Thoughts on Investment, IS-LM & Effective Demand
Investment is an essential component of economic growth. Investment supports a healthy inflation rate by providing new money into the economy. What determines investment? Through the IS-LM model, we can understand interest rates and investment.
The IS curve has its own model before it is incorporated into the IS-LM model. In that IS model, investment is a function of GDP (Y) and the interest rate (i).
I = I(Y, i)
“That means that loanable funds doesn’t determine the interest rate per se; it determines a set of possible combinations of the interest rate and GDP, with lower rates corresponding to higher GDP. And that’s the IS curve.” (Krugman)
Do lower rates always correspond to higher investment? No… We still have low interest rates and investment is normal. (FRED data) But what will happen if firms really believe that the Fed will raise interest rates next year? There will be incentive to invest before rates rise. Thus, we obtain higher investment from projected increases in interest rates, more so than the same projected low interest rates.
Investment is a Function of Effective Demand
I add another factor that determines investment along with output and interest rates. I would say that investment is also a function of effective demand.
I = I(Y, i, ED)
Why do I say this? Well, Keynes himself said it.
“The absurd, though almost universal, idea that an act of individual saving is just as good for effective demand as an act of individual consumption, has been fostered by the fallacy, much more specious than the conclusion derived from it, that an increased desire to hold wealth, being much the same thing as an increased desire to hold investments, must, by increasing the demand for investments, provide a stimulus to their production; so that current investment is promoted by individual saving to the same extent as present consumption is diminished.
It is of this fallacy that it is most difficult to disabuse men’s minds. It comes from believing that the owner of wealth desires a capital-asset as such, whereas what he really desires is its prospective yield. Now, prospective yield wholly depends on the expectation of future effective demand in relation to future conditions of supply. If, therefore, an act of saving does nothing to improve prospective yield, it does nothing to stimulate investment.” (Keynes, General Theory, Chapter 16)
In the first paragraph, Keynes is talking about the fallacy that increased saving is good for Effective Demand because the loss in consumption is balanced by an equal increase in investment. One has to understand the difference between Effective Demand and Aggregate Demand in order to understand this fallacy.
Aggregate Demand is equal to Consumption plus Investment. So what you lose in consumption just goes to investment. Yet, Keynes is not referring to aggregate demand, but rather effective demand. Effective demand represents the point at which firms see no profit potential to further increasing output. If you lower consumption potential, you ultimately lower aggregate demand.
Effective Demand is based on the relative strength of labor income to consume.
“All production is for the purpose of ultimately satisfying a consumer.” (Keynes, General Theory, chapter 5)
So if labor share drops, domestic consumption declines. National Saving increases, but “full employment” output falls due to the effective demand limit falling. We saw labor share drop in Germany a decade ago. Long-run output would have fallen in Germany too if they were not able to find other countries to accept more of their exports.
How does effective demand influence investment? Do firms know the difference between effective demand and aggregate demand?
We go to the second paragraph in the above quote. Investment depends on prospective yield, which “wholly” depends on future expectations of effective demand in relation to future conditions of supply. When firms decide to increase production, they must assess the strength of future demand alongside their own marginally increasing production costs. At the effective demand limit, firms in the aggregate choose not to increase production even if aggregate demand is increasing, because demand is not sufficient to warrant higher marginal production costs. Thus the effective in effective demand.
So is there future effective demand for investment? There are two ways to look at this.
First Bill McBride from Calculated Risk needs shades because the future is so bright. He sees aggregate demand building momentum. He sees a long and bright future for investment.
Then there is my view of the effective demand limit. I see that output will fall short of its past full employment level due to consumption potential falling from the drop in labor share. The current momentum in output and employment that Bill McBride sees, for me, is due to firms trying to maintain vulnerable profit levels. That momentum can stop quickly when hiring ceases to bolster profit rates.
The picture I see… Bill McBride is walking with shades so strong that he does not see the effective demand wall right in front of him. He sees more prospective yield than I see.
Let’s take this to the IS-LM Model
The dashed lines for the IS and LM curves is what those like Bill McBride are projecting into the future. They see output growing for years allowing the Fed rate to normalize to around 4%. He sees a larger output at full employment than I do.
I follow Keynes’ principle that says a deficiency of effective demand will lead to reduced output at full employment. I see the full employment output more to the left. So I bend the dashed lines to the full employment level that I see. Krugman says that we do not know where full employment output is. Be that as it may, I think I do.
At the effective demand limit, a change in the interest rate will have less effect on output (in terms of utilizing labor & capital) because the IS and LM curves go inelastic. When the IS curve goes inelastic at the effective demand limit, expansionary monetary policies, which try to shift the LM curve right, have mild impact on output.
