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Will the New Keynesian Macroeconomics Resurrect the IS-LM Model?

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  • Robert G. King

Abstract

The IS-LM model has no greater prospect of being a viable analytical vehicle for macroeconomics in the 1990s than the Ford Pinto has of being a sporty, reliable car for the 1990s. Because of its treatment of expectations, the IS-LM model, as traditionally constructed and currently used, is a hazardous base on which to build positive theories of business fluctuations and to undertake policy analysis. To simplify economic reality sufficiently to use the IS-LM model as an analytical tool, economists must essentially ignore expectations; we now know that this simplification eliminates key determinants of aggregate demand. The last two decades of research have taught economists that the assumption of rational expectations is a powerful part of economic explanations of individual and market behavior, ranging from consumption and investment dynamics to pricing of stocks and bonds. The emphasis on expectations in the macro-model is the end result of a process of building microeconomic underpinnings that was initiated in the 1950s and 1960s, when the goal was to develop dynamic theoretical foundations for the IS and LM schedules; inevitably, consideration of dynamic choice pushed the question of expectations to the forefront. As a result, most of the equations of the IS-LM model are now viewed as summarizing purposeful economic behavior in which choices over time play a central role. However, as we will see, this finding means there is no way to maintain traditional uses of the IS-LM model.

Suggested Citation

  • Robert G. King, 1993. "Will the New Keynesian Macroeconomics Resurrect the IS-LM Model?," Journal of Economic Perspectives, American Economic Association, vol. 7(1), pages 67-82, Winter.
  • Handle: RePEc:aea:jecper:v:7:y:1993:i:1:p:67-82
    Note: DOI: 10.1257/jep.7.1.67
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    References listed on IDEAS

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    1. Milton Friedman, 1959. "The Demand for Money: Some Theoretical and Empirical Results," NBER Chapters,in: The Demand for Money: Some Theoretical and Empirical Results, pages 1-29 National Bureau of Economic Research, Inc.
    2. Plosser, Charles I, 1989. "Understanding Real Business Cycles," Journal of Economic Perspectives, American Economic Association, vol. 3(3), pages 51-77, Summer.
    3. Hall, Robert E, 1978. "Stochastic Implications of the Life Cycle-Permanent Income Hypothesis: Theory and Evidence," Journal of Political Economy, University of Chicago Press, vol. 86(6), pages 971-987, December.
    4. Gordon, Robert J, 1990. "What Is New-Keynesian Economics?," Journal of Economic Literature, American Economic Association, vol. 28(3), pages 1115-1171, September.
    5. John Y. Campbell & N. Gregory Mankiw, 1989. "Consumption, Income and Interest Rates: Reinterpreting the Time Series Evidence," NBER Chapters,in: NBER Macroeconomics Annual 1989, Volume 4, pages 185-246 National Bureau of Economic Research, Inc.
    6. repec:fth:harver:1435 is not listed on IDEAS
    7. Rotemberg, Julio J, 1982. "Sticky Prices in the United States," Journal of Political Economy, University of Chicago Press, vol. 90(6), pages 1187-1211, December.
    8. Abel, Andrew B., 1982. "Dynamic effects of permanent and temporary tax policies in a q model of investment," Journal of Monetary Economics, Elsevier, vol. 9(3), pages 353-373.
    9. Fischer, Stanley, 1977. "Long-Term Contracts, Rational Expectations, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, vol. 85(1), pages 191-205, February.
    10. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
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    JEL classification:

    • E12 - Macroeconomics and Monetary Economics - - General Aggregative Models - - - Keynes; Keynesian; Post-Keynesian

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