An Optimizing IS-LM Specification for Monetary Policy and Business Cycle Analysis

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Abstract
We ask whether relations of the IS-LM type can sensibly be used for the aggregate demand portion of a dynamic optimizing general equilibrium model intended for analysis of issues regarding monetary policy and cyclical fluctuations. The main result is that only one change-the addition of a term regarding expect-ed Future income-is needed to make the IS function match a fully optimizing model, whereas no changes are needed for the LM function. This modification leads to a dynamic, Forward-looking model of aggregate demand that is tractable and usable with a wide variety of aggregate supply specifications. Theoretical applications concerning price level determinacy and gradual price adjustment are included.

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