Let’s take the case of the liquidity trap, where the IS curve crosses the horizontal portion of the LM curve. As output increases, the IS curve may start rising up the LM curve which would warrant a rise in interest rates. But if the Fed thinks there is still too much spare capacity or inflation still too low, they will increase monetary expansion even more. The result is to shift the LM curve to the right making the IS curve cross once again the horizontal portion of the LM curve. Output increases down along the IS curve, but at the cost of keeping the Fed rate at the ZLB. The liquidity trap becomes a self-fulfilling prophecy.
At some point the LM curve needs to shift left through tightened monetary policy in order to give the Fed rate a realistic path to reaching a normalized rate at full employment. The Fed is planning this strategy now.
Moreover, at the effective demand limit, a shift right in the IS curve from an increase in government spending would tend to raise interest rates with mild increases in output. Fiscal policy tends to be ineffective at the effective demand limit. We should have had more fiscal stimulus starting 4 years ago when the IS curve was crossing the horizontal portion of the LM curve far from the full employment level that I see.
People who call for more fiscal stimulus now think the full employment level of output is still years away. They think the liquidity trap (IS curve crossing the horizontal part of LM curve) will last for at least a year more. But I see that QE has been keeping the IS on the horizontal part of the LM curve artificially. Fiscal policy will become ineffective anyway at the effective demand limit, when the LM goes inelastic.
So my view of the last 4 years is that we should have had more fiscal stimulus (shift IS right) and less expansionary monetary policy (shift LM left). This strategy would have better aligned the IS & LM curves toward reaching the target of a normalized Fed rate in relation to full employment output at the effective demand limit. The path of normalizing monetary policy would have been safer. Something like this…
We are getting to the point where neither fiscal nor monetary policy will be effective at increasing output. Profit concerns by firms will curtail further increases in output. The only solution left is to raise effective demand through raising labor share. This would shift full employment output to the right. But would firms tolerate the cut in profit share?
Anyway, looking into the future, I see less prospective yield than others based on effective demand. Therefore I see less investment potential than others. I would caution firms to be careful of over-extending their investment commitments going into 2015.
I go along with Keynes. It’s business animal spirits.
Business investment requires businessmen to believe they can sell the new supply that their investment will create at a profit.
What drives that is current demand so strong that they have no doubts that they sell their additional supply at a very profitable price.
In the corporate world any corporate vice president proposing a new investment believes that it will be very profitable. Typically, they have to demonstrate that the returns will exceed the cost of capital. So what do they do, is just plug in the necessary sales assumption that will justify the current investment. Remember, corporate vice presidents are the most insecure people in business
So what gives them the confidence to stick their necks out and take a big chance. Current sales!! They are selling all they can produce and have no trouble raising prices.
That is why despite the beautiful theory that higher rates stifle investment is a crock.
The data clearly shows that investment has a very strong correlation with both rates and inflation and this is why. It is simple, the very condition that cause business animal spirits to soar is also what causes strong growth and inflation.
Thank you for your great points.
Do you think we will see price wars? or rising prices?
“But would firms tolerate the cut in profit share?”
I don’t see them taking much of a cut in profit if they can avoid it. But consumers may force some price cuts by delaying discretionary spending.
Tonight Elizabeth Warren is on the national news condemning the Republican attempt to strip out the prohibition against federal government bailouts of swaps entities.
I apologize for being off topic. But this Republican action to enable government bailouts of the financial industry will be the recognized for years to come as a disaster.
The Commodity Futures Modernization Act of 2000 severely limited the regulation of credit default swaps. Now the Republicans want the government to be able to insure that part of a bank dealing with them!
If this bill becomes law, the government WILL insure some banks dealing in credit default swaps. The banks will profit handsomely by this arrangement. And in the end this will be a backdoor bailout.
Dear Mr. Lambert,
This is perfectly reasonable. I would just make the following 3 observations, which should be relatively uncontroversial (for once) in the confines of the model.
1) Even in the confines of a macroeconomic representative agent model, is it the actual increase in the money supply, or the expectation of the increase in the money supply that maintains the liquidity trap? There is an indirect connection between aggregate supply and the LM curve – this would follow from your statement that the Federal Reserve sees inflation as too low, and that’s why they continue to expand. This is when the LM curve starts sloping up, with the “marginally increasing production costs”. My own thinking is that production costs may not be increasing as yet, but if the Federal Reserve in essence announces interest rates will rise, corporate bond yields have to rise in sync, to just fund ongoing operations, never mind about increasing output with investment. Isn’t there some possibility of a shift in this sort of a “financing-production cost” connection here? Presumably if the Federal Reserve sees production costs aren’t rising, but that interest rates have, they would shift back, but there seems to be an assumption missing here.
2) In a more “macroeconomic” model, with a variety of industries and agents, the curves would really be curves and not straight lines, as different industries start seeing the marginal production costs increase differently. But even here, there would seem to be a distinction between mid-range firms, that need and can obtain bank loans, and so have to face the rising interest rates directly, and larger firms, that can rely on retained earnings, and so can choose to ignore the rising market interest rates for a while.
