"With easier money we had a small rise in real interest rates, which mostly reflect expected real economic growth. Inflation expectations also rose. Of course this is all completely inconsistent with the Fed’s operating model; they think we need to lower long term rates. And it’s also completely inconsistent with the standard IS-LM model, as interpreted by Keynesians. But it’s completely consistent with the market monetarist version of IS-LM, as developed by Nick Rowe...
...Authors need to re-write the IS-LM model to show upward-sloping IS curves.
Market monetarism: Describing the world as it is, not as textbooks say it is."Now I don't have a real problem with market monetarism, but this whole business of an upward sloping IS curve seems to make a mistake that you see intro students make a lot: confusing shifting curves with shifts along curves. Part of me is hesitant to make so simple a critique of guys like Scott Sumner and I suppose Nick Rowe (it's been a while since I've read the post on why he thinks the IS curve should be upward sloping), but since other intellectually formidable guys think it's nonsense, it's worth throwing this out there.
The IS curve is downward sloping because holding all else constant, a reduction in interest rates increases investment. Changing only interest rates, demand increases. But this is very different from interest rates changing as a result of a shift of the IS curve itself due to changes in demand that are unrelated to changes in interest rates. This bugs my students a lot - it takes a couple weeks to get used to the idea that "increasing demand" is an ambiguous statement. I press them - do you mean increasing quantity demanded or increasing the demand schedule? It all depends on what's causing the change - is it due to a change in price or a change in something else? One is a shift of the curve, one is a shift along the curve.So what are we dealing with here? We have increasing interest rates. Why? Sumner himself says we have increasing interest rates because of growth expectations. Anticipated increases in future income shift the IS curve to the right. And if we can sum up the impact of this morning's policy announcement in one phrase it would be "anticipated increase in future income". We try to segment monetary policy into movements of the LM curve and fiscal policy into movements of the IS curve for obvious reasons, but when we're talking about changes in expected future income we have to be careful. There are two questions to ask:
1. Is demand changing because interest rates are lower? If the answer is "yes", then you are moving along the IS curve.2. Is demand changing because something other than interest rates is making investors willing to invest more than before, given the same interest rate as before? If the answer is "yes", then you are shifting the IS curve itself.
It is quite plausible to have both. But saying "we observe demand increasing with interest rates" is not the same as saying "holding all else constant, an increase in interest rates increases demand".We often see prices and demand both go up simultaneously in other markets - one need not throw out downward sloping demand curves over that.
Right? Tell me if I'm thinking about this the wrong way, please.