Self-prepared Additional Reading Material, Monetarism V.S. Keynesian (ChatGPT
Generated)
Monetarism and Keynesian economics are both schools of thought in economics that
propose different solutions to managing the economy, particularly in relation to monetary
policy, fiscal policy, and the control of inflation and unemployment. Here are some key
differences:
1. **Role of Government: ** In Keynesian economics, there is a strong role for
government in managing the economy. This includes using fiscal policy (taxation and
government spending) to stimulate demand in the economy during recessions and to cool
down the economy during periods of high inflation. Monetarists, on the other hand,
believe that the economy is inherently stable, and that the government should limit its
involvement, focusing primarily on managing the money supply to control inflation.
2. **Fiscal vs. Monetary Policy: ** Keynesians advocate for active fiscal policy (changing
government spending and taxation) to influence the economy, especially during downturns,
while monetarists believe in the power of monetary policy (controlling interest rates and
the money supply) as the primary tool for managing the economy.
3. **Price Stability and Inflation: ** Monetarists prioritize price stability and believe
that inflation is primarily caused by changes in the money supply. They argue that
increasing the money supply faster than economic growth can lead to inflation. Keynesians,
however, believe that inflation can also be caused by demand-pull (too much demand for
goods and services) or cost-push factors (increases in costs of production), not just
changes in the money supply.
4. **Expectations and Adaptation: ** Monetarists often incorporate a strong belief in
rational expectations theory, the idea that people in an economy will act based on their
expectations of future economic conditions, and these expectations can make policies
less effective. Keynesians, however, tend to emphasize that economic actors can be
influenced by "animal spirits" or non-rational factors, and that economies do not always
quickly self-adjust to changes.
5. **Economic Stability: ** Monetarists tend to believe in the natural stability of the
market and the self-correcting nature of free markets. They argue that if left alone,
markets will adjust and economic stability will be achieved. Keynesians, however, believe
in the possibility of market failures and economic instability (such as prolonged
recessions) without government intervention.
6. **Philosophical Underpinnings: ** The Keynesian view is generally more interventionist
and based on the belief that active policy can be used to improve economic outcomes and
mitigate the impact of economic cycles. Monetarism, in contrast, tends to have a more
laissez-faire approach to economic management, emphasizing the importance of steady,
predictable policy and the dangers of overactive policy intervention.
7. **Unemployment: ** Keynesians believe that unemployment is influenced by a lack of
effective demand and that government spending can be used to increase demand and
reduce unemployment. Monetarists, however, view unemployment as largely influenced by
the supply side of the economy, such as labor market regulations and the natural rate of
unemployment.
It's important to note that these are general tendencies within each school of thought,
and there can be considerable variation within each. Also, in modern economic
policymaking, elements of both schools of thought are often combined. For example, many
central banks today use a mix of monetary policy to control inflation (a monetarist
approach) while also employing some level of discretionary fiscal policy (a Keynesian
approach).
Sticky Wages
The term "sticky wages" refers to a concept in economics where the nominal wages of
employees are slow to respond to changes in economic conditions. This can occur for a
variety of reasons, including contractual obligations, labor laws, and the simple reluctance
of workers to accept pay cuts.
Here's a bit more detail:
1. **In a Declining Economy: ** When an economy is declining or experiencing a recession,
it would be expected in a purely efficient market that wages would decrease to match
the lower demand for labor. However, due to contracts, labor laws, and the resistance of
employees to wage cuts, these wages can remain "sticky" and not decrease as expected.
This can result in higher than necessary unemployment.
2. **In an Improving Economy: ** Similarly, in an improving economy where demand for
labor is high, wages might be expected to rise quickly. However, again due to contracts
and institutional inertia, wages might not rise as quickly as they would in a perfectly
efficient market.
The concept of sticky wages is important in Keynesian economics. Keynesians argue that
because wages are sticky, decreases in demand can lead to prolonged periods of high
unemployment. They argue this is a type of market failure and that in such situations, it
may be necessary for government to intervene, for example by increasing its own
spending to boost demand.
On the other hand, the concept of sticky wages is less emphasized in some other schools
of thought, such as in classical or neoclassical economics, which tend to stress the selfadjusting nature of markets.
