The Keynesian School versus the Monetarist School

There are two main schools of thought or views on how the economy behaves and how it must
be managed. That is, the Keynesian school and the Monetarist school. These two different
schools of thought provide different viewpoints on how the economy must be managed based on
their varying underlying assumptions on how the economy behaves.
The Keynesian School
John Maynard Keynes is regarded as the pioneer of the Keynesian school. The underlying belief
behind the Keynesian school’s views is that, if markets are left out to operate on their own, there
is a possibility that the economy will be stuck in an equilibrium below full employment hence
widespread unemployment is the supposed scenario. According to the school, unemployment is
caused by lack of sufficient aggregate demand (cyclical or demand deficient unemployment) and
therefore, the government must intervene through the use of expansionary fiscal policy to
stimulate aggregate demand. This promotes economic growth by closing the deflationary gap
through the multiplier effect. That is, the government should run budget deficits during periods
of recessions and budget surpluses in subsequent periods. The nature of expansionary fiscal
policy the school considers more effective is that of increasing government spending as opposed
to tax cuts because, tax reductions may not thrift spending but rather result in an increase in
saving hence lowering the value of the multiplier. The belief is that, it is aggregate demand that
stimulates growth in output. In other words, this means that, demand creates its own supply. The
school emphasizes the paradox of thrift, that is, a rise in savings results in lower income. Since
this reduces aggregate demand, firms reduces production output.
To explain in detail, the school of thought emphasizes the short run scenario in which there is an
excess capacity, prices of factors of production e.g. wages and prices of goods and services are
inflexible due to legal contracts and inflation expectations are assumed to be constant or not
changing (static expectations). For instance, the expectation on inflation will be that the economy
will continue to experience the same rate of inflation. As a result, an increase in government
spending arising from an increase in money supply stimulates aggregate demand which in turn
incentivize firms to expand output. The Keynesian school also provide explanations behind the
cost push and demand pull theories of inflation. According to the Keynesian school, cost push
inflation is considered to be a phenomenon of a rise in cost of production e.g. a rise in wages not
matched by a rise in productivity due to powerful trade unions which results in producers passing
on the cost to consumers through price increases. Demand pull inflation occurs when aggregate
demand increases faster than aggregate supply, a situation that results in bidding up of prices by
consumers. The school purports that both demand pull and cost push inflation are most likely to
occur when the economy is close to full employment. This scenario, for instance, increases the
power of trade unions to achieve wage increases and also lack of excess capacity results in
supply failing to match demand. It must be well understood that the Keynesian school takes into
consideration that actual output is not always equal to its full employment or potential level.
A Critique of the Keynesian School
The school ignores the possibility of government failure, that is, the unintended negative effects
of government action. In this regard, the Keynesian school believes that information failure on
part of government in terms of how much government spending is required to close the
deflationary gap is overcome by the knowledge of the multiplier concept. This is hypothetically
correct. However, in reality, the estimated model may be inaccurate because the economy is
more complex than what theory predicts. Further, the possibility of government creating
unemployment e.g. through the minimum wage are ignored. The NAIRU is also overlooked, so
is the short run trade-off that exist between inflation and unemployment (Philips curve). In
addition to the other negative effects of deficit financing, government spending may crowd out
private investment by exerting an upward pressure on interest rates through competition for
funds in the market. This is if the government decides to borrow locally. The advantage
associated with borrowing locally is that, paying back the money is an internal transfer in the
sense that the money will still be circulating within the domestic economy and there is no
exposure to exchange rate risk compared to external borrowing. Nonetheless, the possibility of
supply creating its own demand is overlooked. That is, for instance, a rise in savings can result in
increased investment due to increased availability of loans and promote long run economic
growth. Therefore, the paradox of thrift is a short run phenomenon. That is, the Keynesian school
overlooks the long run scenario. Moreover, in reality, prices of factors of production are not
always inflexible in as much as inflation expectations may not always be static. Other criticisms
associated with government intervention and the fiscal policy are also relevant.
The Monetarist School
According to monetarists, actual output is always equal to potential output hence there is no need
for government intervention. Assumptions of the monetarist school are that prices of goods and
factors of production are flexible, there is no excess capacity (actual output is always equal to
full employment or potential output) and rational expectations. Therefore, the Monetarist school
provides a long run analysis. Rational expectations means that economic players (consumers and
firms) incorporate all the relevant information in order to come up with the best or an optimal
guess of future inflation and further incorporate their guesses in their decision making.
