If you were on the D.C. metro last night and you saw me tracing out IS-LM curves in the air with my fingers with a puzzled look on my face, it was because I was thinking about this post. Nick Rowe asks what a simple IS-LM model would imply about the consequences of default. He says that the IS curve would shift to the right, the IS-LM equilibrium would shift to the right, and the IS-LM model would say we would be better off.
This is odd, right? In the guts of the IS curve, ignoring what's going on with the LM curve, the equilibrium shifts left and the equilibrium savings/investment level decreases. The equilibrium interest rate is higher but because of a negative shock to the supply of savings. Investment demand equilibrium decreases and there's no clear mechanism for an increase in government or consumption spending, so the ultimate salutary result is puzzling.
Most of the responses have focused on the LM curve. Brad DeLong says it should shift money demand out as well, canceling the shift in the IS curve. This isn't implausible to me. Money demand is a security blanket, so the idea that it would increase makes sense, particularly given Paul Krugman's point that the primary difference between inflation and default (which Nick considers comparable) is that default doesn't directly affect the value of cash the way inflation does.
My reaction was somewhat different. Treasuries are assets, and if those assets suddenly become worth much less it's going to impact demand. How is this any different from mortgage backed securities exploding in people's faces (oh right... it's different because this isn't inevitable - but there's nothing analytically different about it)? So my first thought wasn't Brad DeLong's thought that adjustments in the demand for money would cancel out any counter-intuitive expansion due to a higher risk premium. My thought was that within the IS curve itself decreasing demand would be at least as strong as increasing interest rates due to a supply of loanable funds curve that shifts left.
Nick says "this is like an increase in inflation", but it's really not is it? Inflation has some nice side effects for debtors. Inflation can have the consequences of spurring investment. Does default do that? Put it this way - if we can just think of inflation and default as comparable, why do so many governments seem to prefer inflation to default? If they were exactly the same wouldn't they default more often?
Does this make sense at all?
UPDATE: Hmmmm... thinking more about it and I'm not really sure it's all that different from inflation after all. Anyway - thoughts welcome.
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