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Friday, October 07, 2011

Mankiw: The IS-LM model

I haven't bothered with the LM versus MP curve debate because it's all been done before, and because there's really nothing to debate. But I forget that many of you weren't around in 2006 (when the post below was written). For me the bottom line is easy, some questions are easier to answer using the IS-LM model (e.g. see here), some with the IS-MP model (in both cases, coupled with a model of AS), but in general, as noted below, "There is no truly substantive debate here. These two models are alternative presentations of the same set of ideas":

The IS-LM Model, by Greg Mankiw: A reader emails me the following question:

Dear professor Mankiw:

I like your blog a lot. I daily go to it in order to read good economics. Keep up the excellent work!

May I ask you why economists authors of textbooks on intermediate macroeconomics like you keep using the IS-LM model even though we already know that the Central Bank does not set the monetary supply. Instead, it does set the interest rate. Shouldn´t you do like Wendy Carlin and David Soskice in their recent and fantastic book "Macroeconomics: Imperfections, Institutions and Policies" where they replace the LM curve by a monetary rule (for example, a Taylor rule). Wouldn´t that be more representative of what occurs in reality rather than supposing that the institution gets the control of the quantity of money?

Thanks for your attention in advance.

Best,
[name withheld]

... My email correspondent wonders whether it would be better just to jettison the traditional IS-LM model in favor of an alternative framework that ignores the money supply altogether and simply takes an interest-rate rule as given. This approach has been advocated by my old friend David Romer. (Economics trivia fact: I was the best man at David Romer's wedding, and he at mine.) You can find David's approach here (figures here). David calls his alternative presentation the IS-MP model, because it combines an IS curve with a monetary policy reaction function.

The first thing to understand about the choice between IS-LM and IS-MP is that it is not about determining which is the better model of short-run fluctuations. There is no truly substantive debate here. These two models are alternative presentations of the same set of ideas. The key issue in deciding which approach to prefer is not theoretical or empirical but pedagogical.

The IS-LM approach has a long history behind it. That is one reason to stick with it, but it is not dispositive. If I were convinced that the IS-MP model was a clear and substantial step forward, I would switch. So far, however, I am not convinced that the new approach is easier to teach or more intuitive for students.

The key difference between the two approaches is what you hold constant when considering various hypothetical policy experiments. The IS-LM model takes the money supply as the exogenous variable, while the IS-MP model takes the monetary policy reaction function as exogenous. In practice, both the money supply and the monetary policy reaction function can and do change in response to events. Exogeneity here is meant to be more of a thought experiment than it is a claim about the world. The two approaches focus the student's attention on different sets of thought experiments.

I like the IS-LM model because it keeps the student focused on the important connections between the money supply, interest rates, and economic activity, whereas the IS-MP model leaves some of that in the background. The IS-MP model also has some quirky features: In this model, for instance, an increase in government purchases causes a permanent increase in the inflation rate. No one really believes that result as an empirical prediction, for the simple reason that the monetary policy reaction function would change if the natural interest rate (that is, the real interest rate consistent with full employment) changed. This observation highlights that neither model's exogeneity assumption should be taken too seriously.

In the end, I remain open-minded, but at this point I prefer the IS-LM model when teaching (at the intermediate level) about the short-run effects of monetary and fiscal policy. If one were to teach IS-MP to undergrads, I would prefer to do it as an supplement, rather than a substitute, for IS-LM.

Related link: Here (and here in published form) is Paul Krugman's cogent defense of teaching the IS-LM model. The article was written quite a while ago, before IS-MP hit the scene, so I don't know what he would say about this alternative framework. But the Krugman piece is interesting, if only vaguely on point, so I wanted to give it some free advertising.

    Posted by on Friday, October 7, 2011 at 02:43 PM in Economics, Macroeconomics, Methodology | Permalink  Comments (22)

          


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