Microfoundation for IS-LM

Abstract

This paper provides a somewhat intertemporal microfoundation for IS-LM in an economy where there is a monopoly issuer of medium of exchange, money. The core microfoundation in this model comes from the Arrow-Debreu general equilibrium result that riskless interest rate may not be uniform across sectors. Thus, people in different positions have different expectations regarding maximum riskless interest rate possible. This allows one to justify the so-called investment curve. LM curve is justified by "real bills doctrine" of central bank operations. The resulting IS-LM model from fully intertemporal microfoundation requires components of IS-LM to be interpreted differently, and some of the results are qualitatively different. Nevertheless, it keeps ordinary curve shape of IS-LM. As can be expected, the IS-LM model is a static simplification of the fully intertemporal model that incorporates changes in expectation of future variables by change in curves. The static IS-LM model can however be safely used when fiscal/monetary policies anchor expectations of future variables, and especially when liquidity trap phenomena, typically said as the flat region of the LM curve arises.