Vertical LM is Not Vertical AS

Would it be a better analogy to say that you can't add power to your engine by sticking a wind turbine on the roof?

Mr. Caplan,

You illustrate your belief in a vertical LM in a previous post by saying that you've never held more cash because interest rates were lower.

Well, actually, mutual funds do that. They increase their ratio of cash when they suspect that their subscriber's time horizon has shortened, that is, when conditions make investment uncertain.

I'm surprised to see how much confusion revolves around the whole issue in this blog:

1) People should not forget that the thrift paradox, like any other type of economic shock, is a short term matter - not long term.

2) The purpose of governement pending was to prevent the "liquidity trap", if such a thing exist, not at a long-term matter.

It is rather hard to see how there can be any crowding out with rates near zero. At least fiscal stimulus gives monetary stimulus space to operate. Wider monetary stimulus could work but proposers need to specify where they would go from here since the Fed is already moving to lend on any and everything from asset backed securities to commercial paper to mortgages. While they have lowered a broad swathe of rates, they could do more. More bonds? Whose? Longer term? How long? Lower rates? Which ones? To what? Why should we expect it to be more effective than what has already been done?

Lord:
1) Health care & education are inflationary sectors. Do you really think that expenditures in these & countless other areas would be free of crowding out just because rates are zero? Really?

2) How long have you given monetary policy to start working? Since the stimulus package doesn't even get into full swing until 2010, I presume you are willing to give it a year, at least. Are you willing to give monetary stimulus a year? If the monetary policies that have already been done end up being enough to help lead to a recovery this year, would we even know right now?

This discussion is literally decades out of date. Apparently it is framed in terms of the old IS-LM model with no supply side and thus no aggregate supply curve. The proper model includes such a curve, call it SS, as well as modifications to the old Keynesian IS curve to recognize the effects of the Permanent Income/Life Cycle Hypothesis on consumption demand, capital theory on investment demand, Ricardian effects on anticipation of future taxes (if people can anticipate their future incomes, as in PermInc/LifCy, why not their income *net of taxes*, which is what they should anticipate?), plus of course some form of expectations formation that is rational at least in the long run. Put all that stuff in and the the updated IS-LM-SS model does just fine. See the 3rd edition of Branson's old (indeed, decades old) but excellent text for a pretty good treatment.

The main thing here, though is the interaction of IS, SS, and LM. Near-verticality of LM is irrelevant in the long run. Output and the interest rate are determined by the intersection of IS (which in fact is just aggregate demand) and SS. Prices then change to shift LM until it passes through the intersection of IS and SS. In the short run, life is more complicated, and the precise path of the economy in response to a disequilibrating shock depends on how people perceive the shock initially and how they update their perceptions as time passes, but once again Y and r are determined by IS and SS, not LM. LM determines only prices. All this assumes prices are flexible. Behavior under sticky prices is really difficult because economists don't have a theoretically convincing and empirically validated theory of why prices are sticky. The reason for the stickiness makes a huge difference to the predictions for economic behavior in response to a shock. Thus, economists right now can do much better predicting long-run effects than short-run effects, and, as I said above, near-verticality of the LM curve is irrelevant in the long run.

Kebko:
1) Absolutely. Inflation in these sectors is just what is needed to cause their expansion as they do for most any other sector that expands. More resources must be drawn into them, and there is no means of doing so other than increasing spending on them.
2) Monetary policy is already at its limit and has been for some time while the economy is getting dramatically worse and we border deflation, but it can be changed rapidly as the situation changes, therefore waiting is riskier than not and responding later with tighter monetary policy is easier.

Thank you, Mr. Seater;

your post really sorts out the confusion in this debate, in my opinion.

I would like to read your suggestion (Branson) but I don't know that author and what book it is. Can you be more specific?

Thanks!

Francis,

The citation is

"Macroeconomic Theory and Policy (3rd Edition)"
William Branson
Harper & Row, 1989

If you want to buy it, it's available on Amazon and some used book cites. It starts out somewhat deceptively simply, with a very simple model that gradually builds up to a very sophisticated one.