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Monetarist and Keynesian School of Thoughts

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Monetarism

Monetarism school of economic thought that maintains that the money supply is the chief determinant on the demand side of short-run economic activity

American economist Milton Friedman is generally regarded as monetarism’s leading exponent.

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The monetarist approach became influential during the 1970s and early ’80s.

The foundation of monetarism is the Quantity Theory of Money.

The theory is an accounting identity—that is, it must be true.

It says that the money supply multiplied by velocity equals nominal expenditures in the economy.

As an accounting identity, this equation is uncontroversial.

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What is controversial is velocity. Monetarist theory views velocity as generally stable, which implies that nominal income is largely a function of the money supply.

Variations in nominal income reflect changes in real economic activity (the number of goods and services sold) and inflation (the average price paid for them).

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The quantity theory is the basis for several key tenets and prescriptions of monetarism

• Long-run monetary neutrality: An increase in the money stock would be followed by an increase in the general price level in the long run, with no effects on real factors such as consumption or output.

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Short-run monetary no neutrality: An increase in the stock of money has temporary effects on real output (GDP) and employment in the short run because wages and prices take time to adjust (they are sticky, in economic parlance).

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Constant money growth rule: Friedman, proposed a fixed monetary rule, which states that the Fed should be required to target the growth rate of money to equal the growth rate of real GDP, leaving the price level unchanged. If the economy is expected to grow at 2 percent in a given year, the Fed should allow the money supply to increase by 2 percent.

The Fed should be bound to fixed rules in conducting monetary policy because discretionary power can destabilize the economy.

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Interest rate flexibility: The money growth rule was intended to allow interest rates, which affect the cost of credit, to be flexible to enable borrowers and lenders to take account of expected inflation as well as the variations in real interest rates.

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Many monetarists also believe that markets are inherently stable in the absence of major unexpected fluctuations in the money supply.

They also assert that government intervention can often destabilize the economy more than help it.

Monetarists also believe that there is no long-run trade-off between inflation and unemployment because the economy settles at long-run equilibrium at a full employment level of output

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Friedman contended that the government should seek to promote economic stability, but only by controlling the rate of growth of the money supply.

It could achieve this by following a simple rule that stipulates that the money supply be increased at a constant annual rate tied to the potential growth of gross domestic product (GDP) and expressed as a percentage (e.g., an increase from 3 to 5 percent).

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Characteristics of Monetarism

1. The theoretical foundation is the Quantity Theory of Money.

2. The economy is inherently stable. Markets work well when left to themselves. Government intervention can often times destabilize things more than they help. Laissez faire is often the best advice.

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The Fed should be bound to fixed rules in conducting monetary policy. They should not have discretion in conducting policy because they could make the economy worse off.

Fiscal Policy is often bad policy. A small role for government is good.

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In the late 1970s and early 1980s, after a decade of increasing influence, monetarism’s reputation began to decline for three main reasons.

One was the growing belief, based on plausible interpretations of experience that money demand is in practice highly “unstable

The second was the rise of RATIONAL EXPECTATIONS economics

The third was the Federal Reserve’s famous “monetarist experiment

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During the 1970s, inflation rose in the United States, as well as in many other industrial nations, to levels unprecedented on a multiyear basis during periods of relative peace.

This occurred as a consequence of various “shocks”—oil price increases, the Vietnam War, and especially the 1971–1973 demise of the Bretton Woods system of fixed exchange rates

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This demise left central bankers with a major new responsibility; namely, to provide a nominal anchor for national fiat currencies to replace the GOLD STANDARD.

on October 6, 1979 the Fed would try to hit specified monthly targets for the growth rate of M1, with operating procedures that emphasized control over narrow and controllable monetary aggregate, nonborrowed reserves

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the events that occurred from October 1979 to September 1982 are widely viewed as the crucial beginning of a necessary and successful attack on inflation

Short-term interest rates jumped dramatically in late 1979 under the tightened conditions, and 1980 witnessed a major fall in output in one quarter followed by a major jump in the next, due primarily to the imposition, and then removal, of credit controls.

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1981 and into the middle of 1982, a sustained period of monetary stringency brought about the deepest recession since the GREAT DEPRESSION of the 1930s and began to bring inflation down, more rapidly than many economists anticipated, toward acceptable values

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Keynesian Economics

Keynesian economics was developed by the British economist John Maynard Keynes during the 1930s in an attempt to understand the Great Depression.

Keynes advocated increased government expenditures and lower taxes to stimulate demand and pull the global economy out of the Depression.

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Subsequently, the term “Keynesian economics” was used to refer to the concept that optimal economic performance could be achieved by influencing aggregate demand through activist stabilization and economic intervention policies by the government.

Keynesian economics is considered to be a “demand-side” theory that focuses on changes in the economy over the short run.

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The main plank of Keynes’s theory, which has come to bear his name, is the assertion that aggregate demand the most important driving force in an economy.

Keynes further asserted that free markets have no self-balancing mechanisms that lead to full employment.

Keynesian economists justify government intervention through public policies that aim to achieve full employment and price stability.

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There are three principal tenets in the Keynesian description of how the economy works:

Aggregate demand is influenced by many economic decisions—public and private.

Private sector decisions can sometimes lead to adverse macroeconomic outcomes, such as reduction in consumer spending during a recession.

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Prices, and especially wages, respond slowly to changes in supply and demand, resulting in periodic shortages and surpluses, especially of labor.

Changes in aggregate demand, whether anticipated or unanticipated, have their greatest short-run effect on real output and employment, not on prices.

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Keynesianism evolves

Particularly noteworthy were his arguments with the Austrian School of Economics, whose adherents believed that recessions and booms are a part of the natural order and that government intervention only worsens the recovery process.

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Keynesian economics dominated economic theory and policy after World War II until the 1970s, when many advanced economies suffered both inflation and slow growth, a condition dubbed “stagflation.”

Monetarist economists doubted the ability of governments to regulate the business cycle with fiscal policy and argued that judicious use of monetary policy

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Members of the monetarist school also maintained that money can have an effect on output in the short run but believed that in the long run

Keynesian economists largely adopted these critiques, adding to the original theory a better integration of the short and the long run and an understanding of the long-run neutrality of money

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Both Keynesians and monetarists came under scrutiny with the rise of the new classical school during the mid-1970s

A new generation of Keynesians that arose in the 1970s and 1980s argued that even though individuals can anticipate correctly, aggregate markets may not clear instantaneously; therefore, fiscal policy can still be effective in the short run.

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“If you were going to turn to only one economist to understand the problems facing the economy, there is little doubt that the economist would be John Maynard Keynes. Although Keynes died more than a half-century ago, his diagnosis of recessions and depressions remains the foundation of modern macroeconomics. Keynes wrote, ‘Practical men, who believe they to be quite exempt from any intellectual influence, are usually the slave of some defunct economist.’ In 2008, no defunct economist is more prominent than Keynes himself.”- , Harvard professor N. Gregory Mankiw

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The global financial crisis of 2007–08 caused resurgence in Keynesian thought.

But the 2007–08 crisis also showed that Keynesian theory had to better include the role of the financial system. Keynesian economists are rectifying that omission by integrating the real and financial sectors of the economy