The shock is that all the bond rating agencies downgrade the rating on government bonds. Specifically, the rating agencies say that whereas the previous default risk was zero, there is now a 1% chance per year that the government will renege on 100% of all promises to pay money on its bonds. (Or a 10% chance per year of reneging on 10% of repayments, whatever.) And assume that everybody believes the rating agencies. Further assume that the central bank holds the interest rate on government bonds constant, by offering to buy and sell unlimited amounts of government bonds at prices commensurate with that same interest rate. [Update: but is this assumption reasonable? See comments by Brad DeLong, Andy Harless, Scott Sumner, and me, below]. Further assume that fiscal policy stays constant.

Take the standard ISLM model straight off the shelf (or straight out of the second-year textbook). Draw the LM curve horizontal; either because the central bank conducts monetary policy by setting a rate of interest, or because the economy is stuck in a liquidity trap where money and government bonds are perfect substitutes. Now let's hit it with a shock.

[Update 2. Paul Krugman weighs in . Like Brad DeLong, and Scott Sumner (in comments), he questions my assumption that the central bank can keep the interest rate fixed, without buying all the outstanding bonds.]

Any good economics student who has completed intermediate macro and really understood the material and has the capacity to think (rather than just memorise results for the exam) ought to be able to take a decent crack at this question.

My answer to this question is the same as the standard textbook answer to the question where the shock is an increase in expected inflation by 1% (one percentage point, strictly).

The IS curve is drawn as a function of the expected real interest rate, because desired savings and investment depend on the expected real interest rate -- the nominal rate minus expected inflation. And the LM curve is drawn as a function of the nominal interest rate. Because the demand for money is a function of the nominal interest rate, or, in this case, because the nominal interest rate is what the central bank sets.

There are three ways to handle a 1% increase in expected inflation in the ISLM diagram: first, put the nominal rate on the vertical axis, and shift the IS curve vertically up by 1%; second, put the real rate on the vertical axis, and shift the LM curve vertically down by 1%; third, put both interest rates on the vertical axis, but put a vertical 1% wedge between the IS and LM curves to the right of the intersection point. I prefer the third, "wedge" method. But all three ways give exactly the same answer. The 1% increase in expected inflation causes the ISLM equilibrium point to move to the right, to a higher level of real income and lower real interest rates. The increase in expected inflation causes the Aggregate Demand curve derived from that ISLM model to shift right in {price level; real income} space. This is standard second-year stuff.

And if you: did believe in the ISLM model; and did believe that the economy was stuck in a liquidity trap; and did believe the economy needed an increase in Aggregate Demand; and did believe that fiscal policy either should or could not be used, for whatever reason; you would say that this increase in expected inflation is a good thing.

And, at first sight, the answer to the question "what is the effect of a 1% increase in perceived risk on government bonds?" is exactly the same as the answer to the question "what is the effect of a 1% increase in expected inflation?". At least, in this model, given my assumptions. Both result in the same 1% fall in the real risk-adjusted rate of interest on private saving and investment and the same rise in AD and real income.

And the ISLM model is no straw man. Simple, yes. Crude, yes. But straw, no. No model that has survived 70 years is a straw man. Paul Krugman likes it. So do I, sort of. And it's not really that different from the canonical New Keynesian model, at least for this question.

So, why aren't US Keynesians cheering the possibility of budget impasse and the downgrading of US bonds? Or did I miss it?

That's not necessarily a rhetorical question. There may be answers. But they aren't in the model.

1. Yes, a downgrading of US government bonds would be a good thing in the short run, because it would enable the economy to escape recession, but it would be a bad thing in the long run by raising the costs of rolling over and financing the debt when the economy gets back to normal.

2. Yes, a downgrading of US government bonds would be a good thing in the short run, because it would enable the economy to escape recession, but it would be a bad thing in the long run because bond prices would fall when the economy gets back to normal and this might cause some banks to get into trouble. (But so would increased inflation).

3. A promise is a promise, and it's bad if you break your bond even if good things happen.

4. ?

Is anybody out there celebrating this rather large silver lining? Or don't Keynesians believe their own models?