Economics essay: Keynesian and Monetarist schools of thought

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Critically examine the main differences between Keynesian and Monetarist (neo classicist) schools of economic thought in respect of the pursuit 

of macroeconomic policy in the United Kingdom.  There is a diagram available at the bottom.

Discuss whether any elements of agreement have emerged in recent years between the two schools of thought.


The discussion will introduce the main Keynesian and Monetarist concepts.  It will then provide the diagrams for the two schools of thought.  These diagrams can be used to explain why particular decisions were made regarding macroeconomic policy.  The problems with the different schools of thought are then addressed in their historical context. 

The second half of the essay is then considered with the growing consensus between the schools of thought.  This emerging agreement is partly because inflation and unemployment have become arguably less serious in the last 10 to 15 years.  The discussion concludes by arguing that there is still a role for Keynesian thinking in the formation of United Kingdom macroeconomic policy-making.

An example of Keynes’ influential work was the General Theory of Employment Interest and Money, published in 1936.  Aggregate demand is the total demand for goods and services at any given price.  Keynes argued that a low level of aggregate demand could persist for a long period.  Demand deficiency occurs when people are unemployed because the level of aggregate demand is below the full capacity output level (Wall 2003:68).  To confront the problem of demand deficiency, Keynes suggested that deficit spending would be needed to solve unemployment.  That government should pursue expansionary fiscal and monetary policies, during economic downturns, to reduce unemployment.  An example, of an expansionary fiscal policy could be spending on a public works programme to recruit unemployed workers.  Such government programmes could be financed, by borrowing, until the economy recovered (Wall 2003:170).  His views were in contrast to the classical view that wages would fall during a depression until employers began to take on labour again.  Classical economists believed that unemployment would solve itself with a reduction in wages (Wall 2003:169).  This was based on “Say’s Law” that the supply of labour, if cheap enough, creates its own demand for labour.   

Keynes was concerned that a (classically argued) fall in wages might reduce consumption and so cause the economy to reach an equilibrium level of output below that of full employment.   Many economists have developed Keynes’ ideas and applied them to new situations, given that the current situation contrasts with the depression of the 1930s.  However, Keynesian ideas can be understood as having “a strong commitment to maintaining a level of aggregate demand at which unemployment rates would be relatively low” and “active use of fiscal and monetary policies to control the level of aggregate demand” (Wall 2003:170). 

Much of the essay will focus on the debate between Keynesians and monetarists.  Monetarists, or neo-classical economists, revived classical economics after Keynes had challenged it in the 1930’s.  Monetarists analyse macro-economic trends to emphasise the link between the money supply and the rate of inflation.  They also emphasise the importance of controlling the growth of the money stock to prevent inflation from increasing (Wall 2003:170). 

Monetarists disagree with the Keynesian prescription of using government expenditure to cure unemployment.  Monetarists see the control of inflation as a greater priority than a reduction in unemployment.  They see government expenditure as a source of inflationary pressure; as will be explained using diagrams. 

The shape of the aggregate demand curve will be the first concept to be considered using diagrams.  Keynesians argue that the AD curve is relatively steep (diagram 1).  They believe that changes in the price level have little impact on aggregate demand.  “They argue that increases in the price level have little impact on interest rates” and changes in interest rates have little impact on consumption (Anderton 2000:216).  To Keynesians the main determinant of consumption is disposable income.  Classical theorists would argue that there is a strong relationship between the price level and aggregate demand; giving a shallower curve (diagram 2).  They argue that increases in the price level can have a strong influence on interest rates and so consumption.  They would put more emphasis on interest rates in influencing consumption expenditure than Keynesians. 

Monetarists and Keynesians see the long run aggregate supply curve differently.  Neo-classical economists argue that in the long run wages and prices are flexible and therefore the L.R.A.S.  Curve should be vertical.  In the long run there should not be any unemployment because all workers who want a job (the supply of labour) will be offered a job (the demand for labour).  Regardless of the price level, output will always be constant at the full employment level of income (see diagram 3).  Traditional Keynesian economists would argue that in the long run unemployment could be persistent.  This is because wages do not necessarily fall even if there is unemployment.  When there is mass unemployment, output can be increased without any increases in costs and so prices.  Only when the economy nears full employment will higher output lead to higher prices.  At the full employment level, the economy cannot produce any more goods and services; so additional consumption will feed through only to higher prices (diagram 4). 

