Question

The Circular Flow and Income-Spending Streams tell us that in the economy, total output must equal total spending. This idea is the basis for all macroeconomic analysis. John Maynard Keynes and his followers (the Keynesians) use this idea, and Milton Friedman and his followers (the Monetarists) do too. However, they come up with very different conclusions regarding the role of government in the economy.

Your assignment is to explain the basic arguments of each school of thought, Keynesian and Monetarist, what each recommends for the proper role of government in the economy, and the basis for those beliefs. What are each side's beliefs or assumptions about the macroeconomy, about equilibrium, and about full employment that lead them to their different conclusions? Also, what are the risks of both approaches to improving the economy? In other words, if we were to use either Monetary or Fiscal policy to stimulate the economy, what are the risks or problems we need to look out for?

HINT: When the Keynesians say “total output = total spending” they write it GDP = C + I + G + X_n. (See chapter 7 - They are focusing on the sources of spending in the economy.) When the Monetarists say “total output = total spending” they write it MV = PY. (See Chapter 13 - They are focusing on the Equation of Exchange.) These are important differences, but you must also explain the thinking behind them.

Answer 1

The most basic difference between the two schools is that Keynasians are concerned with the short run economy while Monetarists are concerned with mostly the long run economy. This leads them to have different believes about the role of government (mainly during an economic crisis). Keynasians belief that government must intervene during an economic crisis by increasing its expenditure (G component) which would in turn affect the levels of spending like consumption, investments (C and I components) in the economy through the multiplier effect. The government can change taxes and affect disposable income to change C and I through multiplier effect (through mpc and mpi). This is why they write it as Y=C+I+G+X_n. While the Monetarists belief that fiscal policy is ultimately ineffective in the long run. So it is the money supply which regulates and controls the economy. This is why they write it as M(money supply)V=PY. They belief that it is the amount of money supply determines level of economic activity.

This view on the role of government by both schools is based on their beliefs and assumptions about the macroeconomy. The Keynasians belief in a demand side economy while for the Monetarists - supply side economics is a more dominant belief. The Keynasians take wages to be rigid (fixed) in the short run (fixed by institutions) while Monetarists belief in the presence of flexible wages in the absence of minimum wages and trade unions. This is based on their belief in sticky and flexible prices respectively. This is why the Keynasians belief that there are trade off between unemployment and inflation while Monetarists are of the belief that the trade off is only persistent in the short run. This leads to their varied beliefs in fiscal policy. Monetarists belief that if government does not maintain a balanced budget situation then it will creates debts in the future. The increase in expenditure would increase interest rates and crowd out spending. While Keynasians belief that during a recession, it is safe to increase spending as economy at that time is performing below its potential. Further they are in favor of government borrowing because this offsets decrease in private saving during recession. Here again Monetarists argue that during recession, people save more and consume less. Hence Keynasians are a believer in fiscal policy(control spendings) while Monetarists believe in the effectiveness of monetary policy (control money supply).

The unemployment story differs as well. The Keynasians belief in a demand deficient unemployment while Monetarists belief in a supply side unemployment. When there is fall in demand and so the spending (Y=C+I+G+Xn) falls, which leads to lower labor demand and would decrease employment and income and in turn would create cycle of fall in income, demand and unemployment. Since wages are fixed this happens. If wages were to fall, employment would increase for the Keynasians. So for them full employment is in the absence of any cyclical unemployment. While monetarists belief that unemployment increases only due to a fall in anticipated income (based on Milton Friedman's permanent income hypothesis). A temporary decline in employment (like structural and seasonal) will not impact real output and hence full employment levels.

The risk of a fiscal policy is primarily that it can increase fiscal deficit and increase debts on future generations. Fiscal deficits can crowd out invesment becuase governent might borrow more to pay for the previous debts (for e.g, borrow from Central bank or privately), this will decrease national savings and impact long run growth. Other set backs are that policies can be politically motivated or the tax cut incentive gets spend more on imports which would decrease GDP. There are few vital risks with monetary policy but the main risk is the time lag of the policy. The effect which is required within a month, would take 7 to 8 months to reflect its effects. Other risks are a risk of hyperinflation, inability of the policy to affect only certain sectors of the economy as the policy impacts the entire economy equally and the risk of meeting a zero lower bound when stimulating the economy by a Monetarist's policy.