"Examine the major areas of disagreement between Keynesians and monetarists. Comment briefly on the view that their disagreements are as much a matter of ideology as of economics."

University Degree Business and Administrative studies

“Examine the major areas of disagreement between Keynesians and monetarists. Comment briefly on the view that their disagreements are as much a matter of ideology as of economics.”

Claudia Hafenmayr, 020664947

Term 2

Module: Macroeconomic Analysis

The Keynesian Theory was founded by John Mainard Keynes, who published “The General Theory of Employment, Interest and Money” in 1936. During the 1930s the Classical economic theory failed to state the reasons for the economic problems in the great depression. They could not explain why the economy settled into an equilibrium at a high rate of unemployment. While Keynes was convinced that because of imperfect markets a modern economy could be at equilibrium at any rate of unemployment. “ [T]he postulates of classical theory are applicable to a special case only and not the general case, the situation which it assumes being a limiting point of the possible positions of equilibrium.” (Keynes, 1936, p.6) He concluded that an active fiscal policy is necessary to reduce high rates of unemployment.

Throughout the 1960s and 1970s economists started to critique the Keynesian Theory and propounded a theory that stressed the efficiency of the free-market mechanism and the overriding importance of the money supply in economic policy .The monetarist concepts were originated from the Classical economics but they modified some of the Classical views. One of the academic leaders was Prof. Milton Friedman, who demonstrated a close correlation between changes in the money supply and the rate of change of money GDP, and therefore prices. So the monetarists suggestion was that there is a strong causal relationship between the supply of money and inflation.

The very basic Keynesian equation is the national income accounting equation:

Y = C+I+G, (Y= National Income, C= Consumption of the private sector, I = Investment, G= Government expenditure.)

Government expenditure and investment are exogenously given and the consumption is determined by C=Cv+cY (Cv= Autonomous Consumption , c= marginal propensity to consume).

C+ I * G ´´

C+I+G´

´ Y´ Y* Y´´

Y*-Y´= recessionary gap

Y´´-Y*= inflationary gap

If the aggregated demand is not sufficient economy will settle at an equilibrium where not all resources are fully employed (Y´). Keynes argues that this lack in AD can be eliminated by increased government expenditure and therefore economy will settle again at the full employment equilibrium (Y*). Fiscal policy is especially efficient in Keynes model because of the concept of the Keynesian Multiplier. The Multiplier ( k=1/(1-c) ), suggests that a small changes in the level of aggregate demand will raise the final income by a amount greater than the original change. As the money spend by the government will increase the income of some people they will as well spend more money, which increases the income of other persons, and so. The magnitude of the multiplier effects depends on the marginal propensity to consume, i.e. if the marginal propensity to consume (c) is 6, the multiplier is 2,5, so the change in exogenous expenditures would produce a change in income 2.5 greater.

The quantity theory of money is the foundation for the monetarist theory:

M x V = P x T (M=money supply, V=velocity, P=price level, T= volume of transactions, which equals Y (= real output))

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The quantity theory of money is the foundation for the monetarist theory:

M x V = P x T (M=money supply, V=velocity, P=price level, T= volume of transactions, which equals Y (= real output))

The monetarists assume that the velocity is predictable and therefore can be ignored. So if money supply increases either P or T increase but as T is supposed to be fixed, a growth in M will only increase the price level and produce inflation. So they believe that any growth of the money stock, e.g. to finance a higher government expenditure will result in inflation. “The conclusion is that substantial changes in prices or nominal income are almost invariably the result of changes in the nominal supply of money.” (Friedman, 1968a, p.434)

Another model for macroeconomic analysis is the Aggregated Supply- Aggregated Demand Model.

Keynesians believe that prices and wages are quite inflexible especially downwards because of the collective bargaining of trade unions, long term contracts and the assumption that workers would rather accept a cut in real wages than in nominal wages (money illusion).