3) This happens often, but yet another “fuel cell revolution” has been announced by GE, in http://www.pennenergy.com/articles/pennenergy/2014/07/the-new-power-generation-fuel-cell-startup-could-spark-a-revolution.html. There’s something to what Spencer is arguing. But I would limit it more than he does, not to increasing capacity in current markets with current technology, where I would find Chapter 11 General Theory is quite adequate, but to guesses as to what what would happen with technological change and investment.
Will there be price wars or rising prices?
I do not know, probably both as we are now seeing.
Look at what happened to unit labor cost over the last 5 quarters.
2013 IV. -2.1
2014 I. +11.4
2014. II – 3.7
The horrible first quarter number was due to the shock of the extreme weather last winter. Excluding 2013 IV this average -2.2% and the spread between unit labor cost and the non-farm business deflator was 4.0%, about as wide as it ever gets. This spread is a major determinate of profits growth.
Sorry, need to proof before I post.
I meant, of course, that you should exclude the 2104 I quarter.
Hello Julian Silk,
I think your two main points in your first part are expectations of an increase in money supply maintaining the liquidity trap and if production costs are rising.
It certainly seems that financial markets expect accomodative actions everytime there is bad news to the point that it seems an addiction. Does bad news mean that the LM curve is starting to slope up? No… The economy in the US is weak from lack of productive investment and low liquidity among many people. The Fed knows there are large pockets in the economy with scarce liquidity and they try to inject it… but the transmission mechanisms are broken. Capital income is simply taking more than their socially optimum level. So the economy trudges along with labor/consumers in need of more liquidity. The financial market sits their waiting for the liquidity that should go to labor. The system is not working.
Now to production costs and the LM curve sloping up. It is better to look at marginal profits, as Keynes said to look at future demand and future supply. Those determine profit potential / prospective yield. The LM curve will naturally want to rise as transactional demand rises with rising output only if the Fed does not fully accommodate with sufficient money to keep interest rates unchanged. Increased investment will also raise money demand but interest rates will not rise if the Fed is fully accommodative.
The key is future effective demand weighing down on prospective yield. The money is there but uncertainty in demand is great. And the Fed constantly falling back to full accommodation creates concerns about future prospective yields.
The mere thought of raising rates makes the financial markets nervous. That tells you that the production costs are rising. Like Larry Summers says, there is not enough destruction of inefficient firms at the present. Fed accommodation is protecting inefficiency. Interest rates need to rise to strengthen the economy. Yes there would be a slowdown as inefficiency works itself out of the system, but then there would be a surge to carry the Fed rate to normalized levels.
Your point #2 explains the essence of macro, where diversity is expressed by one aggregate number. Macro analysis can still work though.
I see more price wars ahead. Inflation wants to decline as there is over capacity to produce in relation to weak wages. I get the sense now that China needs to flood our markets with lower priced goods. Inflation is falling in China.
Demand is low. Firms want to be able to compete with lower prices. It is getting probable that we could see inflation below 1% in the US within a year or two.
Dear Mr. Lambert,
I think you will get modest inflation, but there is a sense in which we are still not connecting. Suppose the Federal Reserve raised interest rates, and the actual inflation rate was zero. There would be a shift out of equities into bonds, and bond yields would have to rise in keeping with the rise in Federal Reserve rates, to limit the flight to quality and keep ongoing operations, that have some risk, financed for the firms that can issue and sell bonds. So there’s an effect that you get at zero, and then the add-on that you get from markets, or later Federal Reserve actions that follow markets, which are trying to adjust to actual inflation. Suppose you ignore political interference, in that the incoming Congress clearly wants higher rates, and will probably give the Federal Reserve grief until it gets them, and just ask what the Federal Reserve should do if inflation is zero. My story is that the Federal Reserve winds up QE, expecting rates to rise, and they don’t. Your story fits the add-on, but not the zero-level effect. So there is likely to be an overreaction, and this missing relation I am trying to get to would explain it.
Inflation has a good chance to fall below 1%. What should the Fed do? They will not be able to raise the Fed rate.
They are too far behind the curve now. There was a window that they had to go through a couple years ago in order to start raising rates. They had to bite the bullet and challenge the markets at that time. There has to be more destruction in the economy in order to have more productive firms. The markets needed discipline but the Fed kept babying markets. The economy is now basing its production and investment decisions upon low rates. They know that the Fed is incapable of disciplining. The Fed cannot risk a downturn from disciplining the markets. The markets had resilience a couple of years ago but not now.
So I agree with you that rates will not rise. Money demand is not going to be strong on its own. The Fed has been forcing artificial money demand for too long. In general the economy still wants to save. There should have been much more fiscal stimulus.
So now I say that the liquidity trap has become a self-fulfilling prophecy. The Fed was unable to discipline the markets. Now they are weak and accostumed to being spoiled even though profits are high. The system is not working. Standards of excellence have fallen. The economy is decaying.