DP3898 | Money and the Transmission Mechanism in the Optimizing IS-LM Specification


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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.