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classical vs keynesian vs monetarist

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The major concern is “role of money” in the economy for stability of aggregate demand. Accessed Mar. Both instruments (monetary and fiscal) are required to attain the dual objective. The essence of Mundell model is that while there may be infinite number of budget surplus—interest rate combinations consistent with the maintenance of external balance; there will be but one unique combination able to satisfy both objectives simultaneously. Thus, we conclude that both monetarism, old monetarism, neo-monetarism and neo-monetarism— and Keynesianism—post-Keynesianism and neo-Keynesianism—are one-sided and partial. Start studying Classical vs. Keynesian (and Monetarist). Board of Governors of the Federal Reserve System. A single policy, acting independently, cannot achieve an overall balance or the desired objectives of full employment and trade balance. Classical and Keynesian economics are both accepted schools of thought in economics, but each had a different approach to defining economics. But according to Professor Friedman there are considerable time lags of uncertain length between changes in money supply/stocks and the variables affected by such changes, including the price level. Mundell’s original diagram (Fig. In other words, the clear practical implication of his analysis is that changes in any of the important real aggregates of the economy are beyond the reach of the short-term policy instruments of government, fiscal or monetary. However, both the objectives can be attained by a combination of both monetary and fiscal policies. Monetarism 1. monetarism MS Salma Shaheen 2. Chapter 43: Keynesian vs. monetarist/new classical view of LRAS (2.2) Keynesian model of AS “The real difficulty in changing any enterprise lies not in developing new ideas, but in escaping from the old ones”. When institutional interest rate limit is there no possible solution is indicated other than successful devaluation (which effectively lowers the balance of payments function for any given income and interest rate (combination). People want to take all the cash that the central bank (Fed) pushes out and put it into their checking accounts instead of buying interest paying securities, such as bonds. Unemployment, low income, and related poor rates of growth are costly ways of achieving trade balance. These accounts are building up fast, as the growth of M1 shows, yet they turn over less frequently than the money in regular checking accounts. By the mid-1970s, however, the debate had moved on to other issues as monetarists began presenting a fundamental challenge to Keynesianism. In zone 4—there is inflation and payments deficit. Keynesian economics suggests governments need to use fiscal policy, especially in a recession. The superiority of ‘monetary over Keynesian models has not been demonstrated. At one extreme, the Monetarist thinking of Milton Friedman sharply disagrees with the Keynesian view, arguing instead that the role for government in the economy is minimal. In the Figure such a contractionary monetary policy will gain equilibrium at point E in the BOP curve curing the trade deficit (CD) in trading account. Ultimately, the money could be trapped in the hands of the people who are supposed to spend it and we will be approaching something like ‘liquidity trap.’. Many Keynesian economists initially believed that the Keynesian vs. monetarist debate was solely about whether fiscal or monetary policy was the more effective tool of demand management. Higher rates (contractionary monetary policy) will discourage imports and at the same time attract short-term capital. In zone 1—both the policies produce recession and a balance of payments deficit. In short, there is no deficit or surplus in the official settlements version of the balance of payments. Monetarism emphasises the importance of controlling the money supply to control inflation. Classical theory is the basis for Monetarism, which only concentrates on managing the money supply, through monetary policy. The economists have not been able to in fact, could not make it out—that the Federal Reserve (of USA) is pumping out plenty of money (dollars) in 1980s but it is just not circulating. Then there is the case of missing transactions—not captured in the GNP statistics and thus not properly noted. 48.2), it is hardly likely to induce substantial capital inflows whereas when it rises above the ‘world average’—the response will be much more immediate and significant. That, they say, is one possible explanation for the cooling of the velocity of money. Monetarism began with the Milton Friedman’s article “The Quantity Theory of Money: A Restatement” in 1956. Classical economics places little emphasis on the use of fiscal policy to manage aggregate demand. Opinions expressed by Forbes Contributors are their own. Thus, external and internal balance can be achieved with a judicious mix of both the policies. Share Your Word File The modern quantity theory (monetarism) has also close relation with classical economics in the sense not because it lays stress on the importance of the money supply, but also because it goes back to the classical idea that a market economy is not essentially unstable. "When Did the Federal Government Begin Collecting the Gas Tax?" Jackie_Nunnally7. Both of these macroeconomic theories directly impact the way lawmakers create fiscal and monetary policies. The post-Keynesian position is that it attempts to select the best from both the camps: post- Keynesians argue along with the fiscalists that the major impact of the monetary policy is transmitted to the real sector indirectly through changes in the interest rates of non-money financial assets. Here at this point the dual objective {i.e. Classical theory is the basis for Monetarism, which only concentrates on managing the money supply, through monetary policy. 