Sunday, October 16, 2011

An IS-LM Model That Almost Has It All

There is an ongoing debate in the blogosphere on the usefulness of the IS-LM model taught in undergraduate economics.  Brad DeLong nicely summarizes the problems with this model:
We really need a model with five moving pieces:
  1. Money demand equilibrium M = L(i, PY) as a function of the level of spending and the short-term safe nominal interest rate.
  2. Flow-of-funds S = I + (G-T) as a function of the level of spending and the long-term risky real interest rate.
  3. Expected inflation to get you from the nominal to the real interest rate.
  4. A term premium as a function of expectations to get you from the short-term to the long-term real interest rate.
  5. Risk spreads to get you from the safe to the risky real interest rate.
Well Brad, there actually is such an undergraduate IS-LM model that fufills most of these criteria.  It is developed by Charles L. Weise and Robert J. Barbera in this paper here.  It incorporates the short-term policy rate, the natural interest rate, the long-term risky real interest rate, the term premium, the risk premium, and the term structure of interest rates.  The model has an IS curve, an AS curve, and a TS or term structure curve.  The model can also be easily drawn in (r, Y) space. The big drawback is that money and its importance for recessions--money is the one asset one every market and thus the one asset that can disrupt every market--is ignored.  Still, the Weise-Barbera IS-LM model is still a vast improvement over the standard undergraduate IS-LM.  Do take a look.

2 comments:

  1. Where do the risk spreads come from? Exogenous ? Don't we need a theory of risk?

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  2. David , this is another vast improvement on the meagre offerings of US textbooks:

    http://eprints.uwe.ac.uk/12644/2/Money_in_macro.pdf

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