Keynesians, Monetarists and New Classicals

Keynesians, Monetarists and New Classicals

Compare and contrast the main theoretical and policy distinctions between Keynesian and Monetarist/New Classical economists.

Macroeconomic theories have continuously evolved throughout history. They are very easily refuted, as they are based on simplified models of the world. These concepts are very sensitive towards changes in the environment of the economy, those alterations can easily cause them to collapse.

All macroeconomic models described here are reactive: former theories, who were believed to be true could no longer be applied to reality, due to the dynamic nature of external factors. So in reaction to the new circumstances new models arose.

Keynes, a former classical economist, had to (rethink) his idea of the economy, in the background of a collapsing economy after the 1st world war and the following depression of the 1930's. The Monetarists and New Classicals offered an altered theory, when the problem of stagflation occurred, which contradicted Keynes theory.

The basic ideas of those theories shall be shown here under these spotlights:

- The flexibility of prices and wages,
- The analysis of unemployment,
- The flexibility of aggregate supply,
- The role of expectations in the working market,
- The market for loanable funds and the analysis of inflation, as well as
- Policy implications.

Since the Monetarist and the New Classical theory do not differ very much, the latter will be neglected in the main body and their difference shall only be described in short.

Keynesians believe that prices and wages are rather inflexible downwards.

In the case of a decrease in demand (indication of a recession), A decrease in aggregate demand will cause an alteration of aggregate supply, as the latter is highly elastic downwards. To be able to keep up a stable level of employment wage cuts should occur. But powerful trade unions will be able to resist any salary cuts. Companies also fear to lose skilled labour and motivation if lowering wages and therefore rather release unskilled work force and keep wages on a higher level. Keynesians also argue, that if wages were cut to restrict a recession, this would set off an even further decrease of demand, as workers will not be able to spend as much anymore. Thus recession will deepen. It is also arguable for them, whether a reduction in wages will lead to more employment. Companies will enjoy the lower costs of labour, but are rather unlikely to take on more labour, if the market environment does not seem to be recovering. As wages are sticky and often the cost-plus pricing method is applied, prices are not flexible downwards either. Also industry becomes more concentrated and therefore can dictate prices. They rather reduce production (release labour) or build up stock instead of lowering prices in case of a fall in demand. Therefore unemployment is directly linked to demand. If aggregate demand is too low, there will be a downward economic trend leading to releases of labour. The level of demand depends on several factors, which are investment, government expenditure, as well as exports ( the so called injections) and consumption demand. If any of these are extended it will give a rise to aggregate demand. Firms in response will produce more, employing more labour and extending investment. Hence leading to a boost of the national income, which will result in more consumption and higher demand. This chain of events is the so called Multiplier Effect. Therefore the aim of Keynesians is to keep a high level of demand, to maintain a big (?) equilibrium employment.

In Keynesian theory there is a certain amount of unemployment (Umin) which will persist. It can't be eliminated by increased demand, but has got to be tackled with structural policies, for example by retraining miners whose profession is no longer demanded. Monetarists on the other hand believe that wages and prices are flexible. Their idea is that the economy will automatically create a equilibrium market. When shifts of demand occur, both firms and workers will respond quickly in a free play of market resources. In the case of a sinking demand, firms will ask for less labour, resulting in an excessive supply of labour. This will trigger wages to fall until demand equals supply again. Likewise prices will fall until equilibrium is restored Employment will in the long run always return to its `natural' level. As shown before, through a series of adjustments an equilibrium will be restored. The amount of unemployment that persists is either frictional, structural or technological unemployment. Monetarists assume that changes in demand have no influence on the extent of employment, but will spark of in- or reflation.

These two schools of thought also take different viewpoints concerning the flexibility of aggregate supply. While Keynesians believe, that aggregate supply is very flexible, Monetarists claim that it is inelastic. Keynesians believe that a change in aggregate demand will directly lead to a change in aggregate supply, which is very responsive. Firms experiencing more demand, will be willing to invest, produce and employ more, thus enhancing supply. Monetarists believe that a change in aggregate demand will bring about the same amount of supply only on a different price level. Aggregate supply solely depends on the quantity and productivity of factors of production. The Monetarists apply Says law stating that supply creates its own demand.

Which role do the two groups attribute now to the expectations in the working of the market? Keynesians believe that firms will presume from demand increases faster growth and expansions of markets. The mere expectation of a rise in demand can cause an actual increase in demand, a typical self-fulfilling prophecy. This is caused, because firms in a slack economy respond very quickly to signs of boom. In expectation of the increased demand they will produce and invest more, thus employing more labour, which will increase the national income, resulting in more demand.

Monetarists in contrast believe, that the economy noticing higher demand automatically expects inflation. The background for this assumption is this: if there is more demand, the prices will rise, because more people want to buy the same output available. For workers to maintain their life standard they claim higher wages, in order to be able to buy the same amount. So the factor cost is rising for companies, meaning that their raise of prices will not result in more profit. The risen prices in turn will decrease the demand to the old level. So the individuals and firms realise that the expected increase in sales caused by higher demand is an illusion.

Now let us turn to the market for loanable funds and inflation. How do the different circles perceive the workings of this market? What relation is there between the savings and investment? And how does inflation develop? The Keynesians argue, that neither saving nor investment is very responsive to changes in the interest rates and therefore to make either one more attractive the interest rates have to be altered (on a large scale, heavily?) to restore the equilibrium.

