Money and Self-Justifying Economic Models

Michael Stephens | March 13, 2012

Philip Pilkington shares a discussion he had with Dean Baker about, among other things, the Post-Keynesian take on the limitations of some conventional economic models (of the “LM” part of IS-LM, in particular.  And if that just looks like an arbitrary string of letters to you, Pilkington has an accessible explanation at the beginning of his post).  His description of the “self-justifying” dynamics of the IS-LM view of money and central banking is worth quoting:

By assuming an upward-sloping LM-curve – that is, a fixed supply of funds – there is an implicit assumption that actions on the part of the central bank are somehow neutral. ISLM enthusiasts implicitly assume that the central bank is simply responding to some otherwise ‘equilibrating’ market conditions and adjusting its rates in line with this. …

… [The standard ISLM model] buries the fact that the central bank is actually taking a specific stance on policy and then tries to pass off this stance as a sort of quasi-market response (i.e. as if there were a market for a fixed supply of funds). But the central bank’s policy stance is nothing of the sort. Instead it is a sort of a simulation of what a market response is thought to be. Thought to be by whom? By economists that adhere to models similar to the ISLM, of course!

In a related vein, Greg Hannsgen points me to the latest volume of essays published in honor of Wynne Godley, “Contributions to Stock-Flow Modeling,” in which Marc Lavoie highlights this Godley quotation on the fixed stock of funds assumption in IS-LM:

Godley was always puzzled by the standard neoclassical assumption, found in both the IS/LM model and among monetarists, of an exogenous or fixed stock of money, the worse example of which is Friedman’s money helicopter drop. As Godley says, ‘governments can no more control stocks of either bank money or cash than a gardener can control the direction of a hosepipe by grabbing at the water jet’.


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