The LM Curve: A Not-So-Fond Farewell
NBER Working Paper No. 10123
One of the most significant changes in monetary economics in recent years has been the virtual disappearance of what was once a dominant focus on money, and in parallel the disappearance of the LM curve as part of the analytical framework that economists use to think about issues of monetary policy. Today's standard workhorse model consists of an aggregate demand (or IS) curve and an aggregate supply (or price setting) curve, with the system closed when appropriate by an equation that represents monetary policy by relating the nominal interest rate to variables like output and inflation, but typically not either the quantity or the growth rate of money. This change in the standard analytics is an understandable reflection of how most central banks now make monetary policy: by setting a short-term nominal interest rate, with little if any explicit role for money.' But the disappearance of the LM curve has also left two lacunae in how economists think about monetary policy. Without the LM curve it is more difficult to take into account how the functioning of the banking system, and with it the credit markets more generally, matter for monetary policy. Abandoning the role of money and the analytics of the LM curve also leaves open the underlying question of how the central bank manages to fix the chosen interest rate in the first place.