Article summary of Romer 2000

Article summary of Romer 2000 Project description Please follow the instruction carefully: Article Summaries: You are expected to provide a typewritten summary of two articles during the quarter. It would be difficult to provide a complete summary in less than two pages. Also, it is expected that the summary contains your reaction to the article, either within the summary or with a short paragraph or two at the end. Feel free to include questions about the material or additional thoughts that you have Keynesian Macroeconomics without the LM Curve David Romer T he IS-LM model has been a central tool of macroeconomic teaching and practice for over half a century. Legions of earlier writers have offered criticisms of the model that have become familiar with the passage of time: the model lacks microeconomic foundations, assumes price stickiness, has no role for expectations, and simplifies the economy’s complexities to a handful of crude aggregate relationships. But countless teachers, students, and policymakers have found the model to be a powerful framework for understanding macroeconomic fluctuations. Recent developments have created new difficulties for the IS-LM model. Although the new difficulties are less profound than the traditional ones, they are more likely to be fatal. Like all models, the IS-LM model is not universal. Its assumptions and simplifications make it better suited to analyzing some issues than others, and to describing some economic environments than others. But neither the issues nor the environment of macroeconomic fluctuations are fixed. In terms of issues, one major change is that the debates between Keynesians and monetarists about the relative effectiveness of monetary and fiscal policy that were central to macroeconomics in the 1960s and 1970s now play only a modest role in the analysis of short-run fluctuations. In terms of the environment, one important change is that most central banks, including the U.S. Federal Reserve, now pay little attention to monetary aggregates in conducting policy. But the IS-LM model is particularly well-suited to presenting the debates between Keynesians and monetarists, and one of its basic assumptions is that the central bank targets the money supply. In short, recent developments work to the disadvantage of IS-LM. This obser- vation suggests that it is time to revisit the question of whether IS-LM is the best y David Romer is Professor of Economics, University of California, Berkeley, California. Journal of Economic Perspectives—Volume 14, Number 2—Spring 2000 —Pages 149 –169 choice as the basic model of short-run fluctuations we teach our undergraduates and use as a starting point for policy analysis. The thesis of this paper is that it is not. There is an old adage that it takes a theory to beat a theory. Joining the many earlier authors who have pointed out weaknesses in the IS-LM model, and describ- ing how many of those weaknesses are particularly important for macroeconomics today, will not persuade economists to depart from the model unless I can show that there are alternatives that avoid some or all of its weaknesses without encoun- tering even greater ones. I therefore make the case against IS-LM mainly by presenting a concrete alternative. The alternative replaces the LM curve, along with its assumption that the central bank targets the money supply, with an assumption that the central bank follows a real interest rate rule. The new approach turns out to have many advantages beyond the obvious one of addressing the problem that the IS-LM model assumes money targeting. As I describe over the course of the paper, it avoids the complications that arise with IS-LM involving the real versus the nominal interest rate and inflation versus the price level; it simplifies the analysis by making the treatment of monetary policy easier, by reducing the amount of simultaneity, and by giving rise to dynamics that are simple and reasonable; and it provides straightforward and realistic ways of modeling both floating and fixed exchange rates. The fact that there is one alternative that appears superior to IS-LM for macroeconomics today does not mean that this particular alternative is necessarily the best baseline model. In addition to presenting my specific alternative to IS-LM, I therefore also briefly consider some other possibilities. The IS-LM Model The simplest version of the IS-LM model describes the macroeconomy using two relationships involving output and the interest rate. The first relationship concerns the goods market. A higher interest rate reduces the demand for goods at a given level of income. In almost all formulations of the model, it reduces investment demand; in many, it also reduces the demand for consumer durables or for consumption in general. In open-economy versions with floating exchange rates, it bids up the value of the domestic currency and thereby reduces net exports. Because a higher interest rate reduces demand, it lowers the level of output at which the quantity of output demanded equals the quantity produced. There is thus a negative relationship between output and the interest rate. This relationship is known as the IS curve; the name comes from the fact that in a closed economy, the condition that the quantity of output demanded equals the quantity produced is equivalent to the condition that planned investment equals saving. The second relationship concerns the money market. The quantity of money demanded—that is, the demand for liquidity—increases with income and decreases with the interest rate. This liquidity preference combines with the quantity of money supplied by the central bank to determine equilibrium in the money 150 Journal of Economic Perspectives PLACE THIS ORDER OR A SIMILAR ORDER WITH US TODAY AND GET AN AMAZING DISCOUNT :)