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An Optimizing IS-LM Specification for Monetary Policy and Business Cycle Analysis

  • McCallum, Bennett T
  • Nelson, Edward

We ask whether relations of the IS-LM type can sensibly be used for the aggregate demand portion of a dynamic optimizing general equilibrium model intended for analysis of issues regarding monetary policy and cyclical fluctuations. The main result is that only one change--the addition of a term regarding expected future income--is needed to make the IS function match a fully optimizing model, whereas no changes are needed for the LM function. This modification leads to a dynamic, forward-looking model of aggregate demand that is tractable and usable with a wide variety of aggregate supply specifications. Theoretical applications concerning price level determinacy and gradual price adjustment are included.

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Article provided by Blackwell Publishing in its journal Journal of Money, Credit and Banking.

Volume (Year): 31 (1999)
Issue (Month): 3 (August)
Pages: 296-316

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Handle: RePEc:mcb:jmoncb:v:31:y:1999:i:3:p:296-316
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  1. Christiano, Lawrence J & Eichenbaum, Martin, 1995. "Liquidity Effects, Monetary Policy, and the Business Cycle," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 27(4), pages 1113-36, November.
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  8. McCallum, Bennett T., 1981. "Price level determinacy with an interest rate policy rule and rational expectations," Journal of Monetary Economics, Elsevier, vol. 8(3), pages 319-329.
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  13. David Gruen & Geoffrey Shuetrim, 1994. "Internationalisation and the Macroeconomy," RBA Annual Conference Volume, in: Philip Lowe & Jacqueline Dwyer (ed.), International Intergration of the Australian Economy Reserve Bank of Australia.
  14. Sargent, Thomas J & Wallace, Neil, 1975. ""Rational" Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule," Journal of Political Economy, University of Chicago Press, vol. 83(2), pages 241-54, April.
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