Most economists agree that many of the features of business cycles, high unemployment and low capacity utilization during recessions and high inflation rates during booms are problems for the economy. For the most part, however, the agreement ends there.
There are debates about whether the government should intervene in the economy to try to address these problems. In addition, there are debates how the government should act if it does intervene. In this lecture, we will take a look at some of the major points from this debate within macroeconomics.
Keynes' General Theory was published in 1936 during the midst of the Great Depression. The U.S. economy was in sad shape at the time. Real GDP plummeted over 30 percent in three years (1930-1932), and unemployment soared to about 25 percent. Moreover, the economy had been in this sorry state for several years.
It is no surprise, then, that Keynes believed the economy's ability to correct itself, as claimed by classical economists, had failed. In Keynes' view, the economy can languish in recession because wages tend not to fall significantly (they are sticky downward), thus impeding the economy's ability to correct itself. Investment spending also falls and does not increase until a recovery begins.
Thus, in Keynes' view, the government can initiate a recovery through expansionary demand-side policies. Keynes developed the concept of the multiplier to show that active fiscal policy can have large effects on the economy. More recently, the term "Keynesians" has come to mean economists who advocate active government intervention in the economy. The Keynesian belief in activist governmental economic policies prevailed throughout the 1960s and early 1970s.
The stagflation of the 1970s and subsequent recessions cast some doubt on the government's ability to manage the economy. We will now turn our attention to two of the major schools against an active role for government economic intervention: monetarism and new classical economics.
Keynes sought to distinguish his theories from and oppose them to "classical economics," by which he meant the economic theories ofÂ David RicardoÂ and his followers, includingÂ John Stuart Mill,Â Alfred Marshall andÂ Arthur Cecil Pigou. A central tenet of the classical view, known asÂ Say's law, states that "supply creates its own demand". Say's Law can be interpreted in two ways. First, the claim that the total value of output is equal to the sum of income earned in production is a result of a national income accounting identity, and is therefore indisputable. A second and stronger claim, however, that the "costsÂ of output are always covered in the aggregate by the sale-proceeds resulting from demand" depends on how consumption and saving are linked to production and investment. In particular, Keynes argued that the second, strong form of Say's Law only holds if increases in individual savings exactly match an increase in aggregate investment.
Keynes sought to develop a theory that would explain determinants of saving, consumption, investment and production. In that theory, the interaction of aggregate demand and aggregate supply determines the level of output and employment in the economy.
Because of what he considered the failure of the "Classical Theory" in the 1930s, Keynes firmly objects to its main theory-adjustments in prices would automatically make demand tend to the full employment level.
Neo-classical theory supports that the two main costs that shift demand and supply are labour and money. Through the distribution of the monetary policy, demand and supply can be adjusted. If there were more labour than demand for it, wages would fall until hiring began again. If there was too much saving, and not enough consumption, then interest rates would fall until people either cut their savings rate or started borrowing.
MonetarismÂ is the view withinÂ monetary economicsÂ that variation in theÂ money supplyÂ has major influences onÂ national outputÂ in the short run and theÂ level over longer periods and that objective ofÂ monetary policyÂ are best met by targeting the growth rate of theÂ money supply.
Most monetarists do not advocate activist monetary stabilization policies. They are against expanding the money supply during bad times and slowing the growth of the money supply.
Monetary policy cannot affect income. Most monetarists, including Friedman, blame much of the instability in the economy on government. Friedman has advocated a policy of slow and steady money growth especially that the money supply should grow at a rate equal to the average policy of accommodating real growth but no inflation.
Keynesian and monetarism are at odds with each other. Many Keynesians advocate coordinated monetary and fiscal policy tools to reduce instability in the economy to fight inflation and unemployment. But not all Keynesian advocate an activist government. Some reject the strict monetarist position that only money matters in favour of the view that both monetary and fiscal policies make a difference, but at same time believe at the best possible policy for government to pursue is basically non-interventionist.
The debate between Keynesian and monetarist was the central controversy in macroeconomics. That controversy still alive in now-s-days economy confronts.