What’s needed in a macro model?

Paul Krugman defends IS-LM as a pedagogical device on the grounds that it’s part of “the minimal model that has goods, bonds, and money”. Greg Mankiw circa 2006 does much the same, favoring the IS-LM model “because it keeps the student focused on the important connections between the money supply, interest rates, and economic activity, whereas the IS-MP model leaves some of that in the background”.

But do the “important connections” in the model bear any correspondence to reality? Not really—and understanding why not is a great deal more interesting than any attempt to muddle through outdated diagrams.

As I pointed out last week, the “LM curve” represents a version of monetary policy that disappeared decades ago: a target for the money supply. Given a particular value for the money supply, higher output must be accompanied by higher nominal interest rates, which offset the increase in money demand that tends to accompany a larger economy. We’re left with an upward-sloping curve in (i,Y) space—that’s LM.

Now that Fed uses interest rates to implement monetary policy, does this make any sense? Excerpting his textbook, Greg Mankiw claims that the LM mechanism is still a useful way to understand how central banks do business. After all, with a few exceptions they still implement interest rates by using open-market operations to adjust the supply of reserves. In this light, we can say that the Fed is moving the LM curve to achieve its desired interest rate. Right?

Not quite. For LM to be useful in understanding the implementation of monetary policy, it can’t be just a long term relationship—that’s merely the near-obvious statement that all else equal, a larger economy will eventually need more money. It needs to be valid in the short term as well, the horizon over which the nitty-gritty of monetary implementation takes place. And there’s no reason why that should be true.

Indeed plenty of reason to think exactly the opposite—that at high frequencies, declines in output lead to increases in money demand. Anyone who’s read a newspaper over the last few years has surely come across the notion of a flight to liquidity. When the economy dips, there’s an increase in demand for liquid assets that vastly outweighs whatever tiny drop you’d expect in transactions demand for money. In practice, LM probably slopes the wrong way. (This is also the difficulty with Brad DeLong’s argument that LM applies to quantitative easing—QE tries to change the spread between long rates and the expected path of short rates, but there’s no reason to assume that spread has any particular relationship with output, much less a positive one.)

This isn’t to say, of course, that we should force undergraduates to scribble downward-sloping LM curves. Of course not. Rather, the exact relationship between “M”, “Y”, and “i” is so complicated and time-contingent that we shouldn’t waste time trying to model it at all. As far as I know, the guys at the New York Fed who actually implement interest rate targets don’t rely on some hyper-complicated model of the relationship between reserve demand and 132 macro variables. Instead, they inject reserves into the system when rates are above target, and take them out when rates are below target. It’s a pretty mechanical process, but it works, and you don’t need any more than supply and demand to understand why.

There’s a broader question here: what mechanisms do you really need in a macro model? For decades, monetary economists painstakingly hashed out functions for “money demand”, and spent untold amounts of econometric energy trying to estimate them. You’d see horrendously tedious papers exploring how the effects of government policy X depended on the exact specification of the money demand function. Even as late as 1999, one prominent monetary economist worried that innovations in financial markets would turn the central bank into an “army with only a signal corps”, as they brought down the demand for government-issued money.

As Mike Woodford pointed out a decade ago, none of this actually matters. Central banks today (at least the ones in developed countries) only care about money demand to the extent that it affects their ability to control interest rates, and this remains perfectly feasible when money demand is small or even zero. The messy regulatory and technical issues that determine banks’ demand for reserves on the fed funds market have virtually nothing to do with the effects of monetary policy on the economy. Obsessing over money demand is a waste of time.

When you think about it, this is fairly obvious. The “LM” curve embeds two claims about the demand for money: that it increases with output and decreases with interest rates. But there are countless other influences on the demand for money (at least base money created by the Fed), many of which are just as important in the short term. How many $100 bills do drug dealers need to evade notice? Are paper dollars still popular in countries with underdeveloped banking systems? How many ATMs has Bank of America built? Do gas stations demand payment in cash?

If you seriously believed that modeling money demand was important, you’d be working overtime to build a model with all these features. Sure, you’d probably have a “transactions demand” block like everybody else, but you’d also be surveying coke dealers to keep abreast of changes in their cash management. The fact that no one actually deems a survey of coke dealers necessary to understand monetary policy—even when their effect on money demand is quite plausibly larger than the effect from most other economic activity put together—is powerful evidence that no one really thinks the details of money demand matter.

