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I am going to present a standard macroeconomic model called IS-LM to give us some perspective on the current economic situation. This post is part 1, which will cover the IS part of the model and over the next couple days I will post part 2 on the LM part and how the IS and LM interact. (As a disclaimer, I should say that I first heard about IS-LM through Paul Krugman, but I honestly had a little trouble understanding his post on it, so I thought I'd write one for the lay audience now that I have studied it more. But you can certainly check out Krugman's explanation too.)
Before starting, you will need to understand how bonds work to understand the IS-LM model. For a quick overview see my previous post on bonds and quantitative easing.
On to IS-LM!...
What is IS-LM?
IS-LM is a model that helps think about the economy as a whole and find out how the market for goods and services interacts with the money market (bonds essentially). IS stands for Investment-Saving and LM for Liquidity-Money. It should be stated at the start that like any model, this makes simplifying assumptions to get a basic grasp of what is going on in the economy and is not a magic tool that can scientifically calculate to the nth degree. Nonetheless, it allows us to make some basic predictions and see if they are true.
What IS-LM shows is the approximate interest rate in the economy and the level of GDP. Different interest rates will have different effects on the level of GDP. Likewise, a change in GDP can change the interest rate. If you are unsure what exactly I mean by "interest rate," since I'm speaking rather generally, read on and you will see what it means.
The IS part of the model has to do with the market for goods and services, i.e. cars, doctor visits, IPods, and so on for everything in the economy. Specifically, we want to look at it from a company's point of view. A company will only invest in a project if it can get a reasonable return on its investment. So let's take an imaginary company, Company X, and four projects it is thinking of funding:
Project A: Company X expects to get a 10% return on its investment, i.e. for every $100 invested it will make a profit of $10.
Project B: 8% return expected
Project C: 6% return expected
Project D: 4% return expected
Company X then needs to borrow money from a bank or other lender to fund its project. Once it makes a profit it can pay back the bank with some profit still intact. As Company X looks for a loan it finds the going interest rate is 7%. (In reality, there is no one single interest rate, since every bank can loan at what interest rate it wants. But market forces cause interest rates to more or less be in the same ballpark. For simplicity's sake, we are assuming that there is one interest rate).
Company X sees that Project A will make a 10% profit, so it can pay back the 7% interest and still make a profit. The same is true of Project B. But Projects C and D both have investment returns of less than 7%, so if Company X purses these investments it will lose money. So Company X funds Projects A and B.
The important point is that if the interest rate had been lower, say 3%, then all four projects would be funded. If the interest rate had been ridiculously high, say 11%, then none of the projects would be funded. In the big picture then, as interest rates on loans increase, investment (and thus GDP) decreases. As interest rates on loans decrease, investment (and thus GDP) increases. GDP is really what we are after.
We can represent this graphically with interest rate on the y-axis and GDP on the x-axis:
What does this have to do with the current economy?
Right now, interest rates are incredibly low. The Federal Reserve has the federal funds rate, which is the rate it loans money to banks, at around .25%, so banks likewise have low rates. So why aren't companies investing in the economy if the interest rate is virtually zero? Because they don't think they can get a worthwhile return on their investment. Conservatives claim this is due to excessive regulation and taxation on profits, which I find hard to buy, but that's another story. I think a more realistic argument is that there is not enough consumer demand, so companies just don't see enough customers purchasing their product. High unemployment means people are spending less.
I have left a lot to explain, specifically the LM part of this model and how the IS and LM curves interact. That will come in my next post....
Adam Weiss blogs at politicalcreativity.net