Recently, an interesting debate took place, not for the first time, between Paul Krugman and Steve Keen over the usefulness and appropriateness of the IS LM model in macro economics. While Keen believes it is inadequate as it does not deal with concepts such as debt and leverage, the debate also centred around the issue of equilibrium and disequilibrium. Krugman has used the ISLM framework to good effect during this crisis, while Keen had thought that Krugman was always assuming that the ISLM was in equilibrium. On the contrary, Krugman uses the ISLM in the current context to display the liquidity trap scenario and accompanies this with a diagram of investment and savings that represents that economy at full employment, something that it is not at present.
Coincidentally, the ISLM also came up at the LSE lecture that I mentioned last week. Olivier Blanchard was asked about the teaching of macroeconomics and while he said that post-graduates should be looking more into credit, leverage and financial stability, he said that for undergraduates he would look into extending the IS LM framework. Specifically, he said he would add a wedge between the interest rate set by the central bank and that faced by the real economy. This wedge, or spread, would be a function of the financial sector’s ability to function as an efficient transmission mechanism of central bank policy. So, can the two issues of IS LM disequilibrium and two distinct interest rates be brought together? What might this extended framework look like?
Blanchard’s ISLM Equilibrium
From his excellent undergraduate textbook, the diagram shown below depicts how Blanchard brings together the IS curve, representing equilibrium in the goods market, with the LM curve, representing equilibrium in the financial markets. As shown, where these two curves intersect is the resulting equilibrium in the economy, with the equilibrium interest rate and output that correspond to this intersection. In this setting, the central bank can shift the LM curve with an increase in the money supply that results in a lower interest rate. Shifts of the IS curve can be achieved through changes in taxation or government spending, for example.
A broken monetary transmission mechanism
As Blanchard discussed at the LSE lecture, he would now introduce two interest rates into this framework. This spread between the interest rates would be a function of a less than ideal financial system, or in a simpler way, represented by a bank, where the spread is determined by the health of this representative bank. Consequently, what this entails for the above diagram is an economy that is no longer achieving the combined equilibrium. Due to the inefficiency of the bank or financial sector, the economy is now in disequilibrium, implying a fault in the system that prevents the economy from reaching its ideal outcome.
How could this be represented in the basic IS LM Model?
The picture drawn below is one way that this interest rate spread might be depicted in this framework. It shows an IS LM diagram similar to that of Blanchard, but with an additional curve to the left of the ideal equilibrium. This extra curve attempts to articulate this interest rate spread: it cuts the LM curve at an interest rate iLM which is lower than where it cuts the IS curve at iIS. The gap between these two rates is the level of malfunction in transmitting the interest rate from the financial sector to that of the goods market. As this curve is to the left of the ideal equilibrium, it also implies that the level of output is less than desirable. This malfunction is causing the goods market to face an interest rate that is higher than it otherwise would be, resulting in a lower output than equilibrium.
This extension can also be applied to the ISLM framework as it is used in the current context of the liquidity trap. The liquidity trap scenario describes an economy that has suffered a severe shock that has shifted the IS curve a long way to the left. This results in an intersection with the LM that is at the zero lower bound of interest rates. More technically, this is what is meant by the term liquidity trap, as once the economy is at this point, the Central Bank cannot alter the interest rate by swapping money for bonds, as short term bonds are now paying almost a zero return.
The scenario of an economy in a liquidity trap that is also experiencing a dysfunction in the financial sector may describe an economy like that of current day UK. The economy fell into the liquidity trap after the financial crisis and short term interest rates have been essentially at zero for quite a while. This has encouraged the Central Bank to engage in QE (quantitative easing) as an unconventional form of monetary policy to escape this trap by shifting the IS curve back to the right. However, the authorities have also realised that the banking and financial sector are not functioning as ideally as desired and the real economy is facing higher rates than it should be at present. This has resulted in the policy of the Funding for Lending scheme, which is having mixed results thus far. From an ISLM point of view, the scheme is designed to lessen the spread between these interest rates.
A pictorial view of a broken transmission mechanism
Just to provide a more concrete example of a broken transmission mechanism, the following diagram is taken from a Federal Reserve Bank of New York presentation. The picture shows the channels of monetary policy that were impaired right after the financial crisis. Although the Federal Funds rate target was lowered dramatically, term lending was impaired and credit spreads widened. According to Jonathon McCarthy, these problems reflected severe strains in the financial markets and little willingness of investors to take on any risk.
Larry Summers and two ways for Economics to proceed
In the question time of the LSE lecture, Larry Summers made some very interesting points. He spoke of his wariness of DSGE models (Dynamic Stochastic General Equilibrium models) and his concern that just adding more frictions to these models misses the main lesson from the crisis. I interpreted this to suggest that the Economics profession should also be exploring ‘disequilibrium’ models and frameworks. We need to understand things like the build-up of credit and leverage and how this might lead to a large crash like that of 2007 and 2008. Overall, it probably makes sense to pursue both paths, that is, put more effort into adding financial market frictions to existing models, while also developing theories that are prone to disequilibrium.
 Goods and Financial Markets: The IS-LM Model. Olivier Blanchard. Prepared by Fernando Quijano and Yvonn Quijano.
 The Federal Reserve and Monetary Policy. Jonathan McCarthy, Federal Reserve Bank of New York.