of the plutocracy’s stupidly single-minded dream of ever-growing trade. Investment in factories which are as unnecessary as the throw-away consumables (and bombs) they produce, without regard for the environment and man’s need for both a livelihood and responsibilities to develop [self-] worth, is not only stupid but probably sustainable long enough to endanger man’s survival.

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