April Fools' Festival Day XVI: No, Steve Keen Doesn't Know What He Is Talking About. Why Do You Ask?

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From the Archives: Paul Krugman:

Minunderstanding IS-LM: Some readers have asked me to reply to this Steve Keen piece claiming that I don’t understand the IS-LM model. Sigh. I really don’t want to spend time fighting against people with whom I don’t really have a current policy disagreement — and this is so silly, besides. But to satisfy those who are for some reason nervous, here’s a brief explanation of why somebody doesn’t understand IS-LM.

Keen starts from a picture I drew to illustrate the nature of a liquidity trap. He then says, aha! The IS market is out of equilibrium when we’re in a liquidity trap, but Krugman writes as if it were in equilibrium! Gotcha!

Um, it pays to read the labels. Those savings and investment curves are what the supply and demand for funds would be if the economy were at full employment. They’re not the curves that actually apply when the economy is operating below full employment. In the IS-LM model, the quantity of funds supplied is always equal to the quantity of funds demanded — because the level of output adjusts. This is true both when the zero lower bound applies and when it doesn’t.

In fact, that’s the essential insight of IS-LM: both liquidity preference and loanable funds are true, which is possible because both the interest rate and income are adjusting variables. Hicks could have told you that; in fact, he did.

So what Keen thinks is a big logical fallacy on my part is just a failure of reading comprehension on his part.

Look, IS-LM could be all wrong; but I am accurately reflecting the way that model works. And while I am not infallible, I have done a lot of economic modeling in my time; if you think that I’ve made an elementary logical error, you might want to check your reasoning very carefully before going with it.

So can we get back to serious stuff?