Economic Schools of Thought
Economic Schools of Thought
What is included on this page should give readers a general idea of the thought processes used by advocates of different points of view.
Current philosophy of macroeconomic policy is generally thought of as being a clash between two distinct points of view, Keynesian and Monetarist. The viewpoints of Keynesians and Monetarists both have evolved over the years, and the result of this evolution has led to some confusion and misinformation about what the viewpoints actually are. I believe that a brief description of the historical evolution of these points of view will help clear up this confusion. More importantly, a study of how this difference in viewpoint developed over the years will go a long way towards learning what the current debate is about.
The Keynesian school of thought began with John Maynard Keynes, who developed an alternative to the classical economic school as a result of the realities of the Great Depression in the 1930s.
Classical economists had believed that an output level below full-employment level - which is the case during a recession - is not a position of equilibrium, and that market forces would bring the economy back to the full-employment level. This is the self-correcting nature of laissez-faire economics: no government intervention in the economy is needed because the economy will shortly correct itself. This self-correction involves the following process:
Unemployment created by a recession means that an excess labor supply exists in the economy. This excess labor supply will drive down the wage rates, and lower aggregate demand will drive down the overall price level. As prices decrease, consumers will have more real wealth in terms of purchasing power, and would increase consumption spending. This change in real wealth is called the wealth effect. As consumption spending increases, aggregate demand in the economy will increase until the full-employment level of output is reached. There is no need for government interference in the economy because the economy will correct itself.
During the Great Depression of the 1930s, however, it became obvious that this self-correcting mechanism did not kick in. The economies of nations around the world remained, for a long period of time, at a level far below the full-employment level. This meant that either equilibrium was reached below full employment - in which case the economy would never correct itself - or the self-correcting mechanism would take much too long to be acceptable to society. Keynes came along with his own economic theories to explain this. He published his theories in a book called “The General Theory of Employment, Interest, and Money”, in 1936.
Keynes believed that the classical theory was incorrect. He believed that wages and prices were resistant to downward pressure, so that the self-correcting mechanism could not kick in. Lower wages and prices are the necessary incentive for self-correction, in the classical view. Indeed, since Keynes’ time, historical events have shown that wages and prices are indeed resistant to downward pressures. Since this self-correction would not occur, Keynes advocated government intervention - but only during times when the economy was in a recession or a depression. His advice was strong fiscal and monetary policies in order to correct the economy.
Keynes believed that fiscal policies (lower taxes, increased government spending) and monetary policies (controlling the money supply and interest rates through the use of various central banking actions) were both effective. But he believed that fiscal policies were more effective than monetary policies.
Other notable beliefs of Keynes include: Mild inflation redistributes wealth from the “idle” classes to the “active” classes, including businesses. This ensures a healthy level of business profits. These profits would in turn be available for investment, which would create economic growth. But Keynes also believed that business confidence was extremely volatile and unpredictable, causing investment spending to fluctuate. Keynes also believed that the strong statistical evidence of a correlation between consumption spending and disposable income meant that disposable income caused consumption spending, not the other way around.
Contrary to many current beliefs, Keynes was not socialist or anti-capitalist. He believed strongly in capitalism. He believed that during a recession, the government can help the economy recover much better than it could do if left alone. He did not advocate government intervention during normal economic times.
Keynes’ viewpoints became the consensus view among economists, and this view prevailed throughout his lifetime. He died in 1946. By the time that Monetarists (led by Milton Friedman) came along in the 1950s to challenge the Keynesian point of view, the debate had changed. It was no longer Keynesian vs. Classical.
Government intervention during recessions was advocated by both Keynesians and Monetarists; indeed, by almost all mainstream economists. The debate throughout the 1950s and 1960s was about the relative strength of fiscal and monetary policy. Keynesians believed that fiscal policy was more effective, and monetarists believed that monetary policy was more effective.
