Rescuing the LM (and the money market) in a modern Macro course

Roberto Tamborini

No 706, Department of Economics Working Papers from Department of Economics, University of Trento, Italia

Abstract: This paper considers recent proposals of introductory-level macroeconomic models that drop the LM apparatus in favour of the straightforward use of the Taylor rule as a means to determine the nominal interest rate and to link the monetary block with the real block of the economy. Whilst one can only agree with the various complaints made against the traditional treatment of the LM apparatus that still survives in modern textbooks, the new IS-AS-TR workhorse has several drawbacks as well, the most serious one being that it completely hides the concept of monetary equilibrium from view, transmitting the faulty idea that the central bank can set the (real!) interest rate at will, with no connection at all with money demand and supply. The paper suggest how a Macro course could be structured around a model of New Keynesian inspiration where the LM block is amended rather than suppressed. Section 2 surveys the foundations of the macro-model. Section 3 deals with the foundations of the role of money in the model, and shows how to derive a consistent LM "gap function" in relation to "output gaps" and "inflation gaps" according to current practice. Section 4 expands upon the monetary block, highlighting that it admits of two monetary policy regimes, the "exogenous-money regime", and the "endogenous-money regime". The latter leads quite naturally to the Taylor rule, while making it clear that this is a particular choice of the central bank, and that it implies an endogenous path of the money stock determined by the underlying money market equilibrium. Section 5 concludes.

Date: 2007
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
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