Keynesianism and Monetarism.

I. The major economic argument for the past 60 years has been whether governments can effectively intervene in the business cycle and move economies away from recessions more quickly than would otherwise happen.

Classical economists in the 18^th and 19^th century (Adam Smith in "The wealth of Nations") argued in favour of "laussez-faire". They argued that economies tended towards a general equilibrium in which all resources were fully and efficiently used. They insisted that in an economy which is powered by free enterprise (= private enterprise) and individualism natural forces such as self-interest and competition naturally determine prices and incomes. They were sure that in the long run economies tend to a full employment equilibrium. Classical economic theory also states that in the long run if people save a lot of money, interest rates will fall. It will encourage business to borrow money and invest.

II. Yet the depression of the 1930s showed that, at least in the short term, this was untrue , that the market system does not automatically lead to full employment. John Maynard Keynes was a great English economist who was the founder of modern macroeconomics and has a school of economic thought named after him.

In his book «The General Theory of Employment, Interest and Money»:

• He worked out a macroeconomic method of scientific research, widely used by international economies;

• He argued that there was a certain interconnection (interdependence) between national income and savings;

• He developed the idea of composite (aggregate) demand and supply;

• He worked out a theory of state regulation in the economy, including the sphere of increasing the level of employment (the theory of governmental intervention in the company);

• He argued that market forces might provoke a high unemployment equilibrium.

In what way? The answer is obvious.

If people are pessimistic about the future, if they are worried about the possibility of losing their jobs, they will save more money and consume less. It leads to a fall in demand, and consequently to a fall in production and employment. Surely in this situation producers are not interested in making new investments, people's saving remain unused. Fewer goods are produced, fewer people are employed, rates of income and investments are reduced, and the economy will settle into a new equilibrium at a lower level of activity.

So Keynes was convinced that market economies are unstable and without a self- correcting mechanism, except perhaps in the long run, but as he put it, "in the long run we are all dead".

What measures did Keynes recommend to counter the business cycle?

Keyns therefore recommended governmental intervention on the economy, in order to counter the business cycle. The Keynesian theory doesn’t certainly argue that it can dispose of the business cycle altogether and eliminate recessions, it can only make the business cycle a little bit flatter.

Keynes believed that if the government borrows and spends more money, economic activity will increase, this will affect interest rates and business investments.

During a period of inflation(an inflationary boom) recommended governments to decrease their spending or increase taxation.

During a period of recession, on the contrary, he recommended them to 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. According to the traditional Keynesian theory even a small increase in government spending and private investment leads to a larger increase in output.

Keyns suggests that if the government increases its budget deficit, or the amount of money in circulation, it boosts domestic demand and stimulates a contracting economy. People start spending more money that influences the economy through the multiplier effect.

The multiplier effect means that most of the money is repeatedly respent by its
new owners, except for the proportion they choose to save.

Keynesian policy is often described as «demand management». It means attempting to reduce the level of demand during an inflationary boom, and increasing it during a recession.

III. The post-war period was the era of Keynesianism. For over a quarter of a century after the Second World War, the governments in many industrial countries successfully used Keynesian policies. But events after the oil crisis in 1873-74 demonstrated that Keynes did not have all the answers.

Many countries began to experience "stagflation" - a prolonged recession or stagflation at the same time as high inflation. This showed that Keynesian attempts to increase demand and reduce unemployment worked in the short term, and didn't work in the long term. As far back as in the 1950s and 1960s monetarists,most notably Melton Friedman criticized the Keynesian fiscal policy:

• They criticize for having negative long-run effect, that is medium or long-term economic growth is damaged by short-term Keynesian government policies to

stabilize the economy;

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They completely disagree with Keynes' recommendation to the government to increase the money supply and reduce interest rates during a recession to stimulate the economy;

They also subjected Keynes to criticism for his idea of ‘demand management’;

They argued that governments should abandon any attempt to manage the level of demand in the economy through fiscal policy;

They were critical of interventionist policy because they believed of might accentuate cycles and make them worse.

Unlike Keynesians, monetarists insisted that money is neutral. By the neutrality of money the mean that in the long run the only effect of changing the money supply (the amount of money in circulation) are сhanges in price and that the money supply doesn't influence demand, output or employment. So governments should guarantee that there is a constant and non-inflationary growth in the money supply.

According to monetarist, recessions are not caused by long-term market failures. They're caused by short-run errors by firms and workers who don't reduce their prices and wages quickly enough when demands fall. But the government is usually not able to recognize a coming recession more quickly than the companies. Consequently, its intervention and fiscal measures come too late and take effect when the economy is already recovering. So it can easily do more harm than good. It can make the next swing in the business cycle even greater, accentuate the cycle and make it worse.

IV. ‘Supply-side’ theorists agree with Keynesians that there is a role for economic policy, but they argue that it should focus on aggregate supply or potential output rather than on aggregate demand. They recommend boosting supply in stagnant economy by lowering taxes on capital and business profits, which will lead to an increase in the supply of inputs, namely capital and labour.

V. Keynesians today are often called neo-Keynesians.They argue that wages are inflexible or ‘sticky’ because of:

• Labour union contracts

• Government regulation

Moreover, business can't change their prices too frequently because there are many costs involved known as 'menu costs'.

Neo-Keynesians believe that individuals and firms are unable to find right prices. This leads to rising output and high or full employment. Economies can get locked into disequilibrium for long periods. So they believe that there is still a role for expansionary and deflationary government policies.

VI. Keynes argued that people’s economic expectations about the future were erratic and random, and could consequently be wrong. In the 1970s, the Rational Expectation School, led by Robert Lucas and Thomas Sargent, began to argue that, on the contrary, people make rational choices according to information available to them. If people anticipate that the government will cut taxes or allow the money to grow or interest rates to fall, so as to boost employment and stimulate demand, they will plan and behave accordingly. Even before the government announces such measures, companies will plan price rises, and trade unions will demand higher pay. This means that predictable and systematic policies to stabilize the business cycle ( monetary expansion or tax cuts) will instantly be compensated for and thus become ineffective, in other words, fiscal and monetary policy will only affect output and employment if it’s unpredictable and comes in a surprise.

Date: 2015-12-24; view: 1215