Critique of IS - LM : fiscal deficits , loanable funds , Keynesian Cross and IS

This paper intends to discuss some problematic aspects that IS-LM have when dealing with fiscal deficits, especially when considering loanable funds model. Many others have focused on its assumptions for criticism of IS-LM, but I will mainly focus on its fundamental modelling nature. To say more specifically, I will argue that ordinary ISLM analysis is in contradictory nature to simultaneous equilibrium system, and therefore loanable funds. I will stick completely with IS-LM language for this paper. Therefore, any opinion expressed about economy in this paper stems from either IS-LM or correction of IS-LM analysis, not from my academic and personal stance toward economy. 1. Short-run and long-run It seems that there are two variants related to loanable funds model. First is that while money market determines short-run interest rate(s), loanable funds market determines long-run interest rate(s). Second is that money market determines nominal interest rate, while loanable fund market determines real interest rate, though sometimes money market is also seen as determine real interest rate together with loanable fund market. In this paper, I will discuss mainly the second interpretation. 2. The General Theory and the birth of IS-LM In Chapter 14 of The General Theory of Employment[1], Interest and Money by John Maynard Keynes, it is argued that loanable funds model cannot only determine the rate of interest, because saving curve is dependent on total income economic agents receive. So suppose that government spends to stimulate economy. Then loanable funds model would say that the rate of interest increases due to fiscal deficit in short-run. However, this is only because total income Y is considered as constant, which is not going to be true. It is in this spirit that IS-LM was born. It is not really important here whether Keynes had a real influence on the originators, like Harrod and Hicks, of IS-LM, so I will not discuss this matter.