Different Schools of Thought

Demand management policies wouldn’t have been important if there was no fluctuation in
demand, taking the output away from the full employment level of output. As to why demand
fluctuates and the output gap persists, there are various theories. They are discussed below.
A) Classical School of Thought (Hayek, Robbins, and Schumpeter)

There is no necessity for government intervention.

Leave it on its own. Markets will take care of itself.
 The economic system self-corrects through price mechanism, and input and
output markets return back to equilibrium without government intervention.
B) Keynesian School of Thought (Keynes)

 Observed that during recession, markets did not take care of itself.
 economic agents behave like animals, economic agents become pessimistic
about the future then consumers start spending less money, firms cut down
their production, and the economy enters into a recession.
 government intervention is necessary to restore the economy to full
employment level of output.
 to bring the economy back to normalcy and out of recession, there is need for
active government intervention through demand management policy.

C) Neo-Classical School of Thought (Phillips)

 Initially, the Keynesian prescription of managing aggregate demand was
biased towards using fiscal policy.
 In 1958, A. W. Phillips showed wage inflation varying inversely with
unemployment. Higher inflation (resulting from higher nominal wage rate)
will lead to lower unemployment rate.
 Following Phillips’ works, the Keynesian economists started to accord
importance to monetary policy, in addition to fiscal policy, for controlling the
output gap.
US into stagflation – stagnation (unemployment) and inflation. The Keynesians were puzzled
by the outbreak of stagflation because the original Phillips curve ruled out simultaneous
occurrence of high inflation and unemployment. The new classical school emerged during
the 1970s as a response to the failure of Keynesian economics to explain stagflation.
Stagflation:- Stagflation refers to an economy that has inflation, a slow or stagnant economic
growth rate, and a relatively high unemployment rate. With stagflation, a country's citizens
are affected by high rates of inflation and unemployment.
D) New-Classical School of Thought (Milton Friedman and Robert Lucas, Jr.)

 They Suggested that demand management policy had little role to play in
managing the output gap.
 Monetarists believed that fiscal policy would be less efficient in the context of
developing and less developed countries in particular.
 Friedman argued that money supply had no role to play in controlling the
output gap. There is essentially no long run trade-off between inflation and
unemployment.
 Friedman suggested that if inflation were to last for several years, workers
start adapting during salary time thus causing firms input cost As there is no
change in real wage, firms will not have any incentive to hire more labour.
Therefore, prices will increase without reducing the level of unemployment.
 During the early 1980s, a newer approach to explain the existence of output
gap emerged. This is known as the real business cycle theory, pioneered by the
works of F.E. Kydland and E.C. Prescott,9 and J.B. Long and C. I. Plosser.
 The real business cycle approach argued that it is quite natural to have an
output gap.
 According to the new classical view, this disequilibrium will be self-correcting
– market forces will take care and there is no necessity for government
intervention.
 In sharp contrast to both these hypotheses, the real business cycle school of
thought argues that each stage of the business cycle, be it boom or bust, is at
an equilibrium.

E) New Keynesian School of Thought (Gregory Mankiw, Lawrence Summers, Olivier
Blanchard, Edmund Phelps, and John Taylor, among others)

 The cause of market not clearing was wage and price stickiness.
 Unlike their new classical counterparts, the new Keynesians did not believe in
full wage and price flexibility.
 able to show that it is possible that market will not clear in presence of price
and wage stickiness. Worsen the situation
 The reasons for price stickiness can be attributed to ‘menu cost’, and imperfect
market structure.
 wage stickiness is a result of the presence of labour unions.
 Price stickiness may also lead to coordination failures among firms.