Article summary of Romer 2000

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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 aIDressing 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 aIDition 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 -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