Tuesday, August 19, 2008

The 'Great Moderation' in an IS/LM Model with Full Employment

What explains the sustained nature of low inflation in the advance economies--and to a lesser extent in the emerging economies--since the end of the 'Great Inflation'? William White has a recent paper that takes a looks at this question. In it, he evaluates the standard reasons given for the ongoing low inflation: (1) better monetary policies, (2) increased deregulation and competition in domestic markets, (3) increased globalization, and (4) a global saving glut. White concludes that no one reason can explain the sustained drop in inflation. He does, however, believe that a broader story that involves these factors acting in a complimentary manner can explain the facts. Interestingly, he weaves a story using these factors with the help of an IS/LM model that has a vertical full employment line, such as the one used in the Abel/Bernanke/Croushore textbook:
Perhaps the key to a better understanding is to recognise that the character of the shocks hitting the global economy has changed over time, and that some forces affecting inflation have been more important at some times than others. Demand side factors, driven largely by domestic monetary policies, seem to have been central to macroeconomic developments in the 1970s and 1980s. Gradually, however, supply side elements, arising from both domestic deregulation and globalisation, have risen in importance. Consider both the early period and the later period in turn, using as the basic analytical framework a global model of the traditional IS/LM sort, with a vertical real output line at full capacity.

It seems generally agreed that the rise in inflation in the ICs in the late 1960s and 1970s was a by-product of excessive demand, fuelled in many countries by expansionary monetary policies and a failure to recognise how easily inflation expectations might rise. In effect, the LM function shifted to the right, raising aggregate demand and pushing up inflation. While oil price increases are commonly thought to have arisen from supply side shocks, in fact the sharp increases in prices in the early and late 1970s were in large part discrete upward adjustments to re-establish earlier relative prices that had been eroded by generalised inflation.34 Inflation was brought down quite rapidly in the early 1980s by a sudden, sharp tightening of monetary policy. In both the expansionary phase and the contractionary phase of policy, real growth and interest rates moved in a fashion consistent with nominal forces being behind the observed outcomes. That is, inflation rose when demand exceeded potential (estimated on the basis of earlier “normal” growth rates) and fell when growth receded. Interest rates also rose as the expansion proceeded, first only in nominal terms (real rates actually fell) but then rose sharply in real terms as well. After inflation did begin to decline in the early 1980s, nominal rates fell as did real rates, but with the latter declining more slowly.

Explaining the more recent phenomenon of continuing low inflation, in spite of rapid real side growth and continuing low interest rates, demands recourse to all of the arguments above. In effect, it is necessary to postulate changes in all three functions of the model to obtain all three of the observed results. For simplicity, assume here that inflationary expectations are fixed although they would most likely be biased downwards during any period of excess supply. Begin by accepting the assumption of disinflationary pressures arising from some combination of increased domestic deregulation and competition, increased global competition and higher productivity. This provides an explanation for a rightward shift in the real output (aggregate supply function). Then consider the “saving glut” hypothesis, or perhaps more accurately the “investment strike” hypothesis. This constitutes a downward shift in the IS curve, leading to a transitional phase of output being below potential, thus accentuating the disinflationary pressures arising from supply side developments. Finally, in response to these developments, one must postulate a rightward shift in the LM function. In effect, more effective (expansionary) monetary polices lower interest rates, inducing an additional expansion of demand, determined by the slope of the IS curve, until in equilibrium aggregate demand and supply are once equal at full employment. This occurs at a higher level of output, with no further pressure on prices, and with the real interest rate at a lower level than previously.
Does this seem like a reasonable interpretation to you? And do you like the use of the IS/LM model with the full employment line?


  1. I like the IS-LM framework when teaching because it provides a decent visual example of the interactions in an easy-to-understand general equilibrium framework. However, it is substantially difficult to try to explain several changing factors in a dynamic system using a static diagram.

  2. Like any model, it is good for illustrating - though not explaining - some issues. For example, the inflation - then-disinflation of the 1970s and 1980s.
    But I dont think it is of much use for enlightening us on the asset price boom and subsequent bust of Japan or the ongoing 20-year asset boom and bust of the US.
    Why does excess credit sometimes dissipate in goods market inflation and sometimes in asset market inflation? The model is silent.
    And why would you want to foist on students the LM curve in an endogenous money world where the banks set credit supply and the Fed supplies whatever base is needed ?
    To a large extent, I think Fischer Black's argument that today money supply and inflation are not well-determined is accurate. See his Journal of Finance article, "Noise"
    on that.