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

Author(s): Edward Nelson
Publication Date: May 2003
Keyword(s): monetary policy, money, optimizing IS-LM specification, transmission mechanism
JEL(s): E52, E58
Programme Areas: International Macroeconomics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=3898

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.