Scott Sumner has an excellent post on his concerns with IS-LM theory. I endorse most of it, but I want to point out where I disagree. He writes,
Michael Woodford and I agree on one thing; changes in the expected future path of monetary policy are much more important than changes in the current stance of some monetary instrument.
Sumner does a nice job of attacking the notion that the short-term interest rate is a single lever that can determine macroeconomic outcomes. He also attacks the notion that the money supply is a single lever to determine outcomes. But he seems to take the view that the expected path of monetary policy is the magic lever to determine outcomes. I personally do not believe that the typical micro-level decision is based on expectations for macro policy variables.
We should not assume that a policy lever necessarily exists that will fix macroeconomic problems. We cannot undo the housing crash. We can only undo a little of the financial crash, and I am not convinced that what we are attempting there is useful for those of us outside the financial sector. We cannot make labor market adjustments painless and instantaneous.
It would be really nice if we could wave a wand and animal spirits would appear in sectors of the economy where future growth is a realistic prospect. But why government should know better than individual investors where those sectors are eludes me. That makes me skeptical about fiscal policy. Monetary policy presumes a lower level of unrealistic centralized knowledge, but it presumes that we do have a wand that can stir up animal spirits.
READER COMMENTS
Youri_Kemp
Apr 13 2009 at 1:38pm
Hi Arnold,
Indeed. To think that macro-policy instruments, are a tool to fix and induce micro-animal spirits, is in itself arrogant.
I guess some folks have to say something.
Best,
Youri
http://globalviewtoday.blogspot.com/
Lord
Apr 13 2009 at 5:31pm
The answer is it does not need to know, all it needs to do is buy time. Buying time is not cheap, but not buying it can be even more expensive.
Bill Woolsey
Apr 14 2009 at 9:59am
Sumner does believe that the base money determines nominal expenditure in the economy.
It is because base money serves as the medium of account. The dollar is defined in terms of base money denominated as a dollar. That is what provides the nominal anchor.
It is just that he doesn’t assume that the demand for base money is constant. That means looking at the current level or growth rate of base money tells us nother certain about whether its current quantity is consistent with some particular growth path of nominal expenditure.
Still, given the demand for base money, (which may be different than it was last week or last year,) if base money is greater than that demanded amount, nominal expenditure will rise. Further, if the quantity of base money is at the level that would be demanded with nominal income at target, (understanding that this isn’t something that is constant,) then nominal income will rise to target.
Now, just because nominal income is on target doesn’t mean that there are no problems with needed reallocations of resources or with real financial intermediation. Sumner insists, however, that nominal income below target causes further problems. And, in fact, most certainly will exacerbate problems with financial intermediation.
Greg
Apr 14 2009 at 11:36am
Government doesn’t, by fiat, know best what sectors are the “best” however it is crystal clear to me that “private” investors are , potentially, equally clueless. Government CAN, however, nudge and support valuable endeavors. It all depends on who is running the govt. Private investors were pushing the housing market for 12-15 years. Everyone was a contractor. All the Wall St firms(private by the way) were packaging mortgage and credit card debt as a “product”. Our whole credit bubble based growth of the last 8 years was cheered on by our president and his minions. The private sector spoke loud and clear and it was horribly wrong. It made false assumptions and chased illusory growth in favor of real growth.
This false dichotomy of “private” vs government has got to end. Private is not necessarily “right”. Government is not necessarily evil or wrong. Until we admit that all human decisions can be flawed, whether they are part of a corporation, entrepeneur or government entity we will never realize our potential.
fundamentalist
Apr 14 2009 at 12:51pm
Dr. Reisman has a devastating critique of the IS/LM model in his book “Capitalism”, which is available for download in pdf form free. His main critism is with the assumption that the marginal efficiency of capital necessarily declines with greater investment. This assumption is the foundation of the IS curve from which the aggregate demand curve is derived. In short, the IS/LM model is worthless, not just flawed.
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