Working Paper: CEPR ID: DP3898
Authors: Edward Nelson
Abstract: This Paper discusses criticisms of the IS-LM framework in the macroeconomic literature of the last 40 years, and how the modern optimizing version of IS-LM addresses those criticisms. It is argued that models that include the optimizing IS-LM specification are legitimate vehicles for dynamic analysis: the evolution of nominal wages and prices is treated endogenously, and there is full recognition of the intertemporal nature of households? saving decisions. The optimizing version of IS-LM analysis remains vulnerable, however, to the monetarist critique: by recognizing an insufficient number of distinct assets, the IS-LM framework tends to understate the value of money as an indicator for monetary policy.
Keywords: monetary policy; money; optimizing ISLM specification; transmission mechanism
JEL Codes: E52; E58
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| optimizing ISLM framework (E12) | dynamic analysis of monetary policy (E63) |
| endogenous wages and prices (E64) | complexities of monetary policy transmission (E52) |
| optimizing ISLM model (E12) | intertemporal nature of household saving decisions (D15) |
| failure to distinguish real and nominal interest rates (E43) | undermines validity of traditional ISLM model (E12) |
| optimizing ISLM model (E12) | nuanced understanding of interest rate effects on aggregate demand (E43) |
| optimizing ISLM framework (E12) | explanatory power compared to traditional ISLM analysis (E12) |