Monetarists are of the belief that government intervention that involves a monetary expansion
can only cause inflation in the long run. The propositions of the school is underpinned by the
quantity theory of money through the equation of exchange. According to the quantity theory of
money, in the long run, growth in money supply will result in a proportionate growth in price
level. This is because, when money supply increases, inflation expectations increases also hence
this results in an increase in wages and prices rather than the increase in output since output is
already at its maximum level. Milton Friedman is the pioneer of monetarism. He stated that,
“inflation is always and everywhere a monetary phenomenon”. The equation of exchange does
not only explain monetary inflation (demand pull inflation) but also its acceleration. That is, an
increase in the money supply growth rate also increases the rate at which prices increase
(inflation acceleration). Accelerating inflation shall be dealt with later on, under the Philips curve
analysis.
A Critique of the Monetarist School
Monetarists assume that the economy is always at full employment by assuming market clearing
or flexible wages and prices as well as rational expectations. Therefore, Monetarists emphasize a
long run scenario. As a result monetarists ignores the problem of unemployment by assuming
full employment and hence emphasizes the control of inflation through the monetary policy by
regulating money supply growth. Moreover, the equation of exchange, from which Monetarism
stems from has been criticized of being an identity and not an equation. Nonetheless, in a modern
economy with rapid innovations in forms of money it is far more difficult to assume regulation
of the growth in money supply.
Reconciliation of the Keynesian and Monetarist Views
The independent views of each school can be considered partially correct. This is because, the
Keynesians emphasize a short run scenario and the Monetarists consider a long run situation.
That said, Keynesians believes that the supposed fiscal policy is more effective in managing the
economy and competitively, Monetarists also believe that their supposed monetary policy action
is more effective. This stems from the fact that both schools focus on different macroeconomic
problems. Keynesians focus on unemployment meanwhile Monetarists focuses inflation.
Nonetheless, both policies are similar in the sense that they both affect the aggregate demand.
Therefore, the Keynesian views are crucial in order to avoid short term fluctuations in output and
unemployment. That is, expansionary policy is useful when the economy is experiencing a
deflationary gap and a contractionary fiscal policy is necessary when the economy is
experiencing an inflationary gap. At the same time, Monetarist views are crucial in order to help
prevent inflation and achieve low and stable inflation by emphasizing the need to regulate or
control the growth in money supply.
The Philips Curve
The Philip’s curve is a curve that shows the relationship between inflation and unemployment. In
the short run, a trade off exist between inflation and unemployment hence the short run Philips
curve. As a result, any attempt to reduce unemployment in the short run by increasing aggregate
demand comes at a cost of a higher inflation rate (accelerating inflation). In the long run, the
inflation and unemployment trade-off is non-existent since the long run is associated with full
employment hence any attempt to increase aggregate demand will only accelerate inflation
without changing NAIRU.
The Non-Accelerating Inflation Rate of Unemployment (NAIRU)
At this moment, it is important to get into detail with NAIRU. At any given time in an economy,
there is a certain level of unemployment which is associated with a stable or non-accelerating
inflation rate (NAIRU). NAIRU usually ranges between 3 to 5 percent.
Changes in NAIRU
Anything that influences the productive capacity or aggregate supply of the economy affects
NAIRU. Recap that any factor that decreases the cost of production increases aggregate supply
and vice-versa. Equally, any factor that increases the aggregate supply reduces NAIRU since it
increases the possibility of producers making more profit without need to increase prices by
increasing output and hence lowering unemployment. Therefore, supply side policies reduces
NAIRU since they do not exert an upward pressure on prices unlike monetary and fiscal policies.
Monetary and fiscal policies on their own do not have an impact on NAIRU as they are
associated with accelerating inflation. Therefore, supply side policies must be implemented
before using monetary and fiscal policies in order to reduce unemployment without accelerating
inflation.
Short Run Philips Curve (SRPC)
The graph below shows the SRPC. The vertical axis measures inflation and the horizontal axis
measures unemployment. We shall assume a NAIRU of 3 percent as the original position of an
economy at a given point in time.

