A derivation of the IS-LM model from explicit optimizing behavior

Abstract

A general equilibrium analysis which closely resembles the ad hoc IS-LM model of traditional macroeconomics is derived from explicit optimizing behavior in an overlapping generations model in which individuals have finite lives and generations are not linked by the bequest motive. Therefore tax finance and bond finance are not equivalent, and the conventional analysis of open-market operations, and bond-financed changes in government spending and in current taxes require the changes in expected future taxes to be fully specified. These fully specified policy changes are analyzed under rational expectations.