Question

The costs of fighting inflation are higher according to the New Classicals compared to the New Keynesians. Would you agree with this statement? Explain it

Answer 1

Introduction

There are two popular schools of thought when it comes to economics these are known as Classical School of Thought and Keynesian School of Thought.

The Keynesian School of Though was developed by economist John Keynes when he reviewed the Great Depression of 1930’s, he stated that government involvement in economics was extremely necessary to ensure that development can take place in the economy and recession does not take place. This involvement could be direct by investment or indirect by infrastructure expenditure and taxation.

On the Contrary, The Classical School of thought lays prime importance to inflation in the economy and blames redundant government policies or the rise in monopoly to be the real evil for any society.

The main point of difference between the Keynesian School of thought and the Classical School is that one considers unemployment to be the most important factor whereas Classical School considers inflation to be the biggest evil. It believes that full employment can be achieved if a country were to spend its resources in a way that business was left to be handled by businessmen as they would produce those goods and services which the country really needed.

Case Specifics: -

The case describes the cost which is spent in fighting inflation. For this it is important to understand the meaning of inflation. Inflation takes place in any economy, primarily when the prices of goods and services increase. The main cause for such increase is that the demand in the economy is relatively higher than the supply side. When this happens, the net result is that producers increase the prices of the products. This also happens when the currency in circulation in the economy is relatively higher.

Now let us look at how these two models tackle inflation. The Keynesian model is silent on inflation as such, however instils that government intervention is required to achieve harmony in the economy. The government directly reduces the flow of money into the country by increasing taxation or by altering the interest rates. This usually comes at no added costs. The supply of money is changed and savings are encouraged to lower the inflationary pressure.

On the contrary, the Classical Approach believes that full employment will lead to lesser inflation. It says that privatisation of industries and allowing free trade to happen will lower inflationary pressure. This is true in countries which are developed. and can afford expenditure which 1) Allow all demands of people to be met 2) Are backed by financial knowledge and investment. However, this requires huge capital inflows and working knowledge when compared to Keynesian model which just changes the supply of money. As a result, it has been correctly said that the cost of fighting inflation is higher for new classical when compared to new Keynesians. This is because maintaining an economy that runs on the classical model of thought requires adequate expenditure to achieve full employment and fulfil the needs and wants of the economy.

Even the best of countries which have deployed free trade such as the United States have faced issues in the past wherein the inflation rate had to be managed by the government. This is because Classical Models are relative and theoretical in nature and the expenditure required to build a self-sufficient economy which is dependent on just the markets is very high and not many countries are able to achieve it fully while the developed ones do indeed have some of its key elements.

Conclusion: -

Classical School of thought tackles inflation by allowing for full employment which has huge capital overlays. It stresses on the need for minimum government control. On the contrary Keynesian's tackle inflation by government interference and are more concerned about unemployment.

Please feel free to ask your doubts in the comments section if any.