Wednesday, April 15, 2009

Michal Kalecki: Economics Is The Science Of Confusing Stocks With Flows

J. R. Hicks invented the IS/LM model to compare and contrast his interpretation of Keynes' General Theory with "classical economics". Franco Modigliani later appended a supply and demand model of the labor market. Even later, John Hicks rejected this model.

Offhand, I can think of three issues with the IS/LM model:
  • The LM curve shows a stock equilibrium, while the IS curve shows a flow equilibrium. Thus, it is not clear to me that they can be graphed on the same diagram.
  • Both curves are drawn for a given set of expectations. If one curve shifts, the expectations upon which the other is drawn can hardly remain constant. Thus, both curves must shift and the equilibrium point becomes indeterminate.
  • The curves replicate the separation between nominal and real values that Keynes was trying to transcend with his monetary theory of production. Thus, the model cannot be a valid representation of the theory Keynes was so laboriously trying to express.
The first point challenges the internal validity of the model. The second suggests the model cannot empirically predict. The third is a point about the history of economic thought and would be expressed better if I remembered better some of Keynes post-General Theory work.


Duncan said...

Nice post.

YouNotSneaky! said...

The first point is basically why the LM curve has been ditched (even in some undergrad textbooks) and replaced with some kind of relationship between nominal interest rates and inflation, usually based on the behavior of central bank (which personally I think sort of begs the question, but that's short run fluctuations for you)