Keynes also attacked the idea that a cut in workers’ wages was a way to restore profits. He showed how a cut in wages would lead to less demand for goods, more bankruptcy and even more unemployment. Keynes thought governments should borrow money and spend to stimulate demand in the economy. In this way, he believed, governments were capable of preventing crises from breaking out. Crises exist, he argued, either because workers are not paid enough, or unemployment is too high, which means there is effective demand to absorb the goods produced. The result, therefore, is that goods remain unsold, profits are not realized, firms go bust and the economy does into crisis. For Keynes the solution to the critical problem of boom and bust must be solved by creating effective demand.
The neoclassical Keynesian approach
There are two structures representing the neoclassical Keynesian approach to Keynes’s analytical framework. The first approach is Hick’s IS-LM analysis, which argues that Keynesian involuntary unemployment is due to the existence of the liquidity trap (The situation in which the demand for money is perfectly elastic with respect to a low positive rate of invests). A different approach, called disequilibrium theory, interprets Keynes’s principles of effective demand in a context in which the economy move itself from one situation of partial equilibrium to another of general equilibrium.
The classical counter-revolution
Friedman and the Monetarists
In the late 1960s the neoclassical Keynesianism suffered attacks from a different school of thought, called monetarism, when many economies began to experience high rates of inflation. This theoretical attack came in the form of re-establishing the quantity theory of money to macroeconomic analysis. The debate between “Keynesian” and Monetarist economists was focused on two specific points: 1) the relationship between the money, interest rate and the level of price and output, and 2) the role and conduct of macroeconomic stabilization policy.
The Monetarists express the view that money is extremely important in macroeconomics, either because it affects temporarily the output and employment levels or by the fact that, in the long run, changes in the money supply affect only the price level. In Friedman’s own words, “...money is all that matters for changes in nominal income and for short-run changes in real income”
If money matters, which should be the monetary rules to maintain stability in the economic system? Friedman’s 1968 article, The Role of Monetary Policy, considers this subject. Arguing that the Keynesian theory does not have a monetary explanation for a long-run theory of unemployment, Friedman concentrates his analysis on two questions: What are the limitations of monetary policy? How should the monetary authorities run monetary policy?
The answer to the first question is related to the Friedman’s expectations-augmented Phillips curve model. Friedman’s argument is that, in the long run, the Phillips curve is unstable because policymakers incorrectly assume they can interfere in the economic system (according to the Philips curve, there is always a trade-off between the rates of inflation and unemployment). Friedman presents a modified version of the Phillips curve which incorporates expectations about inflation to explain why this view by policymakers is mistaken. The assumption made by Friedman is that economic agents adapt their expectations in light of past experience and revise their expectations for each period of time.
Friedman’s conclusion is that, in the long run, monetary policy cannot cause real fluctuations in the economy. As a consequence, Friedman rejects the long-run stability of the Phillips curve. In Friedman’s own words,
“...there is always a temporary trade-off between inflation and unemployment; there is no permanent trade-off. The temporary trade-off comes not from inflation per se, but from unanticipated inflation, which generally means, from a rising rate of inflation”
Friedman and the Monetarists believe that the economy is inherently stable - that is to say, the economy always returns to its long-run equilibrium at the natural rate of unemployment. In this context, monetary and fiscal policies only increase instability. Implicit is the view that free market is the solution for stabilizing the economic system at full employment.
The new classical theory
The New Classicals became dissatisfied with neoclassical Keynesian models due to the fact that they could not provide a logical explanation for the “stagflation” process, i.e. both high unemployment and inflation, of the world’s economy in the early 1970s.
Given that neoclassical Keynesian models have some econometric failures because they cannot predict the value of certain economic variables (e.g. the levels of output and employment and the price level); the New Classicals argue that Keynes’s theory is not a good guide for monetary and fiscal policies.
In contrast to the neoclassical Keynesian models, the New Classicals investigate the microfoundations of macroeconomic theory. The new classical approach to macroeconomics presents three main hypotheses: 1) the rational expectation hypothesis, 2) the hypothesis that prices and wages are set at market-clearing levels, and 3) the aggregate supply hypothesis (There are two microeconomics assumptions related to the aggregate supply hypothesis: 1) workers and firms optimize their behavior; and 2) the supply functions of labor and output by workers and firms depend upon relative prices).
According to New Classicals, expectations about the future value of inflation are not necessarily a stable function of its past values. At this point, the new classical models introduce the idea that the expectations are rational.
The new Keynesian Theory
New Keynesian theory, developed during the 1980s as a response to new classical theory, aims at presenting a theoretical structure, based on the microeconomic foundations of “Keynesian” economics, critical of the new classical models (According to New Keynesians, the new classical theory does not provide a consistent explanation why labor and output supply functions do not change when there are demand shocks).This new Keynesian structure investigates what the New Keynesians believe to be the essential aspect of Keynes’s theory: the existence of price and wage rigidities. According to Mankiw and Romer, “[b]ecause wage and price rigidities are often viewed as central to Keynesian economics; much effort was aimed at showing how these rigidities arise from the microeconomics of wage and price setting”.
Why are prices and wages inflexible? What are the macroeconomic implications when prices and wages are sticky? The new Keynesian theory tries to answer these questions.
Wage rigidity is explained by models related to disequilibrium in the labor market, such as efficiency wages, implicit contracts, and/or insider-outsider workers. On the other hand, price rigidity is explained by models related to imperfect competition in the goods market, such as the high marginal costs of price adjustment.
Since labor is not a homogenous good, the models of efficiency wages suppose that labor’s productivity is affected by the wage paid by firms. If the quality of workers is related to the wages received, any wage reduction proposed by firms will cause a fall in labor’s productivity; as a result, profit also falls. In this situation, firms will not cut wages when demand declines.
Two questions related to the central hypothesis of the new Keynesian theory, price and wage rigidities determining macroeconomic fluctuations, deserve some reflections: What do price and wage rigidities imply in general equilibrium analysis? The answer was partly presented by the disequilibrium theory developed during the 1970s. The originality of the new Keynesian theory, however, lies in the attempt to find a consistent microeconomic theory of price and wage rigidities, showing how the economic agents optimize their behavior under such imperfections. Why such models are called Keynesian? The explanation seems to be associated with a misleading reading of the GT: Keynesian involuntary unemployment is interpreted by New Keynesians, not as the result of an insufficiency of effective demand, explained by the existence of money per se, but rather due to the fact that prices and wages are sticky. In other words, the New Keynesians argue that underemployment equilibrium can only occur if prices and wages are not perfectly flexible.
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