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