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The evolution of different economic thoughts can be traced back to 1800 BC by the Babylonia and until present days the evolution still going on and on from the Greek to Real Business Cycle and New Keynesians. It is impossible that all these just pop up from nothing. Drawing Darwin's Theory of Evolution as analogy that all life is related to one another and descended from the previous generations, we may be able to apply the similar theory in economic thoughts. Similar to the idea of natural selection in Darwinism, the economic thoughts are the descendant of the previous ones and they are related with one another.
As the economic thoughts evolved over time, the ones that no longer work accordingly to the contemporary economy will be eliminated and being replaced by a better one. Only the ones that work in that particular situation will survive over time. The evolution is a very gradual process but certain to occur as time go by. This process will finally result in the changing school of thoughts to adapt to the happenings in the environment as what we are learning now. This bring up to the issue that we are going to discuss in this paper which is, how these happenings or events have led to the emergence of the old Keynesian, Monetarism, the New Classicals and the New Keynesians macroeconomic schools of thought?
2.0 Old Keynesian
Prior to 1930s the classical school of thought had dominated the world economy since the year 1776 when Adam Smith published his book, Wealth of Nation. Classicals advocate the idea of supremacy of market economy which will be driven by competition and self-interest. State interference in the economy will only bring about inefficiencies as shown during mercantilism. The state should just take the role to provide an environment conducive to the functioning and progressing of market economy like provision of national defense and infrastructure. Say's law was practiced with strong faith that economy will always in equilibrium and there will be no overproduction or insufficient demand. There was 'invisible hand' which coordinates the working of whole economy.
Old classical model worked well in the period of 1923 to 1929 where economy worked so well with low unemployment, rapid economic growth and almost no inflation. The condition somehow changed in 1930s. The growths of money supply, nominal and real GDP and price level even fall to negative in 1930-1933. Unemployment soared up to 25%. The assumed full flexibility of price and wage by old Classics did not turn out as it should be. Doubt on the Classical school arose as the free market did not adjust back fully to the optimum level automatically even after a long period. The Great Depression brought about the exposure of the flaws in Old Classical model. For instance, the most criticized idea of quantity theory of money did not bound to the happenings during Great Depression. The velocity was assumed to be constant as it depends on the transaction practices like payment systems which change very slowly over time. In fact, what happened was that the drop in money supply led to the drop in velocity and thus led to the burst out of Great Depression.
The Great Depression brought to the collapse of Old Classical and the birth of Old Keynesian developed by John Maynard Keynes in General Theory. Besides than the 'trigger' for Great Depression, Old Keynesians was heavily influenced by the economy behaviour in the late 1930s as well. The expansionary monetary policy was implemented after the depression to reduce the short-term interest rate and thus stimulate the economic growth. However, the result did not turn out as so. The velocity growth was still in negative value and the high unemployment remained unsolved. Further increase in money supply had no longer affect the economy as the interest rate was already near zero.
2.1 Comparison between Old Classical and Old Keynesian
The Great Depression and the attempt to recover the economy brought up to the Old Keynesian' focus on aggregate demand, fiscal policy and the idea of sticky price. Keynesian suggested the concept of aggregate demand in influencing the economy as a whole instead of the classical idea which emphasized on the role of money supply to the economy. He stressed on the factors like consumers' preferences and prices of other goods, either complements or substitutes that will affect the aggregate demand and causing changes in output and employment. Besides, Old Keynesian also opposed the idea of Say's Law in Old Classical. The interaction between both supply and demand will determine the price and the output instead of just the supply side. Factors like wage and price stickiness will also indicate the inflexibility of the market to adjust promptly for equilibrium.
Finally all these led to Keynesians advocate of state intervention due to the existence of market failure. Government should play a role in the economy to regulate its proper functioning. Fiscal policy in particular is favourable in Old Keynesians to regulate the proper functioning of the economy. And the result seemed to be consistent to Keynesian idea as shown during World War II. The economy was great with high economic growth with almost none unemployment and inflation.
