Yes, the Fed has a reaction function, and it can vote to raise rates in response to perceived inflationary pressures associated with deficit spending. But that is a different matter. That is fighting against the “natural” gravitation.

Is there some reason the straightforward framework Krugman laid out is wrong? Yes, as even its creator went on to acknowledge. MMT rejects the IS-LM framework that Krugman uses to demonstrate the conclusion that widening budget deficits put upward pressure on interest rates and crowd out private investment.

The model remains the workhorse for many mainstream Keynesians. MMT considers it fundamentally flawed. It is incompatible with much of Keynes’s “The General Theory of Employment, Interest and Money.” It was designed for a fixed-exchange rate regime, and it is not stock-flow consistent.

Here’s the framework Krugman presents as a challenge to MMT.

Each of the IS curves (1-3) represents a different fiscal stance. This framework shows that the government can expand its deficit and move the economy from a depressed condition at point A to full employment by shifting IS1 to IS2. The economy is now at full employment, but with higher interest rates and lower private investment.

Keep this in mind: Higher deficits give rise to higher interest rates, which give rise to lower investment. The last bit is referred to as “crowding out.” This is the inherent tradeoff that MMT denies and Krugman defends.

And it’s easy for him to defend it because his model assumes a fixed money supply, which paves the way for the crowding-out effect!

Krugman’s framework treats investment as a simple function of the interest rate. Higher rates mean lower investment, and vice versa. Central banks can juice (or slow) the economy simply by lowering (or raising) interest rates. It’s Pavlovian in its simplicity: stimulus-response.

Keynes’s analysis was more nuanced. Investment decisions were forward-looking, heavily influenced by “animal spirits,” and overwhelmingly dependent on the state of profit expectations. When the profit outlook is sufficiently grim, no amount of rate cutting will entice businesses to borrow and invest in new plant and equipment (think Great Recession).