Keynes's Dynamic ISLM versus Taylor's Rule.
| Author | Padhi, Satya Prasad |
| Position | Investment savings-liquidity preference-money supply |
Introduction
Monetary policy generally targets the current short run, and in the orthodox stance, short run is defined by the orthodox static price theory. In this understanding, an economy can experience normal growth (and adjustments to productivity shocks) if in the short run, the values of the crucial variables reflect fundamentals of static price theory. The only (or primary) source of short run instability comes from monetary disturbances, which in turn can disrupt adjustments to productivity shocks. This understanding, for instance, is also central to the New Keynesian Taylor's rule that, following Wicksell (1898), articulates that if banks create credit at "low" rate of interest, the consequent higher endogenous growth of money can lead to inflation (Lavoie, 2006 for a critical review of the rule). The low rate is defined in relation to the fundamentals of price theory where the real (natural) rate of interest is the one that corresponds to the actual use of capital stock for the production of consumer goods and defines a potential output in the period i.e. the marginal productivity of the capital-based natural rate of interest. The rule only adds that due to price rigidities, the above aggregate demand-led inflation in a certain range can permit output to increase up to the potential output (Sims, 2014). Then, the natural real rate of interest comes with some inflation. However, if an economy were to experience exogenous embodied technological progress, which has a propensity to grow, but confirms the price theory's marginal productivity theory (with the inflation), the natural rate of interest would increase pari passu with the rate of growth. The rule of interest rate management to manage inflation adjusts (at least in principle) the actual one to this real rate of interest, in every short period.
The above monetary theory, however, remains silent on realism with respect to how the short run decisions/fundamentals generate actual and current growth prospects. The latter are held to be variable, but not to be analyzed by the economic theory; the fundamentals cannot indicate the current growth prospects (Solow, 2000).
On the other hand, Keynes (1936-henceforth GT)'s monetary policy would argue in favor of low interest rates to sustain higher growth prospects. Here, GT is an attempt to provide a short run that can incorporate growth propensities --actually, it is conceptualized on the basis of "investment" that can define growth prospects. As would be argued later, Keynes maintained that the marginal productivity theory-based investment (i.e. maintenance of current capital stock in a static theory) is to be viewed as "costs of production", whereas the current production of consumption goods has to be dependent on new investments i.e. addition to capital stock. This new investment, targeting additional output flow, would depend on future expectations (future investment flows that define expectations of growth prospects), and (therefore) takes place under uncertainty (see Davidson, 1978; Kregel, 1998). Every short run then captures these expectations, which are held (by agents concerned) in varying degrees.
This understanding of "short run with a particular growth prospects" is important; it would provide a valid criticism of the Taylor rule of interest rate management.
To start, the expectation of growth prospects, seen as a historical sequence of subsequent short runs, influences the current short run rate of interest. The main focus in GT is on the bond rate--expectation of future demands for bonds, based on a particular growth prospect, defines the current demand for bonds, and in turn determines the bond rate. At the same time, favorable growth expectation defines current new investment that is independent of current prior savings, and it induces higher expected current production, which is also prior to receipts. Then, bank lending, induced by the needs of actual production, and independent of prior savings (deposits) is crucial both for the current income determination process and growth prospects.
This is the endogenous money thesis, which takes place with an accommodating stance of the central bank (Kaldor, 1970; Lavoie, 1984). Here, it is hypothesized (to be elaborated later) that the lending rate has to be aligned to the current bond rate, to permit the required flow of endogenous money supply.
However, such monetary prospects also depend on how growth is expected to pan out: the exact expectations regarding the aggregate supply function that embodies the expected evolution of prices and wages would determine the transaction demand for money. This influence on the monetary prospects should be taken note of.
