Why IS-LM doesn’t capture Keynes’ approach to the economy

25 November, 2016 at 12:39 | Posted in Economics | 2 Comments

benfineSuppose workers are unemployed. As a result, although willing to work even at lower wages, they are unable to buy consumption goods. As a result, firms are unable to sell those goods if they produced them. So they do not employ the workers who, as a consequence, do not have the wages to buy the consumption goods. The economy is caught in a vicious cycle of deficient demand. According to the IS/LM framework, this would lead to a fall in prices and wages, raise real balances and boost demand. But falling prices and wages might have the effect of both reducing effective demand and confidence, deepening rather than resolving the problem of unemployment.

These considerations raise serious doubts whether the IS/LM approach, despite being the standard representation, fully captures the Keynesian approach to the economy other than in name …

The appeal of the IS/LM lay not only in its formalisation of what is falsely taken to be Keynes’ specific contribution but also in compromising with a Walrasian approach to the economy.

hicksbbcBen Fine and Ourania Dimakou have some further interesting references for those wanting to dwell upon the question of how much Keynes really there is in Hicks’s IS-LM model.

My own view is that  IS-LM doesn’t adequately reflect the width and depth of Keynes’s insights on the workings of modern market economies for the following six reasons:

Almost nothing in the post-General Theory writings of Keynes suggests him considering Hicks’s IS-LM anywhere near a faithful rendering of his thought. In Keynes’s canonical statement of the essence of his theory — in the famous 1937 Quarterly Journal of Economics article — there is nothing to even suggest that Keynes would have thought the existence of a Keynes-Hicks-IS-LM-theory anything but pure nonsense. John Hicks, the man who invented IS-LM in his 1937 Econometrica review of Keynes’ General Theory — “Mr. Keynes and the ‘Classics’. A Suggested Interpretation” — returned to it in an article in 1980 — “IS-LM: an explanation” — in Journal of Post Keynesian Economics. Self-critically he wrote that ”the only way in which IS-LM analysis usefully survives — as anything more than a classroom gadget, to be superseded, later on, by something better — is in application to a particular kind of causal analysis, where the use of equilibrium methods, even a drastic use of equilibrium methods, is not inappropriate.” What Hicks acknowledges in 1980 is basically that his original IS-LM model ignored significant parts of Keynes’ theory. IS-LM is inherently a temporary general equilibrium model. However — much of the discussions we have in macroeconomics is about timing and the speed of relative adjustments of quantities, commodity prices and wages — on which IS-LM doesn’t have much to say.

IS-LM forces to a large extent the analysis into a static comparative equilibrium setting that doesn’t in any substantial way reflect the processual nature of what takes place in historical time. To me Keynes’s analysis is in fact inherently dynamic — at least in the sense that it was based on real historic time and not the logical-ergodic-non-entropic time concept used in most neoclassical model building. And as Niels Bohr used to say — thinking is not the same as just being logical …

IS-LM reduces interaction between real and nominal entities to a rather constrained interest mechanism which is far too simplistic for analyzing complex financialised modern market economies.

IS-LM gives no place for real money, but rather trivializes the role that money and finance play in modern market economies. As Hicks, commenting on his IS-LM construct, had it in 1980 — “one did not have to bother about the market for loanable funds.” From the perspective of modern monetary theory, it’s obvious that IS-LM to a large extent ignores the fact that money in modern market economies is created in the process of financing — and not as IS-LM depicts it, something that central banks determine.

IS-LM is typically set in a current values numéraire framework that definitely downgrades the importance of expectations and uncertainty — and a fortiori gives too large a role for interests as ruling the roost when it comes to investments and liquidity preferences. In this regard it is actually as bad as all the modern microfounded Neo-Walrasian-New-Keynesian models where Keynesian genuine uncertainty and expectations aren’t really modelled. Especially the two-dimensionality of Keynesian uncertainty — both a question of probability and “confidence” — has been impossible to incorporate into this framework, which basically presupposes people following the dictates of expected utility theory (high probability may mean nothing if the agent has low “confidence” in it). Reducing uncertainty to risk — implicit in most analyses building on IS-LM models — is nothing but hand waving. According to Keynes we live in a world permeated by unmeasurable uncertainty — not quantifiable stochastic risk — which often forces us to make decisions based on anything but “rational expectations.” Keynes rather thinks that we base our expectations on the “confidence” or “weight” we put on different events and alternatives. To Keynes expectations are a question of weighing probabilities by “degrees of belief,” beliefs that often have preciously little to do with the kind of stochastic probabilistic calculations made by the rational agents as modeled by “modern” social sciences. And often we “simply do not know.”

6  IS-LM not only ignores genuine uncertainty, but also the essentially complex and cyclical character of economies and investment activities, speculation, endogenous money, labour market conditions, and the importance of income distribution. And as Axel Leijonhufvud so eloquently notes on IS-LM economics — “one doesn’t find many inklings of the adaptive dynamics behind the explicit statics.” Most of the insights on dynamic coordination problems that made Keynes write General Theory are lost in the translation into the IS-LM framework.

Given this, it’s difficult not agree with Fine and Dimakou. The IS/LM approach doesn’t capture Keynes’ approach to the economy other than in name.

2 Comments »

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  1. We can make arguments from an accounting perspective.

    Like QTM theory, IS-LM equations in fact contradict the following accounting identities, which are valid for all time periods independent of market supply and demand.

    (a) Md V = P Q
    (b) Md/P = LM(r,y) = IS(r,y)/PV

    In other words, a given GDP (either IS(r,y) or PQ in above identities) at any time period has determined a specific money demand(Md) and its velocity (V) in real economic production flows from exchanging goods/services/labors with money demands. They can be calculated from NIPA accounts.

    Md and LM are not independent variables and functions any more once a GDP is given and cannot be arbitrarily assigned by using equilibrium of money supply (Ms) as in QTM and liquidity preference as in IS-LM. This is exactly where QTM and IS-LM should be considered as economic fictions. They do not reflect economy reality when Ms(t) ≠ Md(t) or LM(t) ≠ IS(t)/P(t)V(t) at any time period t.

  2. “According to the IS/LM framework, this would lead to a fall in prices and wages, raise real balances and boost demand.”

    According to the G.T. there are circumstances where

    ” A reduction in money-wages is quite capable in certain circumstances of affording a stimulus to output, as the classical theory supposes.”
    https://www.marxists.org/reference/subject/economics/keynes/general-theory/ch19.htm


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