The Reformation in Economics by Philip Pilkington

Author:Philip Pilkington
Language: eng
Format: epub
Publisher: Springer International Publishing, Cham

We can demonstrate this graphically by flattening out the left-hand side of the LM-curve, as is done in many macroeconomics textbooks. We can see this in Fig. 7.8.

Fig. 7.8ISLM model w/liquidity trap

What the graph in Fig. 7.8 shows is that moving the LM-curve to the right-hand side will have no effect on the level of activity. It also shows that if we shift the IS-curve to the right-hand side, not only will we see an increase in income and economic activity but we will not see a rise in interest rates. Mainstream economists who support fiscal intervention in times of severe downturns like Krugman consider this to be a sort of free lunch situation. You can see this clearly if you look at the far right-hand side of the graph. When the IS-curve moves to this point, the normal ISLM emerges intact. Thus, outside of a liquidity trap, interest rates will rise if the IS-curve is pushed to the right and some borrowers (like, say, the government) will crowd out other borrowers (like, say, private firms).

It should be manifestly obvious why this is incorrect. As we have seen in Fig. 7.5, the LM-curve is always flat and so a rise in investment never leads directly to a rise in the money interest rate. If we turn back to Fig. 7.5, we must imagine that if the central bank raises or drops interest rates, they will merely move the LM-curve up or down rather than right or left. 22 So, provided we accept the shape of the IS-curve (for the purposes of this chapter, at least), we can still discuss the effect that shifting the LM-curve has if we take it to be a strictly independent policy function that moves up or down at the whim of the central bank rather than left and right. But clearly, talking about a liquidity trap leading to a situation in which increased borrowing and investment by, say, the government does not provoke a rise in interest rates is nonsensical because, given the manner in which modern banking systems are set up, an increase in borrowing and investment never leads directly to a rise in interest rates. 23 Even though some proponents of the liquidity trap argument, like Krugman in his 1998 paper, do use a slightly different model to the ISLM, they nevertheless come to make the same incorrect predictions as to what should happen when investment increases outside of a liquidity trap. In reality, once we accept endogenous money theory, then the LM-curve is always flat and the liquidity trap theory loses one of the legs on which it stands.

If you make the above arguments to many mainstream economists, they will look at you patronisingly and say that they know all this already. But listen carefully to that very same persons next time they talk about concrete policy issues and you will hear them quickly revert to all the old fallacies within just a few seconds. While it is true that the ISLM

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