Is there an IS-LM Curves For Dummies?
Jan. 26th, 2012 12:50 am![[personal profile]](https://www.dreamwidth.org/img/silk/identity/user.png){kind=small}
koganbotMy understanding of economics is so primitive that I don't even have a good idea of what I need to know but don't. But beyond the basic "supply and demand" stuff, I'd say the crucial concepts one needs to understand right now are (a) cumulative advantage and (b) IS-LM curves. The first I grasp so well — or think I do, anyway — that I wrote about it for the Las Vegas Weekly. But the latter is something I'm not yet close to understanding. I gather it's a critically important technical elaboration on one of Keynes' most crucial ideas and that it's a model that reconciles two apparently contrary stories of what determines interest rates ("reconciles" may be the wrong word: the IS curve gives you one set of possible interest rates, the LM curve gives you another, and where the two intersect is where you'll get your interest rate). Also, it's a model, not a law, but it's one that helps us understand the situation we're in — except that I'm not yet one of the "we" who understand it.
Paul Krugman wrote a blog post last October attempting to explain IS-LM to people like me ("IS-LMentary"), but the explanation still contained too many ellipses — too many points I needed explained further, or at least that I hadn't yet been able to see into. My greatest difficulty was with his explanation of the LM ("liquidity-money") curve. I've bolded the two sentences that were just too condensed for me. If there's anyone who would like to walk me through them real slow, pointing out all the notable sights and features, please do so. Or maybe you could direct me towards someone who can explain this more thoroughly than Krugman did in that post. (I assume it's in some textbooks; but also, if Krugman can't explain it easily, it's probably not easily explainable — not to me, anyway.) Krugman:
Meanwhile, people deciding how to allocate their wealth are making tradeoffs between money and bonds. There’s a downward-sloping demand for money — the higher the interest rate, the more people will skimp on liquidity in favor of higher returns. Suppose temporarily that the Fed holds the money supply fixed; in that case the interest rate must be such as to match that demand to the quantity of money. And the Fed can move the interest rate by changing the money supply: increase the supply of money and the interest rate must fall to induce people to hold a larger quantity.
Here too, however, GDP must be taken into account: a higher level of GDP will mean more transactions, and hence higher demand for money, other things equal. So higher GDP will mean that the interest rate needed to match supply and demand for money must rise. This means that like loanable funds, liquidity preference doesn’t determine the interest rate per se; it defines a set of possible combinations of the interest rate and GDP — the LM curve.
My problem is that I'm not understanding the word "must," as in "the interest rate must be such as to match the demand to the quantity of money" and "increase the supply of money and the interest rate must fall to induce people to hold a larger quantity." Why "must" rather than "should" or "we would want it to"? That is, if I could explain why this does happen, why the interest rate matches the demand to the quantity of money in the first case and why the interest falls in the second case, I would probably understand the concept. I assume that this is crucial to know, and if I don't know it I won't really have a clue what the Fed is doing that determines interest rates. Also, when someone uses the term "interest rate," I'm not always able to answer the question, "Interest rate on what?"
Paul Krugman wrote a blog post last October attempting to explain IS-LM to people like me ("IS-LMentary"), but the explanation still contained too many ellipses — too many points I needed explained further, or at least that I hadn't yet been able to see into. My greatest difficulty was with his explanation of the LM ("liquidity-money") curve. I've bolded the two sentences that were just too condensed for me. If there's anyone who would like to walk me through them real slow, pointing out all the notable sights and features, please do so. Or maybe you could direct me towards someone who can explain this more thoroughly than Krugman did in that post. (I assume it's in some textbooks; but also, if Krugman can't explain it easily, it's probably not easily explainable — not to me, anyway.) Krugman:
Meanwhile, people deciding how to allocate their wealth are making tradeoffs between money and bonds. There’s a downward-sloping demand for money — the higher the interest rate, the more people will skimp on liquidity in favor of higher returns. Suppose temporarily that the Fed holds the money supply fixed; in that case the interest rate must be such as to match that demand to the quantity of money. And the Fed can move the interest rate by changing the money supply: increase the supply of money and the interest rate must fall to induce people to hold a larger quantity.
Here too, however, GDP must be taken into account: a higher level of GDP will mean more transactions, and hence higher demand for money, other things equal. So higher GDP will mean that the interest rate needed to match supply and demand for money must rise. This means that like loanable funds, liquidity preference doesn’t determine the interest rate per se; it defines a set of possible combinations of the interest rate and GDP — the LM curve.
My problem is that I'm not understanding the word "must," as in "the interest rate must be such as to match the demand to the quantity of money" and "increase the supply of money and the interest rate must fall to induce people to hold a larger quantity." Why "must" rather than "should" or "we would want it to"? That is, if I could explain why this does happen, why the interest rate matches the demand to the quantity of money in the first case and why the interest falls in the second case, I would probably understand the concept. I assume that this is crucial to know, and if I don't know it I won't really have a clue what the Fed is doing that determines interest rates. Also, when someone uses the term "interest rate," I'm not always able to answer the question, "Interest rate on what?"
no subject
Date: 2012-01-29 08:57 am (UTC)Also, when they say "interest rate", they basically mean general market interest rates. It's a catchall, really, for bonds.
The Fed screws around with money supply through open market operations - buying or selling bonds to the public - and this affects a variety of different interest rates, which are all put under the umbrella of "interest rate". This stuff gets a little confusing, and there's a lot of things in the banking system to study in order to understand exactly why the Fed can do this.
There seems to be more than one diagram
Date: 2012-01-29 03:00 pm (UTC)So, I'd say your answer to the question I posed in the title — "Is there an IS-LM Curves For Dummies? — is "No."
What's a good textbook that discusses IS-LM curves?
When I Google "Money Market Diagram" I get a whole lot of different diagrams.
Re: There seems to be more than one diagram
Date: 2012-02-09 04:07 am (UTC)Sorry for the late reply.
Re: There seems to be more than one diagram
Date: 2012-02-09 05:21 am (UTC)Drives me nuts too
Date: 2012-04-16 06:12 am (UTC)I dont get the very last bit:
increase the supply of money and the interest rate must fall to induce people to hold a larger quantity
Why 'induce'. If you shovel out more money, interest rates (price of money) go down; but this is caused by the supply and demand for money, not as something being done to 'induce' people.
Re: Drives me nuts too
Date: 2012-04-16 08:08 am (UTC)I actually got that Mishkin book that a commenter had recommended, got it through Inter Library Loan, but it turned out that what I'd ordered was the Business School Edition — which leaves out the IS-LM chapters as being not directly relevant to the students' interests. He recommends that those interested in that stuff get the regular edition.
But we're in luck. To compensate for this omission, he makes those chapters available on the Web! Prince of a fellow he is. Here's his site:
http://www.pearsonhighered.com/mishkin
Look for the Business School 2nd edition, go to "Companion Website," and then to "Student Resources."