The two different groups will come to different conclusions about a rise in aggregate demand.  For example, an increase in wages for public sector workers would be viewed differently.  The neo-classicist equilibrium position would be at point A, in diagram 5.  A rise in aggregate demand would lead to a shift to the right in the AD curve and will result in a movement along the SRAS curve (from A to B).  Output and prices both increase.  In the long run, the SRAS curve will shift upwards.  This is because the economy is operating at above full employment so firms will find it difficult to recruit labour (or purchase raw materials).  They will increase the demand for labour so wages and other supply costs will be increased.  A rise in wages, and other supply costs, will shift the short run aggregate supply curve to the left (i.e. upwards).  Short run equilibrium output will fall and prices will rise.  “The economy will only return to long run equilibrium when the short run aggregate supply curve has shifted upwards from SRAS1 to SRAS2 so that aggregate demand once again equals long run aggregate supply at C” (Anderton 2000:228).  In the long run, an increase in aggregate demand will only lead to an increase in the price level (from A to C).  There will be no increase, in long run equilibrium output, from an increase in demand.  Neo-classical economists believe that increases, in aggregate demand, without any increase in aggregate supply will lead only to inflation. 

The Keynesian aggregate supply curve is shaped as in diagram 6.  A shift in demand from AD4 to AD5 will be purely inflationary, if the economy is already at the full employment level – OD.  Thus there would be agreement with monetarists on this point.  However, if there was a serious depression, as in the United Kingdom of the 1930’s, then Keynesians would argue that an increase in aggregate demand will lead to a rise in output without an increase in prices.  “The shift in aggregate demand from AD1 to AD2 will increase equilibrium output from OA to OB without raising the price level from OP as there are unused resources available” (Anderton 2000:229).  If the economy is below, but near to, full employment e.g. at OC.  This will increase both (equilibrium) output and (equilibrium) prices.   

The next diagram, diagram 7, shows an increase in long run aggregate supply.

“A rise in long run aggregate supply means that the potential output of the economy has increased” (Anderton 2000:229).  This can be seen as a genuine increase in economic growth.  Economic growth increases when there are greater incentives to work (perhaps through the end of a minimum wage policy), or if there was an improvement in technology.  In the classical model (diagram 7), an increase in aggregate supply will lead to higher output and lower prices.  In diagram 7, a shift in the supply curve from LRAS1 to LRAS2 will increase equilibrium output from OL to OM.  Equilibrium prices are argued to fall from ON to OP because long run aggregate demand is said to be unaffected.

In the Keynesian model, shown in diagram 8, an increase in aggregate supply will increase output and lower prices if the economy is at full employment.  “With aggregate demand at AD1, a shift in the aggregate supply curve from LRAS1 to LRAS2 increases full employment equilibrium output from YE to YF.  If the economy is at slightly less than full employment with an aggregate demand curve of AD2 then a shift to the right in the LRAS curve will still be beneficial to the economy increasing output and reducing prices (Anderton 2000:229).  However, the core difference is that: if there is an aggregate demand curve at AD3 then an increase in aggregate supply will not be useful to the economy.  This is because output and prices remain unaffected.

The historical context can now be examined.  Keynesian thinking depended upon the ability of national governments to adjust the level of demand.  But the growing openness of national economies, and intensified international competition, has undermined the economic autonomy of national governments (Lansley 1994:152). The Wilson and Callaghan governments found that they could not get out of recessions unilaterally.  A regional policy, to invest in say the Lancashire textile industry, would be unlikely to work as jobs would still be lost to cheaper producers such as in South East Asia.

International trade, in particular in oil, meant that it was more difficult for policy makers to manage the economy.  The Keynesian ‘lever’ of demand management no longer seemed to work.  It was not possible to cure unemployment by the expansion of demand because it would compound the growing problem of inflation (Lansley 1994:61).  The ‘Keynesian orthodoxy’ was being challenged, as the economy appeared to be reaching full capacity (see diagram 4 and 6).  By 1976 it appeared that it was no longer possible, for the United Kingdom economy, to ‘spend its way out of recession’ (Callaghan quoted in Jenkins 1987:18).

A willingness to raise spending during a recession would lead to voter demands for permanent, not temporary, increases in spending.  Permanent increases in spending could be inflationary, as increased spending would lead to higher wages if the economy were operating at capacity.  This spending would have to be balanced by higher taxes that would be undesirable economically; in terms of reducing motivation and incentives to work.  The long run aggregate supply curve would not shift to the right.  Also spending would be unfeasible politically, assuming the public are unwilling to pay higher taxes (Thurow 1996:216).  Since raising taxes, and increasing public spending to provide a Keynesian boost to the economy was no longer possible then a monetarist alternative emerged.

The preceding discussion suggested that, after the 1970’s, fiscal (tax and public spending) changes were unlikely to be made for macro-economic control of demand.  Therefore, the main tool for altering the level of aggregate demand was going to be monetary policy (Wall 2003:202).  Incomes policies had been used, in the 1960’s and 1970’s, to control inflation.  “Usually it meant that pay increases were limited to a certain percentage” (Wall 2003:149).  However, monetarists believed that pay demands needed to be constrained by monetary policy. 

