Abstract
Some years ago (before the outbreak of the financial crisis) most of the major central banks—in general— shifted to interest rate control. But does this fact render obsolete the ISLM scheme, which is apparently tied to money supply control? And isn’t it necessary to find a solid basis for interest rate control instead of just following ad hoc policy functions? This paper is a sensible approach based on the important pioneering work of William Poole [1], which shows firstly that the static ISLM framework can be further developed for the case of interest rate control and that secondly the current financial crisis and especially the policy reactions of central banks can be explained. Thirdly also the optimization behavior of central banks can be adequately represented in the dynamic version of our model framework. Especially in times of financial and economic crises (when central banks possibly switch their monetary policy instruments back to quantitative easing), it seems to be very helpful to be able to display both interest rate control and money supply control within one single model framework. Our analysis will show that retaining the LM curve is both practical and indispensable for didactic and analytical reasons.
Highlights
Some years ago most of the major central banks—in general—shifted to interest rate control. Does this fact render obsolete the IS-LM scheme, which is apparently tied to money supply control? It seems that some economists think so and replace the LM curve with a policy function (“ MP”, “TR”)
A lot of economists argue that the current financial crisis and especially the policy reactions of central banks cannot be explained with common macroeconomics
The IS-LM framework originating from Keynes’ disciples Alvin Hansen and John Hicks can—as has been demonstrated by this contribution—be appropriately extended to the case of interest rate control conducted by central banks without having to abandon the equilibrium concept of the IS-LM analysis, as has been vehemently maintained by advocates of “New Keynesian Macroeconomics” for years
Summary
Some years ago (before the outbreak of the financial crisis) most of the major central banks—in general—shifted to interest rate control. Can it make sense to blind out explicit money market equilibria within monetary macroeconomics by assuming a priori that central banks follow Taylor rules and by merely applying policy functions (“ MP ”, “ T R”), as advocates of “New Keynesian Macroeconomics” do?. Even if all major central banks should have abandoned any money supply control (which is not the case at all in the current crisis), it would remain important from a theoretical point of view to regard the pursuit of a money supply control as a reference solution, especially if there are strong indications that it has advantages in comparison with an interest rate control under certain conditions (cf Sell [3]) For this purpose, a theoretical framework is required which permits an undistorted comparison of both concepts. A Poolean interest rate control seems to be appropriate in a twofold way: does it retain the concept of the explicit money market equilibrium, it can be oriented contractively or expansively depending on the requirements, irrespective of whether the acting central bank is committed exclusively to the aim of price level stability or to the overall economic output and/or the aim of creating employment
Sign-in/Register to view highlights & summary 
Published Version (
Free)
Talk to us
Join us for a 30 min session where you can share your feedback and ask us any queries you have
Schedule a call