Low Interest Rate: Savings, Monetary Policy, and the IS-LM Model

Via Mark Thoma comes an interesting discussion from The Economist as to why interest rates are low:

The most popular explanation is that there is a global glut of savings, which has driven yields down … 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 Economist dismisses this explanation, which represents an inward shift of the IS curve and argues that low interest rates are due to an expansionary monetary policy, which Mark notes is an outward shift of the LM curve. While recent output growth may be high for nations such as the U.S., it still seems plausible that many nations (such as the U.S.) are below full employment given the investment-led recession a few years ago.

In other words – could the lower interest rates be due to both an inward shift of the IS curve and an outward shift of the LM curve? For the U.S. economy, national savings have declined which by itself would tend to shift the IS curve outward – but we witnesses a significant decline in investment and exports during the 2001 to 2003 period. Therefore – the fact that U.S. national savings has declined is not inconsistent with the premise that the IS curve has shifted inward.