Tag: ISLM analysis

There has been an interesting debate recently about whether the austerity policies being pursued in the UK are the correct ones. What would have happened if the government had pursued a more expansionary policy? Would the increase in borrowing, at least in the short term, have triggered a financial crisis?

Without austerity policies, would the eurozone crisis have led to a collapse in investor confidence in the UK, especially if Greece had been forced out of the euro?

On the one side, Kenneth Rogoff argues that increasing the UK’s budget deficit would have been dangerous and could have led to a flight from the pound. Generally, but with some reservations, he supports the fiscal policies that have been pursued by the Coalition.

I am certainly not arguing that the UK or other advanced countries handled the post-crisis period perfectly. There should have been more infrastructure spending, even more aggressive monetary policy and probably more ruthless bank restructuring. But there has to be a balance between stimulus and stability. To assume we always knew things would calm down, and to retrospectively calibrate policy advice accordingly, is absurd

Paul Krugman and Simon Wren-Lewis challenge Rogoff’s arguments. Paul Krugman uses a version of the IS-LM model to analyse the effect of a loss of international confidence in the UK following problems in the eurozone and worries about excessive UK borrowing.

In the model, the LM curve (labelled MP in Krugman’s diagrams) illustrates the effect of an increase in real GDP on interest rates with a particular monetary policy (e.g. an inflation target or a Taylor rule, which involves a mix of two policy objectives: an inflation target and real GDP). As GDP rises, putting upward pressure on inflation, so the central bank will raise interest rates. Hence, like the traditional LM curve, the monetary-policy related LM curve will slope upwards, as shown in the diagram.

Initial equilibrium GDP is Y₀. The rate of interest is at the minimum level, r₀ (i.e. the rate of 0.5% that the Monetary Policy Committee has set since January 2009). This, in the model, is the liquidity trap, where any increase in money supply (a rightward shift in the LM curve) will have no effect on interest rates or GDP.

In Rogoff’s analysis of a crisis triggered by excessive borrowing and problems in the eurozone, the IS curve will shift to the left (as illustrated by curve IS₁) as capital flows from the UK and confidence collapses. Real GDP will fall to Y₁. This will be the outcome of fiscal expansion in the world of the early 2010s.

Krugman argues that the opposite will occur. The outflow of capital will drive down the exchange rate. This will lead to an increase in exports and a decrease in imports. Aggregate demand thus rises and the IS curve will shift to the right (e.g. to IS₂ in the diagram. Real GDP will rise (e.g. to Y₂ in the diagram). If the rise in aggregate demand is sufficient, the economy will rise out of the liquidity trap and interest rates will rise (e.g. to r₂ in the diagram).

Not surprisingly, Rogoff challenges this analysis, as you will see if you read his second paper below. He doesn’t criticise the model per se, but challenges Krugman’s assumptions. For example, a depreciation of sterling by some 20% since 2008 doesn’t seem to have had a major effect in stimulating exports (see the chart in the news item, A balancing act). And exports could well have declined if the eurozone economy had collapsed, given that exports to the eurozone account for around 44% of total UK exports.

Rogoff’s assumptions in turn can be challenged. Simon Wren-Lewis argues that, provided a credible long-term plan for deficit reduction is in place, maintaining a fiscal stimulus in the short run, to keep the recovery going that was beginning to emerge in 2010, would help to increase investor confidence, not undermine it. And, with a policy of quantitative easing, which involves the Bank of England buying central government debt, there is no problem of a lack of demand for UK gilts by the private sector.

What is clear from this debate is the willingness of both sides to accept points made by the other. It is an extremely civilised debate. In fact, it could be seen as a model of how academic debate should be conducted. There is none of the ‘shouting’ that has charaterised much of the pro- and anti-austerity lobbying since the financial crisis burst onto the world stage.

Britain should not take its credit status for granted Scholars at Harvard from Financial Times, Kenneth Rogoff (3/10/13)
Ken Rogoff on UK austerity mainly macro, Simon Wren-Lewis (3/10/13)
Phantom Crises (Wonkish) The Conscience of a Liberal, Paul Krugman (3/10/13)
Three Wrongs do not make a Right Scholars at Harvard from Financial Times, Kenneth Rogoff (7/10/13)
Is George Osborne really a hero of global finance? The Guardian, Robert Skidelsky (24/10/13)

Questions