Discussant Paper: Extending the IS LM Curve to Include an "Environmental Equilibrium" Curve
1. I. What question is the author trying to answer?
In Extending the IS-LM Model to Include an ‘Environmental Equilibrium’
Curve, Philip A. Lawn explores how to incorporate environmental constraints into
the IS- LM (Investment Saving- Liquidity preference Money supply) curves in a way
that does not require a decrease in sustainable output. Lawn introduces Heyes’
Environmental Equilibrium (EE) curve into the IS-LM model as a solution to the
necessity of environmental constraints to be taken into account within
macroeconomic models used for policy analysis. The EE curve cannot withstand in
an economy alone- policy tools must be used to ensure the restriction of “the
incoming resource flow to the maximum sustainable rate” as well as to facilitate
efficient allocation of natural resources. Heyes’ approach concludes that expanding
monetary policy (the Federal Reserve’s command of the nominal interest rate) will
result in an increase in output, or expanding fiscal policy will result in a decrease in
output. Lawn’s approach is to provide solutions to the question of how to
incorporate environmental constraints into the IS-LM curve without causing a
decrease in output, as Heyes’ approach does with an expansion of fiscal policy.
II. What solutions are offered?
Lawn first reviews the equations for the IS, LM and EE curves, giving insight
into what kind of variables the EE curve is dependent upon. The IS and LM curves
are dependent upon output, and the ex ante real interest rate described by the
Fisher equation, which is ex ante real interest rate=nominal interest rate-expected
inflation. At equilibrium, IS=LM=EE, with the IS-LM equilibrium describing an
economy where the money markets and goods are in equilibrium. The
2. environmental equilibrium is where the economy is producing at maximum output
and is using the cleanest technology possible with polluters/users of a resource
bearing the entire cost of pollution. Above this point, the economy is exhausting its
long-term resources, and below this point, the economy is producing below
sustainable output potential.
Lawn’s approach to a sustainable equilibrium between the IS-LM-EE curves
(where output is at its potential and natural capital is not being exhausted) is
through the introduction of tradable resource use permits and assurance bonds.
Tradable resource use permits are used in Lawn’s approach to “restrict the
incoming resource flow to the maximum sustainable rate”, while assurance bonds
(polluter or user pays for all costs of pollution before using the resource) are to
facilitate efficient allocation of resources. Rather than either an increase or decrease
of output depending on the type of policy expansion and shifting the IS and LM
curves as concluded by Heyes, Lawn’s implementation of assurance bonds and
tradable resource user permits allows the EE curve to shift to a sustainable
equilibrium. This results in either an increase in output, or for output to remain
constant, a favorable approach to Heyes’ approach.
Tradable resource permits are a way to limit the amount of resources being
extracted, necessitated by Lawn’s explanation of how a price ought to signal the
scarcity of a resource now and in future generations. However, people discount the
future value of resources, which results in a price that does not accurately signal the
scarcity of the resource in the future. The second policy tool needed is to allocate
3. resources efficiently. Because the permits will be auctioned off originally, funds may
be collected to “facilitate efficient allocation”.
III. Conclusion and Review
Lawn concludes by urging once more the importance of incorporating this EE
curve into our IS-LM model in a way that does not favor the movement of the IS and
LM curves, as Heyes’ approach does. Lawn suggests that moving the EE curve is a
more favorable approach. This is done by implementing tradable resource permits
and assurance bonds so that output will only increase or stay constant with
monetary or fiscal policy expansions, while Heyes’ approach will decrease output if
using fiscal policy expansion.
IV. Criticisms
Lawn introduces several new concepts in his conclusion such as a Balance
Payments (BP) curve as well as suggests looking at “international transactions”,
which I found to be a bit confusing and this muddled the clarity of his conclusion.
Furthermore Lawn ignores the significance of long-run output in his explanation of
the environmental equilibrium, only mentioning that prices do not accurately reflect
the depletion of a resource stock for future generations. The IS-LM model is based
on a level of output that is a rate that signifies either an economy that is above
potential output or below potential output. Potential output is determined by the
output that the economy would produce if all inputs were utilized at their long-run
sustainable levels. Lawn does not include a review of the environmental equilibrium
curve’s relevance to long-run sustainable levels other than explaining that we need a
4. policy tool for the price of resources to reflect the scarcity to future generations
(tradable resource use permits).
V. Suggestions
Lawn introduces the idea that two separate policy tools are needed to fully
implement the EE curve into the IS-LM model early on in the paper. These tools are
based on the problem that incoming resources must be restricted to achieve the
maximum sustainable rate, and that these resources need to be allocated efficiently.
Rather than focusing on a mere efficient allocation of resources, Lawn ought to
include an efficient and equal allocation of resources. This model is meant to capture
spillover costs of pollution (that are borne by those other than polluters) through
the user or polluter fully internalizing the pollution cost. Without including an equal
allocation of resources, the largest firms with the most wealth will be able to buy up
all of the resource use permits. This could result in a skewed distribution of
resources, though it may be the most efficient.
This leads us to Lawn’s policy tool suggestion to facilitate efficient allocation-
assurance bonds. As mentioned earlier, assurance bonds are meant to make the firm
pay for the costs of pollution before they are even able to buy a resource use permit.
This is a problem because the methods used to determine the costs of pollution (and
other waste) can be very inaccurate, ranging from mere surveys to abstract
concepts that can be based on opinion. My main suggestion for Lawn is that he
include some sort of sensitivity variable in his EE curve that incorporates how
reliable the methods used to evaluate the costs of pollution are, so to be more
accurate with assurance bonds and to minimize spillover.
5. Sources Cited
Lawn, Philip A. “Extending the IS-LM Model to Include an Environmental
Equilibrium.” Australian Economic Papers Volume 42. Issue 1 (March 2003): p. 118-
134
