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Keynesian economics without the LM and IS curves: a dynamic generalization of the Taylor-Romer model

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  • Evan F. Koenig

Abstract

John Taylor and David Romer champion an approach to teaching undergraduate macroeconomics that dispenses with the LM half of the IS-LM model and replaces it with a rule for setting the interest rate as a function of inflation and the output gap - i.e., a Taylor rule. But> the IS curve is problematic, too. It is consistent with the permanent-income hypothesis only when the interest rate that enters the IS equation is a long-term rate - not the short-term rate controlled by the monetary authority. This article shows how the Taylor-Romer framework can be readily modified to eliminate this maturity mismatch. The modified model is a dynamic system in output and inflation, with a unique stable path that behaves very much like Taylor and Romer's aggregate demand (AD) schedule. Many - but not all - of the original Taylor-Romer model’s predictions carry over to the new framework. It helps bridge the gap between the Taylor-Romer analysis and the more sophisticated models taught in graduate-level courses.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Dallas in its series Working Papers with number 0813.

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Date of creation: 2008
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Handle: RePEc:fip:feddwp:0813

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Keywords: Economics - Study and teaching ; Taylor's rule ; Interest rates ; Macroeconomics ; Monetary policy;

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  1. John B. Taylor, 2000. "Teaching Modern Macroeconomics at the Principles Level," American Economic Review, American Economic Association, vol. 90(2), pages 90-94, May.
  2. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  3. William Kerr & Robert G. King, 1996. "Limits on interest rate rules in the IS model," Economic Quarterly, Federal Reserve Bank of Richmond, issue Spr, pages 47-75.
  4. David Romer, 2000. "Keynesian Macroeconomics without the LM Curve," NBER Working Papers 7461, National Bureau of Economic Research, Inc.
  5. Dale W. Henderson & Warwick J. McKibbin, 1993. "A comparison of some basic monetary policy regimes for open economies: implications of different degrees of instrument adjustment and wage persistence," International Finance Discussion Papers 458, Board of Governors of the Federal Reserve System (U.S.).
  6. Athanasios Orphanides, 2002. "Monetary-Policy Rules and the Great Inflation," American Economic Review, American Economic Association, vol. 92(2), pages 115-120, May.
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