Keynesianism and monetarism

Keynesianism and monetarism One of the most urgent questions of our century is the question about the role of government in all spheres of life and first of all in economy. Can governments effectively intervene in the business cycle and move economies away from recessions more quickly than would otherwise happen? I’d like to present to you two theories, Keynesianism and monetarism.Classical economic theory argued that economies tended towards an equilibrium in which all resources are used. Adam Smith in “The Wealth of Nations” argued in favour of “laissez-faire”. He insisted that natural forces such as individual self-interest and competition naturally determine prices and incomes.

It was argued that a perfectly competitive economy would produce a general equilibrium. This in turn would lead to “allocative efficiency”, the point at which all the resources of the economy are being fully and efficiently employed.The depression of the 1930s showed that, at least in the short term, this was untrue.

John Keynes, who has a school of economic thought named after him, had another point of view. To explain his ideas let me refer to his book “The General Theory of Employment, Interest and Money”. As it’s written there, Keynes argued that market forces, which are considered as being able to produce supply-demand equilibrium in economy, definitely could do it but with high unemployment of indefinite duration.For example, if people are worried about the possibility of loosing their jobs in the near future they will probably start saving money and consume less, which will lead to a fall in demand, and consequently in production and employment.

In such circumstances producers will clearly not interested in making new investments. So people’s savings will remain unused, and the economy will settle into a new equilibrium at a lower level of activity – with fewer goods being produced, fewer people employed, and reduced rates of income and investment.Classical economic theory stated that in the long run, excess savings would cause interest rate to fall and investment to increase again, but to disagree with this statement the most suitable are words of Keynes – “In the long run, we are all dead”. Keynes therefore recommended governmental intervention in the economy, to counter the business cycle. During an inflationary boom, governments could decrease their spending or increase taxation.

During a recession, on the contrary, they could increase their expenditure, or decrease taxation, or increase the money supply and reduce interest rates, so as to stimulate the economy and increase output, investment, consumption and employment.

Keynes also argued that even a small amount of additional government spending or an increase in private investment causes output to expand by an amount greater that itself, because of the multiplier effect: the new money is repeatedly respent, except for the proportion that people choose to save. The ultimate aim of Keynesian governmental intervention or “demand management” is full employment – when no involuntary unemployment exists.

However, this is now widely considered to be impossible and even undesirable, as it cause inflation to rise. In the 1960s it was believed that there was a “trade-off” or exchange between low unemployment and high but stable inflation.For over a quarter of a century after the Second World War, the governments in many industrialized countries successfully used Keynesian policies.

But after the oil crisis in 1973-74 many countries began to experience stagflation – a prolonged recession or stagnation (including high unemployment) at the same time as high inflation, which disprove ideas of Keynesains. For monetarist economists, this showed that although Keynesian attempts to increase demand and reduce unemployment worked in the short term, the only long-term effect was to increase inflation.Unlike Keynesians, monetarists insisted that money is neutral, meaning that in the long run, changes in the money supply will only change the price level and have no effect on output and employment.

So government should abandon any attempt to manage the level of demand in the economy through fiscal policy. On the contrary, they should try to make sure that there is constant and non-inflationary growth in the money supply.Monetarists argue that recessions are not caused by long-run market failures but by short-run errors by firms and workers who do not reduce their prices and wages quickly enough when demand falls.

When economic agents (I’ll explain this word later) recognize that prices and wages have to fall, the economy will come back to normal. Since the government will not be able to recognize a coming recession any more quickly than the companies that make up the economy, it will only be able to act at the same time as everyone else is recognizing the need to cut prices and wages.Consequently, its fiscal measures will take effect when the economy is already recovering, and so will merely make the next swing in the business cycle even greater.

Monetarists claim that Keynesian attempts to stabilize the business cycle only lead to rising process and the crowding out of private investment and that the business cycle, inflation and unemployment are the unintended results of misconceived government interventions.They insist therefore that free market and competition are efficient and should be allowed to operate with a minimum of governmental intervention.

If money supply, rather than fiscal policy, is the major determinant of nominal GNP growth, the role of government should be to ensure a fixed growth rate for the money supply. One more difference between monetarists and Keynesians is in their attitude towards people’s behavior. For Keynes people’s economic expectations about the future were generally erratic and random, and could consequently be systematically wrong.In the 1970s, the Rational Expectations school, led by Robert Lucas and Thomas Sargent, began to argue that, on the contrary, people (or “economic agents”) generally make rational choices according to the information available to them. this means that predictable and systematic policies to stabilize the business cycle (e.g. monetary expansion and tax cuts) will instantly be compensated for and thus become ineffective.

In other words, fiscal or monetary policy will only affect output and unemployment if it is unpredictable and comes as a surprise, in much the same way as only random news shocks stock market prices.

But I guess nowadays Keynesians (today often called neo-Keynesians), they have something to add to this theoretical debates.Whereas neo-classical economic theory assumes prices and wages to be flexible enough to eliminate excess supply or demand, Keynesians argue that wages are inflexible or ‘sticky’ because of labour union contracts, government regulation, and so on. Furthermore, businesses cannot change their prices too frequently, because they do not have perfect information, and because there are too many costs involved.

These are sometimes known as ‘menu costs’, drawing on the example of restaurants, which cannot afford to print menus with new prices every day according to small fluctuation in demand.Neo-Keynesians still maintain that because individuals and firms are unable to find the right prices that would lead the economy to rising output and high or full employment, economies can get locked into disequilibriums for long periods.

Thus unlike the monetarists, who insist that free markets and competition are efficient and should be allowed to operate with a minimum of governmental intervention, Keynesians believe there is still a role for either expansionary or deflationary government policies.So, there were two different theories, and each of them has logical points of view. What to prefer in reality, I might ask. It’s rather difficult to give absolutely truthful answer, but most economists would nowadays agree on two things, that in the short run it may be possible to increase employment at the cost of slightly higher inflation, but they will also feel that in the long run there is actually very little trade-off between inflation and unemployment.

If you have an increase in employment that is brought because you have allowed inflation to increase, that the economy will then have to be reined back (it may be in the way of interest rates being raised) and that will then raise unemployment, so that over the longer term there actually isn’t a conflict between inflation and unemployment.

So most of the industrialized world is now run with the aim of keeping inflation relatively low and stable, because the belief is that in the long run, that will tend to mean that unemployment will be also kept relatively low. But I guess by doing that government will only solves a half of the problem. The way we can solve it is by improving what is known as the supply side of the economy, by raising the level of capacity, or by raising the quality and qualification of the work force so that we can simultaneously keep inflation low and allow unemployment to fall.