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Why LM Is Still Here

Matt Rognlie asks:

Why is LM still there?: [T]he “LM” curve? It’s implicitly describing a monetary policy rule that disappeared decades ago. Here’s the story: the central bank has a target for the nominal money supply…. Generally, higher real output (“Y”) will increase the demand for real money balances, while higher nominal interest rates (“i”) decrease it. The set of possible equilibrium pairs (Y,i), therefore, has positive slope: when high Y is elevating demand for real money, i has to rise as well to bring demand back into line with the fixed supply.

Fair enough. But central banks today don’t target the nominal money supply: in the short run, they target nominal interest rates directly. In this light, a more sensible “LM” curve would be horizontal…. [D]epicting policy as a relationship between “Y” and “i” misses what’s really going on—better to abandon the upward-sloping LM curve altogether and use a simple horizontal line to depict the current policy rate…

The Federal Reserve, September 21, 2011:

Federal Reserve issues FOMC statement: [T]he Committee decided today to extend the average maturity of its holdings of securities. The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less…

The Federal Reserve, November 3, 2010:

FRB: Press Release: The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month…

The Federal Reserve, December 16, 2008:

FRB: Press Release: [O]ver the next few quarters the Federal Reserve will purchase large quantities [i.e., up to $600 billion] of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant…

Let me be the first to say that I really, really wish the Federal Reserve would pull a Paul Volcker--would change its operating procedures--and announce that it will buy as many risky and long-duration assets for cash as it needs to in order to push market expectations of nominal GDP five years hence back to its pre-2008 trend level of $18 trillion/year.

But it really, really, really looks as though monetary policy decisions right now consist of the FOMC deciding to make a discrete quantitative change in the monetary base (or the near-monetary base of extremely short-term zero-yield government liabilities). And as long as policy takes the form of throwing discrete chunks of money at the problem, the LM curve is very useful--indeed, necessary if you are going to get anywhere in your analysis.

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