They take this position analysing the following context: in case of increased savings the interest rates will fall, but that there will be a decline in consumption as well. Firms who encounter this decrease in demand, are discouraged to invest (even if interest rates are lower) causing the interest rates to fall even further. They will only wish to invest if there is an buoyant market. If the business confidence is not there because of a recession, the lack of demand for investment will lead to even further recession. Furthermore the heightening of money supply might lead to more output. The alteration of real income of individuals will be an incentive to consuming more. If there is a slack in the economy the increased demand will lead to more production, leading to more employment and investment. If there are no idle factors of production, but an excessive demand inflation will occur. Inflation after the 1970's was caused by several factors, on of them being a demand shift. The increased demand in certain sectors couldn't be met by supply, because there were no idle factors available, for other, less demanded sectors weren't flexible downwards and stuck to their old level of output and employment. So the excessive demand in one sector wasn't offset by the excess supply in another sector. Besides large multinational companies were powerful enough to maintain a high level of prices for there products, or even raise them to an unjustifiable level (OPEC). Moreover the wage increase expectations of the workers couldn't be backed up by the output growth, so inflation resulted.

Monetarists differ from this analysis of the market for loanable funds. They assume that increases in money supply will in the long term always lead to price raises. This is how the quantity theory of money is explained: an increase in money supply will in the short run increase demand, raise prices and employment. But again, with rising prices workers expect wage increases, lowering company profits, which will make them release labour again. So the money supply raise causes in the long run inflation, but not employment or output growth.

Likewise a reduction of money supply might in the short run reduce employment but will in the long run only cause prices and wages to fall. The equilibrium will be installed again only on a lower level of prices and wages. This process is hindered though if workers insist on their amount of wages or expectations of inflation still exists. So for Monetarists there is a demand-pull inflation: it depends on demand, which is determined by money supply.

Owing to these differences in the understanding of the workings of the economy the different schools of thought derive diverse policies for the government.

For Keynesians free markets are often highly imperfect and will not lead to optimal allocation of resources. Interference of the government is needed to ensure that markets clear.

The government's basic aim should be to keep a stable, high rate of growth, which can be achieved by flattening out fluctuations and maintaining a high demand. As Keynesians believe that the economy can be boosted by heightening demand, they suggest mainly demand side policies. This is explained in the simple context: more aggregate demand, will expand supply which will result in more employment.

The suggested policies can be subdivided into fiscal and monetary policies. Within fiscal policies the government has two different means of influencing the national income and the total expenditure. Firstly they can alter government expenditure and inject therefore spending in the aggregate demand. Secondly the government could change the level of taxes withdrawing money from the national income and therefore reducing consumption. For example in a recession it should raise government expenditure with little import content (to keep burden off balance of payment) and/or lower taxes, to increase aggregate demand and consumption. If there is too fast growth in the economy they should follow contractionary fiscal policies increasing taxes and lowering government spending. This change in government actions depending on the state of the economy are also called stop - go policies. In order to fulfil these aims the government should be prepared to run a budget deficit if needed.

The government can also apply monetary policies. It could alter interest rates or money supply. These two means can be efficient in influencing the market for loanable funds: increased money supply will not only alter demand, but probably will also lead to increased saving. Changes in interest rates could also make saving or investing more attractive. This policy is not as reliable though, since the extra money could also be spend for speculating rather than for real goods and services. It is best to pursue a combination of fiscal and monetary policies, for instance government spending should be financed by increased money supply in order to limit crowding out. To reduce unemployment Keynesians suggest supply side policies in the form of enhancing geographical labour mobility or influencing industries to settle in regions where there is high unemployment. They consider it also important to provide training for workers to improve occupational mobility. Keynesians demand also a greater co-operation between government and industry.

Monetarists above all suggest the pursuit of laissez-faire policies, signifying as little government interference in the play of the free market forces as possible. Government should concentrate on encouraging enterprise and competition, whilst removing market hindrances like too strong trade unions. Monetarists dismiss all sort of influence on the demand, as they believe this only sets off inflation. Demand therefore should be curved. They advocate supply side policies, since supply creates demand. Tight control over money supply is required to maintain a stable inflation, which will improve business confidence. If this is not ensured, it will worsen long-term output and employment growth by discouraging investment. It is also damaging to the country's competitiveness in international trade. Government needs to ensure a balanced budget.

On the labour supply side, they should introduce policies increasing mobility of labour, offering retraining and cutting social security benefits to give incentives to a quicker matching of workers and jobs.

Monetarists criticise that demand side policies might make fluctuations in the business cycle even worse, if it takes too much time for certain policies to be adopted and work. Time lags might result in one policy being adopted, when the economy needs already the total contrary.

The New Classical school of thought remembered the classical theory and demanded pursuit of their policies. They are an extreme Ausprägung of the Monetarists. They assume that markets adjust very quickly to new circumstances and clear. Expectations of workers as well as firms respond virtually instantaneously to new situations.

An increase in the money supply will therefore lead immediately to expectations causing inflation and will not even bring about a positive short term effect for employment. Likewise will a tight monetary policy not lead to more unemployment, but only to reflation. If rising unemployment occurs it is entirely due to changes in the natural rate of employment, for instance if there is a major modification in the structure of the labour market.

The conclusion I would like to discuss with you (please).

The problem with these theories is that they all make sense and can be argued überzeugend.

Zusammenfassend ist zu sagen, dass alle drei theorien durchaus nachvollziehbar sind, und es sehr schwer ist sie als fehlerhaft zu bezeichnen.