Further Problems With the Static Framework of the ISLM

by Philip Pilkington

Article of the Week from Fixing the Economists

Last week I did a short post on how the ISLM model misrepresents how interest rates function because it views them as static. Today I would like to make a further, if more difficult point: namely, that the very way in which the interest rate stimulates investment is inherently limited in that it cannot produce cyclical upswings in effective demand — and thus, cannot produce cyclical upswings in output. In doing this I will be drawing on Jan Kregel’s excellent paper Of Prodigal Sons and Bastard Progeny which in turn draws on some of Joan Robinson’s own writings on the ISLM.

Follow up:

As Kregel shows in the paper, Robinson had a very clear-sighted view about how interest rates function. The first part of Robinson’s article is quoted by Kregel as such,

Relatively to given expectations of profit, a fall in interest rates will stimulate investment somewhat, and by putting up the Stock Exchange value of placements [i.e. share prices], it may encourage expenditure for consumption. These influences will increase effective demand and so increase employment… But even when the rate of interest can be moved in the required direction, it may not have much effect. The dominant influence on the swings of effective demand is swings in the expectation of profits. (My Emphasis)

Here then there are two channels through which a fall in the interest rate works. On the one hand, it increases investment directly — presumably by lowering the cost of borrowing somewhat and giving a temporary boost to the animal spirits. On the other, it increases consumption expenditure through the wealth-effect as the net worth of those that hold shares rises. The increase in effective demand then arises due to the increase in investment and consumption that arises due to the fall in interest rates.

However, as I highlighted in the above quote, Robinson takes a properly Keynesian/Kaleckian view of how such increases in investment may or may not prove self-reinforcing: that is, in order for a cyclical upswing to be maintained expected profits must increase. Robinson is skeptical that this will occur under the influence of monetary policy because she thinks that the fall in interest rates will lead to,

…a boom which will not last because after some time the growth in the stock of productive capacity competing in the market will overcome the increase in total expenditure and so bring a fall in the current profits per unit of capacity, with a consequent worsening of the expected rate of profit on further investment.

The increased investment creates a bigger pool of productive capacity which then competes in the market for profits. This, in turn, drags down the profit on each unit of productive capacity. Since profit expectations are now somewhat dampened and since the fall in the interest rate has run its course further investment will fall off and the boom created will fizzle out. In the book from which Kregel draws the quotes, Economic Heresies, Robinson makes crystal clear that this is the Keynesian view proper.

[Keynes’] account of a boom is to say that a high rate of investment causes a fall in expected profits as the supply of productive capacity increases… one thing he would have never have said is that a permanently lower level of the rate of interest would create a permanently higher rate of investment.

This ties into Kalecki’s argument that if central banks try to control the level of effective demand through the interest rate they will find that they will have to drop the interest rate over and over again as each boom peters out until, ultimately, they end up at the zero-lower bound. As Steve Randy Waldman of Interfluidity notes, this appears rather prescient if we look at the period after 1980 when central banks moved toward trying to steer the economy by using the interest rate alone. He presents the following graph which shows precisely this dynamic,

As we can see, after each recession the central bank had to drop the interest rate ever lower to ensure that an expansion could take place. This is precisely what Keynes, Robinson and Kalecki would have expected.

The problem here, as in my original post on the ISLM, is that its adherents do not seem to understand the difference between statics and dynamics. Kregel states this quite clearly, all the while drawing on Robinson,

[U]sing Hicks’ IS curve, “a permanently lower level of the rate of interest would cause a permanently higher rate of investment”. This Keynes “could never have said” for it confused equilibrium with a process of change: “Keynes’ contention was that a fall in the rate of interest relatively to given expectations of profit would, in favourable circumstances, increase the rate of investment”. But, this would cause expectations to change and the marginal efficiency of capital curve to shift, and presumably the IS curve with it. An IS schedule could not be built upon the static relation between interest and investment.

Where many Post-Keynesians, and even some New Keynesians like David Romer, today focus on the LM-curve when critiquing the ISLM framework, Robinson showed how the IS-curve was simply not compatible with Keynes’ own theory. At the same time she showed how it was inapplicable to any world in which investment was based on the expectation of future profits.

Again, we should emphasize the underlying problem here: the ISLM model is based on a static framework that simply cannot conceptualize dynamics. What is more, the framework is not some ‘provisional’ outline sketched out prior to a more sophisticated dynamic analysis; indeed, it cannot be as it falls apart under dynamic conditions. Nor are the misinterpretations it produces ‘innocent’ in the sense that the errors only exist in the abstractions of the model; it is quite clear that those who use the model will likely come to extremely wrong-headed policy prescriptions (the call for a negative rate of interest today as the cure of our ills being one that comes to mind…).

The ISLM discourages economists from thinking in the very manner that they should think: that is, in terms of the historical time in which we all live, historical time in which expectations formed under uncertainty are of the utmost importance. It trains economists into thinking that they are like social engineers who understand the economy as one might understand the functioning of a piston-engine. But economists are no such thing and any economist who convinces themselves otherwise will soon find themselves running headfirst into the double-glazed window that the rest of us call ‘reality’.

Addendum: For a further critique of the idea of using the interest rate to control economic fluctuations see here for a completely different but equally powerful and, I think, somewhat novel argument by your’s truly.

Make a Comment

Econintersect wants your comments, data and opinion on the articles posted. You can also comment using Facebook directly using he comment block below.

 navigate econintersect .com


Analysis Blog
News Blog
Investing Blog
Opinion Blog
Precious Metals Blog
Markets Blog
Video of the Day


Asia / Pacific
Middle East / Africa
USA Government

RSS Feeds / Social Media

Combined Econintersect Feed

Free Newsletter

Marketplace - Books & More

Economic Forecast

Content Contribution



  Top Economics Site

Investing.com Contributor TalkMarkets Contributor Finance Blogs Free PageRank Checker Active Search Results Google+

This Web Page by Steven Hansen ---- Copyright 2010 - 2018 Econintersect LLC - all rights reserved