Keynesianism and Monetarism represent two major schools of thought in macroeconomic policy. Their differences lie primarily in their views on government intervention, money supply, and the role of aggregate demand.
Keynesianism:
Keynesian economics, developed by John Maynard Keynes during the Great Depression, emphasizes the role of aggregate demand in determining output and employment. According to Keynesians:
- Fiscal policy (government spending and taxation) is the primary tool to manage economic fluctuations.
- During a recession, increased government spending can stimulate demand, reduce unemployment, and restore growth.
- Monetary policy is seen as less effective, especially in deep recessions or liquidity traps, where interest rates are low and consumer confidence is weak.
- Prices and wages are sticky, meaning they don't adjust quickly to restore full employment on their own.
Implication: The government should actively manage the economy, especially during downturns, using fiscal stimulus to boost demand.
Monetarism:
Monetarism, led by Milton Friedman, emerged in opposition to Keynesianism, particularly in the 1970s. Monetarists believe that:
- Money supply is the main determinant of nominal GDP and inflation.
- Excessive growth in money supply causes inflation, while stable money growth supports economic stability.
- Fiscal policy is often inefficient, delayed, and can crowd out private investment.
- The economy is generally self-correcting in the long run; markets adjust through flexible prices and wages.
Implication: Governments should focus on controlling the growth of money supply, rather than intervening heavily with fiscal policy.
Crisis in Keynesian Economics and the Revival of Monetarism
Crisis in Keynesianism:
The 1970s stagflation—a combination of high inflation and high unemployment—posed a major challenge to Keynesian theory. According to the original Phillips Curve, there should be a trade-off between inflation and unemployment. However, during this period:
- Inflation rose due to oil shocks and loose monetary policy.
- Unemployment remained high, contradicting the expected trade-off.
Keynesian models, which focused primarily on demand management, failed to explain the supply-side shocks and rising expectations of inflation. The inability to address stagflation effectively led to a decline in confidence in Keynesian policies.
Revival of Monetarism:
Monetarists, particularly Milton Friedman, offered an explanation through the expectations-augmented Phillips Curve. They argued:
- People form adaptive expectations of inflation.
- Attempts to maintain unemployment below its “natural rate” only lead to accelerating inflation.
- The long-run Phillips Curve is vertical, meaning there’s no trade-off between inflation and unemployment in the long run.
Monetarism gained influence in the 1980s, especially in the U.S. and U.K. under leaders like Ronald Reagan and Margaret Thatcher, who prioritized:
- Controlling money supply growth,
- Reducing inflation,
- Limiting government intervention.
Monetary targeting became a central feature of policy frameworks in these countries.
Monetary-Fiscal Policy Mix and Economic Growth
Over time, both extremes—complete Keynesian demand management or strict Monetarist money targeting—proved insufficient on their own. Modern economics recognizes the importance of a balanced policy mix:
1. Monetary Policy:
- Best suited for short-term stabilization, especially inflation targeting through interest rate adjustments.
- Central banks like the Federal Reserve and European Central Bank now focus on inflation targeting with forward guidance.
2. Fiscal Policy:
- Becomes crucial during recessions or when interest rates are near zero (as seen during the 2008 Global Financial Crisis and COVID-19 pandemic).
- Governments used fiscal stimulus (e.g., direct cash transfers, infrastructure spending) to boost demand when monetary policy was constrained.
3. Policy Coordination:
- A coordinated approach allows both tools to complement each other.
- For example, during COVID-19, monetary easing (low interest rates, quantitative easing) supported fiscal stimulus, ensuring liquidity and demand simultaneously.
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