Key differences between ISLMAS model and two alternatives that replace LM curve with monetary policy Essay

Hickss (1937) ISLM model is main tool for shortrun macroeconomics analysis. The model is based on assumptions, that make it unrealistic. The paper briefly shows key differences between ISLMAS model and two alternatives that replace LM curve with monetary policy.

Romer (2000) assuming central bank uses interest rate rule rather than targeting money supply introduces ISMP model replacing LM with MP curve. According to Romer his approach is more simple as firstly, it uses real interest rate for MP equation, that avoids confusion related to ISLM model, where IS curve is derived using real interest rate and LM curve is derived using nominal interest rate and secondly, LM curve is derived analysing money market, whereas real interest rate rule is simply following function r=r() or alternatively r=r(Y,). The interaction of IS and MP curves gives equilibrium output and interest rate for a given inflation rate. From ISMP is derived AD curve that describe negative relation between inflation and output (see Appendix ). While AD curve derived from ISLM models describes relation between the price level and output. Based on the Teylors rule is derived inflation adjustment curve (IA), which is horizontal. ADIA interaction gives equilibrium inflation and output (Appendix ).
For deeper analysis of macroeconomic as an another alternative to ISLMAS model ISPCMR model is introduced by Carlin and Soskice (2005). This model includes time lag of policy measures of forwardlooking central bank trying to minimize utility loss in response to a chock. The model consists of three equations IS, Phillips curve (PC) and monetary policy rule.
First, it
conforms with the view that monetary policy is conducted by optimizing forwardlooking
central banks. Second, since aggregate demand responds to interest rate
changes with a lag, aggregate demand and aggregate supply shocks cannot be fully
offset even by a forwardlooking central bank. Third, in response to a shock, the
central bank guides the economy back to equilibrium with target inflation.
The model brings to the fore the relationship between the central banks preferences
and the form of the interest rate rule. In the CS model, the interest rate
rule shows the interest rate responding to current deviations of inflation from target.
An advantage of the model is that, modified with an additional lag it becomes
the SvenssonBall model. In that case, the response of inflation to output is lagged
and the central bank must forecast the Phillips curve a further period ahead, which
produces an interest rate rule that takes the familiarTayl or rule form to include contemporaneous
inflation and output shocks. Although we believe the SvenssonBall
model is too complex to use as an undergraduate teaching model, it will be useful
for students to see the relationship between the two, and hence a derivation of the
standardTayl or rule.
ISMPIA model describes modern economics more precisely than ISLMAS.
The LM curve assumes, that Central bank is targeting money supply and this assumption does not reflect current monetary policy in most countries, as central banks target interest rates.