The economy in 1950s was dominated by the Old Keynesian idea with great state intervention especially in US during World War II when the Fed peg the long-term government bond interest rate and printed money to cover the fiscal deficit resulted from the war expenditure. There had been instability in the economy during 1950s because of the government's decision. Korean War caused the hike in government expenditure in 1950-1953 and then decrease in 1953-1954 which resulted in mild economic recession. This recession was addressed easily by expansionary monetary policy through reduction of short-term interest rate. To address the increasing inflation, Fed increased interest rate gradually but this led to sharp recession in 1957-58 and another recession in 1960-61. All these events brought exposure to the flaws of Keynesian that advocated state intervention. As explained above, the government military spending was the main cause for instability in aggregate demand. Besides, there are no general standard to determine to what extent the fiscal and monetary policies should be conducted.
Prior to the emergence of monetarism was the new economics of Walter Heller. Expansionary fiscal policy by reducing the tax was implemented to address the recession and unemployment instead of monetary policy in early 1964. The fiscal policy was adjusted in 1966 to contractionary policy by increasing income tax for the Vietnam War expenditure. The economic happenings in 1950s and idea of new economics in 1960s brought up the issue of 'fiscal fine tuning'. Fiscal policy always failed to turn out to be effective as expected due to legislative lag and permanent income hypothesis.
The weaknesses of fiscal policy and the flaws state's intervention which was 'out of control' seemed to be the entry point of the emergence of monetarism by Milton Friedman in 1968. The income-expenditure approach of Keynes was attacked by Monetarism and an alternative macroeconomic approach was proposed which view money as the root source of major economic downturns. Friedman's approach which favour monetary policy over fiscal policy and fixed rules over policy was as a reaction to the then-prevalent Keynesian approach to macroeconomic theory and policy. To improve these flaws of Keynesian, monetarism targeting at economic stabilization with rule of constant growth rate for money supply instead of fiscal policy. The practice of monetarism was further strengthen by the failure of fiscal policy in slowing down the economy through increase of income tax in 1968 and the impact of tight money in ending the expansion in 1969. This led to the contrast economic thought of Keynesian and Monetarism.
3.1 Comparison between Old Keynesian and Monetarism
Friedman revived classical economic doctrines in building his theory and ideas of monetary, as in his classic studies of Quantity Theory of Money (1956), which made monetarism a different economic thought in 1990s as compared to the others. Monetarism is contrast with Keynesian in the view on source of economic instability. Keynesian identified money supply which was in insufficient level that led to economic collapse, and thus made it crucial to maintain the stability of currency value favourable economic condition. On the other hand, monetarism viewed price stability as the most important driver of the economic and make it crucial to achieve stable money market equilibrium for stable economic.
But how to ensure the price stability as in Monetarism? Friedman argued that "inflation is always and everywhere a monetary phenomenon" and thus advocated control by central bank to keep the money supply and demand at economic equilibrium, which is measured by a balanced growth in productivity and demand. This is what proposed by Friedman, fixed 'monetary rule' where the money supply would be fixed accordingly to the identified macroeconomic and financial factors and desired inflation level. The economic will bound to this fixed rule and lose the central bank lose flexibility of adjustment. This is favourable for the businesses as the monetary policy will be within their expectation.
The origin of Monetarism began with quantity theory of money in Old Classical. The main argument in Monetarism here is that money supply does play an effective role in affecting the economy. When money supply increase when it is in equilibrium state, consumers would have money surplus and consequently spend the extra money. This will then stimulate the economic situation as the increase in consumption lead to increase in aggregate demand. And vice versa. Friedman able to challenge the Keynesian theory that money supply is ineffective in affecting the economic. This was how the term' monetarist' was coined where they believe in the 'power' of money supply in influencing the total spending in economy and thus justified the higher effectiveness of monetary policy as compared to fiscal policy.
3.2 Fading of Keynesian, rising of Monetarism
Monetarism gained its popularity as Keynesian economics seemed unable to explain or address the problems of stagflation which is the rising of both unemployment and price inflation erupted after Bretton Woods gold standard system collapsed in 1972 and the oil crisis shock in 1973. The contradiction in the policy implementation for this problem exposed the weakness of Keynesian demand management and consequently results in the worst recession of the post-war period. Many Monetarists attacked the Keynesian view that state intervention is needed to correct the market failure by raising classical view that the free market economy will be stable enough. They suggested that active demand management by the state, particularly fiscal policy have no real effect on aggregate demand, but will bring more harm to the economy and therefore is unnecessary.
