Tag Archives: Austerity

UK Think Tank Says Deficit Paranoia Increases Debt

A think tank in the UK has pointed out (as the IMF did in less vocal tones about Europe as a whole) that focusing on reducing government deficits is actually leading to greater debt.  The UK has taken an approach of tax increases and spending cuts to keep debt from going too high.  But the reduction in consumer spending from taxes and reduction in government spending has slowed economic growth, meaning that there is a smaller tax base from which to generate revenue.   The typical Keynesian picture seems vindicated: the government should spend in hard times, and save in good times.  Important to keep in mind here in the US when conservatives (and many Democrats too for that matter) talk about cutting government spending.   Granted Republicans won’t raise taxes, but as I have repeated over and over on this blog, they aren’t serious about cutting deficits either.  But for the sake of argument, let’s assume they did cut spending significantly.  Especially if the economy is in its current state, then that would slow down growth, decreasing the tax base…you get the idea.

A Basic Macroeconomic Model Tutorial: IS-LM Part 2

This is part 2 of an overview of the IS-LM economic model and how we can use it to understand today’s economy.  Read part 1 here.

In my last post, I described the IS (Investment-Saving) part of the IS-LM model.  Remember that the IS-LM model demonstrates the relationship between the interest rate and GDP.  The main point to draw from that was that as the interest rate rises GDP declines, because companies are less inclined to borrow money for investment.  Now onto the LM side…

What is LM?

LM stands for Liquidity-Money.  This refers to the financial market, i.e. the demand for money.  More specifically, it refers to the bond market.  (See my post on the Fed for an overview of how bonds work.)  If the economy is not doing well, there will be low demand for money by businesses for investment.  They will use their excess money to  buy bonds so that their money can earn interest rather than be idle.   (Bonds are primarily held by the federal government, but there are municipal bonds and corporate bonds.  For our purposes, I will refer only to US government bonds).  This is where liquidity comes in.  Liquidity simply means that money can be spent for various purposes (the same way a liquid can move around easily).  So if the the economy is bad and money is stored in bonds, liquidity is low.  On the other hand, if the economy is doing really well, liquidity is high because there is a high demand for money, meaning a low demand for bonds.

As we did with the IS aspect of the model, we need to examine the role of the interest rate.  If the demand for money is high and everyone is selling bonds, the government will increase interest rates to give banks and businesses more incentive to store money in bonds.  (The Fed also does this to keep inflation low.)  Let’s lay this out in more detail as an events chain, bringing in GDP.  GDP can increase by a variety of forms, but let’s imagine the economy improves and businesses increase their level of investment:

investment increases –> GDP increases –> increased demand for money –> decreased demand for bonds –> increase in the interest rate

And of course the opposite is true (and more relevant for our current economy)

investment decreases –> GDP decreases –> decreased demand for money –> increased demand for bonds –> decrease in the interest rate

In this last example, why does the interest rate decrease?  Because more businesses are seeking to store their wealth in bonds, so  the government can decrease the amount it pays on those bonds.  Just as it has to offer a higher interest rate as an incentive if demand for bonds is low, it can reduce this incentive when the demand for bonds is high.

Absolutely Key Point: As GDP increases, so does the interest rate.  As GDP decreases, so does the interest rate.

But if we remember the IS part of the model,the interest rate and GDP are inversely proportional.   How do we reconcile this with the fact that in the financial market (LM) the interest rate and GDP are positively correlated?  Just like supply and demand, we need to find an equilibrium rate of interest and level of GDP.  In other words, we need to find both an interest rate and GDP level where the market for goods and services is in equilibrium with the market for money.

Let’s look at some visuals to spell this out more.  Leaving aside GDP for the moment, the chart below shows how the interest rate is determined by the interplay of the supply and demand for money.

