A Theoretical Framework for Law and Macroeconomics

Abstract

This article considers the effects of law within a Keynesian macroeconomic model. Using the investment-savings and liquidity-money (IS/LM) model at the heart of “short-run” macroeconomics, I argue that law affects spending (“aggregate demand”) and that the changes in spending induced by law can affect output. I contrast the law and macroeconomic perspective with the law and microeconomic approach that has dominated law and economics. I demonstrate that law’s effects on aggregate demand, invariably ignored in law and economics, become particularly important when monetary policy is constrained by the “zero lower bound” (ZLB) on nominal interest rates. At the ZLB, interest rates cannot adjust to bring aggregate demand into balance with the economy’s supply potential. Economic output falls short of its potential due to inadequate demand. At the ZLB, I argue that some micro-economically disfavored legal instruments, such as command and control regulation crafted to increase spending, become appealing relative to seemingly superior alternative instruments such as Pigovian taxation. I conclude by arguing that law offers a potentially important but unexplored instrument of macroeconomic policy.