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…