Review - Perspectives, Vol. 14, No. 2 (Spring 2000), 149-169. [JSTOR]

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SYED SAYEM SHAKIR


309132088

Review
-

Romer, David, “Keynesian Macroeconomics without the LM Curve,” Journal of Economic
Perspectives, Vol. 14, No. 2 (Spring 2000), 149
-
169. [JSTOR]


Article Summary


In this article, “
The Journal of Economic Perspectives

, Author Dav
id Romer
indicates the
limitations

to the basic IS
-
LM
-
AS curve

and therefore he provides a

research
that
follows a line of
exceptional theories of Keynesian Macroeconomics without the LM curve.
The author, David Romer
,
provides an

alternative to the IS
-
LM model bec
ause to his perspective there is a trade off between
the nominal rate versus the real rate and the inflation versus the price level. He starts with the basic
IS
-
LM model where he clearly identifies that the model assumes fixed price level and does not take

into account about the inflation fluctuations. Defining the basic model, we find that the LM curve is
derived from the money market where an increase in the output requires an increase in the interest
rate at a given money stock and the equilibrium in the

goods market implies that an increase in the
interest rate leads to a decrease in output

(Blanchard & Sheen, 2009).


Romer
indicated that “Central Banks pay little attention to the money supply in making
policy” (p
-
154), and on the other the model of IS
-
L
M
-
AS assumes that Central Banks sets a fixed
money supply. He also figured that nominal rate does not affect the actual economies rather the real
interest rates which is adjusted with inflation holds

the key to the monetary policy, and the author
describes

them with models and diagrams. He also brings in the dynamic picture of the open
economy where floating exchange rate makes the net investments more responsive to real interest
rate. Overall, David Romer brings an alternative to the basic IS
-
LM
-
AS model

a
nd widely defines the
unique way of monetary policy’s way of changing the real interest rate to fix the economic variables.

Critical Analysis of the Intuition


Romer demonstrated his work into series of advantages for his models. He started off with
moneta
ry policy and how the Central Bank targets the real interest rate rather than aggregate
money supply. The advantages are as follows:


Advantage 1
: The assumption that the central bank follows and interest rate rule more realistic
than the assumption that i
t targets the money supply

.(P
-
155).

Real interest rate is adjusted with inflation whereas nominal interest rate in unadjusted

for inflation
(Anderton,

A.

2008). In economic theory it is believed that due to inflationary expectations and
pressure nominal r
ate usually increases, therefore Central Banks use real interest rate in order to
fight inflation such is the case in the 1980s where Federal Reserve nominal reserve fund rates
(Goodfriend, 1998). Hence it is easier to take real rate since it affects the I
S curve.


Advantage 2
: The new Approach describes monetary policy

in terms of the real interest rate

.(p
-
156)

Here
Romer tried to explain that when high inflation
persists

in the economy, Central Banks
generally chooses a high real interest rate to dampen the situation and lowers it to increase the
outpu
t when inflation is stabilized. This brings in the third advantage where he depicts his theory
into diagram.

SYED SAYEM SHAKIR


309132088


Advantage 3
:

A real interest rate is simpler than the LM curve.”(p
-
156)

Romer brought a curve what called MP (Monetary Policy) curve, a horizontal curve which depends
on the real interest rate, and the IS curve determines the output.
When inflation is high, the MP
cur
ve shifts upwards increasing the real interest rate, and thus the IS curve shows the output.
Whereas, IS
-
LM curve higher price level reduces money supply and give rise to the interest rate
equilibrium at given output.


Advantage 4
: In the new approach, th
e aggregate demand curve relates inflation and output”.(p
-
157)

In this approach Romer observes that when inflation is high, aggregate demand falls, there is a
movement upwards in the AD curve, thus MP curve shift upwards raising the interest rate to lower
the inflation. He also assumed that inflation cannot be reduced when it is below natural level of
output, hence he depicted a curve IA (inflation adjusted) curve which is also a horizontal curve which
determines the interest
rate

and the interest rate dete
rmines the output.

SYED SAYEM SHAKIR


309132088



The rest of the advantages that Romer talked about emphasized again on the monetary
policy and the real interest rate. It seemed like he is trying hard to explain why real interest rate is so
important for the monetary policy and cent
ral banks. He al
so states that when consumer confidence
falls there is a shift of the AD curve to the left and eventually there is a fall in inflation. Romer made
some observations about the price rigidity which were quite ambiguous, and it was difficult t
o
understand what he tried to explain. He brought in the persp
ective of open economy where both
floating and fixed exchange rates with which the model could be used to
analyse

high capital
mobility.

Limitations of the model


Although
Romer

justified his po
ints, but he

did not
mention

that rising income leads to
higher demand of money which actually affects the LM curve. He precisely focused on the short
term analysis of the matter and did not consider external shocks such as rising house prices and oil
prices. He disregarded the IS
-
LM
-
AS model though it is seen to be useful

at times when financial
markets are concerned. His series of “advantages” focused and emphasized on the real interest rate
and monetary policy all the time.


At few areas he also exaggerated that the IS
-
LM model.
At

some point Romer declared the
little would be gained with the IS
-
MP model, and it is easier to work with AD
-
IA model. This might
make the students or the readers of the article

feel ambiguous towards the end.
In order to justify
his arguments he should ha
ve been more precise and not repeat the same thing over and over again.
The model had few equations, similar to the IS
-
LM model, and the diagrams were not elaborately
explained.

SYED SAYEM SHAKIR


309132088

Conclusion



Although Romer introduced lots of good points regarding his model
, but he lacked to back
them up with real life examples. He emphasized lot on real interest rate and inflation, whereas he
could justify his model with better diagrams and equations to support it.
Nevertheless, this review
has explained the intuition and l
imitations of the model that the author wanted to establish.


Reference list :

Anderton, A. 2008. Economics : “The Rate of Interest”. 4
th

ed. Pearson Education, Edinburgh Gate,
Harlow, Essex. P
-
558.

Blanchard, O. & Sheen, J. 2009.
Macroeconomics

: “Goods and Financial Market


The IS
-
LM
model.”3
rd

ed.
Pearson Australia. P
-
102

Goodfriend, Marvin S. 1993. “Interest rate Policy and the Inflation Scare Problem: 1979
-
1992.”
Federal Reserve Bank of Richmond Economic Quarterly. Winter,79, pp. 1
-
24

Romer
, David, “Keynesian Macroeconomics without the LM Curve,” Journal of Economic
Perspectives, Vol. 14, No. 2 (Spring 2000), 149
-
169. [JSTOR]