I have been convinced by David Romer's arguments that it is time to downweight the LM curve, and to return the teaching of intermediate macroeconomics to a close relationship with reality by focusing on (i) the IS curve, and (ii) the fact that central banks target interest rates and not money stocks. The core of Romer's argument is given in the three quotes below, along with the reference to his--brilliant--article.
In my view, there are four reasons to downplay the LM curve in intermediate macroeconomics:
- Its motivating assumption that central banks fix money stocks is simply false.
- It makes it extremely hard for students to read about monetary policy in the newspaper--there is simply no connection between shifts in the LM curve and the actions that newspapers report that central banks undertake. It is long past time to bring the textbook presentation much closer to what people will find when they open the Wall Street Journal.
- It adds significant complexity to the algebra of determining the economy's short-run output-interest rate equilibrium, and produces no corresponding benefit.
- It traps discussions of dynamics into a framework in which a change in monetary policy leads to a one-time permanent jump in the price level--a framework that is hard to apply to a real world in which shifts in monetary policy are associated not with permanent jumps in the price level, but with changes in the inflation rate.
False to reality, unconnected with the flow of news, needlessly complex, and leading to problems in discussing the dynamic evolution of the economy--these four reasons to downplay the LM curve are not balanced by any offsetting advantages.
You can see the contortions that people get themselves into by examining how modern textbooks attempt to convince students of the applicability of the IS-LM framework for understanding macroeconomic events. For example, one major textbook has a long discussion of the relevance of IS-LM--all of it discussing the effects of changes in central bank-controlled interest rates. There is no discussion at all of shifts in or movements along the LM curve. Smart students notice this incongruity. They wonder what is going on. Other students don't wonder, but then they have a very hard time understanding the newspaper: "why," they ask, "does the newspaper talk about interest rate changes instead of shifts in the LM curve?"
I believe major reason for giving the LM curve a central place is historical: it allows you to present the Keynesian-monetarist debate of the 1970s as a debate about the relative slopes of IS and LM curves. Steep LM curve or shallow IS curve, and the monetarists are right--the money stock is the principal determinant of output, unemployment, and inflation. Shallow LM or steep IS curve, and the Keynesians are right. But it has been a long time since macroeconomics courses focused on the Keynesians vs. monetarist debates of the 1960s.
Greg Mankiw disagrees. But I cannot figure out why. Page 290 of his Macroeconomics is an attempt to justify his decision to continue to teach students as if central banks pegged the money stock rather than the interest rate. But I do not understand the justification.
David Romer (2000), "Keynesian Macroeconomics without the LM Curve" (Cambridge: NBER Working Paper No. W7461):
Changes in both the macroeconomy and in macroeconomics suggest that the IS-LM-AS model is no longer the best baseline model of short-run fluctuations for teaching and policy analysis. This paper presents an alternative model that replaces the assumption that the central bank targets the money supply with an assumption that it follows a simple interest rate rule. The resulting model is simpler, more realistic, and more coherent than IS-LM-AS, not just in its treatment of monetary policy but in many other ways...
The debates between Keynesians and monetarists about the relative effectiveness of monetary and fiscal policy that were central to macroeconomics in the 1960s and 1970s now play only a modest role.... Yet the IS-LM model is particularly well-suited to presenting those debates.... [M]ost central banks... pay little attention to monetary aggregates.... But one of the IS-LM model's basic assumptions is that the central bank targets the money supply.... [R]ecent developments work to the disadvantage of IS-LM...
[R]eplac[e]... the LM curve, with its assumption that the central bank targets the money supply, with an assumption that the central bank follows a real interest rate rule. This new approach turns out to have many advantages besides the obvious one of addressing the weakness of IS-LM that it assumes money stock targeting.... [I]t avoids the complications that arise with IS-LM involving the real versus the nominal interest rate and inflation versus the price level; it simplifies the analysis by making the treatment of monetary policy easier, by reducing the amount of simultaneity, and by giving rise to dynamics that are simple and reasonable; and it provides straightforward and realistic ways of modelling both floating and fixed exchange rates...
From N. Gregory Mankiw, Macroeconomics 4e (Worth Publishers), p. 290:
Our analysis of monetary policy has been based on the assumption that the Fed influences the economy by controlling the money supply. By contrast, when you hear about Fed policy in the media, the policy instrument mentioned most often is the federal funds rate, which is the interest rate that banks charge one another for overnight loans. Which is right? The answer is both.
In recent years, the Fed has used the federal funds rate as its short-term policy instrument. This means that when the FOMC meets every six weeks to set monetary policy, it votes on a target for this interest rate that will apply until the next meeting. After the meeting is over, the Fed's bond traders in New York are told to conduct the open-market operations necessary to hit that target. These open-market operations change the money supply and shit the LM curve so that the equilibrium interest rate (determined by the intersection of the IS and LM curves) equals the target interest rate that the FOMC has chosen.
As a result of this operating procedure, Fed policy is often discussed in terms of changing interest rates. Keep in mind, however, that behind these changes in interest rates are the necessary changes in the money supply. A newspaper might report, for instance, that "the Fed has lowered interest rates." To be more precise, we can translate this statement as meaning "the FOMC has instructed the Fed bond traders to buy bonds in open-market operations so as to increase the money supply, shift the LM curve, and reduce the equilibrium interest rate to hit the new lower target."
Why has the Fed chosen to use an interest rate, rather than the money stock, as its short-term policy instrument? One possible answer is that shocks to the LM curve are more prevalent than shocks to the IS curve. If so, a policy of targeting the interest rate leads to greater macroeconomic stability than a policy of targeting the money supply.... Another possible answer is that interest rates are easier to measure than the money supply. As we saw in chapter 7, the Fed has several different measures of money--M1, M2, and so on--which sometimes move in different directions. Rather than deciding which measure is best, the Fed avoids the question by using the federal funds rate as its short-term policy instrument.