Keynesian Economic and Monetarist Economic Policy - Research Paper Example

 Keynesian Economic and Monetarist Economic Policy Economics The Golden Age of Capitalism between 1945 and the mid-1970’s showed the effectiveness of Keynesian economic policies. However, rapidly rising inflation and low economic growth in many countries in the world after the mid-1970’s showed that Keynesian economic policies had flaws according to the monetarists. Introduction There is no doubt that one of the greatest economic growth periods was ‘The Golden Age’, after the Second World War. During the 1960s and the early 1970s, the US enjoyed high economic growth with low inflation and unemployment. Such impressive growth was the outcome of Keynesian policies, such as the needs of intervention by the government (Discover the networks, 2012). This period was the golden age of Keynesianism. However, the world economy faced the big recession, which resulted from not only rising inflation and unemployment but also dropping economic growth, after 1973. People began to believe the newly risen Monetarism, which claims fiscal policy is not useful, due to the failure of Keynesianism. This essay will show the characteristics and differences between Keynesian economic policy and Monetarist economic policy as well as the reason why the Golden Age collapsed. Finally the essay will highlight which policy is more suitable in the currently economic situation. Keynesian Economic Policies Keynes emphasised that aggregate demand in the economy can be influenced very effectively by altering the levels of government spending as well as tax rates (Nelson, 2006). The neoclassical economic theory could not explain the factors that led to the economic collapse of the country and was also unable to make some appropriate public policy that would help to solve the economic crisis. While the need for any kind of government intervention was rejected by the orthodox neoclassical economists, Keynes advocated that inactiveness on part of the government would only worsen the condition of unemployment in the economy and aggravate the situation of economic downturn. John Maynard Keynes stated that in order to improve the economies the governments should raise levels of public spending and cut taxes. Neo classical economists did not approve of this action in the given economic context since there was an established view embracing the lassie faire mode of economy that claimed that in the market economy, if the market equilibrium is disturbed, the economy has the potential to make an automatic recovery, without necessitating any government intervention. In contrast to this, Keynes argued that in an economy in which there is high rate of unemployment with low aggregate demand, the economy would ultimately get weaker if indefinitely demand is allowed to fall short of the productive capacity of the economy. The solution proposed by Keynes was to stimulate the demand in the economy. The policy directions made by the economists were discretionary fiscal policy changes that were to the made by the government in accord with the condition of the economy. When the country is in recession, the government is responsible for increasing public spending so that it raises the aggregate demand in the economy. Higher levels of government spending would boost demand both directly and indirectly. Government's expenditure increases the incomes of the workers who make higher levels of demand. This increases not only the production of goods and services in the economy but also the incomes of the workers further. This is known as government expenditure multiplier that sets off “a chain reaction of increased demand from workers and suppliers” (Nelson, 2006). A tax cut also positively affects demand by increasing disposable income for the consumers. Keynes maintained that the correct fiscal policy to be followed by the government when faced with high unemployment is to run a deficit in the budget. The thought that budget deficit is bad, was changed during Keynesian era. The End of Golden Age During the Great Depression, people out of their natural reaction started hoarding money. Lack of money spending stopped the process of circular flow of money and it resulted in the stagnation in the economy. Keynes had prescribed that the solution to this problem would be government interference with tax cuts and increased spending. According to him, this policy would be effective in inspiring the people to make more spending, thereby stimulating money exchange in the economy. The Keynesian thinking monopolised the economic policies in the US and also many other developed countries across the globe for almost four decades, starting from the mid-1930s. This period was the golden age of the Keynesian economic thoughts (McEachern, 2007). But this group of thinking lost its space in the face of rising inflation and increasing levels of unemployment. According to critics, such as Henry Hazlitt, the Keynesian school claimed that if a disposable income in the hands of the consumers rises, they would make higher amounts of spending. However, the other possibility was ignored that people might also hoard money. Besides, Hazlitt also pointed out the fact that Keynes concentrated on the aggregates of macroeconomic variables, which shows a combined relationship among many microeconomic variables such as wage rates and individual prices (Ebeling, 2004). Since Keynes held an aggregate thinking he was opposed to the practice of restoring equilibrium in the market by making gradual and small adjustments. Thus, the effect on demand had to be achieved by inflating the level of money supply, which increased the price level. As the government makes higher levels of spending, the IS curve shifts to the right. Therefore, the aggregate demand in the economy is higher than the actual level of output in the economy. This increases the price level in the economy. Continuous increase in government spending would lead to constant rise in prices thereby creating inflationary pressure on the economy (Iastate, 2006). According to the Federal Reserve Board (2004), inflation level reached a record high level of more than 10 percent during the 1970s. This situation is illustrated by the following IS-LM diagram. Figure 1. IS-LM Curve (Pennsylvania State University, 2010) In order to bring the economy back to equilibrium, the LM curve moves to the left. The interest rate rises and the economy moves to the new equilibrium at the same level of output. The Keynesian economics failed on this ground and economy