Editing IS–LM model (section)

==IS–LM model with interest targeting central bank==

The fact that contemporary central banks normally do not target the money supply, as assumed by the original IS–LM model, but instead conduct their monetary policy by steering the interest rate directly, has led to increasing criticism of the traditional IS–LM setup since 2000 for being outdated and confusing to students. In some textbooks, the traditional LM curve derived from an explicit money market equilibrium story consequently has been replaced by an LM curve simply showing the interest rate level determined by the central bank. Notably this is the case in [[Olivier Blanchard]]'s widely-used<ref name=Courtoy>{{cite web |last1=Courtoy |first1=François |last2=De Vroey |first2=Michel |last3=Turati |first3=Riccardo |title=What do we teach in Macroeconomics? Evidence of a Theoretical Divide |url=https://sites.uclouvain.be/econ/DP/IRES/2021023.pdf |website=sites.uclouvain.be |publisher=UCLouvain |access-date=17 November 2023}}</ref> intermediate-level textbook "''Macroeconomics''" since its 7th edition in 2017.<ref name=Davis>{{cite journal |last1=Davis |first1=Leila E. |last2=Gómez-Ramírez |first2=Leopoldo |title=Teaching post-intermediate macroeconomics with a dynamic 3-equation model |journal=The Journal of Economic Education |date=2 October 2022 |volume=53 |issue=4 |pages=348–367 |doi=10.1080/00220485.2022.2111385 |s2cid=252249958 |url=https://www.tandfonline.com/doi/full/10.1080/00220485.2022.2111385 |access-date=17 November 2023 |language=en |issn=0022-0485|url-access=subscription }}</ref>

In this case, the LM curve becomes horizontal at the interest rate level chosen by the central bank, allowing a simpler kind of dynamics. Also, the interest rate level measured along the vertical axis may be interpreted as either the nominal or the real interest rate, in the latter case allowing inflation to enter the IS–LM model in a simple way. The output level is still determined by the intersection of the IS and LM curves. The LM curve may shift because of a change in monetary policy or possibly a change in inflation expectations, whereas the IS curve as in the traditional model may shift either because of a change in fiscal policy affecting government consumption or taxation, or because of shocks affecting private consumption or investment (or, in the open-economy version, net exports). Additionally, the model distinguishes between the policy interest rate determined by the central bank and the market interest rate which is decisive for firms' investment decisions, and which is equal to the policy interest rate plus a premium which may be interpreted as a risk premium or a measure of the market power or other factors influencing the business strategies of commercial banks. This premium allows for shocks in the financial sector being transmitted to the goods market and consequently affecting aggregate demand.<ref name=blanchard/>{{Rp|195-201}}

Similar models, though called slightly different names, appear in the textbooks by [[Charles I. Jones|Charles Jones]]<ref name=araujo>{{cite journal |last1=de Araujo |first1=Pedro |last2=O’Sullivan |first2=Roisin |last3=Simpson |first3=Nicole B. |title=What Should be Taught in Intermediate Macroeconomics? |journal=The Journal of Economic Education |date=January 2013 |volume=44 |issue=1 |pages=74–90 |doi=10.1080/00220485.2013.740399 |s2cid=17167083 |url=https://www.tandfonline.com/doi/full/10.1080/00220485.2013.740399 |access-date=17 November 2023 |language=en |issn=0022-0485|url-access=subscription }}</ref> and by [[Wendy Carlin]] and [[David Soskice]]<ref name=Davis/> and the [[CORE Econ]] project.<ref name=Davis/> Parallelly, texts by Akira Weerapana and [[Stephen Williamson (economist)|Stephen Williamson]] have outlined approaches where the LM curve is replaced with a real interest rate rule.<ref name=araujo/><ref>{{cite journal |last1=Weerapana |first1=Akila |title=Intermediate Macroeconomics without the IS-LM Model |journal=The Journal of Economic Education |date=2003 |volume=34 |issue=3 |pages=241–262 |doi=10.1080/00220480309595219 |jstor=30042548 |s2cid=144412209 |url=https://www.jstor.org/stable/30042548 |access-date=18 November 2023 |issn=0022-0485|url-access=subscription }}</ref>