The greatest goal of economics is to maximize net social benefits. Just imagine how great the United States is. We have great resources in terms of human and capital. Then look at how poorly the economy is performing for society. Obviously, something is wrong, terribly wrong with the economy. What can the Fed do?
Can we blame the IS-LM model?
The IS-LM model is used by many top economists as a first approximation of the economy. It can tell us why the economy may not be performing well. It can guide us on how we might use fiscal policy, monetary policy and other policies to increase GDP output hopefully to a stable and bountiful level of full-employment of capital and labor.
Top economists look at the IS-LM model and see that we are still in a liquidity trap. (link to source)
From this diagram, if monetary policy loosens up to push LM to LM’, there is no effect on output, Y*, nor the interest rate, i. If fiscal policy pushes IS to IS”, output would increase, but the interest rate would not change. In the absence of fiscal stimulus, output would grow at a slower pace. This seems to explain where the economy is.
The Liquidity trap is the result of many policies over time for taxes, financial regulation, wages, unions, etc… Many of those policies did not maximize net social benefits but rather sought to maximize benefits to certain private interests. Since the IS-LM model reflects the consequences of those policies, we cannot blame it for creating the liquidity trap.
Can the IS-LM model guide the Fed to maximize net social benefits?
We know that real GDP has fallen to a lower trend line. So output is low and would require a long path to get back to potential trend. In that sense, interest rates would stay low along an LM curve that slides along the zero lower bound.
The goal of using the IS-LM model is to increase output and set interest rates for economic stability based on full-employment of capital & labor and inflationary pressures. The Federal Reserve can use their discretion in analyzing the model to set the interest rate. The discretion of the Federal Reserve seeks to maximize benefits to economic growth, with the hopes that economic growth will be distributed correctly so as to maximize net social benefits. The problem is that those benefits are not being distributed correctly. That is not the fault of the Fed.
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