An IS-LM Model That Almost Has It All

There is an ongoing debate in the blogosphere on the usefulness of the IS-LM model taught in undergraduate economics.  Brad DeLong nicely summarizes the problems with this model:

We really need a model with five moving pieces:

  1. Money demand equilibrium M = L(i, PY) as a function of the level of spending and the short-term safe nominal interest rate.

  2. Flow-of-funds S = I + (G-T) as a function of the level of spending and the long-term risky real interest rate.

  3. Expected inflation to get you from the nominal to the real interest rate.

  4. A term premium as a function of expectations to get you from the short-term to the long-term real interest rate.

  5. Risk spreads to get you from the safe to the risky real interest rate.

Well Brad, there actually is such an undergraduate IS-LM model that fufills most of these criteria.  It is developed by Charles L. Weise and Robert J. Barbera in this paper here.  It incorporates the short-term policy rate, the natural interest rate, the long-term risky real interest rate, the term premium, the risk premium, and the term structure of interest rates.  The model has an IS curve, an AS curve, and a TS or term structure curve.  The model can also be easily drawn in (r, Y) space. The big drawback is that money and its importance for recessions–money is the one asset one every market and thus the one asset that can disrupt every market–is ignored.  Still, the Weise-Barbera IS-LM model is still a vast improvement over the standard undergraduate IS-LM.  Do take a look.
This post originally appeared at Macro and Other Market Musings and is reproduced with permission.