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

  • Bennett T. McCallum
  • Edward Nelson

This paper asks 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 imparts a dynamic, forward-looking aspect to saving behavior and leads to a model of aggregate demand that is tractable and usable with a wide variety of aggregate supply specifications. Theoretical applications concerning price level determinacy and inflation persistence are included.

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Paper provided by Carnegie Mellon University, Tepper School of Business in its series GSIA Working Papers with number 1997-71.

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Handle: RePEc:cmu:gsiawp:73
Contact details of provider: Postal: Tepper School of Business, Carnegie Mellon University, 5000 Forbes Avenue, Pittsburgh, PA 15213-3890
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  19. Jinill Kim, 1998. "Monetary policy in a stochastic equilibrium model with real and nominal rigidities," Finance and Economics Discussion Series 1998-02, Board of Governors of the Federal Reserve System (U.S.).
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  29. Evan F. Koenig, 1993. "Rethinking the IS in IS-LM: adapting Keynesian tools to non-Keynesian economies Part 2," Economic and Financial Policy Review, Federal Reserve Bank of Dallas, issue Dec, pages 17-35.
  30. Lucas, Robert Jr., 1994. "Comments on Ball and Mankiw," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 41(1), pages 153-155, December.
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