IS-LM model

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Union of the IS curve with the LM curve to form the IS-LM model

The IS-LM model ( I nvestment- S aving / L iquidity Preference- M oney supply) is a model of the economics and describes the overall economic balance, which by the combination of equilibrium models for real sector ( IS curve , goods market ) and the monetary sector ( LM curve , money market ). When the model is expanded to include the balance of payments ( ZZ curve ), one speaks of the Mundell-Fleming model (also IS-LM-ZZ model). The AS-AD model was developed to expand the model to include a balance in the labor market .

history

The idea for the IS-LM model arose at a conference of the Econometric Society in Oxford in September 1936, just 8 months after the publication of the General Theory of Employment, Interest and Money by John Maynard Keynes . John R. Hicks published his paper for this conference in April 1937 under the title Mr. Keynes and the "Classics": A Suggested Interpretation. Alvin Hansen , appointed to Harvard in 1937 , also contributed to the IS-LM model and it was taught as the Hicks-Hansen synthesis in the United States and popularized by Paul A. Samuelson in his 1948 bestselling textbook Economics: An Introductory Analysis . John Hicks himself later declared his dissatisfaction with the IS-LM model, which was rejected by Keynes students such as Joan Robinson , and referred to it as "a classroom gadget".

Hicks had also emphasized from the beginning that the money supply in the LM function should not be assumed to be constant because those responsible for monetary policy would prefer to expand the money supply in order to prevent a rise in interest rates. Thus, the elasticity of the LM curve depends more on the elasticity of monetary policy.

Although the IS-LM model is taught at universities as a Keynesian model, it does not actually contain Keynes’s knowledge and insights, but it is also officially called a neoclassical synthesis and reduces Keynes’s theories to a general equilibrium model . Because the reputation of classical and neoclassical was ruined after the global economic crisis, some approaches of Keynes' criticism were taken up, such as that money is not neutral and the labor market does not find equilibrium over a long period of time in order to incorporate them into neoclassical ideas and then as to present the Keynesian model to the public. Franco Modigliani even claimed in his article Liquidity Preference and the Theory of Interest and Money (Econometrica, 1944) that the only difference between Keynes and classical economics is the rigidity of wages.

Joan Robinson described the representatives of so-called Neo - Keynesianism , i.e. the neoclassical synthesis and the IS-LM model, as bastard Keynesians who would wrongly invoke Keynes.

The model is currently criticized because the central banks no longer consider the money supply and the model does not deal with the real interest rate, which is crucial for investments. A Keynesian consensus model is being discussed as a new standard model , in which the central bank does not control the money supply, but rather determines the interest rate according to the Taylor rule .

background

IS curve shifts to the right, in the new equilibrium an increase in national income and interest

The IS-LM model deals with the overall sizes of an economy. The decisive factors are the equilibria in the goods market (aggregate demand for goods = aggregate supply of goods = national income) and the money market (demand for money = supply of money). The IS curve represents a goods market equilibrium curve. As such, it represents all combinations of interest (i) and national income (Y) for which the goods market is in equilibrium. The LM curve is a money market equilibrium curve and indicates all combinations of interest rate (i) and national income (Y) for which there is an equilibrium on the money market. At the intersection of the IS curve with the LM curve, there is a simultaneous equilibrium of the goods market and the money market and thus an overall economic equilibrium.

However, this point of equilibrium is only reached theoretically, since, according to Keynes, in practice there are constant changes that lead to a shift in the point of equilibrium. The IS-LM model therefore examines the effects of various imbalances.

Definitions

The IS-LM model is viewed in a neoclassical context, i. H. flexible wages are assumed.

Goods market equilibrium (IS curve):

The IS curve has a negative slope, since investments (I) decrease with increasing interest rate (i), with which the goods market can only be in equilibrium with a lower national income (Y).

Money market equilibrium (LM curve):

The LM curve has a positive slope because the demand for money (L) increases with increasing national income (Y). However, with the increased demand for money, the money market can only be in equilibrium at a higher interest rate (i).