And that’s the great thing about economic modeling: you don’t have to include every conceivable, small-bore mechanism. You can’t! Instead, you need to focus on what matters—and as the economics profession has finally come to realize, the precise characteristics of money demand just don’t make much difference. LM is irrelevant.

Fortunately, monetary economics offers plenty of other material to keep us busy.

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10 Comments

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10 responses to “What’s needed in a macro model?

  1. Adam P

    Matt, let me assume that you’d agree that the demand curve for apples (from micro) is downward sloping.

    This can’t be right, when you think about it, it’s obvious. The downward sloping demand curve for apples embeds two assumptions about the demand for apples: that it increases with income and decreases with the relative price of apples. But there are countless other influences on the demand for apples, many of which are just as important in the short term. For example the price of the pastry, or the wage of the chef, used to make apple pie in relation to the demand for apple pie. whether or not apples are still consumed in countries that can’t grow their own. The supply of substitutes like pears.

    If you seriously believed that modeling apple demand was important, you’d be working overtime to build a model with all these features.

    The point of course is that the LM curve is a partial equilibrium relation much like the demand curve for apples. It traces out the solution to a subset of the equations that describe the economy holding other things constant. In particular, it traces out the solution to money supply = money demand holding the money supply M constant. Changes in any of those other things shifts the curve, just like changes to the price of pears shifts the demand curve for apples.

    Now, as I said last time, your point that we should discard the LM curve in sophisticated models and that we should discard money demand is a point I agree with. That is very different from the LM curve being horizental which I disagree with.

    But I also think Krugman and DeLong have a point. If you stop thinking about the supply and demand for money and start thinking about the supply and demand for liquidity then you can get back to a certain IS-LM framework. Open up Holmstrom and Tirole’s “Inside and Outside Liquidity” and the first point is about the limit’s to the aggregate supply of liquidity due to limits to how much output is pledgable in the form of liquid claims. Since their are also limits to how much output the government can extract fromt the economy then their are clearly limits to the aggregate supply of liquidity even including government.

    If you think of the LM curve as (Y,i) combinations for which liquidity demand equals liquidity supply then I think it does slope upward and I think you can think of the supply of liquidity as being set exogenously. The liquidity stock would still shift, and government policy could shift it, but the government doesn’t have the power to just set it at whatever level it wants.

  2. Adam P

    Also, I think the increased demand for government debt during “flights to liquidity” should actually be understood as contraction in the supply of liquidity as assets like MBS that used to serve a liquidity purpose suddenly do not. It’s not an increase in demand for liquidity, it’s an increase in demand for government debt because the substitutes aren’t there anymore. This is like an increase in the demand for apples because the entire crop of pears went rotten.

    In that sense we again are back to an IS-LM theory of recessions where the proximate cause is a contraction in the supply of aggregate liquidity.

    • I’ve argued as much before, and I can’t really disagree except to say that I think the demand response for liquid assets is probably important too—people don’t head to Treasuries or whatever solely because other liquid assets no longer serve their purpose, but also because the recession creates an endogenous increase in demand. (Admittedly, though, I don’t have much data to back this up—just intuition.)

      I still think that “LM” doesn’t really work as an account of fluctuations because the demand for liquidity, even if it doesn’t change much in the short-term, almost certainly increases at least a little in slumps. At best, we don’t know the sign of the response, and it’s a little weird to use a diagram that relies on a particular sign.

      I too like to talk about “liquidity” specifically rather than money, even though people sometimes use “money” expansively to describe both liquid assets in general and base money. I find the latter practice exceedingly confusing, and I think it leads to all kinds of bad reasoning. Liquid (and riskless) assets in general are very different from base money—for one thing, the Fed conventionally adjusts monetary policy by manipulating the spread between the two. If we used “money” in the more expansive sense, open market operations would simply be a trade of money for money, leaving no change in the aggregate supply of money (except a small impact on transactions accounts, whose reserve requirements are now less costly). This strikes me as a very confusing depiction of monetary policy.

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  8. BH

    Does the recession generate the increased demand for liquidity – or does the increased demand for liquidity (*not met by an increased supply by the central bank*) generate the recession?

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