The stupidest thing we do in macroeconomics is draw a downward-sloping IS curve. It's the stupidest thing we do, because we know it's stupid. (And I've done it hundreds of times.)
And because we do this stupid thing, we associate tight money with high interest rates. Unless of course we are someone like Scott Sumner, who never did get his head around the ISLM model, and so never made the false association between tight money and high interest rates. Come to think of it, I don't think Milton Friedman ever got his head around the ISLM model either, and he didn't associate tight money with high interest rates.
With an upward-sloping IS curve, and a vertical LM curve, because the central bank ought to make it vertical by targeting nominal GDP, everything falls into place. Tight money means shifting the vertical LM curve left, which causes interest rates (both real and nominal) to fall. Because you are moving down along an upward-sloping IS curve. Scott Sumner and ISLM: reconciled.
Why do we know it's stupid?
We know that investment is strongly pro-cyclical, more so than consumption. Even though consumption is larger than investment, the changes in investment over the business cycle are usually bigger than the changes in consumption.
And we know why too.
Who would want to invest in the depths of a recession?
In a recession, output is low, and so labour, or capital, or both, is idle.
If labour is idle, then the ratio of capital to employed labour is higher than normal, so the marginal product of capital is lower than normal, so the desired stock of capital is lower than normal, other things equal.
And if capital is idle, then the Marginal Revenue Product of capital is zero. Unemployed resources, whether labour or capital, are Zero Marginal Revenue Product workers or machines. Not because they can't produce any extra output, but because the firms can't sell the extra output that they could produce, so can't get any extra revenue from that extra worker or extra machine. So the desired stock of capital is lower than normal, other things equal.
In a boom, when labour and capital are fully employed, it's the exact opposite. Employment is high, so the ratio of capital to employed labour is low, so the marginal product of capital is high. And firms can easily sell the extra output produced by extra capital, so the marginal revenue product of capital is higher still.
For a given real rate of interest, the desired stock of capital will be higher in a boom than in a recession.
Investment is a flow, and the capital stock is a stock. If it weren't for adjustment costs, a small change in the desired stock of capital, above or below the actual stock of capital, would cause an infinitely large positive or negative flow of desired investment. So if the desired stock of capital depends on income, the marginal propensity to invest (the change in desired investment divided by the change in income) could be very large indeed.
We know this. There's nothing new here. The Old Keynesians knew this.
If the marginal propensity to consume plus the marginal propensity to invest exceeds one (mpc+mpi>1), then the IS curve is upward-sloping. That does not mean an increase in the rate of interest causes income to rise. It means an increase in the rate of interest causes income to fall and keep on falling. Equivalently, it means that an increase in income causes a rise in that interest rate at which desired saving would equal desired investment. Suppose income increased by $1, then desired consumption plus desired investment would increase by more than $1. So the real rate of interest would need to increase at the same time to offset it, and make sure that desired consumption plus desired investment rise by only $1.
Again, there's nothing new here. We knew all this.
So if business cycles are caused solely by monetary policy shifting a vertical (or at least steeper than IS) LM curve left and right along a fixed upward-sloping IS curve, we would see high real interest rates in booms and low real interest rates in recessions. Low real interest rates are caused by tight money. High real interest rates are caused by loose money. Which is what Scott Sumner says. And Milton Friedman said.
We all know that firms have a strong incentive to invest in a boom and not invest in a recession. And we know this is what they do. So we know that mpc+mpi>1 is a very plausible assumption, and one that fits the facts. So why don't we want to believe it?
1. Because mpc+mpi>1 makes equilibrium in the Keynesian Cross model unstable, and we don't like an unstable equilibrium, so we make the Keynesian Cross equilibrium stable by assuming mpc+mpi<1, and then use it to teach where the IS curve comes from. And mpc+mpi<1 gives us a downward-sloping IS curve.
2. Because we can't escape the "dominant discourse" (sorry) of monetary policy as setting a rate of interest. That's what central banks do. That's the monetary policy transmission mechanism. So the LM is horizontal. And if you have a horizontal LM and an upward-sloping IS it's an unstable equilibrium. All the dynamics are wrong. If you shift the LM up, by having the central bank raise the rate of interest, which is a tightening of monetary policy, income does not rise to the new ISLM intersection. It falls, and keeps on falling. The ISLM intersection tells you where the equilibrium is, but the economy won't go there. We don't like models like that.
We don't like models like that, but that doesn't stop them being true.
A central bank that conducts monetary policy by setting a (contingent) time-path for the nominal rate of interest is double pole dancing. It is balancing one pole upright, on the palm of its hand. And there's a second pole, balanced upright on the top of the first pole. And it has to dance like crazy, to try to keep both poles upright, and in about the position it wants them to be.
The first pole we know about. It's embodied in the Howitt/Taylor principle. The central bank sets a nominal interest rate, but what matters for consumption plus investment is the real interest rate. If the central bank sets the nominal interest rate too low, desired consumption plus investment will be too high, so inflation will rise, and expected inflation will rise, and the real interest rate will fall, and inflation will rise even more. It's unstable. So if inflation rises by 1%, the central bank must respond by raising the nominal interest rate by more than 1%, to bring inflation back down. It has to move the bottom of the pole (the nominal interest rate) by more than the top of the pole (the inflation rate) to keep the pole from leaning more and more.
The second pole is the result of the upward-sloping IS curve. Even if you ignore expected inflation, so that real and nominal interest rates are the same, the central bank can't hold the rate of interest constant and expect real income to stay constant. If the central bank sets the rate of interest a little bit too high, income won't just be a little bit too low, as it would be with a downward-sloping IS curve. Instead, income will fall, and keep on falling.
Take a bog-standard ISLM plus expectations-augmented Phillips Curve model. Make the LM horizontal because the central bank sets a (contingent) time-path for the nominal interest rate. Then assume mpc+mpi>1, so the IS curve slopes up. The central bank is then double pole dancing, trying to keep two poles balanced upright, one on top of the other.
That's why central banking is hard, if you set a nominal interest rate. And that's why things sometimes fall over.
Thanks edeast for this video link: