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It is indubitable that the IS-LM model that was first presented in “Mr. Keynes and the Classics: A Suggested Interpretation” by John R. Hicks in 1937 has been fundamental to the education of macroeconomics. As an economic instrument, IS-LM is a tool that is designed to simplify and allow observation of the relationships of interest rates, real output in the goods and services market and the money market. David Romer, regarded as a leader in New Keynesian economics and author of Keynesian Macroeconomics without the LM Curve, dismisses the use of IS-LM as an adequate tool for learning. Romer outlines critical weaknesses of the IS-LM model and an alternative that addresses many of the problems with the model. In evaluating the meritoriousness of Romer’s composition, this paper will cogently summarise Romer’s arguments, analyse his interpretation, and identify any limitations or potential extensions to his detailed work.
Romer’s initial proposition is that the simple IS-LM model as an economic instrument is subject to limitations, the first being that it cannot be used to analyse inflation. Romer acknowledges that this model was better suited to the 1950’s and 60’s where inflation was of little concern, however as inflation became increasingly significant, extensions to the model were needed that eventually led to the incorporation of aggregate supply. However, there is a great deal of controversy that surrounds the IS-LM-AS model. The first being that the price level does not adjust immediately and completely to disturbances, where Romer argues the lack of perfect nominal adjustment causes monetary changes to affect real output in the short run. The second controversial decision is the disregard to microeconomic principles such as demands for consumption, investment, money, and the nature of price adjustment, that are postulated and defended on the basis of intuitive arguments rather than derived from analyses of households’ and firms’ objectives and constraints.
Romer presents three choices that make the IS-LM-AS model inappropriate. (1) Different interest rates are pertinent to different parts of the model. The real interest rate is relevant to the demand for goods and thus to the IS curve, while the nominal rate is relevant to the demand for money and thus to the LM curve. (2) Aggregate demand and aggregate supply curves are relationships between output and the price level, while what we typically interested in understanding is the behaviour of output and inflation. E.g. negative shocks to aggregate demand in post war US have led to falls in inflation, not to the declines in the price level. (3) The model assumes the central bank sets a fixed money supply. However most central banks pay little attention to the money supply in making policy.
Romer primarily advocates the use of the IS-MP-IA model as a replacement for the IS-LM model. Keynesian Macroeconomics without the LM curve suggests several advantages of the alternative model. (1) The central bank follows a real interest rate rule; that is, it acts to make the real interest rate behave in a certain way as a function of macroeconomic variables such as inflation and output. The appropriateness of this assumption lies in the way central banks behave. Central banks in almost all industrialised countries focus on interest rate on loans between banks in their short-run policy-making. And therefore, the assumption that the central bank follows an interest rate rule that is more realistic than the assumption that it targets the money supply. (2) The new approach describes monetary policy in terms of the real interest rate. As looking beyond short run, real interest rate rule is more realistic than a nominal rate rule and it is important to the model’s simplicity and coherence. (3) A real interest rate rule is simpler than the LM curve. When inflation is high, its concern about inflation predominates, and so it chooses a high real rate to contract output and dampen inflation. When inflation is low, it is no longer as concerned about inflation, and so it chooses a lower real rate to increase output. (4) In the new approach, the aggregate demand curve relates inflation and output. Inflation determines the central bank’s choice of the real rate, and the IS curve then determines output. (5) In the simple version of the model, there is no simultaneity. That is inflation is inherited from the economy’s past. Inflation determines the real interest rate, and the real rate determines output. (6) The model’s dynamics are straightforward and reasonable. For example a departure of output from normal causes inflation to change, which causes the central bank to change the real interest rate, which moves output back toward normal.
The Money Market
In the MP model, the concept of money is high-powered money, that is being manipulated to make interest rates behave in the way it desires. (7) With the new approach, the correct concept of money to consider is unambiguous. (8) One can fully incorporate endogenous changes in expected inflation into the analysis of the aggregate demand side of the model. Changes in expected inflation affect how the central bank must adjust the money stock to follow its real interest rate rule, but have no further effects on aggregate demand.
The Open Economy
(9) The same framework can be used to analyse a closed economy, floating exchange rates, and fixed exchange rates. (10) With the new approach, one can show how a fixed exchange rate constrains monetary policy without adopting the unrealistic view that it completely determines it. (11) The approach shows the asymmetry in a fixed exchange rate system: the bank is free to pursue policies that create reserve gains, but beyond some point cannot pursue policies that create reserve losses
Other alternative models
Upward-sloping MP Curve
Central banks can also make the real rate depend on output. Cutting the real rate when output falls and raising it when output rises directly dampens output fluctuations. High output also tends to increase inflation and low output to decrease it, this policy also dampens inflation fluctuations.
An expectations-Augmented Aggregate supply curve
In this alternative, the model replaces the assumption that inflation adjusts gradually with the more standard assumption of an expectations-augmented aggregate supply curve.
A Money Market Equilibrium Curve
A more general approach is raised that could show many sets of assumptions imply an upward-sloping curve in output-real interest rate space where the money market is in equilibrium for a given inflation rate. However does not deliver clear-cut answers of what types of developments shift the money market equilibrium curve.
Ultimately, the IS-LM model forms of a pivotal part of macroeconomic education, and it must be used in conjunction with prudence in order to facilitate accurate understanding of economic activity. While the impact of Romer’s composition on changing contemporary teaching model inevitably suffers due to the trade-off between simplicity and accuracy, it is a seminal piece in that it continues to remain a fundamental piece of macroeconomic instruction for students, despite perhaps presenting a flawed means as to how to go about it.
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