In the short run, the money supply is considered to be fixed, hence it is a vertical line.  If demand for money is high, then the interest rate will be low and vice versa.  The letter “i” indicates the equilibrium interest rate in the financial market.  Let’s chart out one of the events chain from above:

investment increases –> GDP increases –> increased demand for money –> decreased demand for bonds –> increase in the interest rate

The economy is growing leading businesses to increased demand for money for investment.  This will cause the money demand curve to shift rightward.  The government will raises the interest rate to offer an incentive to hold bonds, leading to new interest rate i2.  Notice that i2 is the equilibrium rate balancing the supply and demand of money.

Now let’s take GDP into account to make our LM curve.  Remember that MD1 and MD2 correspond to two different GDP levels and two different interest rates.  At the intersections of i1 and GDP1 and i2 and GDP2 we have are two points to draw our LM curve.

Combining the IS and LM Curves

We saw previously that the interest rate and GDP are inversely proportional in the IS part of the model.  So let’s add that to our chart above on the right.  Note i(e) and GDP(e) are the equilibrium interest rate and equilibrium GDP level, balancing both the goods market and financial market.

How can we explain today’s economy?

Let’s start with the financial crisis in 2008.  It was obviously a very complicated affair that this model can only address at the simplest level.  But it gives a good overview of the basics.  I’m actually going to go past the immediate crisis to the subsequent decline in GDP that was most pronounced in 2009.  Here are some event chains with corresponding graphs that culminate in an IS-LM chart.

investment decreased  —> GDP decreased

For any given interest rate, the amount of money businesses were willing to invest dropped off significantly, leading to a GDP decrease.

This spilled over into the financial market…

GDP decreased –> demand for money decreased –> interest rate decreased

MS = money supply, which is fixed in the short run

Then the Federal Reserve lowered the interest rate close to zero.  This is where we have to keep in mind that there is more than one actual interest rate, but market forces keep them in the same ballpark.  In this case, the Fed reduced the rate it lent money to banks, to encourage banks to lend out more freely for investment.  This is essentially the IS side of things, i.e. reduce interest rates so it costs businesses less to invest.

At the same time, the interest rate on bonds decreased, because higher demand for bonds –> increased bond prices –> decreased yields.  In any case, the Fed wanted bond interest rates to be low to encourage businesses to spend money instead of storing it in bonds.

But the real crux, and what makes our current economic situation so unique, is that interest rates have been reduced to almost zero and the demand for money (to invest) is not increasing.  What this also means is that if the Fed were to increase the interest rate, investment would go down even more since the cost of borrowing would be higher andit would hardly increase the demand for bonds since that is where businesses are storing their money anyway.  Even if the demand for bonds did increase, the price of bonds would increase more, bringing the yields back down close to 0%.

So what this means is that the LM curve is flat at zero and will only rise (as normal) when GDP is higher.  But for the IS and LM curves to be in equilibrium at an interest rate above zero, the IS curve needs to shift far to the right.  This is demonstrated by a graph from Paul Krugman’s blog:

So what can get the IS curve to the right?  Increasing the money supply through buying of bonds (quantitative easing) will do very little, if anything, to shift IS right.  Investment will increase if businesses have more opportunities to make a good rate of return.  Such opportunities can be created by increasing consumer spending or government spending or decreasing taxes on both consumers and businesses.  Conservatives claim it’s taxes and excessive regulation that keep investment down, but are taxes or regulation significantly higher than before the crisis?  Of course not.  But if the government increases short-term spending to boost the economy, that will begin a cycle that will increase investment.

Perhaps an even more important lesson of this model is to think about what austerity measures do.  Let’s say conservatives get their way and government spending is cut to try to reduce the deficit.  The IS curve will shift to the left and, in all likelihood, the decline in tax revenues due to smaller GDP can increase the deficit. Worse yet, it will take that much more effort to shift the IS curve back to the right.

Government spending now will restart the economy and when the IS and LM curves intersect near full employment, the government can then reduce expenditures since the private sector will be willing to invest again.  It is intuitive to fear increasing the debt even more now, but as Paul Krugman points out in his recounting of the Washington D.C. babysitting co-op, if everyone saves at the same time the economy goes nowhere.

For those interested in learning more about the IS-LM model, check out Krugman’s blog post about it.  If you have the patience, there is an excellent  youtube tutorial series by a professor at the University of South Africa.