The IS-LM model is the simplest version of the “old Keynesian” approach to macroeconomics. You don’t hear much about IS-LM in the research literature these days, but it’s been coming up a lot on the blogs. Tyler Cowen tells us what he doesn’t like about the model; Brad DeLong and Paul Krugman rise to its defense; Stephen Williamson takes up the gauntlet, and Scott Sumner weighs in.
None of them, in my opinion, has touched the main issue, which is that IS-LM provides absolutely no framework for policy analysis because it makes no assumptions, and draws no conclusions, about what people are trying to accomplish. If you don’t know what people are trying to do, you can’t possibly know how best to help them.
Suppose, for example, that, as Paul Krugman believes, the current state of the economy is being driven by a “liquidity trap”, which means that people are hoarding money instead of spending it, and therefore consuming less, which is why employment is so low. Two weeks ago on this blog, I posed the following question to the IS-LMers:
Why aren’t you thrilled with the current state of the economy? … Why, as the stock of money continues to grow, shouldn’t the joy of hoarding eventually compensate for the annoyance of not having food on the table?
The IS-LM model provides no answer to that question. A model that can’t decide whether the current US economy is in a state of Nirvana is not a useful model for policy evaluation.
Back in July, 2010, I posted a toy model that is designed to address those questions — not because this model is sophisticated enough to be terribly useful, but to illustrate for blogreaders, in general terms, what a useful model might look like.
Greg Mankiw and Matt Weinzierl have recently provided just such a model. Like IS-LM, their model is fundamentally Keynesian. Unlike IS-LM, it is capable of evaluating the relative desirability of various policies. Would we be better off in a world where everyone floats in a vat of money until we all starve to death? The Mankiw/Weinzierl model, reassuringly, says “no”. The IS-LM model, unhelpfully, says “that’s not my department”.
For example: IS-LM says that in certain circumstances, government purchases can increase current output. It gives no indication of whether that output is worth its cost. That’s fine, I suppose, if you fetishize output over individual welfare. But Mankiw and Weinzierl’s model, being designed to address actual policy questions, is capable of saying that we might be happier with some kinds of output than with others. This allows it to conclude, for example, that well designed tax policies are more likely than spending programs to increase the right kinds of output. IS-LM can’t say that, because IS-LM takes no position on what counts as a better outcome.
This is not an endorsement of Mankiw/Weinzierl as the be-all and end-all of macroeconomic policy analysis. It is simply to say that whether you’re a new Keynsian, an old Keynsian, a neo-classical, an Austrian or a Marxist, you can’t do policy evaluation without a model that allows you to ask whether your policies are making people happier. IS-LM is not that model.
Edited to Add: A few hours after I posted this, it was announced that Tom Sargent and Chris Sims had been awarded the Nobel prize for developing macro models that, among other things, are designed to be useful for policy evaluation in precisely the way that IS-LM is not. In that sense, the post could not have been timelier. Congratulations to Sargent and Sims, and to the Nobel committee for a brilliant choice.