THE KEYNESIANS – CLASSICALS MACRO ECONOMIC SCHOOL OF THOUGHT
DEBATE
1.
Introduction
The Keynesians are a group of macro economists who generally favour activist government
involvement in the economy. On the other hand, the classicals are group of macro economists who
generally favour non-activist government involvement. Specifically, they believe in nongovernment involvement in the businesses of the economy. The classicals argued that government
involvement in the economy leads to greater instability in the macroeconomic system and that the
proper role of the government is to provide an enabling environment for private sector driven
economy. That is the provision of security, the maintenance of law and order, and allows the
private sector to undertake the businesses of the economy. Deducing from the definition of who
the Keynesians and classicals are, we noticed that the primary motive of the Keynesians –
Classicals debate was whether government should be involved (Keynesians argument) or not to be
involved (Classicals argument) in the business of the economy, and not primarily a matter of the
use of fiscal or classicals policy in economic management as erroneously claimed by some
economists.
2.
Cause of the Debate
In the early 1930 the microeconomics concepts of the classicals and neoclassicals economists was
the dominant economic philosophy of the time, operating on the assumption of perfect
competition, wages and price flexibility. The economy was assumed to be self-correcting and
equilibrium income would always tend towards it full employment level, especially in the long
run. As the classicals system shows, these concepts were accepted and for a long time formed the
corpus of economic knowledge from which policies were drawn. Governments were admonished
not to intervene in the event of any dislocation arising, say from inadequate aggregate demand.
The events of the great depression (1929 – 1993) shook the very foundation of classicals economic
theory. The prescriptions by the classicals economists could not provide the much needed remedy.
There was much confusion regarding what should be done. Galbraith (1972) has extensively
documented how renowned economists like Irving Fisher misunderstood the crash and in the
classicals tradition argued that the panic that accompanied the great crash was unfounded.
1
3.
The Debate: Keyne’s View
Keyne’s General Theory was written as an attempt to put forward solutions to the method of
economic analysis in the context of the great depression. According to his line of analysis the
economy is not self-adjusting. Keynes based his analysis essentially on the short run (since in the
long run we would all be dead). He argued forcefully that the possibility of equilibrium income
inconsistent with full employment was real. Indeed, such a less than full employment income could
not be remedied by the free forces of demand and supply in the three markets (labor, products and
money). This creates involuntary unemployment. He urges the government to intervene to
eliminate the deflationary gap which the free interplay of the forces of demand and supply in the
markets has been unable to eliminate. He thus advocated government intervention to cure the
unemployment in the economy. This could be achieved through fiscal policies by either increasing
government spending and reducing taxes or imposing higher taxes to restrict/curtail aggregate
demand when the economy is heated up.
Furthermore, some contributions during the period were readily adopted by the traditional
Keynesians to fill the void inherent in the Keynesian framework. For example, the IS-LM model
assumed a fixed price level at less than the natural rate of output/unemployment such that
aggregate demand shocks will affect only the level of output and employment with no inflationary
pressures. So, when the publication of A.W. Philips statistical investigation into the relationship
between the level of unemployment and wage inflation came out in 1958 and Lipsey (1960)
provided the theoretical rationale for the curve (Santomero & Seater 1978), orthodox Keynesian
economists quickly adopted it for three main reasons. First, it provided an explanation of price
determination, and inflation, which was missing in the then prevailing macroeconomic level. In
separate contributions to the theory of money demand after Keyne’s contribution, Baumol (1952)
and Tobin (1958) demonstrated that people choose between holding money balances and securities
(i.e. bonds/equities).
In other words, by assuming that people trade off money balances for securities, or vice versa they
demonstrated the effects of interest rates in transaction (Precautionary) motive. This implied that
higher market rates increase the opportunity cost of holding real money balances for
transaction/precautionary purposes. The result is that individuals hold less money; therefore,
2
income velocity of money will rise. The converse is true for a decrease in market interest rate.