The existence of sticky wages and prices is also one of the rationales for monetary policy.
If the economy is in a recession and wages and prices are sticky downward, reducing the
interest rate can stimulate investment and spending, helping to return the economy to
its potential output more quickly.
Keynesian Aggregate Supply
The Keynesian Aggregate Supply curve can be represented in three distinct stages, often
referred to as Keynes' Law, the Intermediate-Range, and Say's Law.
1. **Keynes' Law (Horizontal Range): ** At high levels of unemployment and a lot of
unused capacity in the economy (which is often the case during a deep recession or
depression), the Keynesian Aggregate Supply curve is horizontal. This means that firms
are willing to supply additional output at the existing price level because they have idle
resources, including unemployed labor. In this range, increases in aggregate demand lead
to increases in real GDP (output), but do not lead to higher price levels (inflation). It's
named after John Maynard Keynes, who argued that demand drives supply, especially
during economic downturns.
2. **Intermediate Range (Upward Sloping): ** As the level of output approaches the
economy's potential output, resources become more fully employed, and firms find it
harder to increase their output without raising prices. In this intermediate range,
increases in aggregate demand led to increases in both real GDP (output) and the price
level (inflation). The supply curve is upward-sloping, indicating that as demand increases,
suppliers can start to charge more for their goods and services.
3. **Say's Law (Vertical Range): ** At full employment, or the economy's maximum
sustainable output, the Keynesian Aggregate Supply curve becomes vertical. In this range,
all resources in the economy are fully employed, and an increase in aggregate demand
cannot increase real GDP (output), but only leads to higher price levels (inflation). This
reflects Say's Law, the idea that supply creates its own demand. In this range, Keynesian
economists argue that demand-side policies have no effect on output and only lead to
price changes.
It's worth noting that this representation of the Keynesian Aggregate Supply curve
captures the idea that the economy can behave differently at different levels of output
and employment. This is in contrast to the classical view, which is often represented by
a vertical long-run aggregate supply curve, indicating that the economy is always at its
potential output in the long run, regardless of the level of demand.
With Monetarism
Monetarism, a school of thought primarily associated with economist Milton Friedman,
places a strong emphasis on the role of money and monetary policy in the economy. Here's
a comparison of Keynesian economics and Monetarism in the context of the aggregate
supply (AS) and the principles of each school:
1. **Long-run Aggregate Supply (LRAS): ** Monetarists, like classical economists,
typically view the Long-Run Aggregate Supply (LRAS) as vertical, implying the economy
is always at or tends toward its potential output in the long run, regardless of changes in
demand. This is in contrast to the Keynesian view, which sees the LRAS as having three
distinct stages (Keynes' Law, Intermediate-Range, and Say's Law), based on the level of
economic output and employment.
2. **Role of Money: ** Monetarists believe that changes in the money supply are the
primary cause of changes in output and prices in the short run and prices in the long run.
They argue that excessive growth in the money supply will lead to inflation, without
permanently increasing output. This contrasts with the Keynesian view, which sees
changes in aggregate demand, driven not just by changes in the money supply, but also by
factors such as government fiscal policy, as crucial in determining output and employment,
especially in the short run.
3. **Stability of the Economy: ** Monetarists generally have more confidence in the
economy's ability to self-correct in the face of shocks and believe that if the money
supply is managed properly, the economy will generally tend towards full employment on
its own. Keynesians, on the other hand, believe that economies can get stuck at less than
full employment due to insufficient demand, sticky wages, and other factors.
4. **Policy Prescription: ** Monetarists advocate for rules-based monetary policy, often
suggesting that the money supply should be increased at a steady, predictable rate to
ensure price stability. In contrast, Keynesians often support discretionary fiscal and
monetary policy to manage demand and stabilize output and employment.
In practice, central banks often combine elements of both schools of thought in managing
monetary policy. They may follow a largely rules-based approach under normal conditions
but employ discretionary policies in response to economic shocks or unusual conditions.
IB Economics
**Keynesian Economics:**
1. **Demand-Side Economics:** Keynesian economics emphasizes the importance of
aggregate demand in determining levels of economic activity. In a downturn, Keynesians
argue for government intervention to stimulate demand and support economic recovery.