By the 1970s, the debate between Keynesians and Monetarists had changed again, to basically what the debate is about today. By this time, the debate was no longer about the relative effectiveness of fiscal policy vs. monetary policy; the consensus had been reached that both policies were powerful and effective. Instead, the debate came to be about the wisdom of using such tools during normal economic times, in order to fine-tune the economy. The Keynesian school of thought became associated with government activism, or using such tools during normal times. Monetarists believe that a slow, steady increase in the money supply, regardless of the current economic situation, was the only activist policy that the government needed. Any other activist policy, according to the Monetarists, would be misguided because it would be less effective and less predictable.
The Wealth Effect: How much a change in the price level will cause a change in consumer spending - and therefore the ability of the economy to self-correct when it produces at a level of output other than the full-employment level - depends on how steep the aggregate demand curve is. If the aggregate demand curve is steep, then it would take a very large change in the price level to cause the wealth effect to bring the economy back to the full-employment level. If the aggregate demand curve is flat, then a small change in the price level will bring about the self-correcting mechanisms that will put the economy back to full-employment. Keynesians believe that the aggregate demand curve is steep, and therefore activist government policy is needed. The self-correcting mechanism would be inadequate. Monetarists believe that the aggregate demand curve is flat, and that only a modest change in the price level will bring about full-employment due to the wealth effect. This view means that activist policy is not needed.
Money Supply Targets: The Fed (central bank) announces its target for the rate of growth in the money supply each year. Monetarists believe that the money supply is the key factor in influencing economic activity. That is why they advocate modest increases in the money supply as the only activist government policy. With this view, Monetarists believe that the target for the money supply growth should be set low and in a narrow range, and rigorously adhered to. The Keynesian view is different. Keynesians do not believe that such a rigid link exists between the money supply and economic activity. Therefore, they advocate setting the targets in a broad range, so that leeway exists to change as economic conditions change.
Velocity of Money: The velocity of money determines the multiplier effect on real output to a given supply of money. Monetarists believe that the velocity of money is stable, and therefore any changes in the money supply will have a predictable and powerful effect on aggregate spending. In their view, fiscal policy has little effect on the velocity of money and therefore is relatively ineffective. Keynesians also believe that monetary policy is powerful, but they view the velocity of money as being unstable and unpredictable. In this view, the unpredictability of the velocity of money means that fiscal policy is at least as powerful and effective as monetary policy. Note that the view is “at least as powerful”, not necessarily “much more powerful”. This difference is one of the misconceptions of Keynesian economics.
Inflation: A statistical correlation exists between the level of the money supply and the rate of inflation: when the money supply grows faster, inflation becomes higher. Monetarists view this statistical correlation as one of cause and effect: They believe that the higher money supply always causes the higher inflation. Keynesians do not believe that this cause and effect relationship is necessarily true. The Keynesian viewpoint is aided by the fact that in statistics, a correlation does not imply cause and effect.
An example of inflation will emphasize this difference: Suppose that higher input prices, caused by a supply shock, caused aggregate supply to decrease. This would lower output and employment, but it would also cause the general price level to increase (a leftward shift in the upward-sloping aggregate supply curve). The central bank, in order to move output back to the full-employment level, decides to increase aggregate demand by increasing the money supply, which gives consumers more money to spend. This increase in aggregate demand will increase the equilibrium output level, hopefully to the point of full-employment. But this also will cause a rise in the general price level (a rightward shift in the downward-sloping aggregate demand curve). The overall result is a decrease in aggregate supply, an increase in aggregate demand, output and employment returning to the full employment level, but higher prices. The monetarist view of all of this is that the increase in the money supply is what causes the price level to increase. Keynesians and other critics of the Monetarist position note that other forces caused the central bank to take action. Prices had already begun to rise before the increase in the money supply, and therefore it is not the increase in the money supply that caused the inflation.
Interest Rates: Monetarists believe that interest rates are the key factor in determining savings and investment. They believe that market equilibrium interest rates will bring about a balance between savings and investment. Keynesians note that savings and investments are made by different sets of people. They believe that interest rates are not the key factor in determining savings, but rather disposable income is. In this view, activist policy targeting disposable income is more effective than allowing the market interest rates to set the amount of savings and investment.