Recently, David Rome (1986) expanded the Baumol-Tobin approach to address the effects of
shifts between money and non-classicals assets in the economy. Other significant contributions in
different directions during the period analyzed the “short – run fluctuations around the trend” as
well as the “long run movement of output by identifying the determinants of the trend and ignoring
fluctuations around the trend”. While the analyses of the short run fluctuations around the trend
had at the centre the Hick – Hansen IS-LM framework (Hicks 1937; Hansen 1953 and Darity &
Young 1995), the long – run movements of output were, in essence, significant contributions to
the development of growth. The instability and the apparent volatility introduced into the money
demand functions by Keynes were at the core of classicals counter attack on Keynesian economics.
4.
The Debate: Classicals’ View
In the mid-1950s and 1960s, Milton Friedman began a steady and systematic three-way assault on
Keynesian economics in the attempt to “re-establish the quantity theory of money approach to
macroeconomic analysis which had been usurped by the Keynesian revolution”. Friedman’s initial
assault started with the restatement of the quantity theory of money in 1956 to counter the three
motive specific analysis of money demand provided by Keynes. Friedman’s restatement was
meant to limit the quantity theory to a theory of the demand for money as well as the proposition
that money matters, and not just a theory of the general price level or money income (Laidler
1981). To show the stability of the money demand function, Friedman included permanent income
because it does not vary much with the business cycle. Based on this, he asserted that the money
demand and velocity functions were highly stable and would only change in a predictable manner
if any of the variables in the demand for money function should change (Laidler, 1993). In a
continuation of the assault on Keynesian economics, Friedman and Schwartz (1963) provided the
most persuasive evidence to support the notion that “changes in the stock of money play a largely
independent role in cyclical fluctuations”. According to Friedman and Schwartz, episodes of
absolute fall in money stock corresponded to the six periods of major economic contractions over
the 1867- 1960 periods.
In Friedman and Schwartz’s view, the Grate Depression was as a “consequence of the failure of
the Federal Reserve Bank to prevent a dramatic decline in the money stock between October, 1929
3
and June 1933. They interpreted this as a demonstration of the potency, rather than the
ineffectiveness of classicals change and classicals policy (Hammond 1996). Arguing on the side
of the classicalss, a number of scholars, Lucas (1972, 1973, 1976, 1980) Sargent (1972, 1976a),
Sargent and Wallace (1973, 1975, 1976), Barro (1976, 1979) and others, dissatisfied with the
Keynes conventional macroeconomic model shave suggested the use of rational expectations
approach to economic modeling. Lucas (1976) has emphatically argued that the kind of short-run
policy that is usually undertaken with macroeconomic models is not capable of giving dependable
results because individuals’ behavior in forming expectations is a function of their perceptions of
the policy rule being followed which the Keynesians analysis could not account for.
The application of the rational expectations thought to macroeconomic management can be
explained by the accelerating inflation typical of the 1970s which made adaptive expectations
untenable; the stagflation of the 1970s confounded earlier Keynesian optimism with the Philips
curve apparently experiencing increasing instability and collapse; and parallel developments in
general equilibrium theory (Anyanwu, 1993). Furthermore, the central though of the rational
expectation school is that no government macroeconomic policy, whether classicals or fiscal, no
matter how excellently formulated and how effectively, implemented, can have any sustained
impact upon real economic variables (Lucas, 1972, 1978; Sargent and Wallace, 1975, 1976; and
Barro, 1976). This seriously questions the Keynesian interventionist demand management
philosophy, noting that any random policy shifts in aggregate demand will affect real variables
and such random actions are not likely to move the economy closer to the realization of desired
economic objectives. This development justifies the need for earlier policy rules as postulated by
Friedman (1968), as opposed to Keynes philosophy if active intervention in the economy
management (Kydland & Prescott, 1977).
