Crisis in Keynesian Economics

The Structural and cyclical crisis of the 1970’s especially the 1974-75 crisis, and the inflation which became chronic and irreparable. All of this taken together disrupted the economic policy and led to obvious confusion as to how the economic difficulties were to be tackled. There was a collapse of the standard Keynesian schemes of business cycle policy, according to which efforts were made to contain inflation, which usually coincided with the upward phase, by limiting demand, and to overcome the crisis by expansionary demand. Another phase in Keynesian crisis is that disenchantment with Keynesian economics developed during the post 1968 period when the rate of growth of output declined. The rate of inflation increased coupled with rising unemployment. This paradox of ‘Stagflation’ is inconsistent with the tenets of Keynesian economics. This led to reconsideration of theories underlying policy making and rival school of thought such as ‘monetarist school’ represents a return to orthodox classical economics and its recent more formal statement the new classical macro economics. Stagflation as defined by PA Samuelson refers to “Stagflation of growth and employment at the same time that prices are rising”. It occurs due to various reasons like shortages and irregular supply of raw-materials, insufficient demand, and power shortages and, various obstacles to growth.


The origin of monetarism may be traced in the writings of long line of University of Chicago’s distinguished teachers and students represented by Milton Friedman. K Brunner was the economist who used the term ‘Monetarism’ in 1968. The monetarist school include Phillip Cagan, James Schlesinger, Leon all Anderson, Meiselman, AH Walters and Allan Meltzer. Monetarism basis lies in the age-old Quantity Theory of Money of 18th Century. So that the QTM is the basis for monetary frame work. Monetarists are the supporters of the ‘Free Market’ believe that all economic problems have their solution in the free and unimpeded operation of the market forms of supply and demand. Monetarism refers to the followers of Milton Friedman who hold that “Only Money Matters”. It attributes the economic variation principally to changes in money supply. They said that the government interference with the working of market forces has mostly failed. According to Milton Friedman, regulation of money supply is one such area where government control is called for but this control must be controlled. Henry Simon who observed that government must provide a monetary framework for a competitive system, but this should be operate under the ‘Rules of Law’ and not under the discretionary powers of the administration. In the wake of Keynesian revolution, the emphasis shifted from monetary policy to Fiscal policy. This gives rise to the fiscal school includes James Tobin, P Samuelson, W Heller, L Klien, Modigliani who suggest the “Money does not matter”. Since 1930’s this debate has continued, and presently the academic opinion has veered more and more round the monetary fiscal mix.

Monetarists emphasized the role of money in explaining short term changes in National Income. They showed that changes in the money supply cause changes in National income. They believe that all recessions and depressions are caused by severe contraction of money and credit and booms and inflations are due to excessive increase in money supply. The Keynesians rejects monetarist’s view that changes in National income are caused solely by changes in money supply but they hold that changes in national income souses changes in money supply and non-monetary factors like investment causes depression and booms. New Monetarism: In the 1970’s Kaldor published his paper” New Monetarism” constitutes: 1) 2) 3) 4) Money alone matters, but fiscal policies are not the matter. Money cannot change the real things. Impact of money supply changes takes time lag. Best monetary policy for stabilization is monitoring a steady growth of money supply.

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