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Romer - Essay Example

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David Romer’s Keynesian Macroeconomics without the LM curve (2000) argues that the IS-LM model is not able to properly predict short-term fluctuations. Thus, the same is not ideal to be used for policy analysis contrary to what is being taught at the college level. Romer…
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Download file to see previous pages... This alternative prevents the disparity between real and nominal interest and inflation against the price level. Simultaneity is reduced by simplifying the analysis of monetary policy and similarly provides a simplified dynamics that makes aspects of the exchange rate more credible. Extensive discussion was provided where Romer identified 11 advantages of the alternative model.
The IS-LM model has not been without criticisms as many regard it as overly straightforward in determining economic intricacies. But the same had been found to be efficient in explaining fluctuation, especially short-term. The most common version of explaining the model is through the relationship of interest rate and output. In a good market economy, an increase in the interest rate will reduce demand at certain income brackets. The same effect can be seen in the demand for investments and general consumption. In an open economy that has floating exchange rates, net exports plummet because the demanded output quantity is equivalent to production. The negative relationship of interest rate to output is called the IS curve. Money market is another definitive relationship in understanding the IS-LM model. This shows that the demand for liquidity increases as income rises while the interest rate concurrently decreases. Equilibrium in the money market is determined by the money supplied and liquidity preference. If the supply of money by the central bank is fixed and there is a simultaneous increase in aggregate income this results in the demand for liquidity. The interest rate rises to an extent that supply is met by the demand for money. This is the relationship depicted in the LM curve (Romer, 2000, pp.150-151).
An important assumption by Romer is that real interest rather than nominal interest, is a more important consideration for the central bank. This falls upon the Federal Reserve to set interest rates in order to control the IS and LM curves. In this ...Download file to see next pagesRead More
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