Policy impotence and the IS-LM model: The case of the liquidity sump

Since introduced by John Hicks in 1937, the IS-LM model has endured repeated criticisms to remain the primary vehicle for the study of macroeconomics at the undergraduate level.  The durability of the IS-LM model is due to its relative simplicity as well as its flexibility, adaptability, and policy relevance.  Special cases of the IS-LM model (or, more appropriately, the IS-LM framework) are capable of explaining either monetary or fiscal policy impotence.  These include “Keynesian” cases such as the liquidity trap, interest inelasticity of investment, and the “classical” case where the demand for money does not depend on the interest rate.  In each of the standard textbook cases, the failure of one policy does not preclude success of another policy.  The existence of a liquidity trap or interest-inelastic investment results in monetary policy impotence and a supercharged fiscal policy.  If the demand for money is inelastic with respect to the interest rate, then fiscal policy is impotent and monetary policy potent.  As in modern dynamic models, the static IS-LM model always provides a “foolproof” policy response to conventional aggregate demand shocks.  In this paper, I examine an overlooked special case of the IS-LM paradigm where neither monetary nor fiscal policy is effective in stimulating aggregate demand. 

The liquidity sump is introduced as a special case in the IS-LM class of models.  A liquidity sump may occur as a result of a financial panic, the bursting of an asset “bubble,” or profound pessimism about the future (“animal spirits”).  The resulting excess supply of tangible assets (capital) leads to a large decline in tangible asset prices.  In the special circumstances of the sump, the excess supply of tangible assets is matched by an excess demand for liquid financial assets.  Interest rates on risky tangible assets increase both absolutely and relative to interest rates on liquid assets.  In sump conditions, any increase in income stimulates an increase in the demand for liquid financial assets as individuals, financial institutions, and businesses attempt to fill in the sump (replenish balance sheets) with less risky liquid assets.  In a liquidity sump, there is no free lunch for macroeconomic policy makers since any increase in income resulting from fiscal or monetary expansion is simply added to liquid assets with no expansionary effect on money, credit, and real GDP. 

The analysis proceeds from the simplest textbook case to progressively more complex versions of the IS-LM model.  Extensions include: open economy, endogenous money, generalized liquidity, and a credit market.  Conjectures are made concerning the dynamics of recovery and growth.  Market participants will not be induced to resume lending and spending until a comfort level of real tangible wealth is attained.  Nature’s way of filling in the sump and restoring the level of economic activity is for deflation to increase the real value of tangible assets.  Potential growth can only be achieved by restoring confidence in the future.  The liquidity sump provides a new perspective in which to view the Global Financial Crisis, the Great Depression, and the Japanese Stagnation.