Intervention

KEYNESIANISM AND MONETARISM

The great depression of the 1930s demonstrated that the market system does not automatically lead to full employment. In The General Theory of Employment Interest and Money (1936), John Maynard Keynes argued that market forces could produce the equilibrium with high unemployment of indefinite duration. Classical economic theories stated that in the long run, excess savings would cause interest rates to fall and investment to increase again. Keynes disagreed, arguing that market economies are unstable.

Keynes recommended governmental intervention in the economy. During an inflationary boom, governments could decrease their spending or increase taxation. During a recession, on the contrary, they could increase their expenditure, or decrease taxation or increase money supply and reduce interest rates, so as to stimulate the economy, and increase output, investment, consumption and employment. Keynes also argued that even a small amount of additional government spending or an increase in private investment causes output to expand because of the multiplier effect.

In the 1950s and 1960s Milton Friedman began to argue that Keynesian fiscal policy had negative long-run effects. Unlike Keynesians, monetarists insisted that money is neutral, meaning changes in the money supply will only change the price level and have no effect on output and employment. They argued that governments should abandon any attempt to manage the level of demand in the economy through fiscal policy. On the contrary, they should try to make sure that there is constant and non-inflationary growth in the money supply.

Monetarists argue that recessions are not caused by long-run market failures but by short-run errors by firms and workers who do not reduce their price and wages quickly enough when demand falls. When economic agents recognize that prices and wages have to fall, the economy will come back to normal. Since the government will not be able to recognize a coming recession it will only be able to act at the same time as everyone else is recognizing the need to cut prices and wages. Consequently, its fiscal measures will take effect when the economy is already recovering.

Whereas classical and neo-classical economic theory assumes prices and wages to be flexible enough to eliminate excess supply or demand, Keynesians (today often called neo-Keynesians) argue that wages are inflexible because of labour union contracts, government regulation and so on. Furthermore, businesses can’t change their prices too frequently, because they do not have perfect information, and because there are many costs involved. Neo-Keynesians still maintain that because individuals and firms are unable to find the right prices that would lead the economy to rising output and high or full employment, economies can get locked into disequilibriums for long periods. Thus unlike the monetarists, w`ho insist that free markets and competition are efficient and should be allowed to operate with a minimum of governmental intervention, Keynesians believe there is still a role for either expansionary or deflationary policies.

Comprehension:

1. What did classical economic theories state?

2. What did Keynes recommend?

3. What did monetarists insist on?

4. Do classical and neo-classical theories assume prices to be flexible?

5. Do Keynesians hold the same opinion?