Scott Sumner on IS-LM

I favor an ad hoc approach to models–use the simplest model that gets at the issues you are interested in.  Start with a simple economy with money and goods, no bonds.  The supply and demand for money determines the price level and/or NGDP.  That’s most of human history.  Add wage price stickiness and you get demand-side business cycles.  Add interest rates and you get . . . well it’s not clear what you get.  Interest rates almost certainly have an influence on the demand for money.  Do they play a major role in the transmission mechanism between money and aggregate demand?  Hard to say.  Short term Treasury yields probably don’t have much impact.  Other asset prices might, but then there is generally no zero bound for other asset prices.  On the other hand monetary policy often operates through purchase of short term T-securities.  Bottom line, it’s complicated.

There are many excellent parts, read the whole thing, I won’t excerpt the best part.  And also there is this:

Friedman thought it was more useful to take a partial equilibrium approach to macro.  By doing so he was able to avoid the mistakes of those who looked at the Depression from an IS-LM perspective.  He was interested in how monetary policy determined NGDP, and then used a separate Phillips Curve approach with a natural rate to explain output fluctuations, to partition NGDP into RGDP and P.  He viewed interest rate movements as a sort of epiphenomenon.  Monetary policy affected rates in a complex way, which made interest rates an unreliable indicator of the stance of monetary policy.


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