A micro-founded IS-LM model

Traditional Keynesian models, like the IS-LM one, were discarded as they lack micro-foundations. They were also subject to the Lucas critique (in the sense that one cannot properly estimate a macroeconomic model if the parameters respond to changes in monetary/fiscal policy).

What mainstream macro has come up with was first the real business cycles approach, and then, the so called dynamic stochastic general equilibrium models which include various nominal and real frictions. Not all economists however think that the old-style IS-LM model is not useful anymore. A known proponent of this approach is Krugman who said: “That doesn’t mean that you have to use Mike’s [Woodford] model or something like it every time you think about policy; by and large, ad hoc models like IS-LM are actually more useful, in my judgment. But you probably do want to double-check your logic using fancier optimization models” (see here and here). Yet another economist who adheres to this point of view is Brad DeLong who says that “To have fake micro foundations for your model is not a feature, but a bug”. Simon Wren-Lewis does an interesting discussion here.

A possible significant contribution to this topic might be the paper by Pascal Michaillat and Emmanuel Saez, “An Economical Business-Cycle Model”. They constructed a micro-founded IS-LM model using the money-in-the-utility function a la Sidrauski. They also introduced unemployment through labor market frictions. Admittedly, their analysis focused rather on the steady state dynamics, excluding issues of key interest, like the effects of monetary policy shocks, the second order moments or estimating the model. Nevertheless, their analysis has shown that the gap between IS-LM could be much smaller than thought

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