48.2. In the diagram we assume that the responsiveness of capital inflows to a change in the rate of interest will depend crucially upon interest rates prevailing elsewhere (in other countries) in the world. But they are of short duration and the basic stability of the economy is brought about by the market forces. Central bank control of the money supply in monetarist’s view is the single most powerful factor to influence the level of economic activity than fiscal measures involving changes in taxes or public expenditures. Clearly, that condition does not obtain today. As a result, the lack of demand for securities keeps rates unchanged. But it would not be able to attain full employment within the economy i.e., internal balance. When Did the Federal Government Begin Collecting the Gas Tax? (ii) Basically still unresolved, the econometric models, exercises, and empirical tests devised to date have not been able to establish conclusively whether the money supply or the Keynesian autonomous variables are the important determinants of changes in output, income, employment, and the price level. The turnover is there—feels the monetarists— but it is not reflected in current output. It is, therefore, clear that money is just not an engine of growth that it once was. If both types of economists were equated to motorists, monetarists would be most concerned with adding gasoline to their tanks, while Keynesians would be most concerned with keeping their motors running. In the Fig. 48.4(B) shows the curve for internal balance. Attempting to control directly the price level is, therefore, likely to make monetary policy itself a source of economic disturbance because of false stops and starts. If the rate of interest is below the average rate prevailing in the world (in other countries i.e., below point ‘O’ in the Fig. The higher interest rates will have a cooling effect on the economy by controlling inflation (high interest rates control money in circulation) restore internal equilibrium. There are conflicting views on the mechanism as to how money supply affects the general economic activities or income level. Now for any given government budget external balance will require lower interest rates which would stimulate the economy, raise imports and restrain the inflow of short-term capital. Professor Friedman stressed the basic essential monetarists idea in 1967 in his presidential address to the American Economic Association while talking of the ‘natural rate of unemployment’—a rate determined by relationships amongst underlying real factors such as real wages, the rate of capital formation, technological changes, etc. The nature of the debate is basically the same as that which existed in the past for many years over the use of Keynesian theory of the determination of the level of economic activity and the quantity theory of money as a theory of the determination of the level of economic activity. The terminology of demand-side economics is synonymous with Keynesian economics. Keynesian economists believe in consumption, government expenditures and net exports to change the state of the economy. Again, IS/LM functions are a useful expositional device for working out the implications of combined monetary and fiscal policies and for classifying the alternative policy in a given situation. See more at Keynesian economics. Thus, the repeated concern or debate with the comparative efficacy of monetary versus fiscal policy is really misplaced; what is required is a judicious and optimal policy mix to deal with any given situation. "What Is Keynesian Economics?" Keynes looked forward to a rise in government remuneration and lesser taxes to provoke demand and take the nation’s economy out of the great depression. The Nixon administration appears to be middle of the road. classical alternative ... the Keynesian and classical Model are applicable in different circumstances. (Keynesian economics is a justification for the ‘New Deal’ programmes of the 1930s.) On the other hand, there are some who argue that it is by changing financial conditions particularly the rates of interest, volumes of lending and borrowing— that the influence of money supply on economic activities can be judged. In essence, the evidence shows that the demand for money is fairly sensitive to the rate of interest, but not equally so sensitive as the earlier Keynesians had claimed. The conventional IS/LM portrayal carries an implicit bias against monetary policy because our original attempt was to popularize Keynesian economics through IS/LM curves. Investopedia requires writers to use primary sources to support their work. Accessed Mar. 48.4(A), the curve shown is external balance curve which shows all the various combinations of fiscal and monetary policy that do not require any government intervention at a given exchange rate to support that rate. Business. Even though the number of instruments may equal the number of declared objectives, the inappropriate use of the respective policy tools may be positively destabilizing. Welcome to EconomicsDiscussion.net! What is the difference between Keynesian economics and monetarist economics? 48.1(A) a horizontal portion of the LM curve expressly assumes the Keynesian liquidity trap and shows that monetary policy is completely ineffective in influencing either the income level or the rate of interest (as indicated by the dotted line) if IS/LM intersection occurs in this region of the liquidity trap. Post- Keynesians argue with the monetarists that money demand is interest inelastic. Before publishing your Articles on this site, please read the following pages: 1. Accessed Mar. Certainly, the debate will continue, as the advocates of monetarism plead that money is the key to these changes in the economic system—while the Keynesians plead—that no doubt money has a role to play—the importance of fiscal instruments of economic stabilization and demand management cannot be minimized. Upward and to the right of the curve is a zone where the policy (A) combinations would result in a payment surplus. Classical theory of unemployment affirms unemployment depends on the level of real wages. 