Neokeinesianos

The New IS-LM Model:
Language, Logic, and
Limits
Robert G. King
R
ecent years have witnessed the development of a New IS-LM model
that is increasingly being used to discuss the determination of macroeconomic activity and the design of monetary policy rules. It is sometimes called an “optimizing IS-LM model” because it can be built up from
microfoundations. It is alternatively called an“expectational IS-LM model”
because the traditional model’s behavioral equations are modified to include
expectational terms suggested by these microfoundations and because the new
framework is analyzed using rational expectations. The purpose of this article
is to provide a simple exposition of the New IS-LM model and to discuss how
it leads to strong conclusions about monetary policy in fourimportant areas.
• Desirability of price level or inflation targeting: The new model suggests that a monetary policy that targets inflation at a low level will keep
economic activity near capacity. If there are no exogenous “inflation
shocks,” then full stabilization of the price level will also maintain output at its capacity level. More generally, the new model indicates that
time-varying inflationtargets should not respond to many economic
disturbances, including shocks to productivity, aggregate demand, and
the demand for money.
• Interest rate behavior under inflation targeting: The new model incorporates the twin principles of interest rate determination, originally developed by Irving Fisher, which are an essential component of modern
macroeconomics. The real interest rate is a keyintertemporal relative
Professor of Economics, Boston University. The author wishes to thank Michael Dotsey,
Marvin Goodfriend, Robert Hetzel, John Taylor, and Alexander Wolman for detailed comments
that materially improved the paper. The views expressed in this paper do not necessarily reflect
those of the Federal Reserve Bank of Richmond or the Federal Reserve System.
Federal Reserve Bank ofRichmond Economic Quarterly Volume 86/3 Summer 2000 4546 Federal Reserve Bank of Richmond Economic Quarterly
price, which increases when there is greater expected growth in real
activity and falls when the economy slows. The nominal interest rate
is the sum of the real interest rate and expected inflation. Accordingly,
a central bank pursuing an inflation-targeting policy designed to keepoutput near capacity must raise the nominal rate when the economy’s
expected growth rate of capacity output increases and lower it when
the expected growth rate declines.
• Limits on monetary policy: There are two limits on monetary policy
emphasized by this model. First, the monetary authority cannot engineer a permanent departure of output from its capacity level. Second,
monetary policy rulesmust be restricted if there is to be a unique rational expectations equilibrium. In particular, as is apparently the case
in many countries, suppose that the central bank uses an interest rate
instrument and that it raises the rate when inflation rises relative to target. Then the New IS-LM model implies that it must do so aggressively
(raising the rate by more than one-for-one) if there is tobe a unique,
stable equilibrium. But if the central bank responds to both current and
prospective inflation, then it is also important that it not respond too
aggressively.
• Effects of monetary policy: Within the new model, monetary policy can
induce temporary departures of output from its capacity level. However, in contrast to some earlier models, these departures generally will
not beserially uncorrelated. If the central bank engineers a permanent
increase in nominal income, for example, then there will be an increase
in output that will persist for a number of periods before fully dissipating in price adjustment. Further, the model implies that the form of
the monetary policy rule is important for how the economy responds
to various real and monetary disturbances.
In...