The New York Gimes The Opinion Pages The Monetary Base, IS-LM, And All That (Very Nerdy) August 23, 2013 10:13 am. Cullen Roche weighs in on my arguments about the usefulness of IS-LM — and I think we've reached a moment of impressive clarity. Basically, we aren’t having a real argument about the economic substance, on which we appear to agree. Instead, Roche and others are misunderstanding both what I mean by IS-LM and my reasons for invoking it in our current predicament. And much of the blame probably rests with yours truly: I probably haven’t been explicit enough about what I’m doing and why. First things first: one thing I do think Roche gets wrong is misunderstanding the reasons I cite Tobin-Brainard (pdt). Yes, it’s half a century old, and it discusses things like changes in reserve requirements as a tool of policy that don’t happen any more. But the whole point of the paper was to ask what would happen if all that stuff ‘went away, if we started to have financial intermediaries that don’t hold reserves at the central bank. In effect, it was an attempt to anticipate the world we now live in, in normal times and th where even commercial banks hold minimal resei large shadow banking sector that has no reserve requirements at all. They asked, would the central bank still have power in such a world? Their answer was yes — and they were right! Until we hit the zero lower bound, central banks clearly retained the power to set short-term interest rates, and this in turn gave them lots of traction on the real economy. But in this more complex world, where even the definition of the money supply becomes highly dubious, why even talk about an LM curve? Well, before 2008 most s didn’ macroeconomi: ey talked instead about interest rate targets, Taylorrules, and all that. Mike Woodford, who is probably our leading macroeconomist’s macroeconomist, has even made one of his signature modeling tricks the building of models in which there is (almost) no outside money. Sensible macroeconomists have known for a long time that quantity-theory type models, if they were ever useful, aren't much use in the modern economy. So why am I bringing IS-LM into the discussion? First of all, I should have been much clearer than I have been that the LM curve I’ve been drawing is for a given monetary base, not a given M1, M2,or whatever. I guess I haven't said that clearly, although it’s implicit in my old Japan paper (pdf), where I do state clearly the point that in the liquidity trap the central bank, while it can control the monetary base, generally can’t control broader monetary aggregates. But still, why use any kind of “quantity-centric” approach at all? The answer is, to refute the bad guys! Remember, in 2009-2010 there were a lot of people pointing to the rapid rise in the monetary base and declaring that massive inflation was coming any day now; some of them are still waiting. So I rolled out good old IS-LM. to show that in a liquidity trap they were all wrong, that even a huge increase in the base would go nowhere. This conclusion, by the way, did not depend on interest on excess reserves. As I've pointed out in the past, Japan did a massive quantitative easing without IOER, and the results were basically the same — nothing much — as QE here. Of course IOER offers a new tool of monetary control — Woodford talked all about that in the 12-year-old paper cited above. But the fundamentals haven’t changed. So, if and when we finally emerge from this trap and reenter the world of significantly positive short-term interest rates, will I still be talking in terms of IS- LM? In normal times central bank monetary policy is conducted in terms of, and best thought of in terms of, the target interest rate — and I won't have to worry about refuting the inflationary scare stories of Allan Meltzer et al. So the LM curve will go back into the drawer. But I will keep it there in case I need it again; it has come in very useful these past five years.© 2017 The New York Times Company