As there is unemployment in the “Keynesian economy” firms can obtain as much labour as they want at the current wage and can therefore increase their production without increasing the costs of labour. As a result the AS curve is almost horizontal in the Keynesian model.

price level

AD´ AD´´ output

Therefore shifts in the AD curve are determining the level of output so Keynes solution for fluctuations in the economy is a countercyclical budgetary policy. Government expenditure should be used, in conjunction with taxes to stimulate the economy in times of depression and “deflate” the economy when its overheated in boom periods.

Like the Classics the Monetarist believe that prices and wages are flexible and that markets in general will clear in equilibrium. But they assume that there is a natural rate of unemployment even if the labour market is in equilibrium. This natural rate of unemployment is determined by “the actual structural characteristics of the labor and commodity markets, including market imperfections,[…] the cost of gathering information about job vacancies and labor availabilities, the cost of mobility, and so on.” (Friedman, 1968b) As prices are flexible the AS curve will establish at this level of output

Y* Y

As the monetarist assume a vertical AS curve it is obvious that they do not think increasing AD is useful in a recession. The shift in the AD curve will only change prices but not output. So if government tries to lower unemployment below the natural rate it will only increase inflation.

Another model which shows the differences between monetarists and Keynesians is the IS – LM Model.

The IS Curve shows all points of equilibrium at the market for goods and services while the LM curve represents all points of equilibrium for the money market. So at the intersection of the IS-LM curves both markets are in equilibrium.

Monetary policy will result in a shift in the LM curve. A increase in the money supply will shift the curve to the right, a decrease to the left. Fiscal policy will shift the IS curve, e.g. a higher government expenditure or lower taxes will shift the curve to the right.

In the Keynesian theory the IS curve is vertical as they believe that investment is not interest-elastic. LM curve is upwards sloping because the demand for money is assumed to be interest-elastic.

Y Y´

Based on the assumed shapes it is understandable why Keynesian prefer fiscal policy to monetary policy. While a shift to the right of the IS curve will increase Y, a shift in the LM curve will only change the rate of interest.

The Monetarists believe on the contrary that LM curve is vertical because money supply is assumed to be not interest-elastic. While the IS curve is downward sloping because they assume that interest rates effect investment.

r LM

Y Y´ Y

Monetarists favour monetary policy because in their model fiscal policy only changes the interest rate but not the output while monetary policy is able to increase Y. The model can be used to show one of the side effects of fiscal policy. Monetarist argued that discretionary fiscal policy may result in “crowding out”. This can happen as a result of the increase in interest rates which result from the budget deficit cause by the higher government expenditure. In order to raise the necessary debt finance the government issues debt instruments which compete with the private demand for finance and raise the interest rate. The increase in the interest rate may reduce any private investment expenditures which are interest elastic. As well as there could be an indirect effect on private consumption. Because of the higher interest rate saving is more attractive and therefore the marginal propensity to consume may decrease. These effects reduce the multiplier size. With a vertical LM curve private sector investment will be reduced by exactly the same amount as government expenditure is increased.

Monetarists believe that normally the private sector is stable and that it is only distorted by governmental influences. Normally the self-correcting mechanisms of the economy work and keep the economy at an equilibrium. In general the monetarists promote a “laissez-faire” policy. Thus they believe that government should stop discretionary policies. To stabilise economy government should establish fixed rules for the growth of money supply in linked to the desired output growth. As measures of fiscal policy they only consider self-correcting mechanism like the income tax or unemployment benefits.

The monetarists believe that inflation is caused only by increasing the money supply. Mainly because governments try to achieve full employment i.e. under the natural rate of unemployment and in order to achieve this have increased their budget deficits, with the consequent growth in the money supply. So Governments can cure inflation, by keeping a tight control over the supply of money.

Keysians believe that the private sector is unstable and as mentioned suggest that government should balances fluctuation in the private sector through a discretionary fiscal policy.

