Tag Archives: Monetary Theory

IS-LM and Making Sense of MMT

The core issue at the heart of debates between the heterodox Modern Monetary Theory (MMT) approach and more mainstream macroeconomics is how the financial economy and the real economy interact. As a consequence we see Keynesians of various hues attempting to illustrate their response to MMT with the standard orthodox Keynesian IS-LM model of the economy, which attempts to illustrate this interaction graphically.

The IS-LM model, as elaborated by various economists after Keynes, consists of upward and downward sloping curves in income (Y) and interest (r) space. (See Figure 1) The downward-sloping IS curve illustrates the inverse relationship between the cost of physical capital (summarised by r) and GDP (Y) where investment is assumed to be the major variable in the latter. The upward-sloping LM curve is a somewhat more complex concept but essentially proposes that given a fixed supply of money, a higher Y leads to a higher interest rate on bank deposits. This interest rate is assumed to feed through to the price demanded for financial capital in such a way that it can be considered as variable r for the purposes of the model.[1] The model is thus somewhat vague in what r is really standing for. Further criticism is that a fixed supply of money is an unrealistic concept; the quantity of money supplied in a modern monetary economy being endogenous to its demand. It is also pointed out that the model mixes up stocks (of money) and flows (of income). Despite these criticisms, the IS-LM structure has been used to characterise MMT ideas in terms of the slopes of the two curves – in its extreme a vertical IS curve (implying investment as independent from any rate of interest) and a horizontal LM curve (implying a technically unlimited supply of money).

Figure 1: The IS-LM Diagram?
Figure 1: The IS-LM Diagram

A Matching Flows Approach
A better way of approaching the real/money interaction might be to work from the viewpoint of two linked flows – that of money and that of its exchange counterparts. We start off with the economy in a steady state, with constant flows of money on one side and of real goods and services and speculative assets on the other. (See Figure 2) There is no distinction between consumer goods and services and productive capital goods in this model, since this is regarded as an arbitrary distinction between goods that have a spectrum of durability and of the timing of flows of utility and/or monetary return. What we will distinguish are goods purchased for use, and those (speculative assets) purchased for resale at (expected) higher prices.[2]

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