The post-Keynesian macroeconomists also challenge the applicability of the rational expectation
thought. Despite Willies (1981), and Sargent and Wallace (1975) insistence on announcement of
free information, Anderson (1986), King (1982, 1983), Shiller (1978), Okun (1980), Harris and
Homsstrom (1983) note that the government may use an information advantage to influence the
variance of real variables. Again, Weiss (1980) and Turnovsky (1980) made a case for the
effectiveness of stabilization policy when some group of persons in the private sector posses’ better
4
information than others. According to Akpakpan (1999), the classicals have a profound distrust of
government and a political process. Politicians (Government) are seen as guided often by politics,
not by society best interest. For this reason they (classicals) argued that government cannot be
relied upon to deal with the problems of the economy. While the Keynesians tend to see
government as an expression of the will of the people; therefore, to them, the government can be
used to correct the problems of the economy. The Keynesians further stressed that the abuse of
government power by interest groups was part of the cost of having government; generally the
benefits of government outweigh the cost of not having government involved in the business of
the economy.
5.
Global Context of the Macro Economic School of Thought
According to Bamidele (2001) the management of the national economy is concerned with the
determination of the general price level, unemployment, national income and other economic
aggregates, which entail setting up of some objectives as a matter of deliberate policy to achieve
social welfare. The direction of the global economy towards the classicals thinking of less or
limited involvement of government in the business affairs of many countries. This is very obvious
considering the economic management approach of privatization adopted by some government in
recent times, which allows for less participation of government and grater or increased private
sector participation in the world economy. This leads to the conclusion that the initial Keynesians
economic thinking adopted in the management of the world economy prior to 1987 had not
achieved the desired economic objectives, probably due to mismanagement perpetuated by high
scale corrupt practices by government managers of these public enterprises; hence the “Uturn” to
the classicals economic thinking for rapid and sustained economic growth and development of the
world economy.
It is the belief that the economic management ideas of the classicals of private sector driven
economy as it is currently going on, should be sustained for a meaningful and rapid growth and
development of every nation. Also the role of the public sector (government) in the management
of the economy should be reduced and rationalized. Government should basically be involved in
the building of infrastructure, development and maintenance of law and order and setting the
philosophy, rules and regulations for economic management. If by this arrangement, the private
5
sector is given more prominence in the running of the economy, labor would move naturally from
the public to private sector. Furthermore, the relative efficiency of the public and private sectors
as an engine of growth may be controversial; the general evidence is that the promotion of the
private sector as a catalyst for economic growth is well pronounced much more than the public
sector and is supported by substantial empirical evidence. This does not in any way ignore the
contributions by the public sector in economic growth and development. Finally, the maintenance
of political stability, peaceful atmosphere devoid of terrorist activities and religious crisis in some
part of the world are very crucial as a precondition for an enabling environment for sustained and
satisfactory private sector led economic growth.
6
References
Akpakpan, E.B (1999). The Economy: Towards a New Type of Economics. Belpot (NLS) Co. Port
Harcourt, Nigeria
Anderson T.M. (1986). Pre-set Prices, Differential Information and Monetary Policy. Oxford
Economic Papers 38(3).
Anyanwu, J.C. (1993). Monetary Economics: Theory, Policy and Institutions. Hybrid Publisher,
Ltd, Owerri Nigeria.
Bamidele E.O. (2001). Policy Issues in Nigeria’s Macroeconomic Management. NES Publication.
Selected Paper for 1998 Annual Conference, Nigeria Economic Society.
Barro, R.J. (1976). Rational Expectation and the Role of Monetary Policy. Journal of Monetary
Economics. 2(1).
Barro, R.J. (1979). Second thoughts on Keynesian, Economics. American Economic Review,
Papers and Proceedings. 69 May.
Baumol, W.J. (1952). The Transactions Demand for Cash: An Inventory – Theoretic Approach.
Quarterly Journal of Economics. No. 66.
Darity, W. & Young, W. (1995). ISLM: An Inquest. History of Political Economy, Nov. 27.
Galbraith, J.K. (1972). The Great Crash 1929. Pengium Books Ltd., Hurmondsworth.
Hammond, J.D. (1996). Theory and Measurement: Causality Issues in Milton Friedman’s
Monetary Economics. Cambridge University Press.
