Confidence is not a fairy and it is not an illusion

Figure 1: The IS-LM-NAC Model

Figure 1: The IS-LM-NAC Model

My coauthor, Konstantin Platonov, and I, have recently completed a working paper, “Animal Spirits in a Monetary Economy”. In this paper, we introduce a framework we call the IS-LM-NAC model that, we hope, will replace the Hicks-Hansen IS-LM model as a way of thinking about the impact of economic policy on output and employment.  Figure 1 depicts  the graphical apparatus we use in that paper.

The IS-LM model originated with a paper by Sir John Hicks, "Mr. Keynes and the Classics", that simplified the major ideas from Keynes' General Theory. Hicks’ simplification of the General Theory can be summarized by  two curves in interest-rate output space.  The downward sloping IS curve presents points where Investment equals Savings, hence I and S. The upwards sloping LM curve presents points where preference for Liquidity equals the supply of Money hence, L and M.

Importantly, the position of the IS curve depends on the animal spirits of investors;  aka confidence,  and on the fiscal and monetary policy instruments of government. The position of the LM curve depends on the balance sheet of the central bank and on the price level which, in Hicks’ world, is historically given. This graph was widely seen as a tool for understanding how the short-run equilibrium positions of output and interest rates are influenced by fiscal and monetary policy.

I first introduced confidence as an independent driver of the steady-state unemployment rate here. My work with Konstantin adds money to that framework. Our model also has an IS and LM curve and they play very similar roles to the IS and LM curves of Hicks’ theory. But we do not see them as short-run curves. They represent possible long-run equilibria positions for the interest rate and output. In our IS-LM-NAC framework, there is a third curve, the NAC curve which represents a No Arbitrage Condition. At every point on the NAC curve, the people in our model are indifferent between holding the stock market and holding government bonds.

Shifts in animal spirits, aka confidence, cause shifts in the NAC and the IS curves. Following a shift in confidence, the price level is initially ‘sticky’, but this has nothing to do with artificial costs of changing prices, as in modern new Keynesian theories. In contrast, it simply reflects the way that people form their beliefs. Eventually, after price adjustment has occurred, the LM curve comes to rest at a point that intersects the NAC and IS curves. How quickly this happens depends on a new fundamental, the belief function, a concept that I introduced in 1993 in the first edition of my book, the Macroeconomics of Self-fulfilling Prophecies

In the paper with Konstantin, we conduct two experiments. We show that an increase in confidence, or an increase in the money supply, may each lead to a self-fulfilling increase in output and employment. Interestingly, the long run impact of monetary policy depends on how people form their beliefs.

Paul Krugman, quoting a piece from Brad Delong,  has doubled down on the confidence fairy. They assert that a big fiscal expansion is the right way to cure a depression. I have read the same empirical papers as Paul and Brad and, as I explained back in January of 2010,  I am not convinced.

In my view, confidence is not a fairy, nor is it an illusion: It is very real.  "Animal Spirits in a Monetary Economy" explains why belief formation matters, in the context of monetary policy.  In an earlier piece I wrote with Dmitry Plotnikov, we show that, if private sector confidence remains depressed, fiscal spending can crowd out private sector spending.  Our argument does not depend on whether the interest rate is, or is not, at the zero lower bound.

Confidence is not a fairy, nor is it an illusion.  If businesses refuse to invest because their confidence is low, the outcome will be just as bad  for output and employment as a supply-side shock like a hurricane. As I explain in my forthcoming book, Prosperity for All, the right way to prevent another Great Depression, is by active intervention in the asset markets. You can pre-order my book from OUP, here.