4.0 New Classical
Monetarism became less credible when once-stable velocity of money defied monetarist prediction and began to move erratically in the United States the early 1980s. Monetarist methods of a single-equation model and non-statistical analysis of plotted data also lost out to the simultaneous-equation modeling favored by Keynesian. Policies and analysis of monetarism lost influence among academics and central bankers, but its core tenets of long-run neutrality of money (increase in money supply cannot have long-term effects on real variables, such as output)and use of monetary policy for stabilization to be part of the macroeconomic mainstream even among Keynes.
During the food-oil crisis in the year 1973-1975 as mentioned above, the oil shock cause the peak up of both inflation rate and unemployment rate that had reached around 10 percent during that period. This event can be said to mark the end of Old Keynesian and the new era of Monetarism began. A relatively prompt fiscal stimulus in early 1975 helped to end the 1974-75 recessions. From that year on until 1979, monetary policy has been encouraged with a further acceleration of inflation by allowing M1 growth rapidly. Then, the Fed adopted monetarist rule and shift toward a money based targeting. Throughout this period, Lucas new classical macroeconomics was developed to replace Monetarism as the main counter-revolutionary theory to Keynesianism. The food and oil crisis happened in 1973 to 1975 have played an important role in helping to build support for new classical economics. Robert Lucas was the key figure in the development of the new classical economics and the main elements of the new classical approach to macroeconomics can be summed as the joint acceptance of three main sub-hypotheses. There are the rational expectation hypothesis, the assumption of continuous market clearing, and the Lucas aggregate supply hypothesis. In these models, variation in output and employment reflects the voluntary response of rational economic agents who have imperfect information.
First of all, the new classical economics is based on Walrasian assumptions where markets continuously clear all possible gains from trade have been exploited and utility has been maximized. In other words, Lucas applied the rule that equilibrium in a market occurs when quantity supplied equals to quantity demanded. In Keynes's view, involuntary unemployment may exist in the labor market even when all the markets for goods are in equilibrium. However,the new classical contradicts with Keynes's viewwhere the labor market must be in equilibrium if all goods markets are in equilibrium. Furthermore, new classical says that firm would not be optimizing if firms did not take the opportunity of earning more profits by paying workers at lower wages when there was involuntary unemployment.Hence, new classical economist built their macroeconomic theories on the assumption that wages and prices are flexible in order to have a unique equilibrium at full employment.
Besides that, new classical models also includes aggregate supply hypothesis based on two basic microeconomic assumptions, which are individuals are viewed as optimizer, and the supply of labor and output are depends upon relative prices. Each individual is assumed to have limited information and to receive information about some prices more often than other prices. So, economic agents could realize an increase in general prices due to inflation as an increase the relative price for its output, leading them to increase their supply of that good.Consequently, it will leads to an increase in output and employment in the economy within a short-term period, but, the output will be decreased when the price turns out to be lower than expected. The rationale of this hypothesis is unexpected increase in the price level can fool workers and firms into thinking relative prices have changed, then causing them to change the amount of labor or goods they choose to supply in the short run. It concludes that only unanticipated government policy can affect real output because people with rational expectations known the policy changes would produce no price surprises.
In the mid of 1970s, Robert Lucas has been adopted rational expectations hypothesis. This hypothesis was the work of John Muth in the context of microeconomics analysis. Muth wrote his article in 1961, he suggested that expectations are informed predictors of the future events, they would be essentially consistent with the relevant economic theory. Muth also argued that if the predictions of the model were correct, and therefore people's expectations were wrong, then they could use the economic model or theory to correct their own expectations. It was irrational if people fail to do so. Furthermore, Muth's hypothesis says that rational people will not make systematic errors. Economic agents use the information cleverly where they know which variables will affect the variables that they are trying to predict. After the rational expectation was caught on in macroeconomics, therewere significant discussions of policy ineffectiveness proposition. Policy ineffectiveness proposition was presented by Thomas Sargent (1975) and Neil Wallace (1976) asserts that systematic monetary and fiscal policy actions that change the aggregate demand will be unable to affect output and employment even in the short run because a rational individual will take into account any 'known' monetary rule in making their expectations. Moreover, if the authorities make unanticipated policy with the purpose of influencing output and employment, it will only raise the variation of output and employment around their natural levels.However, it cannot be used to direct the economy as it was non-systematic policy. This developing work in rational expectations soon came to be known as new classical economics, because its policy conclusions were similar to earlier classical views.