Hansen, A.H. (1953). A Guide to Keynes, New York: McGraw – Hill.
Harris, M. & Holmstrom, B. (1983). Macroeconomic Developments and Macroeconomics.
American Economic Review, Papers and Proceedings. 73: 223 – 27.
Hicks, J.R. (1937). Mr. Keynes and the Classics: A suggested Interpretation. Econometrics. 5:
147–159.
King, R.G (1982). Monetary Policy and the Information content of Prices. Journal of Political
Economy. 90: 247 – 79.
King, R.G. (1983). Monetary Policy and the Information Content of Prices. Journal of Monetary
Economics. 12: 199 – 234.
Kydland, F.E. & Prescott, E.C. (1977). Rules Rather than Discretion: The Inconsistency of
Optimal Paths. Journal of Political Economy. 85: 473– 492.
7
Laidler, D.E.W. (1981). Monetarism: An Interpretation and An Assessment. Economic Journal.
91:1–28.
Laidler, O.E.W (1993). The Demand for Money: theories, Evidence and problems, 4th Edition,
New York: Harper Collins.
Lipsey, R.G. (1960). The Relationship between Unemployment and the Rate of Change of Money
Wage Rates in the UK 1862 – 1957: A Further Aanlysis. Economica. 27:1–31.
Lucas, Jr. R. E. (1980). Method and problems in 1978 Business Cycle Theory. Journal of Money,
Credit and Banking: 7(4) Part 2: 696 – 715.
Lucas, Jr., R. E (1973). Some International Evidence on Output Inflation Tradeoffs. American
Economic Review. 63(3): 326 – 334.
Lucas, Jr., R. E (1976). Economic Policy Evaluation: A critique, in Brunner, K. & Melzer, A.H.
(eds) the Philips Curve and Labour Markets. Journal of Monetary Economics, Supplement.
1(Apr):19 – 46.
Lucas, Jr., R.E. (1972). Expectations and the Neutrality of Money. Journal of Economic Theory.
4 :103 – 124.
Okun, A.M. (1980). Rational – Expectations – with – Misperceptions As a Theory of the Business
Cycle. Journal of Money, Credit and Banking. 12(4 Part 2):817 – 825.
Santomero, A.M. & Seater (1978). The Inflation – Unemployment Tradeoffs: A Critique of the
Literature. Journal of Economic Literature. June.
Sargent, T. J and Wallace, N (1976). Rational Expectations and the Theory of Economic policy.
Journal of Monetary Economics. 2(4):169 – 84.
Sargent, T. J. (1976a). A Classical Macroeconomic Model of the United States. Journal of Political
Economy. 84(4):207 – 237.
Sargent, T.J. & Wallace, N. (1973). Rational Expectations and the Dynamic of Hyperinflation.
International Economic Review. 14: 328 – 50.
Sargent, T.J. & Wallace, N. (1975). Rational Expectations, the Optimal Monetary Instrument and
the Optimal Money Supply Rule. Journal of Political Economy. 83:241 –55.
Sargent, T.J. (1972). Rational Expectations and the Term Structure of Interest Rates. Journal of
Money, Credit and Banking. 4:74 – 79.
Shiller, R.J. (1978). Rational Expectations and the Dynamic Structure of Macroeconomic Models:
A critical Review. Journal of Monetary Economic. 4(1):1–44.
8
Tobin, J. (1958). The interest, Elasticity of the Transactions Demand for Cash. Review of Economic
and Statistics. 28:241 – 247.
Turnovsky, S.J. (1980). The Choice of Monetary Instrument Under Alternative Forms of Price
Expectations. The Manchester School. 45:39 – 63.
Weiss, L. (1980). The Role for Active Monetary Policy in a Rational Expectations Model. Journal
of Political Economy. 88:221 – 233.
Willies, W.H. (1981). Rational Expectations, as a Counterrevolution in Bell, D. and Kristol, I
(eds) The Crisis in Economic Theory, Basic Books, Inc. Publishers, New York, 81 – 96.
9