Has Krugman Finally Turned On ISLM?

By Philip Pilkington

Back in 2013 Paul Krugman, as part of an ongoing debate with MMT/MMR advocate Cullen Roche, said that the ISLM is not a good approach to macroeconomics. Hurrah! Right? Well, maybe not.

islm.wiki

In fact, New Keynesians do not generally use the ISLM in its original form any more. A good example of this is a paper by David Romer entitled Keynesian Macroeconomics Without the LM Curve. What Romer does in that paper is essentially replace the classic LM curve in the ISLM with a Taylor Rule interest rate target.

From a Post-Keynesian/MMT perspective this is certainly more accurate than the classic ISLM, but it raises considerable problems of it own. As the Post-Keynesian monetary economist Marc Lavoie writes in his paper Money, Credit and Central Banks in Post-Keynesian Economics this is just “old wine in new bottles".

The problem with the Taylor Rule is that it rests on the implicit idea of a natural rate of interest which was rejected by Keynes in the General Theory when he wrote:

In my Treatise on Money I defined what purported to be a unique rate of interest, which I called the natural rate of interest - namely, the rate of interest which, in the terminology of my Treatise, preserved equality between the rate of saving (as there defined) and the rate of investment. I believed this to be a development and clarification of Wicksell’s “natural rate of interest", which was, according to him, the rate which would preserve the stability if some, not quite clearly specified, price-level. I had, however, overlooked the fact that in any given society there is, on this definition, a different natural rate of interest for each hypothetical level of employment. And, similarly, for every rate of interest there is a level of employment for which that rate is the “natural" rate, in the sense that the system will be in equilibrium with that rate of interest and that level of employment. Thus it was a mistake to speak of the natural rate of interest or to suggest that the above definition would yield a unique value for the rate of interest irrespective of the level of employment. I had not then understood that, in certain conditions, the system could be in equilibrium with less than full employment.

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