Tuesday, July 22, 2008

Keynesian vs Monetarist Theories

One of my readers wrote to me saying he enjoyed the site, but, couldn't help notice the influence of Keynesianism on my essays.

In a way he is right, in many essays I tend to be sympathetic towards a Keynesian / interventionist viewpoint. When teaching A Level economics we discuss different models of the economy. In particular we show the Keyensian vs Monetarist view of the Long Run Aggregate Supply. This is very simplified view

Keynesian view of Long Run Aggregate Supply

The Keynesian view is that output can be below full capacity for a long time. In a recession, labour markets don't clear and we are left with demand deficient unemployment. Keynes' general theory of money was written in the 1930s, when there was ample evidence of the failing of the free market to achieve full employment. Faced with this mass unemployment, Keynes advocated government intervention (higher government spending) to stimulate a depressed economy.

Monetarist View of Long Run Aggregate Supply

The monetarist view is a development of the classical theory. To simplify the model, Monetarists believe the Long Run Aggregate Supply Curve is inelastic. If AD rises faster than long run aggregate supply, there may be a temporary rise in real output, but, in the long run, output will return to the previous level of Real GDP. The impact of this theory is that government attempts to influence Real GDP through fiscal policy are at best ineffectual. This is because Expansionary fiscal policy only causes inflation. Classical economists argue that the economy will return to full employment, presuming that obstacles to the free working of markets are removed. inflationary pressures.

Sometimes when teaching a student will ask me - Are you a Keynesian Sir?

I am reluctant to say yes, because I feel that a good economist should not be tied to a particular ideological viewpoint. A good economist should always be flexible, ready to criticise his own belief's if evidence points in other directions.

However, broadly speaking, I do believe that governments or Central Banks should attempt to stabilise the economy through monetary and fiscal policy. They should not aim to avoid every cyclical fluctuation. But, intelligent monetary and fiscal policy can avoid the worst excesses of boom and bust. In a recession, fiscal policy can play a role in shortening the duration and intensity of the recession.

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Edward said...

I'm enjoying the blog, many thanks.

My response to your post:
Is the consensus now not that the short run AS curve is likely elastic, while the LR AS curve is inelastic, as monetarists propsed?

That is, in the short run, changes in AD will have an effect on the price level and output, but in the long run changes in AD will eventually be passed through to prices without a change in output.

If you think this is the case (i.e. agree with full price pass through, no output change in LR), then the next question is 'how long is the short run?'.

Tejvan Pettinger said...

Thanks for comment Edward.

Keynes' commment was yes in the long run, real output will increase - but in the long run we are all dead.

The answer to your question depends on the state of the economy. I still believe that in some occassions, increasing AD can increase real GDP

Maulik said...


I recently read a very interesting article thats closely linked to this one. Heres the link: