Dirk Ehnts — Krugman on Unreal Keynesians (IS/LM again)

Dirk Ehnts offers a Godley-based "gadget" to replace ISLM as a heuristic.

My own point of view is that IS/LM is mistaken in assuming that the central bank controls the money supply and that the sectoral balances (private and public) are not made explicit. You actually can get a lot of mileage out of the good old IS/LM model if you let the central bank set the interest rate on the short-term money market (horizontal LM curve) and – because of general depression – determine some level of expenditure (or demand) that does not react to changes in the interest rate (vertical IS curve). The resulting cross is so trivial that I tend to agree with Syll: maybe it is not the best idea to use a macroeconomic model to show that: 

• Demand is exogenous and smaller than potential output
• The central bank creates the interest rate, but that doesn’t matter because of 1.
• Demand is exogenous, but government spending can add to that 

Using a mathematical model with all eyes crossed and all teas dotted to then arrive at this conclusion really is a waste of time. How do we fix this? 

I have published the so-called IS/MY model to show what could be done to improve on the shortcomings of the IS/LM model (working paper version here). First of all, the main idea is that expenditure equals spending in equilibrium. Then, net deposits (money) are created through three mechanisms that rely on the same balance sheet trick. A rise in net debt leads to a rise in deposits for each of the three sectors: private, public and external. The monetary circuit works well as long as the amount of deposits is increasing (given velocity, and ignoring complications of what is money)....

The IS/LM model was not perfect, and never will be. Any alternative will face the same fate. However, it would be nice for the macroeconomist to have something small and “unbreakable” that works on the back of an envelope. The IS/MY model is based on (BoP) accounting relations and assume only that consumption and imports depend on income. Most economists should be able to live with these assumptions. What is left to the economist is to speculate about the quantity of investment, government spending and exports. These will, using the vocabulary of Wynne Godley, determine the fiscal and trade stance and allow discussions of sustainability of macroeconomic regimes.

econoblog 101
Krugman on Unreal Keynesians (IS/LM again)
Dirk Ehnts | Berlin School for Economics and Law