Chains of effects

Crowding-out in the IS-LM model

When the state itself appears as a buyer on the goods market , the IS curve shifts to the right. Depending on the position of the LM curve, this can mean an increase in national income Y. This type of expansionary fiscal policy can be initiated through deficit spending .

If the households keep more speculative coffers (this is the holding of money in order to be able to fall back on this when interest rates and securities are cheap), then deficit spending acts like an initial spark for the economy. The reason for this is that the multiplier (in this case the government expenditure multiplier ) is set in motion.

The way the multiplier works is simple: if demand increases (in this case from the state) on the goods market, production naturally also increases . When production increases, entrepreneurs need more workers. They receive a salary that they partially consume (depending on the marginal propensity to consume). The resulting additional consumption initiates a further expansion of production, which means that, in turn, workers are needed again, who in turn receive a salary to be consumed.

This idea of ​​national debt does not go back to Keynes, as is often assumed, but to Abba P. Lerner . Keynes, on the other hand, demanded previously formed reserves. Since deficit spending (the right shift of the IS curve) represents a debt of the state , the state should, when the economy flourishes, repay the debt through the increased tax revenue ( surplus saving ). The state thus operates a countercyclical economic policy to smooth out economic fluctuations. However, if households only hold transaction balances (that is, the amount of money that is needed to buy goods), then due to the vertical position of the LM curve, this policy has the consequence that only interest rates rise and national income remains the same. This situation is called crowding-out (displacement of private demand, which can occur as a result of an increase in government spending).

Hicks diagram

The representation of the IS-LM functions in the 1st quadrant is the so-called Hicks diagram, which is named after John R. Hicks .

Model extension

The traditional IS-LM model explains macroeconomic equilibria only for closed economies and without taking the labor market into account. The model can also model open economies , taking account of balance of payments relationships . To do this, a third curve, the so-called ZZ curve, is added. This represents all combinations of interest and income for which there is a balanced balance of payments.

criticism

In current economics, the IS / LM model, like the AS / AD model, is now viewed as an outdated model structure, which can still be found in many textbooks. Today it is assumed that a central bank sets the interest rate for central bank money and strives to adhere to its inflation target without causing a larger output gap through a recession or even depression with its monetary policy . The central bank does not pursue a monetary policy and the interest on central bank money is not an equilibrium interest rate on a money market, but is determined by the central bank. Demand and investment are negatively influenced by the interest rate level. The real interest rate is assumed, while the IS / LM model knew no difference between the nominal interest rate and the real interest rate.

The use of the model for economic policy was criticized at an early stage. It remains questionable whether a state policy on demand will actually lead to more economic growth and a reduction in unemployment. This effect will be weaker if some of the additional income is saved by households, or if goods are consumed that hardly create new jobs. Keynes also recognized this problem and therefore propagated an increase in state consumption, which can be directed into labor-intensive areas.

A political and economic problem arises if the willingness to save in boom times is too low because this cannot be communicated politically. In this case, the model often leads to steadily growing national debt in practice.

Since the 1960s, Axel Leijonhufvud and Robert W. Clower have expressed fundamental criticism of the interpretation of Keynes' General Theory that Hicks had presented with the IS-LM model. They argued that this was inadequate as an explanation of involuntary unemployment , and indicated that Keynes had emphasized the importance of imbalance phenomena that are not addressed in the IS-LM model. There are also forces in a market that have a destabilizing effect. Leijonhufvud therefore considers the neoclassical synthesis to be "completely incorrect in its interpretation of Keynes."

Milton Friedman criticized, according to his theory of the so-called time lag , that so much time elapsed between the decline in consumption and the effect of the government demand programs that the economy has mostly recovered on its own and is in a boom phase. The economy will overheat as a result of additional government consumption and inflation will occur .

A more fundamental criticism of the model assumptions has been formulated in recent years by John B. Taylor and David Romer . These two economists point out that real interest rates and not nominal interest rates are relevant for investors. Therefore, the IS curve in the model is not plotted correctly (or should be shifted with the inflation rate). In particular, however, they criticize the assumption that the central bank will fix the money supply. It is more realistic to describe the central bank by an interest rate rule, the so-called Taylor rule . The central bank can control the nominal and real interest rates of the economy with the help of its lending to the banks. It acts with the aim of stabilizing the economy and increases the real interest rate in a boom or high inflation and lowers it in a recession or deflation. With this consideration, fluctuations in the money supply are only a side effect of the modeling. The criticism can be taken into account in the model that the LM curve, which describes an equilibrium on the money market, is replaced by such a policy rule.