Using fiscal or monetary policy to reduce unemployment below NAIRU come at a cost of a
higher inflation rate. From the graph, lowering unemployment from 3% to 3% will cause
inflation to accelerate by 6%. A further reduction to 1% will accelerate inflation further by 4%.

The Long Run Philips Curve or Expectations Augmented Philips Curve

The LRPC
The Money Market
Just like the market for goods and services, we have the market for money. This means that we
have the demand for and the supply of money. The relevant price in the money market is the
interest rate which can be defined as the price of money or the opportunity cost of holding
money instead of an interest bearing asset like a government bond or Treasury bill. Therefore,
the interest rate is the reward one gets for providing or supplying money.
Money Supply
Money supply is the quantity of money circulating within the economy and it can be measured in
different ways. The measures of money supply include the monetary base, narrow money and
broad money.
The Monetary Base
This measure includes notes, coins and reserves of banks held by the central bank.
Narrow Money
This includes notes, coins and current deposits with banking institutions.
Broad Money
It includes notes, coins and all the deposits with banking institutions.
Sources of Money Supply
Money Creation by Commercial Banks
The fractional system allows for banks to create money through the money multiplier. Fractional
system requires banks to deposit a certain percentage of their deposits with the central bank as
reserves known as the cash ratio and are free to loan out the excess funds. The money multiplier
implies that through the fractional system, an initial deposit can generate successive rounds of
deposits hence the multiplier effect. The total quantity of money that the commercial banking
system can create is illustrated below.
1
M= × Initial deposit
CR
Where M is the money supply and CR is the cash ratio.
Net Currency Flows
This involves the movement of money into and out of the country. This is seen from the balance
of payment position of a country. If the net currency flow is positive (net currency inflow),
money supply increases and vice-versa.
Quantitative Easing
This is when the central bank purchases bonds from the public thereby increasing money
circulating in the economy.
Central Bank Action
The actions of the central bank through the monetary policy has an influence on money supply.
For instance, a change in the cash ratio or central bank interest rate.
The Quantity Theory of Money
It is a theory that relates money supply to the price level through the equation of exchange as
illustrated below.
MV = PQ
Money supply (M) is the total quantity of money in an economy
Velocity of circulation (V) is the rate at which a unit of money changes hands in a given period
of time. For instance, we can consider a two person economy in which we have a dairy farmer
and an ice cream making firm. If the dairy farmer and an ice cream maker exchanges a unit of
currency in their two mutually beneficial transactions then the velocity of circulation in that
particular week would be equal to two. This is because at first, the ice cream maker could use a
unit of the currency to purchase milk for his ice cream production and it is also possible that on
that same week the farmer could use the same unit of a currency to buy ice cream hence that unit
of money would have changed hands twice, precisely.
The equation states that at any point in time, the product of money supply and the velocity of
circulation is equal to the value of output produced in an economy as measured by the product of
price level an output. The velocity of circulation and output are assumed to be fixed in the
equation of exchange such that a growth or increase in money supply translate into a
proportionate growth in the price level. According to the quantity theory of money, this happens
with a lag. The reasoning behind the proposed relationship is that money is used to make
transactions that is to purchase goods and services. Hence a rise in money supply triggers
monetary inflation. Therefore, the equation of exchanges depicts a long run relationship. For
instance, due to the existence of legally binding contracts, it takes a bit of time for economic
players to make adjustments in prices and wages following increased money supply through the
printing of new notes by the central bank even though they might have formulated increased
inflation expectations quite earlier. As a result the quantity theory of money is a long run
analysis.
Nonetheless, there are some criticisms that have been levelled against the quantity theory of
money. In particular, in terms of the time lag, the theory provides a range of 12 to 18 months and
not a specific time period for the supposed relationship between money supply and the price
level. More so, the equation of exchange has been regarded as rather an identity and not an
equation. Additionally, the velocity of money is not always fixed and it is influenced by a
number of factors such as technological changes. Hence it is a lot less likely to be fixed in the
long run. Further, the theory does not provide a basis for determining full employment output but
simply stress that there is a full employment or potential level of output. Moreover, the theory
overlooks other uses of money such as storing value by only emphasizing the need to make
transactions or payments.