Tag Archives: diagram

Why is LM still there?

With all the recent discussion of IS-LM, I can’t help but repeat a longstanding question of mine: what on earth is “LM” still doing in the diagram?

The “IS” curve is logical enough: by encouraging investment (not to mention spending more generally), lower interest rates lead to higher output. Sure, there are some flaws. We should really be looking at the full future path of interest rates (which is what matters for spending and investment decisions), not today’s interest rate in isolation. We should also emphasize the difference between nominal and real interest rates—so that if the vertical axis denotes nominal interest rates, inflation will shift the IS curve (which depends on real rates) upward. But as a starting point, this isn’t really so bad: the fact that higher real interest rates, all else equal, push down output is probably the most fundamental observation in macroeconomics.

But the “LM” curve? It’s implicitly describing a monetary policy rule that disappeared decades ago. Here’s the story: the central bank has a target for the nominal money supply. Due to sticky prices, in the short run this corresponds to a target for real money balances as well. Generally, higher real output (“Y”) will increase the demand for real money balances, while higher nominal interest rates (“i”) decrease it. The set of possible equilibrium pairs (Y,i), therefore, has positive slope: when high Y is elevating demand for real money, i has to rise as well to bring demand back into line with the fixed supply.

Fair enough. But central banks today don’t target the nominal money supply: in the short run, they target nominal interest rates directly. In this light, a more sensible “LM” curve would be horizontal. Now, admittedly central banks try to operate according to policy rules, under which the response of interest rates to output (or, more accurately, deviations of output from its potential level) is generally positive. If we reinterpret LM as a monetary policy rule, the upward slope makes a little more sense. In the past few decades, however, the most important feature in central banks’ policy rules has been the response to inflation, not output; the runaway inflation of the 1970s was blamed on an overeager response to the (misperceived) output gap, and for better or worse no one wanted to repeat the same mistake twice. Meanwhile, although the US has never officially joined the bandwagon, many countries now operate under an inflation targeting framework, in which responding to inflation is the key feature of the policy rule. In this environment, depicting policy as a relationship between “Y” and “i” misses what’s really going on—better to abandon the upward-sloping LM curve altogether and use a simple horizontal line to depict the current policy rate.

I’m not alone in this sentiment. David Romer wrote an entire piece for the JEP in 2000 called Keynesian Macroeconomics without the LM Curve. (As the title suggests, he shares my feelings on the matter.) Tyler Cowen puts this at #6 on his list of grievances. It’s a pretty obvious point—yet, for reasons I don’t entirely understand, we still print thousands of undergraduate textbooks a year with LM front and center.

This is nothing, of course, compared to the abomination that is the AD/AS model, also included in undergraduate textbooks. AD slopes down for the same outdated reason that LM slopes up: given a constant money supply rule, lower prices imply higher real money balances and therefore lower real interest rates, which lead to higher demand. (It can also be justified using real balance effects, which are quantitatively irrelevant, or fixed exchange rates, which only exist in a few cases.) This has absolutely nothing to do with monetary policy as it’s currently implemented. Yet the simple AS and AD curves, made appealing by the apparent (but false) analogy to ordinary supply and demand, lurk somewhere in the minds of countless former economics students. This leads to all kinds of bad intuition—like the notion that sticky prices are problematic because they prevent the adjustment to equilibrium on the AD/AS diagram. (Wrong. Under current Fed policy, the price decrease -> lower interest rate -> improvement in demand mechanism is no longer operative, unless deflation combines with the Taylor rule to force a policy that the Fed should have chosen anyway. Certainly this is no use at the zero lower bound, where price flexibility is actually harmful, because it leads to more deflation and higher real interest rates.)

Somehow, the economics profession hasn’t quite completed the transition to a world where money supply is no longer the target of choice. In research papers, of course, the change happened years ago—but intuition and the hallowed undergraduate canon are much slower to change. Meanwhile, we’re left with LM, the strange vestige of an earlier era.



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