The Hidden Credit Boom in IS-LM Monetary Policy Analysis

Abstract

This paper shows that the elimination of the capital market by Walras' Law in the standard IS-LM textbook model hides an interesting aspect of the monetary transmission process of this model. If a look behind the curtain of the IS-LM-presentation of the Keynesian fixed price model is allowed for, this reveals that under quite plausible assumptions, monetary policy can cause a credit boom, which significantly increases its leverage. As is shown, the decisive role monetary policy plays this model is due to the fact that in a fixed price model without money, the interest rate is undetermined. This indeterminacy of the interest rate in the model without money, is the ultimate reason for the strong leverage that monetary policy can exert in the model with money. The analysis shows also that the IS-LM-version of the Keynesian fixed price model can be mathematically derived from different institutional setups of monetary policy, such as a setup, where monetary policy is conducted by open market operations, or a setup, where monetary policy is conducted by financing the government budget.

Keywords: Monetary policy transmission, credit boom, IS-LM-model, subprime crisis

JEL Classification: A20, E51, E43