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Macroeconomics without the LM: A Post-Keynesian Perspective

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  • Thomas I. Palley

Abstract

David Romer (2000) provides an alternative model to the AS/AD and IS/LM models that abandons the LM schedule by having the short-term interest rate set by the central bank. His framework acknowledges the critical role of the central bank in determining short-term interest rates, which moves mainstream macroeconomics closer to Post Keynesian monetary theory.The current paper presents a Post Keynesian construction of macroeconomics without an LM schedule. Rather than describing the financial sector in terms of an exogenously determined interest rate set by the central bank, the model unpacks financial markets by fully specifying a banking sector. The key analytic feature of the Post Keynesian approach is to replace the money market with the loan market. That makes transparent the macroeconomic significance of the loan market and bank behavior, and generates an endogenous money supply driven by bank lending. If banks become more optimistic over the cycle and lower their interest rate mark-up, that increases the likelihood of instability.

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Paper provided by Political Economy Research Institute, University of Massachusetts at Amherst in its series Working Papers with number wp179.

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Date of creation: 2008
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Handle: RePEc:uma:periwp:wp179

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Keywords: bank lending; credit; endogenous money; loan market;

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  1. David Romer, 2000. "Keynesian Macroeconomics without the LM Curve," NBER Working Papers 7461, National Bureau of Economic Research, Inc.
  2. Bernanke, B. & Gertler, M. & Gilchrist, S., 1998. "The Financial Accelerator in a Quantitative Business Cycle Framework," Working Papers 98-03, C.V. Starr Center for Applied Economics, New York University.
  3. Lavoie, Marc, 1996. "Horizontalism, Structuralism, Liquidity Preference and the Principle of Increasing Risk," Scottish Journal of Political Economy, Scottish Economic Society, vol. 43(3), pages 275-300, August.
  4. Bernanke, Ben & Gertler, Mark & Gilchrist, Simon, 1996. "The Financial Accelerator and the Flight to Quality," The Review of Economics and Statistics, MIT Press, vol. 78(1), pages 1-15, February.
  5. Thomas I. Palley, 2007. "Macroeconomics and monetary policy: competing theoretical frameworks," Journal of Post Keynesian Economics, M.E. Sharpe, Inc., vol. 30(1), pages 61-78, October.
  6. Thomas I. Palley, 1988. "Bank Lending, Discount Window Borrowing, and the Endogenous Money Supply: A Theoretical Framework," Journal of Post Keynesian Economics, M.E. Sharpe, Inc., vol. 10(2), pages 282-303, January.
  7. William C. Brainard & James Tobin, 1968. "Pitfalls in Financial Model-Building," Cowles Foundation Discussion Papers 244, Cowles Foundation for Research in Economics, Yale University.
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