Friedman argued that government intervention can make the fluctuations in national output larger than they would otherwise have been (Friedman, 1953). They point out that there are many lags until the fiscal actions effects the economy. First the decisions are based on information which is never really up to date. Most of the information is at least a few months old. Furthermore there are various lags till the political decision are made and till the effects actually arise. So it is possible e.g. that “anti-recession”-actions effect economy much to late when economy is already in a boom period.

time

decision effects occur time

In 1958 A. W. Phillips published his study about the relationship between inflation and unemployment – the Phillips Curve:

The Phillips Curve shows the trade-off between inflation and unemployment, On the curve rates of inflation can be identified for each level of unemployment.

inflation

Unemployment

The curve was consistent with the data from 1861-1957 but during the 70s the economic situation (stagflation) could not be explained with the simple Phillips curve.

The modified Phillips curve considers that unions bargain for real wages rather than nominal wages. Thus the curve has to be shifted up for each level of expected inflation. So there is a short-run trade off between inflation and unemployment for each given expected rate of inflation.

The point on which the vertical Phillips curve stands is the natural rate of unemployment (U*).

Rate of inflation

Unemployment U

The model of adapted expectations says that people will form their expectations about the future prices by projecting their past experience of actual prices. But this also implies that people will always be in error if prices change even if they are able to learn from their former mistakes.

The rational expectations model in contrast says that when actors in the economy form their expectations about the future they will take into account all available information and therefore e.g. anticipate inflation in their collective bargaining. If his is the case it has important implications e.g. if the government attempts to reduce unemployment by expansionary fiscal policies people will anticipate the increase in prices and the effect of the budget deficit on future interest rates and taxes, and adjust their won consumption behaviour to accommodate them, thus neutralising the effects of government policy.

Modern economists believe that the neither the Keynesian nor the monetarist theory is completely right or wrong. Today it is assumed that both theories contain important concepts. But it depends on the situation which theory is more useful. On the long run it is more realistic to assume a vertical AS-Curve and in the short-run a almost flat AS-Curve. So in that way the disagreements between Keynesians and Monetarists are more a matter of ideology as of economics. It is the same for the IS LM model, in reality neither the IS nor the LM curve is perfectly vertical but have an intermediate shape. As shown in the diagram a combination of fiscal and monetary policy can help to increase the output without increasing the rate of interest. E.g. through a higher government spending (shifts IS to the right, Y+, r+) and a increase in money supply (shifts LM to the right, Y+, r-).

IS LM

Y´ Y´´ Y

In conclusion it is obvious that Keynesians and Monetarist have very different views about various factors of economy. Because of those underlying concepts they disagree on the best way to stabilise the economy. They also differ in their main aims, while unemployment is the most important problem for the Keynesians, monetarist concentrate on fighting inflation. So besides the aspect of time, the Keynesian theory offers more solutions for an economy in a recession while the monetarist theory contains answers for inflationary problems in boom periods. So on the whole the theories seem rather to complement than to exclude one another.

Bibliography:

Chrystal, K.A., (1983), Controversies in Macroeconomics, 2nd Edition, Philip Allan.

Dornbusch, R. et al., (1998), Macroeconomics, 7th Edition, Irwin McGraw-Hill.

Friedman, M., (1953), The Effects of a Full-Employment Policy on Economic Stability: a Formal Analysis, Essays in Positive Economics, , University of Chicago Press.

Friedman, M.,(1968a), Money: Quantity Theory, The International Encyclopaedia of the Social Sciences, Vol. 10, David Sills (ed.), Macmillan, pp. 432-447.

Friedman, M., (1968b), The Role of Monetary Policy, American Economic Review, March .

Keynes, J. M., (1936), The General Theory of Employment, Interest and Money, Macmillian.

Levačić R., Rebmann A., (1982), Macroeconomics – An introduction to Keynesian-neoclassical controversies, 2nd Edition, Macmillan.

Shaw, G. K, (1988), Keynesian Economics – The Permanent Revolution, Edward Elgar.

Vane, H. R., Thompson J. L., (1992), Current Controversies in Macroeconomics – An Intermediate Text, Edward Elgar.

"Examine the major areas of disagreement between Keynesians and monetarists. Comment briefly on the view that their disagreements are as much a matter of ideology as of economics."

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