What’s the Minimum Needed to Make a Macroeconomic Model

Updated a bit for clarity, since this post is purely a product of my own mind and might otherwise be really confusing if I didn’t check over it. There are still tons of mistakes I am sure, but hopefully its readable.

Paul Krugman says

[IS-LM] makes it clear that what we’re basically doing is the minimal model that has goods, bonds, and money — that there is nothing arbitrary about the whole thing, that this is basically what you have to do if you want a minimal model of the things that matter for short-run macro. Mark reminds me, by the way, that I published a paper on all this (pdf) a decade ago; you know you’re getting old when you don’t remember all the papers you’ve written.

Except do you really need goods, money and bonds? What about goods, money and banks.

Well, banks and bonds are basically the same thing you might say. My reply is that they are kind of the same thing, but not quite and to the extent they are different the world acts more like its banking matters.

So, why adopt an inferior set of terms? I fully admit we are all talking about the same basic process.

However, IS-LM would make it harder for you to describe what was going on in the Great Recession and indeed, if you took the labels too seriously would have been difficult for you to predict its severity.

On the other hand BL-MP would have led you to think that the end of the world may very well have been nigh.

You could have tried to explain 2008 as a rapid increase in liquidity demand, in which case short term nominal interest rates should have spiked. We have a little of that but not much.

That implies that all of your action could not have been on your LM/MP/MR curve. As you move that curve output and interest rates ought to go in opposite directions.

However, out put was collapsing as interest rates were collapsing. That tells us the action is happening on the opposing curve.

But, how do you make that make sense with IS, per se? You could say that animal spirits for investment dropped off or you could say that desired savings skyrocketed. None of those I think fits the timing.

Here are Total Financial Assets of Households. Its tanking

Yeah, yeah, but that is influenced by stock prices. Okay, lets take out stock prices.

Maybe its just deposits that matter, at least those are rising.

Though take a step back and see that nothing unusual is going on here.

Okay maybe its animal spirits. Planned investment declined, driving the IS curve down.

Now at least we are getting some movement in the right direction. Still I think the timing tells another story. For example, retail sales drops off before New Orders.

Is our story that forward thinking consumers for saw an otherwise unexplained drop in planned business investment? Maybe. But, if so what did they see. At this point we are probably already telling some story about banks.

There is another problem with thinking in terms of planned investment being the driver. It wasn’t worse than Dot-Com.

But Housing Investment you say, I am forgetting the drop in housing investment. Nope. We can look at this a couple of ways. The common way and the one I prefer. Lets start common by looking at Residential Fixed Investment.

Over our five year horizon you see no change in the path. RFI had peaked in 2005.

If anything decline slows slightly just as the US is beginning recession.

We can back up a pit and add my preferred indicator of residential investment, construction spending. It is monthly and does not include net purchases of existing structures or brokers commission’s  on existing structures.

So I am not sure what simple story we tell about IS curve that makes sense of all this. We can of course always say that such-and-such happened in the financial markets and that influenced investment.

However, I think we are going to be tempted to move the LM curve when we think about financial markets and that doesn’t explain why we get interest rates – both real and nominal – and output declining at the same time.

We can tell a very straight forward story about the BL curve. If we look at a measure of the tightness of lending standards, its rising (above zero) and at an accelerating rate as we go into the recession.

I am going to switch to bar graph because zero is a significant number here. Zero indicates just as many banks tightening and loosening standards.

We see lending standards tightening just as the recession starts completely consistent with the BL story. This tells you the BL curve is on the move, irrespective of what savers or investors plan to do.

And what happens if the BL curve is contracting? Interest rates are going down at the same time that output is going down.

Lets zoon out to get some perspective.

Even though this is just a diffusion index and doesn’t tell us anything about how much tightening is going on just what fraction, it still tells us immediately that the Great Recession was a different beast. For one thing, standards tighten more severely and more quickly. For another, they tighten immediately for consumers, foreshadowing, the historic drop in retail sales.