Krugman doesn’t understand IS-LM (Part 1)

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This is a post in at least 4 parts; for part 1, click this link to the Business Spectator article.

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Krugman doesn’t understand IS-LM–Part 1

Krugman describes himself as a “sorta-kinda New Keynesian”, and explains in his book End This Depression NOW! that New Keynesian macroeconomics evolved in reaction to the failure of the new classical approach to “explain the basic facts of recessions”.

His “sorta-kinda” qualification is because both New Keynesian and new classical models are derived from applying assumptions about the behaviour of individuals and markets at the level of the macroeconomy, and he has a healthy scepticism about these assumptions:

 “I don’t really buy the assumptions about rationality and markets that are embedded in many modern theoretical models, my own included, and I often turn to Old Keynesian ideas, but I see the usefulness of such models as a way to think through some issues carefully – an attitude that is actually widely shared on the saltwater side of the great divide.”

This is one aspect of Krugman that I genuinely applaud: the awareness that models aren’t reality. At best they are representations of reality, but some neoclassicals show an amazing capacity to believe that their models are reality – as in this piece by French economist Gilles Saint-Paul which the blog Unlearning Economics deservedly flogged recently – in a way that leads to truly delusional thinking about the real world.

Of course, we need models to think about the economy in the first instance, because it is such a complex entity. Even those who deride modelling in economics are using a model when they talk about the economy – it’s just a verbal (or even unarticulated) one, as opposed to an academic construct.

One might hope that experience and experimentation over time would weed out unrealistic models in economics, but that hasn’t happened. In many ways, the models that dominate economics today are less realistic than those which prevailed as much as seventy years ago.

Krugman alludes to this by his reference to “Old Keynesian ideas” above. In particular, he champions John Hicks’ IS-LM model as an explanation of our economic crisis today.

This model, first published in 1937, seeks to explain the relationship between interest rates on one hand and real output in goods and services and money markets, on the other.

Click here to read the rest of this article

About Steve Keen

I am Professor of Economics and Head of Economics, History and Politics at Kingston University London, and a long time critic of conventional economic thought. As well as attacking mainstream thought in Debunking Economics, I am also developing an alternative dynamic approach to economic modelling. The key issue I am tackling here is the prospect for a debt-deflation on the back of the enormous private debts accumulated globally, and our very low rate of inflation.
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One Response to Krugman doesn’t understand IS-LM (Part 1)

  1. Steve Hummel says:

    Ann Pettifor’s link to this video is utterly apropo……except for one thing.

    Pre-Keynesian economics does not have to be understood as a regression. Why? Because C. H. Douglas was one of the first individuals to understand the “loans create deposits” reality. That plus his grounding in engineering, and his knowledge of double entry bookkeeping as well as its subset cost accounting gave him an excellent understanding of both micro and macro economics. Douglas wasn’t nearly as burdened by the orthodox myth that markets are stable and equilibrating or that capitalism was sacro-sanct in and of itself conceived of by most in America and elsewhere. His grounding in cost accounting enabled him to see the micro-economic problem lack of money for the individual and his understanding of the ex nihilo/creditary nature of money enabled him to envision a macro-economic solution like the retail discount.

    Keynesianism was utterly superior to its neo-classical decedent, but Douglas (whom Keynes probably only unconsciously plagiarized) was in fact both economically and ethically superior to Keynesianism.

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