Let's All Be Keynesians Now

Konstantin Platonov and I have updated our working paper on reinventing the IS-LM model. You can download it from the NBER here, or from an open link on this website. If you haven't read our paper, or our summary on VOX, here are a few highlights.

The Hicks-Hansen representation of The General Theory is summarized by the  IS-LM diagram, a tool that was designed to represent temporary equilibrium in the sense that Hicks used that term in his book, Value and Capital. The price level is  pre-determined in Hicks version of Keynesian economics and it wasn't until Samuelson introduced the idea of the neo-classical synthesis in the third edition of his undergraduate textbook that the current view of sticky-price Keynesian economics was born. Samuelson was the original 'bastard Keynesian' (in the immortal words of Joan Robinson.) 

In our working paper, we reinvent the IS-LM model and add a new curve, the NAC condition, which integrates the value of the stock market into the  model and explains, not just the interest rate and GDP, but also how the price level is determined. In our IS-LM-NAC model, high involuntary unemployment is not just a temporary phenomenon; it is a potentially permanent feature of a market economy. Larry Summers has resuscitated Alvin Hansen's idea of secular stagnation. Our work provides a coherent theory of what that might mean. Building on earlier work  that integrates The General Theory with general equilibrium theory in a new way, our paper offers fresh insights about the role of the asset markets on economic activity that cannot be understood using a more conventional approach.

A second feature of our paper is the introduction of animal spirits as an independent driver of economic activity. We formalize that idea  with a belief function, an idea that was first introduced in my 1993 graduate text, the Macroeconomics of Self-Fulfilling Prophecies. And as in my previous use of that concept, the idea that beliefs are fundamental is completely consistent with rational expectations. Our IS-LM-NAC model provides a coherent way for policy makers to think about the effects of monetary and fiscal policy on output, employment and inflation and we propose that our model be adopted as a viable and superior alternative to the current textbook approach.