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

islm at ED limit

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.

islm at ED limit 4

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…

islm at ED limit 3

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.