A Simple (and Teachable) Macroeconomic Model with Endogenous Money

Abstract

According to Romer (2000), the IS-LM framework has outlived its usefulness as the basic model for teaching undergraduate students about short-run macroeconomic fluctuations. This is because central banks no longer use monetary aggregates as the instrument of monetary policy (as per the assumptions of the IS-LM model), but instead conduct policy by manipulating interest rates (see also Blinder 1997; Taylor 1997; Walsh 2002). Romer’s solution to this problem involves replacing the LM curve with an MP (monetary policy) curve that describes how central banks manipulate interest rates in response to macroeconomic outcomes such as variations in inflation and/or the level of real economic activity. The result is what has come to be known as the ‘New Consensus’ model, in which the central bank varies the interest rate in order to anchor the rate of inflation at its chosen target value, while real activity is governed by a natural rate of unemployment or NAIRU.¹ Simple and teachable variants of this model have already been developed by, for example, Taylor (2000), Carlin and Soskice (2005), and Jones (2008).