Money can be divided into a narrow, more traditional, money measure that comprises notes and coins; and money held by the commercial banks at the Bank of England.  Also there is a broad measure, which includes accounts held by people at bank and building societies.  A broad measure of money was targeted and the government attempted to control money (and credit) through its price.  The growth of money was, and is, controlled through the level of interest rates.

Monetarism, as practised in the United Kingdom in the 1980’s, was based on Friedman’s quantity theory of money (MV=PY).  M is the stock of money, V is the velocity of circulation (or the number of times a given amount of money changes hands as someone’s income). P is the price level, and Y is real national income.  It was based on a stable demand for money (or stable velocity of circulation).  Keynes believed that the demand for money was not stable, as it would vary according to the interest rate (Smith 1988:5).   Keynesians believed that the demand for money and velocity were unstable.  Experience suggests that the velocity of circulation (how fast money is changing hands) is not stable.  Moreover, the way in which velocity is moving (money changing hands more quickly or more slowly) is not predictable either.  Despite Keynesian reservations, monetarists made the case for stable and predictable money demand and velocity (Smith 1988:8).  Therefore, monetarists continued to argue Friedman’s case that the larger the money supply, the more likely were its effects, going to lead to higher prices rather than higher economic growth.  Friedman, in 1980 said, “a successful policy of reducing inflation will have as an unavoidable side effect a temporary retardation in economic growth” (Smith 1988:8).  That is, a temporary shift from C to point D and eventually to point A with lower inflation at the same level of output in diagram 5.  The Thatcher government, in 1979-1980, announced monetary targets for the rate of growth, in the money supply.  They hoped to influence inflationary expectations in the economy, particularly in the area of wage bargaining; which had lost credibility under 1970’s incomes policies. 

The problem was that the money supply was reduced to the extent that Britain endured its worst recession since the 1930’s.  Also, it was too theoretical and appeared to consider a closed economy.  In 1979 and 1980, interest rates were increased to reduce the growth of the money supply measure M3.  This helped increased the level of the pound and many British firms could not compete in domestic or export markets.  Monetarism, as Keynesians would argue, had undermined aggregate demand as manufacturing firms made workers unemployed. Consumption decreased amongst unemployed workers.  A downward multiplier was initiated where the total income in the economy fell due to a circular reduction in consumption.  The United Kingdom was in a situation of mass unemployment as annotated in diagram 4. 

Inflation fell from 25 per cent in the mid 1970’s to 4 or 5 per cent in the mid 1980’s.  This was due to a reduction in commodity prices as oil fell below $10 a barrel in 1986.  However, recession and unemployment had a restraining influence on wage pressure.  Finally, fiscal policy was tightened; e.g. in 1981 benefits and allowances did not rise with inflation.  Keynesian economists would argue that fiscal policy has been as influential in producing low inflation as monetary policy.  According to a letter to the Times from (Keynesian) economists in 1981.  “There was no basis in economic theory, or supporting evidence, that by deflating demand they will bring inflation permanently under control and thereby induce an automatic recovery in output and employment” (Quoted in Jenkins 1987:152).  The revival of the United Kingdom economy after 1981 can be explained by a revival of world trade.  The macro-economic policies, in 1981, arguably were a 1920’s deflation with output moving to an equilibrium below full employment.  There is theoretically, a leftward shift in the aggregate demand curve, say AD4 to AD2, on the Keynesian diagram 6.

The last difference between the two schools will focus mainly on unemployment.  Monetarists believe in a ‘natural rate of unemployment’ or a non-accelerating inflation rate of unemployment (NAIRU).  This is the level of unemployment where inflation is stable (Wall 2003:215).  However, these arguments are unsophisticated as they appear to overlook government attempts to reduce the supply of labour, onto the job market, and the increase in the level of economic inactivity.  “Attempts to reduce the supply of labour by encouraging early retirement and delaying entry into employment by the young have not been sufficient to prevent the steady rise of unemployment” (Lansley 1994:220).    Arguably, the natural rate of unemployment has fallen in the late 1990’s, which could be used to demonstrate the success of government  (neo-classicist) policies; such as training policies related to the ‘New Deal’.  However, if the natural rate of unemployment has fallen then this may have been offset, or more than offset, by an increase in the level of economic inactivity.  “In September 2004, just under 8 million people of working age (16-65) in the United Kingdom were either not looking for, or not available for, work and were therefore classified as being economically inactive” (www.statistics.gov.uk/cci).  On the basis of persistent economic inactivity then Keynes’ analysis could be useful to explain and, maybe, solve the inactivity in the United Kingdom economy (Filho 1996).     

