Monday, October 10, 2011

Cowen on Sims on IS-LM

Tyler Cowen points out that Sims has much the same critique of IS-LM that the Post-Keynesians do. Sims writes:

"ISLM inhibits attention to expectations in macroeconomics, going against the spirit of Keynes’s own approach. This can lead to mistaken policy conclusions and to unnecessarily weak responses to classical critiques of Keynesian modeling. A coherent Keynesian approach, accounting for endogenous expectations, implies very strong effects of monetary and fiscal policy and leads to greater attention to the role of the government budget constraint in making the effects of monetary policy conditional on prevailing fiscal responses, and vice versa."

I don't take this criticism very seriously. Expectations enter IS-LM in the shape of the money demand curve. If you want to say "gee, it would be nice to make that more explicit instead of just saying 'the money demand curve looks like this when expectations are X, and it looks like this when expectations are Y'", I completely agree - that would be nice. But I don't think noting that leaving it implicit might not be fully satisfying is the same as saying that leaving it implicit "goes against the spirit" of an approach that put expectations at its center.

Talking about how expectations impact money demand was the relatively obvious point. Lots of people understood that. What needed more elaboration was how liquidity preference and loanable funds theory of the interest rate worked together to produce a potentially below full employment level of output. That's the point that needed elaboration, and that's the point the IS-LM was designed to make. Demonstrating that IS-LM left expectations implicit is not sufficient for demonstrating that it is antithetical to an expectations based approach. Granted, if your interest is modeling expectations explicitly it's not necessarily the workhorse for you.


  1. Well, another strong point of Hicks's model (despite the fact he disavowed it in his last years) would be that it does fit within the K.I.S.S. principle.

    P.S. Daniel, did you get my e-mail containing Finn Olesen's review of "Aggregate Supply and Demand Analysis" by Paul Davidson?

  2. About the IS-LM curve, I once asked my macroeconomics professor about how one reconciles a stock equilibrium with a flow equilibrium.

    He gladly gave the frank response that is a given limitation of an imperfect tool that still does explain real world problems.

    I myself really like IS-LM. It is indeed imperfect, but placed next to real world situations, it is so strongly supported by empirical reality, I am awed. For Japan and the Asian crisis, IS-LM explains why crowding out of private investment does not happen in such depressed conditions.

  3. I think the point is that a shift in one curve will change expectations and so cause a shift in the other.

  4. Sargent also has had some things to say...


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