could not be increased since output level; remained unchanged. Therefore, the economic boom that occurred after the World War II ended. High rates of interest discouraged enthusiastic productive activities. Collapse of the industrial production caused unemployment to rise. Also, wages were slashed which reduced the security of the workers (Valletta, 2005). The performance of the U.S. economy during the period of ‘Golden Age’ has been better than any other period in the country’s history. There was high economic growth with low inflation and unemployment rate. Average annual growth rate from the 1940s to early 1970s in the U.S. was nearly 4%. The annual rate of unemployment during this period was quite low and crossed 6% mark only two times in 25 years (between 1949 and 1973) (Reuss, 2013). Annual rate of inflation was below 2% for 14 prolonged years during this period. However, in the 1970s US was threatened from rising prices of energy and consumer goods, declining productivity, falling profitability and soaring unemployment. Inflation rate jumped from “3 % in 1966 to nearly 6% in 1971” (Reuss, 2013). In 1975 unemployment rate crossed 8% mark and reached 10% in 1982 (Reuss, 2013). Figure 2. Unemployment rate Figure 3. Comparison between rates in the developed countries in the US (Source: Senate, 2007) (Source: Berkeley, 1995) The Rise of Monetarism and Monetarist Economist Policies Following the establishment of the flaws existing in the Keynesian way of economics and the uncontrolled failure of the fiscal policies of the Federal Government monetarist school of thought challenged the Keynesians. The proponent of the monetarist theories was Milton Friedman. He made strong arguments regarding the pitiable macroeconomic performance of the United States (Boyes and Melvin, 2010). Monetarism is closely associated with classical economics. This school of thought was developed by Friedman in the 1940s but came into recognition in the end of the 1960s and the beginning of 1970s. Monetarist theories are essentially considered to be an extension to the classical economic theory. The rise of monetarism took a step forward to explain the economic phenomenon that arose in the 1970s. It had been named stagflation, which was used to explain the situation of occurrence of two economic problems simultaneously; stagnation and inflation (McCallum, 2008). The basic work of the monetarist economists centred on the role played by expectation of the economic agents in determination of inflation. A major part of the monetarist theory covers the development of the Phillips Curve. This curve is represented below. Figure 4. The Philips Curve (Economics online, n.d.) In the 1970s, rate of inflation in the US and many other developed countries rose to unprecedented high levels. Various significant “shocks” in the economy, such as oil price increase and very importantly “the demise of the Bretton Woods system of fixed exchange rates” (McCallum, 2008) between 1971 and 1973 led to such high inflation. Figure 5. Comparison between inflation and unemployment in US (Source: Pepperdine, 1999) These incidents led the Fed to announce in October 1979 that it would make a new attempt and implement a policy, which would involve drastically revised procedures of operating that embrace some common and important features of monetarist recommendations. In particular, the Federal Reserve would make efforts to achieve the predetermined monthly targets set by the Fed of increasing the money supply. The Fed emphasized on exercising control over a controllable and narrow monetary aggregate. The targeted money supply level was intended to reduce inflation. Although the new level was not specified, it was declared that targets were fixed at pulling inflation rate down from double-digit values to single digit and sustainably lower values (McCallum, 2008). Conclusion Keynes was seriously concerned about the implementation of the right public policy and this brought out his novel theoretical insights regarding the macro variables in the economy and their functioning. The Keynesian macroeconomic theory was developed from an insightful understanding of the causes and effects of the Great Depression that occurred during the 1930s. But during the mid 1970s, expansion of rampant inflation rate was combined with collapse of the industrial production. The economy was stagnant and the unemployment levels went too high. All these phenomena resisted the essential logic of Keynes’ philosophy, in which inflation and unemployment were not hypothetically believed to occur simultaneously (Pilling, 1986). The monetarist theories contradicted the Keynesian theories and held strongly that the fiscal policies are not enough to adjust an economy. Although the fiscal policy proved beneficial for the US economy post the Great Depression in the 1930s, these policies were no more effective in the 1970s. The main cause of failure was that the government spending was unable to increase output in the economy while the price level rose. In the current situation, accommodative monetary policies are more effective than fiscal policies since reducing the rate of interest can boost the productive activities in the economy. The government can purchase bonds and release money into the economy. This would increase the level of money supply and simultaneously increase productive activities, which would increase the economy’s output. Thus, when demand would rise, prices would not increase since sellers would have adequate levels of stock to support the rise in demand. References Berkeley, 1995. The Inflation of the 1970s. Available at: < http://econ161.berkeley.edu/econ_articles/theinflationofthes.html > [Accessed 18 June 2013]. Boyes, W. J. and Melvin, M., 2010. Economics. Connecticut: Cengage Learning. Discover the networks, 2012. Keynesian economic policies. Available at: [Accessed 18 June 2013]. Ebeling, R., 2004. Henry Hazlitt and the Failure of Keynesian Economics Hazlitt Helped to Overthrow the Original and Primitive Keynesian Thinking. Available at: [Accessed 18 June 2013]. Economics online, n.d. The Phillips curve. Available at: [Accessed 18 June 2013]. Iastate, 2006. The IS/LM Model. Available at: [Accessed 18 June 2013]. McCallum, B. T., 2008. Monetarism. 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The Federal Reserve Board, 2004. The Great Inflation of the 1970s. Available at: [Accessed 18 June 2013]. Valletta, R. G., 2005. Rising Unemployment Duration in the United States: Causes and Consequences. Available at: [Accessed 18 June 2013]. Read More