The New Classical and Keynesian's Theory of Monetary Policy - Coursework Example

Full Macroeconomics In the 1930s the economies over the world especially the European ones were suffering from the de merits of the free market (Blanchard). The result was that the governments and the public in general had lost interest in the classical economic theorists. The introduction of a different kind of an explanation for the challenges faced by the economy by Keynes was welcomed. Out of the many theories discussed by the Keynesians (Keynes’s followers), the one that related the unemployment to the inflation rate was the most significant. The followers believed in the Phillips Curve up till the 1960s. The Curve supported the view that a high rate of unemployment went parallel with low inflation rate. The notion was that when the demands for goods are high, companies would hire more workforce, leading to lower unemployment rates and would subsequently raise demand. Stagflation is characterized by both an increasing inflation as well as unemployment rate. When stagflation occurred in the 1970s and the 1980s, there was a shift in the Phillip curve, and the Keynesians reassessed their theory. The Keynesians argued that the discrepancy in the results predicted by Phillips curve was because the curve was shifting in a north-easterly direction. The reason for the shift in the curve was considered to be because of the cut in wages and increase in the costs of the businesses as a result of inflation. The idea was rejected by Keynesians in the start, but has been incorporated into their theory over time. According to the Keynesian’s theory, the answer to the problem of stagflation was to refurbish the supply of materials. According to the theory, the a way to make up for physical scarcity was to either to find a substitute for the resources that were scarce, or to enhance the productivity and the efficiency in order to produce more output from the inputs. For instance, the challenge of oil scarcity of the late 1970s and the early 1980s was met by increasing the worldwide production of oil, and by improving the efficiency of the processes so that more energy is conserved. Ultimately, the concept of NAIRU introduced to deal with the problem. The New Classical view supported the notion that monetary policy could not impact real output and employment. It was of the outlook that only nominal quantities can influence nominal variables like inflation. Since according to the view, unemployment and inflation are not related, its followers attribute inefficient government policies for lower rates of unemployment. The reason for inflation that it proposed was due to the excessive increase in the money supply by the government. So the key factor that led to stagflation was flawed policy measures that caused an unprecedented increase in unemployment and inflation. The New Classicals counter-argued the Keynesian theory by saying that Keynesian theory promoted voluntary unemployment but the New Classical view said that unemployment was dependent on natural rate, and changes in natural rate can cause long bouts of unemployment. Following the New Classical view, the government contracted the monetary policy, which backfired and led to recessions. This contradicted the New Classical view and supported the Keynesians’ theory that stated that restriction on monetary policies can result in fixed-price contracts between businesses rather than the ones adjusted by inflation. 3. The Japanese became more committed to the cause of monetary expansion after the New York Exchange Crash in October 1987. In the previous year, the Louvre and the Baker-Miyazawa agreement facilitated the Japanese to nurture their money supply. With the US encouragement to boost domestic consumption, the Japanese engaged in a major monetary expansion to lower the interest rates. This caused marked increases in the land and equity prices in Japan during the years 1987-1990. This period is referred to as the bubble economy. During this time, the process of land equity and shares went up rapidly, and came crashing down soon after a couple of years (Flath 132). During the bubble economy, the rapid rise in the price of the assets caused imbalances in the distribution of wealth. The philosophy of labor was affected and the participation of the labor had fallen significantly. The government also predicted inflation to rise as a result of the increase in the value of land and stocks. As a result, the government implemented a tightening in the monetary growth of the economy. After that, the country fell into a state characterized by falling profits and less number of investments by businesses. The country also saw rising rates of unemployment and slow economic growth; consumer spending also fell substantially as a result of the contraction on monetary growth. The banking system became extremely delicate, ultimately leading to a credit crunch for small and medium businesses. The increase in the land and stock prices was coupled with an appreciation of yen that had been happening over the past years due to the Plaza agreement and the US pressure. The price of the yen remained relatively low, with a discount rate of 2.5%, in the years from 1987-89. It was thought that the low interest rate would cause the slow down of the appreciation of the yen. This in turn had an effect on the fiscal policy, making it lenient and doing more damage to the Japanese economy than ever by causing an increase in the size of the bubble. In 1991, the Japanese economy fell into recession. The Japanese had suffered poor economic growth ever since, and had remained the economic stagnation had lasted for twenty years. So the prime reason for the poor economy was mainly due to the bubble and some policies the government had adopted that backfired. In the next two decades after the initiation of monetary expansion in 1987, the monetary policy was narrowed significantly, which led to continued deflation and increased interest rates. 6. Balance of Payments (BOP) refers to the set of monetary transactions that countries make with each other. It encompasses outflow of the imports, capital and gold and the inflow of exports, capital and gold. The current account refers to the imports and exports, whereas the gold and capital account refers to the transaction of capital and gold respectively that takes place between countries. The transactions are recorded and presented in double-entry bookkeeping (Levi 98). The BOP is recorded for a specified time period. The BOP serves as a comparison between the financial worth of the imports and the exports. A negative BOP refers to more number of imports than exports, whereas a positive BOP is indicative of more financial investment in the country than the monetary worth of the outflow of capital, gold and exports. An exchange rate is the price of a currency in comparison with another. In a floating-rate regime, the price of the currency is free to fluctuate, without any interventions with the government; the price is dependent on the forces of supply and demand. In a floating rate system, the price of a currency comes to adjusts to a level where the demand for it equals its supply. This has a direct effect on the BOP. Since the currency is at its equilibrium price, where the demand equals the supply, the BOP automatically adjusts to an equilibrium position as well, where the monetary worth of the current account is counterbalanced by that of the capital account. A floating BOP does not put any limitations on the domestic policies of the country since by adjusting the BOP automatically to an equilibrium state, the government can focus on issues like employment. Pegged-exchange rate is also known as the fixed-exchange rate. In this type of exchange rate regime, the value of a currency is compared to another currency or to a group of currencies. It may also be matched to the monetary worth of gold. The main purpose of a fixed exchange rate is that it helps to stabilize the value of the currency according to the currency it has been matched with. One of the implications of a pegged-exchange rate on BOP is that it does not allow the BOP to adjust to an equilibrium position by itself. The government feels constraints in its economic policies. China is one of the countries to use the pegged rate. The reserve of foreign currency held by the country can be used to counterbalance any fluctuation that has occurred in the foreign currency to which the country’s currency has been pegged to, resulting in fluctuations in the market causing inflation or deflation. Pegged regimes culminate in serious financial crisis, because the system is difficult to maintain. The government is restricted to use its economic policies, and in order to keep its economy running smoothly, it has to take reflationary steps like reduction in taxes, which can lead to a trade deficit. When in a trade deficit, the government might retaliate by using measures that cause deflation, which in turn leads to increased unemployment. Works Cited Blanchard, Oliver. Macroeconomics. 2nd ed. UK: Prentice Hall, 2000. Print. Flath, David. The Japanese economy. 2nd ed. Oxford: Oxford University Press, 2005. Print. Levi, Maurice D. International finance. 4th ed. Oxon: Routledge, 2005. Print. Read More