48.4(B). Classical economics places little emphasis on the use of fiscal policy to manage aggregate demand. Macroeconomics studies an overall economy or market system, its behavior, the factors that drive it, and how to improve its performance. Presidents of the USA had been using following different approaches in economic policy making, from time to time, depending on whether their orientation is/was Keynesian—or monetarist. Now either monetary policy or fiscal policy acting independently is able to achieve one of the policy objectives. Economists disagree about the nature, the history and the boundaries of the debate or controversy. Category economics. 48.1. "What Is Monetarism?" It is negatively sloped since with exports assumed constant any increase in imports arising from the expansionary impact of a lowering of the budget surplus must be compensated by an improvement in the capital account via an increase in the rate of interest. Similar, reasoning applies to expansionary and contractionary fiscal policy. The diagram is purely illustrative. A reduction in interest rates (monetary policy), and 2. In the process of restoring equilibrium these balances will be converted into the real goods and services either directly or through the intermediation of financial institutions. We see that the BOP curve is kinked at point ‘O’. The importance of Mundell’s Model lies in emphasizing the fact that efficient stabilization policy requires that policy instruments should be directed towards the policy objectives upon which they exert the most influence. 48.4(B) with internal balance curve. Fiscal Policy. It is worth noting that Roosevelt's New Deal and other policies increased the supply of money in the economy.. The extreme monetarists position is that ‘only money matters’ (or fiscal policy does not matter) as an effective means of demand management. But considering the amount of money which the Fed. Low rates of interest are presumed to be expansionary for the economy as well as for imports and discourage the inflow of short-term foreign capital and hence deteriorate the balance of payments position. 48.1(B) shows a vertical IS curve which is derived from the assumption of a completely interest inelastic demand function and clearly shows that here again monetary policy is of no use, yet new approach stresses the fact that monetary changes will influence expenditure decision irrespective of the investment response. Our mission is to provide an online platform to help students to discuss anything and everything about Economics. The root of the monetarism is from the classical economist. … Thus, the crux of the argument between the Keynesians and monetarists is simply which theory best explains and predicts the actual behaviour of the GNP, prices and unemployment. In the same manner, Fig. Since in the Keynesian model, the AS curve is upward sloping in the short run, economic policies (such as monetary and fiscal policies) that increase aggregate demand succeed in increasing output and employment, from Y 0 to Y 1 and Y F, shown in Fig. The Classical economic theory was developed by Adam Smith while Keynesian theory was developed by John Maynard Keynes. Loanable Funds Theories: Classical vs Keynesian ... Ben Bernanke) set out to devise Keynesian-inspired credit-based models as alternatives to the conventional and popular Keynesian and monetarist "money-based" models that dominated macroeconomics at the time (all of which assumed a special role for money in the determination of aggregate demand But they also argue that since money supply is positively related to interest rate and is relatively interest elastic, the combined interest elasticities of money supply and demand make the LM schedule interest elastic. Economists have argued about this possibility (liquidity trap) ever since Keynes warned of the liquidity trap in the 1930s. The BOP curve summarizes all the combinations of interest rates and income which maintain equilibrium in the external account. Ritter, “Each baby girl and tiny man, that is born into a family nest, is either a little Keynesian, or else a little monetarist”. The policy implications between the Keynesian incomes-expenditures approach and monetarism are important for the economy. What happens to supply and demand? In other words, it follows that the force of external deficit cannot be ignored for long—likewise, there are strong political reasons limiting departures from full employment—the permissible monetary-fiscal policy mix for economic growth is effectively pre-determined as illustrated in the diagram here by dividing it in areas of high and low growth rates. In the current state of the controversy, few economists can be labeled as being completely in the monetarist or fiscalist camps. So the money growth translates into fewer transactions, which in turn, translates into lower output. He felt that it might take years to understand the new features of the velocity of M1. The first-stage is that of taking extreme positions. The pressure of demand for more goods and services will stimulate output and encourage price rises until the value of the output has risen in proportion to the increase in the money supply. If monetary policy is now employed to restore internal equilibrium, it will require a decrease in the rate of interest to a position ‘U’; but such a move generates an increase in the external deficit over its initial level. We will now explain with the help of above figure, how a combination of both the monetary policy and fiscal policy are able to achieve external and