2. **Fiscal Policy:** Keynesians advocate the use of fiscal policy tools such as government
spending and taxation to manage economic fluctuations. In times of recession, this might
mean increasing government spending, cutting taxes, or both to boost demand.
3. **Sticky Wages and Prices:** Keynesians point out that wages and prices don't always
adjust quickly to changes in demand, leading to periods of high unemployment or inflation.
This provides a justification for government intervention to stabilize the economy.
4. **Multiplier Effect:** Keynesians emphasize the multiplier effect, where an initial
change in autonomous expenditures (like government spending or investment) leads to a
larger change in total output.
5. **Keynesian Aggregate Supply Curve:** The Keynesian AS curve has three ranges:
Keynes' Law (horizontal), the Intermediate Range (upward sloping), and Say's Law
(vertical), which reflect different states of the economy from recession to near or at
full capacity.
**Monetarism:**
1. **Importance of Money Supply:** Monetarists emphasize the role of the money supply
in determining the price level and influencing real GDP. They believe that changes in the
money supply are the primary cause of inflation.
2. **Long-run Neutrality of Money:** Monetarists believe that changes in the money
supply can affect real GDP in the short run, but in the long run, it only affects the price
level. In the long run, the economy is self-regulating and will tend to full employment.
3. **Rules-Based Monetary Policy:** Monetarists advocate for a steady, predictable
growth in the money supply, often linked to the growth rate of real GDP, and caution
against active or discretionary monetary policy.
4. **Natural Rate of Unemployment:** Monetarists believe in a natural rate of
unemployment determined by supply-side factors (like technology and labor market
institutions), and argue that attempts to lower unemployment below this natural rate will
lead to accelerating inflation.
5. **Expectations and Inflation:** Monetarists also emphasize the role of expectations
in determining inflation. They argue that if people expect a certain level of inflation,
these expectations can become self-fulfilling, leading to actual inflation.
In both schools of thought, understanding the mechanisms of and interactions between
fiscal and monetary policy, as well as the roles of aggregate demand and supply in the
economy, is critical. Also, real-world economies often combine elements of both
Keynesian and Monetarist policies, so it's essential to understand how these theories
apply in a variety of contexts.
Multiplier
The multiplier effect is a concept in economics that describes how an initial change in
spending can lead to a larger change in national income or GDP. It's based on the idea
that one person's spending goes into another person's income, and then they spend some
of that income, and so on, leading to a ripple effect throughout the economy.
The size of the multiplier effect is influenced by the marginal propensity to consume
(MPC) or the marginal propensity to save (MPS). The marginal propensity to consume is
the proportion of an additional income that a person will spend on consumption, while the
marginal propensity to save is the proportion of any additional income that a person will
save.
The multiplier effect is calculated as 1/(1-MPC) or 1/MPS. If the marginal propensity to
consume is high, then the multiplier effect is larger, as more of each additional dollar of
income is spent and re-spent within the economy. Conversely, if the marginal propensity
to save is high, the multiplier effect is smaller.
**Real-world application:**
A classic example of the multiplier effect in action is in government spending. For
instance, suppose the government decides to invest $1 million in infrastructure
development. The first round of spending includes payments to contractors, laborers,
and suppliers. These recipients of the initial spending will then spend a portion of their
new income on goods and services, creating income for another round of people, who again
spend a portion of this, and so on. The total increase in economic activity will be greater
than the original $1 million because of the multiplier effect.
The multiplier effect is a key justification for expansionary fiscal policy. If the economy
is in a recession, Keynesians argue that an increase in government spending or a cut in
taxes can stimulate a more than proportional increase in economic output, helping to close
the output gap and return the economy to full employment. However, the multiplier
effect can also work in reverse during periods of contractionary fiscal policy, where cuts
in government spending or increases in taxes can lead to a larger decrease in economic
output.
Remember, though, that the multiplier effect is a simplified model. In the real world,
things are more complex. For instance, if the economy is close to full capacity, additional
spending might simply lead to inflation rather than an increase in output. Other factors,
such as changes in consumer or business confidence, can also affect the size of the
multiplier.