In terms of elements of agreement Begg (2005:557) suggests that a hybrid group of (moderate Keynesian) economists have emerged whom are ‘short run Keynesians’ and ‘long-term monetarists’.  They suggest, “Government should accept responsibility for stabilisation policy in the short run” (Begg 2005:557).  This is because in the short run a fall in aggregate demand could cause a significant recession.  These economists believe that the economy will return to full employment in the long run.  They believe that persistent rapid monetary growth will lead to inflation once the full employment position has been reached.  This combination of views suggests that that there may be an emerging consensus between the two groups of economists.

There is arguably a ‘new consensus’ view on monetary policy.  The inflation rate is targeted generally. The attempt to control inflation through interest rates can be seen as using monetary policy.  However, Friedman recommended a low but fixed rate of money growth rejecting the “interest rate activism followed by the Bank of England’s Monetary Policy Committee” (Begg 2005:556).  “The current practice of central banking is at least in part consistent with Keynes’ theory and policy prescriptions.  “Today, monetary policy is aimed to maintain aggregate demand growth compatible with supply-side capacity growth” (Fontana and Palacio-Vera 2004:26).  This framework can be traced back to Keynes’ (1936) General Theory. 

The relationship between wage inflation and unemployment has been described as the Philips Curve.  Since 2000, wage inflation has been in the region of 1 to 3% while (measured) unemployment has been about 5% over the period.  This represents relatively benign recent macro-economic conditions according to Sloman (2007:325).  Thus there has been less need for debate between the two different schools of thought.  With the election of the Labour Government in 1997, monetary policy has generally successfully achieved the aim of targeting inflation.  Sloman (2007:335) suggests if inflation is successfully kept on target then the path of inflation and unemployment will be a horizontal straight line.  If this is the case then there is less debate over policy because inflation appears to be a predictable constant.  There is perhaps agreement because inflation is less of a policy challenge now.  First, the impact of new technologies (Wall 2003:297) in the United Kingdom, such as in computing and the internet in the late 1990’s, has improved productivity in industry.  Technology has increased prosperity among consumers who have been able to buy computer related goods and services more cheaply.  Second, relatively cheap manufactured goods from Asia have reduced the costs of goods to consumers, which has also reduced inflation.  

Wall (2003:170) suggests that improved understanding of the inflationary process and the impact of supply constraints have made the debate between the two schools of thought less relevant.  For example, inflation at different stages is now better understood with the producer price index.  This estimates the prices of goods produced by manufacturers i.e. at the factory gate rather than in the shops.  An increase in the producer price index may signal an increase in the retail price index later on (Gillespie 2002:73).  Thus, the link between producer and retail prices is better understood and so there is perhaps a consensus on the type of inflation that is relevant in a particular situation e.g. cost push inflation from say increasing oil prices.   Also, the two schools of thought perhaps agree upon the impact of supply constraints, such as skill shortages.  Policy-making is not simply a case of making people ‘price themselves into work’ (classical) or providing the demand for additional unskilled employment (traditional Keynesian). 

To conclude, perhaps there has been more agreement, between the two schools of thought, on policies to deal with inflation rather than unemployment.  There has perhaps been a consensus through inflation targeting by the Bank of England, while unemployment remains more problematic.  There could be a consensus between the two schools of thought if is understood that increases in aggregate demand are insufficient and that increases in aggregate supply are needed too (diagrams 7 and 8).  A rightward shift in long-run aggregate supply could occur with improvements to training and skills.

References

Anderton A., (2000), Economics AS Level, Causeway Press

Begg D., Fischer S and Dornbusch R., (2005), Economics, 8th Edition, Mc-Graw Hill, London

Filho F. (1996) Keynesians, Monetarists, New Classicals and New Keynesians, a post Keynesian critique, ANÁLISE ECONÔMICA ANO 14 Março/Setembro p.. 63-75

Fontana G, and Palacio-Vera A, Monetary Policy Uncovered: Theory and Practice, International Review of Applied Economics, Vol. 18, No. 1, 25–41, January 2004

Gillespie A., (2002), AS and A level economics through diagrams, Oxford Revision Guides, Oxford University Press

Jenkins, P., (1987), Mrs Thatcher’s Revolution, Pan Books, London

Lansley S. (1994), After the Gold Rush, The Trouble with Consumer Capitalism and the way forward, Henley Centre, Century Business Books,

Sloman J., Essentials of Economics, fourth edition, Prentice Hall, Harlow

Smith D., (1988), Mrs Thatcher’s Economics, Studies in the UK Economy, Heinemann Educational, Oxford

Thurow L., (1996), The Future of Capitalism, How Today’s Economic Forces will shape tomorrow’s world, Nicholas Brearley Publishing, London

Wall N., (2003), Complete A-Z Economics Handbook, 2nd edition, Hodder Arnold, London


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Christopher Packham,
28 Sep 2010, 12:23
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