Question

After reading page 704 to 707 from the file “Chapter 17- Rittenberg” (available in BB):

a/ Explain in detail the differences between monetarist view and Keynesian view about the functioning of the economy and the role of economic policy ( you discuss both fiscal and monetary policy).

b/ According to Milton Friedman, how did the US economy end up by exhibiting high inflation rate and high unemployment rate early 70s ?

Answer 1

Keynesian views:

Keynes does not believe in free market system. He argues that there should be government intervention in economic activities to deal with recession. Hence, he suggested that government should use fiscal policy during the recession to deal with problem of unemployment.

Further, he does not believe in effectiveness of monetary policy. Monetary policy is not effective enough to deal with problem of recession.

Milton Friedman:

He is supporter of free market system. He believes that intervention of government through fiscal policy creates instability in system. Hence, government should not intervene in economic activities.

He argues that monetary policy is most effective measure to deal with recession. Undersupply of money may lead to recession. Hence, he suggested that real variables are affected by monetary policy. Monetary policy should be used according to fixed rule.

b)

It was called stagflation and Phillips curve had failed. It was witnessed that high inflation and high unemployment rates were co-existing.

Keynesian theory failed to explain such phenomena. Milton Friedman explained stagflation. Future expectation about inflation shifts Phillips curve to right and thereby posing problem of stagflation. If workers expect that inflation will continue to prevail in long run, then they start demanding higher wages which further exacerbate problem of stagflation.

Hence, Milton Friedman suggested that Federal Reserve must decrease money supply in market to reduce inflation. Milton Friedman suggested policy was used to deal with problem of stagflation.