June 6, 2016

Getting out of IS-LM = Getting out of despair

Comment on Nick Rowe on ‘On Olivier Blanchard on IS-LM and Teaching Intermediate Macro. And my despair.’ and on Oliver Blanchard on ‘How to Teach Intermediate Macroeconomics after the Crisis?’

Blog-Reference and Blog-Reference on Jun 7 and Blog-Reference on Jun 13 adapted to context and Blog-Reference adapted to context

Blanchard concludes his article:* “Macroeconomics is a tremendously exciting subject. Most of what we taught before the crisis remains highly relevant. But it needs some dusting and updating. My hope is that a model along the lines above can contribute to it.”

Not so. IS-LM has always been methodologically unacceptable and its proper place is the Pet-Approaches Sematary. The attempts of Blanchard and Rowe to save it with “some dusting and updating” are purely ceremonial.

1. How Keynes got it wrong
Keynes formulated the formal core of the General Theory as follows: “Income = value of output = consumption + investment. Saving = income - consumption. Therefore saving = investment.” (1973, p. 63)

This elementary syllogism is conceptually defective because Keynes never came to grips with profit (Tómasson et al., 2010, p. 12). As a result, all I=S models and the Keynesian multiplier are false (2011).

2. Rectification
The Keynesian premises have to be replaced by the correct macrofoundations. This is achieved as follows.
A0. The objectively given and most elementary configuration of the (world-) economy consists of the household and the business sector which in turn consists initially of one giant fully integrated firm.
A1. Yw=WL wage income Yw is equal to wage rate W times working hours. L,
A2. O=RL output O is equal to productivity R times working hours L,
A3. C=PX consumption expenditure C is equal to price P times quantity bought/sold X.

For the graphical representation of this ABSOLUTE formal MINIMUM see 4-quadrant-chart on Wikimedia.

A1 to A3 asserts: At any given level of employment L, the wage income Yw that is generated in the consolidated business sector follows by multiplication with the wage rate W. On the real side, output O follows by multiplication with the productivity R. Finally, the price P follows as the dependent variable under the conditions of (i) budget balancing, i.e. C=Yw, and (ii), market clearing, i.e. X=O.

Under the conditions (i)|(ii) the price is derived in each period as P=W/R, i.e. the market clearing price is in the most elementary case equal to unit wage costs which vary over successive periods.

In the next period, the households save, i.e. condition (i) is now lifted. The result is shown here.

Consumption expenditures C fall below Yw and with it the market clearing price P. The product market is cleared due to (ii) and there is no such thing as an inventory investment, i.e. I=0. Monetary saving of the household sector is given by Sm=Yw-C.

The business sector makes a monetary loss which is  equal to the household sector’s saving, i.e. Qm=-Sm. Therefore, loss is the exact counterpart of saving; by consequence, profit is the exact counterpart of dissaving. This is the most elementary form of the Profit Law. It follows directly from the profit definition Qm=C-Ym and the definition of household sector saving.

The sector balances always add up to zero, i.e. Qm+Sm=0, and this is the correct accounting identity. Saving and investment are NEVER equal, neither ex ante nor ex post. Therefore: NO IS-curve ever existed. The elaborate interpretation of the IS-LM-nonentity over more than 70 years is on the same level as haruspicy, i.e. old Roman poultry entrails reading.

3. Generalization
The correct profit equation for the investment economy reads: Qm=Yd+I-Sm. Legend Qm: monetary profit, Yd: distributed profit, Sm: monetary saving, I: investment expenditures.

The DIFFERENCE between investment and saving I-Sm plus distributed profit Yd determine monetary profit Qm, which is measurable with two decimal places.

4. The employment equation/Phillips curve
From the differentiated axiom set A1 to A3 follows the structural employment equation which is given here.

From this equation, which is complementary to the structural Phillips curve (2012), follows: (i) An increase of the expenditure ratio rhoE leads to higher employment L (the letter rho stands for ratio). (ii) Increasing investment expenditures I exert a positive influence on employment, a slowdown of growth does the opposite. (iii) An increase of the factor cost ratio rhoF=W/PR leads to higher employment.

Item (i) and (ii) cover Keynes’s arguments about aggregate demand. What is missing in the Keynesian employment multiplier, though, is the ratio rhoF as defined in (iii). This variable embodies the price mechanism. It works such that overall employment INCREASES if the average wage rate W INCREASES relative to average price P and productivity R and vice versa.

The complete employment equation is a bit longer and contains in addition profit distribution, public deficit spending, and import/export. Investment and the interest rate for business loans Jb are connected via the elasticity Eb, and the household sector’s expenditure ratio and the interest rate for loans/deposits is connected via the elasticity Eh. Hence, the structural employment equation fully replaces what Blanchard advertises as his updated IS-LM-Phillips-curve model.

5. Conclusions
(i) All I=S/IS-LM models from Keynes/Hicks to Blanchard/Krugman/Rowe are provable false (2014).
(ii) The investment multiplier is formally defective since Keynes.
(iii) The classical and Keynesian profit theories are false.
(iv) The representative economist has NOT gotten (i) to (iii) until this day because of incurable scientific incompetence.

Egmont Kakarot-Handtke

Kakarot-Handtke, E. (2011). Why Post Keynesianism is Not Yet a Science. SSRN Working Paper Series, 1966438: 1–20. URL
Kakarot-Handtke, E. (2012). Keynes’s Employment Function and the Gratuitous Phillips Curve Desaster. SSRN Working Paper Series, 2130421: 1–19. URL
Kakarot-Handtke, E. (2014). Mr. Keynes, Prof. Krugman, IS-LM, and the End of Economics as We Know It. SSRN Working Paper Series, 2392856: 1–19. URL
Keynes, J. M. (1973). The General Theory of Employment Interest and Money.  London, Basingstoke: Macmillan.
Tómasson, G., and Bezemer, D. J. (2010). What is the Source of Profit and Interest? A Classical Conundrum Reconsidered. MPRA Paper, 20557: 1–34. URL

* See ‘How to Teach Intermediate Macroeconomics after the Crisis?

REPLY to Nick Rowe

You wrote: “OK Nick, but if you don’t like teaching IS-LM, what would you teach instead? Which is a perfectly reasonable question. Which is why I despair. Because what could I teach instead?”

The answer is in my post ‘Getting out of IS-LM = Getting out of despair’. With the structural axiom set A1 to A3 you get the CORRECT FORMAL MINIMUM. These macrofoundations fully replace both the obsolete Walrasian microfoundations and your apples-bananas-mangoes equilibrium model.

It seems that you cannot see the solution for your self-inflicted despair when it is right before your eyes. While it is perfectly understandable that you deleted my post in your analytical agony it would have been perhaps helpful for others if you had at least left a link standing, e.g. this.

After all, other desperate IS-LMers should also have a fair chance to make up their minds. It is of utmost importance to terminate IS-LM teaching once and for all.

For more on IS-LM see cross-references.