Initial Outlines
In the present literature, how a current short run relates to actual growth prospects is fuzzy. The multiplier acceleration hypothesis is notoriously naive (Davidson & Smolensky, 1964; Palumbo, 2009). In this context, the present perspective is an attempt to illustrate an alternative Keynesian short run that can capture actual current growth prospects on a firmer basis. For example, a short run can be discussed in terms of autonomous (finance-led) investment commitment that is more productive, comes with favorable growth prospects--say, productive investment with long run higher market access. In this context, the present perspective relies on the more plausible Youngian-Kaldorian (Young, 1928; Kaldor, 1972) thesis. It allows for the growth of rate of investment that defines the growth possibility. It then defines a sequence of Keynesian short runs along the growth path, each short run capturing the growth possibilities. To generalize, different short periods with different investment commitments would capture different actual current growth prospects.
The purpose is to show that this permits a simple illustration of a dynamic model-based on the ISLM "logic"--to underline the monetary prospects, say, whether the interest rate formations conform to the growth prospects. The initial hypothesis, argued throughout the present article is that evolution of monetary prospects should be aligned to the bond rate. If so, however, as discussed earlier, the evolution of prices that would shape the transaction demand for money becomes important.
The dynamic ISLM would incorporate the long run evolution of an aggregate supply curve that would indicate (hypothesized) co-movements of interest rate and prices. In fact (and contrary to the argument of the price theory), a higher growth phase would be associated with lower pressure on interest rate and prices, and the opposite would be true of the low stagnant growth phases (also see Padhi, 2018). Co-movements of interest rates and prices have a history. It is contrary to the predictions underlying static price theory, which would predict higher interest rate in high growth phases; since along the productivity growth, the aggregate demand would match the supply increases, price stability (zero inflation) is also a natural assumption. The earliest challenge came by way of the Gibson's Paradox (Patinkin, 1968): historically, interest rates and the price level have moved up and down together. Patinkin (1968: 122) invoked the Wicksellian process, which implies increases in aggregate demand more than the supply potential, explaining in turn upward co-movement in high growth phases; for instance, Taylor rule shows how the inflation permits adjustments of output towards potential one, to realize growth prospects.
However, exceptions to the above understanding of Taylor rule--co-movement of output and prices in expansionary phase except as temporary short run bursts--are there. Bruton (1951: 224-27) has noted, again as a historical fact, that the higher growth phases, resulting in the developed status of present day developed countries (and reflecting the impact of technological progress), were associated with a secular decrease in rate of interest (with stable inflation). This cannot be explained by the Taylor's rule. The present dynamic ISLM apparatus is used as a simple illustration to show that the exceptions to Taylor's rule can exist, as a historical possibility. It would take Bruton's "paradox" as a point of departure, explaining that this may not be a paradox after all, but with a rider that the causality does not run from lowering of interest rate to higher growth phases. The focus should be on the reverse causation.
Towards the Long Run ISLM: The Antecedents
It can be argued that the ISLM is only a short run apparatus meant to highlight the two way causation between rate of interest and income. Here, however, it can be stated that in this case, the focus is on the Keynesian synthesis-led interpretation of ISLM apparatus that can underline the marginal productivity theory-based adjustments (Pasinetti, 1974). It can be shown that the variability of interest rate brings the savings into equality with the investment that is required for the purpose of the production of the pre-existing normal output; the corresponding rate of interest rate is the standard price to which employment should adjust, if wage flexibility is allowed, defining the full employment outcome.
In this connection, it is also suggested that Keynes himself believed in this short run apparatus. Patinkin (1987) adds that if the General Theory (GT) has to be viewed as a theoretical exercise, Keynes himself suggested that he has nothing by a way of a theoretical criticism of the basic Hicksian ISLM apparatus (that tries to interpret GT).
Though Keynes's position has generated a debate, the present perspective has a different take on it. Keynes only accepts ISLM as an apparatus; however, he did not accept the Keynesian synthesis logic underlying it and viewed it as a long run apparatus. This needs...
To continue reading
Request your trialCOPYRIGHT GALE, Cengage Learning. All rights reserved.
