A couple of things

1) All Keynesian models assume the same basic dyanmics in the background. Whether we choose IS-LM, or IS-MP, or IS-PC-MR or what I am pushing here, BL-MP, is really just about terminology and helping us easily relate what happens in the real world to what happens in the picture.  The deep underlying models are all the same.

2) By focusing our attention on bank lending we can see a couple of things

  • A liquidity trap is better described as no worthwhile lending opportunities rather than animal spirits causing a drop in borrowing. This is because the risk premium is so high. This could be because of real factors or it could be because bank balance sheets are all torn up and they cannot afford to take risks.

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  • Government borrowing changes the game not because of marginal propensities to consume but because the government is a different type of borrower. The government is always a good credit risk. Indeed, in a world where reserves are swapped for government bonds the government can’t not be a good credit risk.  Thus I rise in government borrowing suddenly makes overall lending safer and the BL curve moves out.
  • Governments which may directly default (rather than inflate) lose traction on the BL curve. It is not at all clear that Greece can move the BL curve.
  • Banks have a special role in the economy such that a trillion dollar loss by banking institutions is a much different thing then a trillion dollar loss by households. Dot-Com vs Subprime.

3) Raising inflation expectations works by making lending safer and pushing out the BL curve. Holding the Fed Funds rate constant higher inflation means that each borrower is more likely to be able to pay back any loan at any given interest rate for any give project.

I like this because it helps nominalize our thinking. Too much thinking – in my opinion – is done in real terms. What’s the real interest rate? What’s the real return on investment?

Does this actually matter in the world we live in? The opportunity cost of funds simply is the federal funds rate. As long as the overnight lending market is functioning, nothing in the real economy can change that. Thus an expanding nominal economy – what ever the source of the expansion – makes it a better idea to lend.

There are some other things I think could be worked out but this is the basic idea.

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