The Is-Lm Model

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The IS-LM model has served as a fundamental building block to short-run macroeconomic theory since its conception, through its simple interpretation of the concepts of Keynes’ General Theory, notably the joint description of goods and financial markets. The framework demonstrates the relationship between output and interest rates as a function of equilibrium in the two markets. As such it acts as a basic model of economic fluctuations for both pedagogic and descriptive/prescriptive purposes, and forms the groundwork for medium-run AS-AD analysis.

Despite its contribution to the emergence of a broad consensus on macroeconomic policy (Vercelli, 1999), the IS-LM model has received substantial criticism, particularly regarding its relevance to modern economies. In his article Keynesian Macroeconomics without the LM curve, Romer suggests that it is limited by its basic assumptions and subsequently suggests a new model. Most importantly, his IS-MP-IA model proposes an overhaul of the IS-LM’s outdated monetary targeting presumption in favour of inflation targeting. For the purposes of consistency and clarity it revises the original model’s use of real and nominal interest rates, and develops a basis for relating output to inflation instead of the price-level for AS-AD modeling in the medium-run. This review will focus on evaluating the validity of these major alterations as well as Romer’s overriding judgment that the IS-LM model is no longer valid in its original form.

The LM curve plots the value of the interest rate associated with any value of income for a given money stock and price level (Blanchard & Sheen, 2009), its basis being the relation between money demand and central bank determined money supply. However, this assumption of monetary targeting has become increasingly irrelevant as central banks have largely shifted to an inflation targeting objective in many industrialised countries including the US, UK, Australia, Canada, Sweden. Accordingly,...
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