Web links

Commons : IS-LM-Modell  - collection of pictures, videos and audio files

Individual evidence

  1. ^ John Hicks: "IS-LM": An Explanation Source. In: Journal of Post Keynesian Economics. Vol. 3, No. 2, Winter 1980/81, pp. 139-154
  2. ^ John Hicks: "IS-LM": An Explanation Source. In: Journal of Post Keynesian Economics. Vol. 3, No. 2, Winter 1980/81, p. 152
  3. ^ John Hicks: Mr. Keynes and the "Classics": A Suggested Interpretation. In Critical Essays. 1967, p. 140
  4. ^ John Hicks: "IS-LM": An Explanation Source. In: Journal of Post Keynesian Economics. Vol. 3, No. 2, Winter 1980/81, p. 150
  5. ↑ Antonella Rancan: Modigliani's 1944 Wage Rigidity Assumption and the Construction of the Neoclassical Synthesis. 2012 ( PDF; 434 kB )
  6. ^ Joan Robinson: Review of Money, Trade and Economic Growth by HG Johnson. In: Economic Journal. 72, September 1962, p. 691
  7. ^ David Romer : Keynesian Macroeconomics without the LM Curve. In: Journal of Economic Perspectives. Vol. 14, No. 2, spring 2000, pp. 149–169 ( PDF; 184 kB )
  8. ^ Johann Graf Lambsdorff & Christian Engelen: The Keynesian consensus model. In: WiSt - economics studies. Issue 8, August 2007, pp. 387–394 ( PDF; 642 kB )
  9. ↑ Faculty of Economics at the University of Passau : Farewell to the LM curve ( memento of the original from November 20, 2013 in the Internet Archive ) Info: The archive link was automatically inserted and not yet checked. Please check the original and archive link according to the instructions and then remove this notice. @1@ 2Template: Webachiv / IABot / www.wiwi.uni-passau.de
  10. ↑ Peter Bofinger : Fundamentals of Economics. 3. Edition. Pearson Studium, Munich 2011, p. 495
  11. ^ Axel Leijonhufvud : On Keynesian economics and the economics of Keynes: a study in monetary theory . Oxford University Press, New York 1968.
  12. ↑ Axel Leijonhufvud : About Keynes and Keynesianism: a study on monetary theory . Kiepenheuer & Witsch, Cologne 1973.
  13. ^ Brian Snowdon: Outside the Mainstream: an Interview with Axel Leijonhufvud , Northumbria University, May 17, 2002. Retrieved January 1, 2015.
  14. ^ Robert W. Clower: The Keynesian Counter-Revolution: A Theoretical Appraisal . In: Frank Hahn , FPR Brechling (Ed.): The Theory of Interest Rates . Macmillan 1965.
  15. ↑ Peter W. Howitt : A Dictionary Article on Axel Leijonhufvud's On Keynesian Economics and the Economics of Keynes: A Study in Monetary Theory ( Memento of the original from September 7, 2006 in the Internet Archive ) Info: The archive link was inserted automatically and has not yet been checked . Please check the original and archive link according to the instructions and then remove this notice. . Brown University . January 29, 2002, p. 2. Retrieved January 1, 2015. @1@ 2Template: Webachiv / IABot / www.econ.brown.edu
  16. ^ Robert W. Clower , Axel Leijonhufvud : The Coordination of Economic Activities: A Keynesian Perspective . In: The American Economic Review 65 (2), 1975, pp. 182-188, JSTOR 1818850 .
  17. ^ "The neoclassical synthesis is utterly incorrect in its interpretation of Keynes". Quoted from: Brian Snowdon: Outside the Mainstream: an Interview with Axel Leijonhufvud , Northumbria University, May 17, 2002, p. 7. Retrieved January 1, 2015.