internal balance. However, neither Keynesianism nor monetarism nor a mixture of the two is capable of initiating development process in developing countries—because these policies emphasise the regulation of supply of and demand for monetary factors—whereas the real problem in developing economies is the generation and regulation of supply and demand for real physical factors in a planned way. TOS4. This curve (BOP) has a positive slope, because if exports are assumed to be exogenous, an expansion of income will deteriorate the trading account (of BOPs) as increased income will lead to more inflow of imports. Due to depreciation there will be more spending on our exports and imports will be discouraged and altered by the domestically produced substitutes. It has been a very unusual situation for the Fed (in USA) to be stepping up money growth but holding real rates of interest high at the same time risking recessions at times. 48.4(A) would shift leftward—to the dotted line and the shift would be large because of the effect on both trade and capital movements. Keynesian They feel that money’s velocity has declined, which in turn, causes’ the trouble. President Reagan in 1980s is not following a different policy either—though the economic policy followed by him in USA is popularly called ‘Reagan Economics’ ; with emphasis on supply, tax cuts and incentives for production. The various conflicts in using fiscal and monetary policies to adjust national income and the balance of payments at the same time can be neatly shown first worked out by the two professors of international economics Trevor Swan and Robert Mundell. Velocity and its assumed stability in Friedman’s equation has been the greatest causality in the process and it appears the assumption of stability of velocity holds true no more—as assumption on which the entire monetarist edifice is built. The Keynesian theory of interest is an improvement over the classical theory in that the former considers interest as a monetary phenomenon as a link between the present and the future while the classical theory ignores this dynamic role of money as a store of value and wealth and conceives of interest as a non-monetary phenomenon. Certain events outside the economic system like wars, strikes, droughts, changes in expectations and preferences, change in foreign demand do cause variations in output and employment around the trend path. Friedman was charged by some critics that he did not really understand the essential character of Keynesians’ analysis, especially the role that uncertainty plays in the Keynesian system.’. Bob McTeer Contributor. So to maintain equilibrium in the external account an expansion in income must be accompanied by an increase in interest rate—i.e., positive relationship—that is why it is said that BOP curve has a positive slope. Enjoy the videos and music you love, upload original content, and share it all with friends, family, and the world on YouTube. Advocates of monetary approach have not yet shown that the changes in money supply have a reliable and predictable effect on expenditure, even the direction of causation between the money supply and income is at issue. He also believes that this process is very simple except when disturbed by outside forces, including government. The Eisenhower administration had essentially a monetarist stance, while the orientation of economic policy under Kennedy and Johnson was primarily Keynesian. The external balance curve in Fig. The British economist, John Maynard Keynes, initiated what we refer to as Keynesian economics in the course of the 1930s in the wake of the Great Depression. Since 1980, however, velocity has been bobbing, and it has fallen dramatically since 1985. There being general agreement that one policy can be more effective than the other under particular situations—monetary policy is more effective in inflation and fiscal policy is more effective in deflation. There are a number of important differences between classical and Keynesian economics, but in general classic theory teaches that things in the marketplace like economic growth and investment capital are most effectively driven by consumers and free choice, while the Keynesian school of thought spends more time considering government regulation and oversight. According to the latter school of Keynesians, the government should play an active stabilising role not by varying taxes and expenditures, but also by such actions which will influence both private spending for consumption and investment paving the way for stabilisation. Milton Friedman was an American economist and statistician best known for his strong belief in free-market capitalism. 48.4(A) external balance curve is shown that has a zone below and to the left of the curve where any combination of fiscal and monetary policy would result in a balance of payments deficit. The linkage between money growth and spending really works through the real rates of interest. The policy implications between the Keynesian incomes-expenditures approach and monetarism are important for the economy. Keynesian and monetarist theories offer different thoughts on what drives economic growth and how to fight recessions. Many economists argue that the real rates of interest (the inflation-adjusted price of money) have not fallen nearly as fast as nominal rates of interest have. ADVERTISEMENTS: In this article we will discuss about the classical, Keynesian and modern views on monetary policy. It being evident that neither monetary policy nor fiscal policy acting alone can deliver the goods and desired goals. Keynes argued that the solution to the Great Depression was to stimulate the economy (“inducement to invest") through some combination of two approaches: 1. • Monetarism is an economic school of thought that stresses the primary importance of the money supply in determining nominal GDP and the price