Wednesday, February 16, 2011

The Economist: Low Long-Term Rates Caused by Easy Money, Not Higher Saving

The Economist argues that the IS-LM model is relevant in a low inflation environment and uses it to answer the question of whether low long-term interest rates are due to easy money or increased saving:

A working model, from The Economist print edition: When The Economist's economics editor studied macroeconomics in the 1970s, the basic model for understanding swings in demand was the so-called IS-LM framework, ... In recent years it has gone out of fashion, dismissed as too simplistic. That is a pity, for not only does the model seem more relevant than ever today, but it also casts useful light on why bond yields are so low...

[L]ong-term bond yields have fallen to historically low levels. ... The most popular explanation is that there is a global glut of savings, which has driven yields down. However, while some parts of the world, notably Asia, may save more than they need to, it is not obvious that the world as a whole is doing so. … An alternative explanation, preferred by some economists, is that bond prices, like other asset prices, have simply been pushed up by excess liquidity (ie, yields have been pushed down).

The IS-LM model helps us to understand these two opposing theories. ... The IS (investment/saving) curve represents equilibrium in product markets … The LM (liquidity/money) curve represents equilibrium in the money market … The point at which the two curves intersect is the only combination of output and interest rates (ie, bond yields) where both the goods and financial markets are in balance … The left-hand chart shows the economy in equilibrium at interest rate r1 and output Y1. If desired saving increases relative to investment (ie, there is excess saving), the IS curve shifts to the left to IS2. Interest rates fall (to r2), and so also will output (to Y2). This does not fit the current facts: last year the world economy grew at its fastest pace for almost three decades, and this year remains well above its long-term average growth rate.

The right-hand chart illustrates the alternative theory. A loose global monetary policy shifts the LM curve to the right, to LM2. Bond yields again fall, to r3, but this time output increases. In contrast to a shift in the IS curve, the economy has instead moved along the IS curve: lower interest rates stimulate global output and hence investment. This seems to fit the facts much more comfortably.

Bond yields are low largely because central banks have created too much liquidity. Despite rising short-term interest rates in America, monetary policy is still unusually expansionary. … over the past couple of years, global liquidity has expanded at its fastest pace for three decades. ... resulting in lower yields. … In fact, the two theories are not mutually exclusive. ... However, the current rapid pace of global growth suggests that excess liquidity is the prime cause of low bond yields. The snag is that central banks will eventually have to mop up the overhang of liquidity and bond yields will then rise. ... In a world of low inflation, IS-LM rides again.

In combination with this post based on a recent paper from the NBER, I believe the excess liquidity story has the upper hand in this debate and is well worth pursuing further. But I'm not ready to endorse the IS-LM framework as the best model to use in the investigation of this issue.

[Update #1: PGL at Angry Bear and William Polley have additional comments]

[Update #2: Brad DeLong also comments and notes that an inward shift in the IS curve is part of the story, as does PGL at Angry Bear.]

And in comments, I noted, like Brad, that the lack of inflation is a puzzling part of the story:

A comment noted "I always thought excess liquidity led to higher inflation..." The response:

I left a piece out that addresses that. The article says:

Why isn't excess liquidity generating inflation? The basic IS-LM model assumed that the price level was fixed, and thus its inability to explain high inflation rates in the 1970s and 1980s hastened its fall from grace. If an economy is at full employment, an increase in money leads to higher prices, not lower bond yields. Today, however, the model may be more relevant because the entry into the world economy of cheap labour in China and other emerging economies is helping to hold down inflation.

His view is that the entry of cheap labor is holding down input costs. So what has changed for the author is the emergence of global markets. But I think you raise a good question that the excess liquidity explanation must address and that's why the IS-LM model may not be the best framework for looking into this. For example, it does not capture inflation targeting and other issues very well and that is an important component of current policy.

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