By the late 1970s, many future of macroeconomics lay in the new classical thinking and also Keynesian economics were dead. Why said so? In the mid of 1970s, inflation and unemployment were positively correlated but not negatively correlated as Philips curve assumed. Hence, a Philips curve estimated under one policy regime would not predict accurately what would happen under a different regime. Robert Lucas argued that economic agent's expectations depends on expected policies, thus, the structure of the model will alter as a policy is used. Any change in an appropriate policy will change the structure of econometric models, and then the model will no longer be appropriate. In other words, macroeconomic models should not be used to predict the effects of future policy since the structure of the models may change as economic agents adjust their expectations to the future policy. This argument is known as the 'Lucas critique'. As we can see, the stagflation of the mid of 1970s has been helped to motivate the formulation of new classical economics.
5.0 Emergence of New Keynesian
Today, new Keynesianism has returned to prominence. The main point of this updated version is the theory that people are not perfectly rational, but nearly rational. This can be explained as people have only an idea of what their prices should be, and make their best guesses. A long lag between the recognition of a recession and the decision to cut prices in earnest occur due to the selfishness in their own interests and they tend to be in lost their own favor, underestimating how much they actually need to cut.
New Keynesian economics is a school that emphasizes the stickiness of prices and the necessary for activist stabilization policies by controlling the aggregate demand so that the market is close to its potential output. It combined with both monetarist ideas about the vitality of monetary policy and new classical ideas about the vitality of aggregate supply in short and long run.Another "new" element in new Keynesian economic thought is the larger use of microeconomic analysis in demonstrating macroeconomic phenomena, especially the analysis of price and wage stickiness. For example, the sticky prices and wages may be a response to the preferences of consumers and of firms. That idea extract from thestudy by economists of the new Keynesian .New Keynesian ideas have been guiding macroeconomic policy and they are the basis for the model of aggregate demand and aggregate supply with which we have been working. One can refer to the core macroeconomic events and policies in 1980s, 1990s, and early 2000s in order to learn how the new Keynesian school has come to dominate macroeconomic policy.
New Keynesian economics emerged in the last three decades as the dominant school of macroeconomic thought for two reasons. First, it successfully incorporated important monetarist and new classical ideas into Keynesian economics. Another reason is that the developments in the 1980s and 1990s caused economists' lose confidence in the ability of the monetarist or the new classical school to explain the changes in macroeconomic alone
M2 and Nominal GDP, 1980-2007
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The tight relationship between M2 and nominal GDP a year later that had induced in the 1960s and 1970s seemed to disappearstarting from 1980s.The unanticipated change in the relationship between the money stock and nominal GDP has causedabout half from public policy. Failure in regulating the banking industry in the early 1980s caused changes in the ways individuals manage his money, therefore changed the relationship of money to economic activity. Banks have been freed to offer a wide range of financial alternatives to their customers. One of the most vital developments was the introduction of bond funds by banks. These funds allowed customers to earn the higher interest rates paid by long-term bonds while at the same time being able to transfer funds easily into checking accounts when needed. Balances in these bond funds are not counted as part of M2. As people shifted assets out of M2 accounts and into bond funds, velocity rose. That changed the once-close relationship between changes in the quantity of money and changes in nominal GDP.
Many monetarists have argued that the experience of the 1980s, 1990s, and 2000s reinforces their view that the instability of velocity in the short run makes monetary policy an improper tool for short-run stabilization. However they still insist that the velocity of M2 remains stable in the long run yet the velocity of M2 appears to have diverged in recent years as noticed. Although it may return to its long-run level, the stability of velocity is still in doubt. Due to its instability in 2000, when the Fed was no longer required by law to report money target ranges, it discontinued the practice.