Will the New Keynesian Macroeconomics Resurrect the IS-LM Model?

Abstract

The IS-LM model has no greater prospect of being a viable analytical vehicle for macroeconomics in the 1990s than the Ford Pinto has of being a sporty, reliable car for the 1990s. Because of its treatment of expectations, the IS-LM model, as traditionally constructed and currently used, is a hazardous base on which to build positive theories of business fluctuations and to undertake policy analysis. To simplify economic reality sufficiently to use the IS-LM model as an analytical tool, economists must essentially ignore expectations; we now know that this simplification eliminates key determinants of aggregate demand. The last two decades of research have taught economists that the assumption of rational expectations is a powerful part of economic explanations of individual and market behavior, ranging from consumption and investment dynamics to pricing of stocks and bonds. The emphasis on expectations in the macro-model is the end result of a process of building microeconomic underpinnings that was initiated in the 1950s and 1960s, when the goal was to develop dynamic theoretical foundations for the IS and LM schedules; inevitably, consideration of dynamic choice pushed the question of expectations to the forefront. As a result, most of the equations of the ISLM model are now viewed as summarizing purposeful economic behavior in which choices over time play a central role. However, as we will see, this finding means there is no way to maintain traditional uses of the IS-LM model.