level. Classical economics was founded by famous economist Adam Smith, and Keynesian economics was founded by … In these diagrams, exchange rates are assumed to be fixed. Before concluding a few final comments may be attempted: “Distinguished economists have said that Professor Friedman’s elaborate formulation of the modern quantity theory of money (monetarism) is really nothing more than an elegant and sophisticated statement of modern Keynesian monetary theory. It may, however, be noted that both the required policy measures serve to raise the rate of interest. It is neutral in its effects on the economy. This school is called the ‘monetary school’ and gives no special emphasis on the rates of interest on the financial assets. You can learn more about the standards we follow in producing accurate, unbiased content in our. 48.4 fiscal policy is shown along the vertical axis with the government’s budget shown running upward from deficit to balance and then to surplus. To counter the recession and to reduce the balance of payments surplus, both fiscal and monetary policies can be expansionary. Although several major issues have emerged and have been clarified, if not resolved—issues yet important to both the monetarists and the Keynesian school are as follows: (i) The question of whether the changes in the money or the changes in autonomous expenditures in the Keynesian sense are most important in explaining short-term changes in output, income, employment and price level; (ii) The basic stability of the demand function for money—a matter primarily of stability of velocity; (iii) The interest elasticity of the demand for money ; and (iv) The ability of the central bank to control the money supply. Given the constraint of a fixed rate of exchange, appropriate stabilization policy requires that monetary policy be directed at external objectives and fiscal policy at internal goals. Inflation, meanwhile, had been fading fast in that year. International Monetary Fund. That is why BOP curve is of kinked nature. It simply affects the price level, but nothing else. Budget deficit results in an expanded economy, higher import and hence a balance of payments deficit. Fed Board (USA) Chairman Paul A. Volcker remarked that M1, the narrowly defined money supply “is not today a reliable measure” of future inflation or economic growth. In brief, the new monetarism implies that the IS curve and LM curve are interdependent in that a change in the money supply would affect expenditure decision directly. Now for internal balance to be non-inflationary, a greater budget surplus or smaller deficit would be required at any given rate. Imagine adding more money to the current economy and the effects it would have on business expectations and the production of goods. In fact, we need not give to the money supply any special significance in the financial mechanism, we need not attribute to it any special direct causal influence on economic activity, and we need not believe that the monetary authorities adopt any very simple mechanism for its control. More recently, the 2007-08 financial crisis led President Obama and other lawmakers to address economic problems by bailing out banks and fixing underwater mortgages for government-owned housing. In these instances, it appears elements of Keynesian and Monetarist theories were used to reduce the national debt. Starting with the point A (which shows the BOPs equilibrium) on the external balance curve, we assume that the budget goes into deficit. However, these economists do not completely disregard the role the money supply has in the economy and on affecting the gross domestic product, or GDP. in USA had pumped out in 1985-86, it is clear that something has gone haywire in the relationship between the money supply and interest rates. Keynesian Economics is an economic theory of total spending in the economy and its effects on output and inflation developed by John Maynard Keynes. They believe that controlling the supply of money directly influences inflation and that by fighting inflation with the supply of money, they can influence interest rates in the future. Perhaps, we can put this debate into somewhat better form if we keep in mind that neither fiscal nor monetary policies in isolation (or taking together) have yet proved adequate to cope with the serious and persistent problem of stagflation. "FEDS Notes: Inflation Expectations in the Recovery From the Great Depression." Accessed Mar. Keynesian Model. Classical economics places little emphasis on the use of fiscal policy to manage aggregate demand. This type of monetarist approach called the ‘Monetarist Counter Revolution’—gave rise to prolonged controversy for more than two decades and there appears to be no end to it. In other words, it means not that the velocity cannot change, but that the changes are gradual and predictable. Fig. Similarly, FF function summarizes all these budget surpluses—interest rate combi­nations which are consistent with balance of payments equilibria. Now, both the curves for external and internal balance are juxtaposed on the same diagram as shown in the diagram (C) which depicts the four distinct zones, each with a different mix of problems. Government investment in infrastructure (fiscal policy). Both the Keynesian multiplier and Friedmanian real velocity are non-starters. High rates of interest do the opposite. Keynesian economists believe the economy is best controlled by manipulating the demand for goods and services. On the other hand, velocity—the rate at which money turns over or changes hands is declining and this has caused lot of trouble in the economic system. The time lags being the real rub, the central bank should not attempt to follow a countercyclical stabilization, policy of changing the money supply/stocks in response to the current economic events. 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