By Isaac Kim
March 16, 2022
The
IS-LM framework has fallen out of fashion in the economics sphere for its
simplicity. Some argue that it cannot account for future recessions, thus
dismissing its utility. Others say that it is outdated by the superior models
used by the Federal Reserve. While these grievances could be valid, this blog
seeks to explore how this framework can still be used to explain certain
economic trends.
Since
the COVID-19 pandemic started, the Federal Funds Rate has been operating at a
near zero figure. (Figure 1) The rationale behind this was to stimulate
borrowing (and thus spending) in the economy, spurring economic growth in a
time of future uncertainty. This has had rippling effects across the economy,
and only now are we seeing the effects of that policy (due to policy “lag”) in
factors like inflation. However, in the case of bond yields, they are unusually
high and rising despite the low interest rates. (Figure 2) This is the opposite
of what one would expect since lower interest rates require lower discount rates
thus increasing bond prices and decreasing bond yields.
Some
economists argue that this is due to an increase in global saving due to the
fears of recession from the pandemic. An increase in saving is an increase in
investment which in turn increases the demand for buying bonds. An increase in
the demand of bonds should increase bond yields. Other economists argue that
excess liquidity is at play. With these low interest rates and stimulus checks
and their effects finding their way into the economy, this theory could also be
sound. As interest rates lower and money supply increases, this should increase
nominal GDP. A higher output from higher liquidity means inflation, and asset
and bond prices should go down (bond yields should go up) to combat the inflation.
To
distinguish which explanation could be at play in this current climate, the
IS-LM framework comes in handy. A look at Figure 3 shows both theories at work.
A decrease the demand for goods and services from increased savings shifts the
IS curve down, and a movement along the LM curve brings the new equilibrium GDP
and interest rates down. This is somewhat incorrect since nominal GDP has
increased in the last year. Also, this does not account for factors like the
stimulus checks which could also boost GDP. The second theory holds up well
under scrutiny. An increase in the money supply from low interest rates and the
stimulus checks increases the LM curve up and a movement along the IS curve
decreases the interest rates and increases the GDP. This is more alike reality
where nominal GDP has risen. Using this framework, one can see that the bond
yields have increased due to excess liquidity. Perhaps the United States
Treasury is using the higher yields to incentivize investors to buy bonds to curb
inflation.
Several conclusions can
be drawn from this case study. First, the stabilization policies used to fix
this excess liquidity will be difficult to map since policy lag is at play.
This means that these historically low interest rates will ripple out into the
economy and future and plans on what to do will be difficult to know if their
effects are still not known (as aforementioned, we are only now seeing the
start of inflation grip the nation). Second, changes in interest rates should
lead to movements along the LM curve and increase nominal GDP. Third, investors
will continue to lower prices of bonds by not investing in them and in turn
increase yields. Fourth, expansionary monetary policy through the lowering of
interest rates could increase the danger of a liquidity trap. Fifth, as long as
the United States remains loose with their monetary policy and the global
economy becomes more interconnected, global liquidity will continue to rise.
Lastly, this historical account displays the usefulness of the IS-LM model and
its ability to describe current events. Perhaps in the future, economists will
not be so quick to dismiss it.
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