In this video we will distinguish between Keynesian and Monetarists economic schools
of thought with respect to how the macroeconomy functions.
Let’s first start with a little background on John Maynard Keynes.
John Maynard Keynes was a British economist who challenged the neoclassical view that
economies self-correct over time by stating “In the long run we are all dead.”
His point was simple, that without government intervention and spending – recessions and
depressions would be unnecessarily deep and prolonged.
He advocated for the use of expansionary fiscal policy and deficit spending during recessions
and depressions with a primary focus on reducing unemployment.
Keynes felt government should spend to prevent the economy from experiencing extended periods
of demand deficient unemployment as businesses are extremely hesitant to invest in uncertain
economic times.
Keynesians believe fiscal policy should lead the way in an economic downturn.
Government spending will boost additional spending through the multiplier effect and
the economy will recover faster than if the government had not intervened at all.
Keynes argued that firms will invest if they have positive future expectations and confidence
that the economy is improving.
He felt demand for capital goods would be interest inelastic since investment does not
only depend on the interest rate – but other factors such as the level of business confidence.
A useful analogy would be to say that you can lead a horse to water, but you cannot
make him drink.
You can setup favorable conditions for firms to borrow, but you cannot force them to unless
they want to.
Let’s return to the Keynesian AD/AS model to discuss this a bit further.
Keynes felt that wages and input prices were sticky downwards – meaning they are hard
to adjust down.
This could be due to minimum wage laws, contracts or regulations.
Therefore, unlike in the classical view, resource prices cannot quickly adapt to changing market
conditions.
GDP will continue to fall and spare capacity will rise.
The economy would have significant spare capacity and Keynes argued this is a key reason for
government spending.
Government spending would increase aggregate demand by a larger amount than the initial
expenditure due to the multiplier effect.
As business activity increased, business confidence would increase and firms would start to invest
more.
Additionally, Keynes felt that monetary policy could be of limited effectiveness due to the
liquidity trap, which will be explored further in a later video.
The short version is that interest rates can only be pushed so low, and beyond this monetary
policy may be of limited success.
Let’s now consider an alternative view, that of Milton Friedman and the monetarists.
Milton Friedman is a famous American economist from the Chicago school who won the Nobel
Memorial Prize in Economic Sciences in 1976.
He was critical of Keynesian economics and became one of the most recognizable names
associated with monetarism, which focuses on the importance of central bank control
of the money supply to manage the price level.
The monetarist position is that the rate of growth of the money supply is the central
driver of economic growth.
According to the monetarist view of the quantity theory of money, velocity is constant and
changes in the money supply can increase output in the short run but ultimately only impact
the price level in the long run.
Inflation is then seen as the result of an excessive growth of the money supply, or M
in this equation.
To monetarists, the key priority of monetary policy is to control inflation.
Too much money results in inflation and too little money results in low inflation, and
perhaps deflation.
Monetarists also believe that firms are influenced by the interest rate when making investment
decisions, as opposed to Keynesians who believe that firms are more influenced by their confidence
in the economy.
-Monetarists believe markets are inherently stable and that a small government and limited
government interference in markets is preferable.
In the monetarist view, the long-run aggregate supply curve is vertical at the full-employment
level of output Y*.
- -Suppose there is an increase in the money
supply.
This will lead to an increase in aggregate demand, and thus real GDP.
However, as output increases and prices rise, workers will likely negotiate higher wages
and suppliers will ask for higher input prices resulting in a leftward shift of the SRAS
curve.
This substantiates the monetarist assertion that changes in the money supply can increase
real GDP in the short run, but only the price level in the long run.
-
- -Similarly, suppose there is a demand shock
that leads to a fall in aggregate demand.
Well, as real GDP falls and unemployment rises, workers will adjust their expectations for
wages and suppliers will accept lower prices for inputs.
This causes the short-run aggregate supply curve to shift rightwards and we are again
along the full-employment level of output in the long run.
- -This perspective assumes that prices are
flexible downwards, and that any deviation from full employment is only temporary in
the short-run.
- -Hopefully this sheds some light on the monetarist
view and their perspective on how the economy self-corrects.
By now you should have a good understanding of the differences between Keynesian and Monetarist
schools of thought with respect to how the macroeconomy functions.
If you have any questions, leave them below.
That’s us done for now and I will see you in the next one!