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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.

IS (Investment-Saving)

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:

Click here for graph

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

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Comment Preferences

  •  Businesses are holding on to cash because banks (3+ / 0-)
    Recommended by:
    AdamWeiss, Gooserock, Sandino

    Are not lending.  Small businesses can't get working capital and the housing market is not recovering because young couples can't afford that first loan.  Obama did to fix the banks and if we don't fix the banks we will stay stagnate for the next 20 years.

    •  Good point... (3+ / 0-)
      Recommended by:
      happymisanthropy, Gooserock, Sandino

      Part of what you are saying is another way to say consumer demand is low, i.e. consumers have less money.  About your first point, though, it's not just small businesses.  Large corporations do not have enough customers to sell to also.  

      •  Which is Why We Need to Punish Customers (2+ / 0-)
        Recommended by:
        Sandino, Pluto

        and reward producers.

        See, the economy is like your bathroom sink. When the drain gets clogged full of hair, there is a recession in water drainage.

        So the answer when there is a recession is to add tons and tons of extra water to the sink, which we do by increasing the supply. We turn on the faucet in the sink, we give tax cuts to businesses in the economy, so the supply will increase. And we cut support to the consumers so their hunger/demand will increase.

        The increased supply combined with the suction of starving downstream sections of pipe will eventually force the drain-blockage / recession to shoot through the pipes, and the economy will begin flowing again.

        You can't argue with that.

        We are called to speak for the weak, for the voiceless, for victims of our nation and for those it calls enemy.... --ML King "Beyond Vietnam"

        by Gooserock on Fri Aug 31, 2012 at 09:37:10 PM PDT

        [ Parent ]

        •  I'm assuming (1+ / 0-)
          Recommended by:

          you're sarcastic.  It would be a first if someone quoting MLK's great anti-war speech were a supply side economist.  On a serious point, I never can get my head around the idea that if you increase investment then somehow the economy will get better.  So according to this logic, businesses will invest even if they don't have customers to buy their products.  Maybe I need to understand supply-side better, since it can't be that simple-minded, but to ignore demand seems rather nonsensical.

          •  Simple explanation of Supply Side Economics (2+ / 0-)
            Recommended by:
            Pluto, AdamWeiss

            Supply Side economics is think-tank produced fake science, like creationism, promulgated to achieve a political end.  Has it ever struck you as strange that every economic malady can be solved, according to voodoo economics, by deregulation and tax cuts for the rich?  It is like the way all creationism research is carried out by reading answers in the bible.

      •  They have enough customers to accumulate several (0+ / 0-)

        trillion in cash.

    •  I realized... (1+ / 0-)
      Recommended by:

      part of what you say makes a lot of sense and deserves more attention, specifically about banks not lending.  I think you could make a good argument that the problem is rooted in lack of demand, but banks are choosy about who they will lend to because there is a lack of confidence that businesses will actually make sufficient profit and pay back the loan.

  •  Bubbles (3+ / 0-)
    Recommended by:
    Sandino, Pluto, AdamWeiss

    In a steady state economy we never spend enough money on development to stimulate growth. The economic bubble has been key. The essence of the bubble is that an irrational amount of money is spent chasing an imaginary potential profit. The result is the creation of jobs and the funding of the support structure around those jobs. We have been an economy of bubbles forever from automobiles in the early 1900s to radio to PCs to .com to the Bush real estate bubble. Our current economy is in a massive hangover from deleveraging the real estate speculative bubble. Compounding this is that there is no new bubble forming.

    There is only one way to get out of this mess. It's up to the government to create a bubble. This is absolutely fundamental as every civilization has grown by virtue of the organizing government creating opportunities and growth, in part, by building an infrastructure. We need a vision of what the future could be. It revolves around sustainability and a complete rebuilding of nations around a new model. It will be a combination of building new and renovating the old. Nothing will remain untouched and we will have a large shortage of labor to do this, (hint...we need immigrants). There are only two factors standing in the way of doing this. The first is lack of vision. Heh, we went to the moon on 1960s technology. The second is the Republican Party. These idiots will destroy this country trying to bring back a Reaganesque world that never existed. We are, in my mind, now standing at that fork in the road.

  •  I like this bit: (2+ / 0-)
    Recommended by:
    Pluto, AdamWeiss
    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.
    We can call this one rate LIBOR, and know that it is manipulated for profit and political gain. Just a few years ago it would have been the wildest CT to suggest that the bedrock rate for modern capitalism would bow to the mere needs of politicians or could be bent by a handful of banksters over brunch.

    Good start. The diary could have gone a bit farther in discussing the cause and results of the collapse in demand.
    Hopefully you will also eventually touch on how the domination of the Finance sector has shifted investment away from long-term investments in productive infrastructure towards high-risk casino capitalism, and schemes to loot and defraud the 'dumb  money' (read you, me, our gov'ts).

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