You are on page 1of 8

Keynesian vs.


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
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 losing 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 re-spent,
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 causes 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 Keynesians. 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

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 debate. 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.
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.

The emergence of monetarist as a counter revolution led to a prolonged,

though inconclusive, debate between the Keynesians and the Monetarists.
While Keynesians hold the view that the level of output and the prices are
determined by the EFFECTIVE DEMAND, Monetarist holds the view that the
quantity of money is the prime factor that determines the level of output
and prices. Keynesians argue that the “money does not matter” in
determining aggregate demand whereas the monetarist argue that only
money matters.
The Keynesian view:

The Keynesian argued that the money does not matter only the fiscal
policies matter. There should be government intervention. The Keynesian
view is that output can be below full capacity for a long time. In a
recession the labour market do not clear and we are left with demand
deficient unemployment. Keynes gave the theory on 1930 when there was
failure of free market to achieve full employment.

Monetarists believe in development of classical model. They believe that

LONG RUN AGGREGATE SUPPLY CURVE is inelastic. If AD rises faster than
long run aggregate supply,there may be a temporary rise in real output,
but in long run output will return to the previous level of real GDP.

Monetary policy is the manipulation of the money supply with the objective of
affecting macroeconomic outcomes such as GDP growth, inflation, unemployment,
and exchange rates. Monetary policy in the United States is conducted by the
Federal Reserve, in particular, by the FOMC.

I. The Money Market

To understand the role of money in the macro economy we first need to look at
money demand and money supply. By money supply we are usually referring to
M1 or M2.

The Demand for Money

Keynes (yes, him again) believed the demand for money came from 3 sources:

1. Transactions demand. People hold money to buy stuff.

2. Precautionary demand. People hold money for emergencies (cash for a
tow truck, savings for unexpected job loss).
3. Speculative demand. People hold money to take advantage of a financial
opportunity at a later date.

The decision to hold money involves a tradeoff. Holding M1 is advantageous in

buying goods and services, however assets in M1 (cash, checking accounts) earn
very little, if any, interest. Holding assets with a competitive interest rate, like
bonds is not convenient for buying goods and services. We can think of the interest
rate as the opportunity cost or price of holding money. The demand for money
(M1) is downward-sloping with respect to interest rates:
An increase in national income will shift the money demand curve to the right,
because people buy more stuff. Also, technology like ATM/debit cards will shift
the money demand curve to the left because people do not have to hold as much
M1 since it is easier to access a savings account.

Money Supply

As seen above, we assume that money supply is set by the Federal Reserve at the
level they choose, so money supply is vertical at the quantity chosen by the Fed.

By shifting the money supply, the Fed can change equilibrium interest rates.
Suppose the Fed buys bonds on the open market. This increases the money supply,
shifting the MS curve to the right, causing interest rates to fall:

II. Money and Aggregate Demand: A Keynesian View

A change in interest rates will in turn affect the spending decisions of consumers
and firms. With lower interest rates it is cheaper for firms to invest and for
consumers to buy durable goods, and this will shift the aggregate demand curve to
the right, increasing output:

Similarly, decreasing the money supply would raise interest rates, decrease
investment and consumption, and decrease aggregate demand:

III. Monetary Policy: Keynesian vs. Monetarist Views

In the Keynesian model above, interest rates & investment are the transmission
mechanism of monetary policy, i.e. that is the way monetary policy affects
macroeconomic outcomes. However, there are other points of view.

The Monetarists believe that monetary policy affects prices, but not real GDP or
unemployment. The impact of monetary policy can be expressed using
the equation of exchange:


Where M= the quantity of money in circulation, V = the velocity of money, P = the

price level, and Q = real GDP. Velocity is the number of times a dollar is used to
purchase goods and services in a given year.
If we assume that V is stable (it doesn't change very often), the a change in the
money supply, M must change P or Q. So no matter what happens to interest rates,
total spending changes. If we assume the Q is near full capacity (the vertical part of
the AS curve) then changes in M only affect P (see figure 15.5, page 301).

This difference in the Keynesian and Monetarists views also leads to different
remedies for fighting inflation and unemployment

Fighting Inflation

Keynesians would advocate a decrease in the money supply (contractionary

monetary policy), which would increase interest rates, decrease spending, decrease
AD, and decrease prices and real output.

Monetarists would argue that if inflation is too high, then interest rates are already

nominal interest rate = real interest rate + anticipated inflation rate

So Monetarists believe that decreasing the money supply will cause nominal
interest rates to FALL (not rise) because the anticipated inflation rate will fall
eventually. Monetarists advocate steady, predictable money growth to keep
anticipated inflation and nominal interest rates low.

Note that both Keynesians and Monetarists advocate a decrease in the money
supply to fight inflation, but they expect it to work for different reasons.

Fighting Unemployment

Keynesians would advocate an increase in the money supply (expansionary

monetary policy), which would decrease interest rates, increase spending, increase
AD, increase prices and output, and decrease unemployment.

But monetarists believe that an increase in the money supply will affect mostly
prices, not output. This would raise inflationary expectations and actually
INCREASE nominal interest rates. Monetarists do not believe that expansionary
monetary policy is effective, unless the economy is WAY below full-employment
(on the horizontal part of the AS curve).

In general, Monetarists believe in fixed money supply targets, or a "rule" for how
much to change the money supply. Keynesians disagree, and believe in more
flexibility or "discretion", with the Fed adjusting money supply to respond to
economic conditions. This debate is known as "rules vs. discretion."