Keynesian Monetarist Monetarism Theory

Monetarism, Keynesian Monetarist, Monetarist Economics Theory

Throughout the 1950s and 1960s, the primary foil to the Keynesians was the monetarists. Under the leadership of Milton Friedman, they provided an effective opposition to Keynesian policy and theory. The consumption function model used by Keynesians in the 1950s had no role for money, nor did it consider prices or the price level. This initial lack of concern about money supply and prices manifested itself in policy based on Keynesian analysis. In an agreement with the Treasury that developed during World War II, the Federal Reserve Bank agreed to buy whatever bonds were necessary to maintain the interest rate at a fixed level. In so doing, the Fed relinquished all control of the money supply. Monetarists argued that the money supply played an important role in the economy and should not be limited to a role of holding the interest rate constant. Thus, the rallying cry for early monetarists was that money mattered.

Keynesians were soon willing to concur with the monetarists that money mattered, but they felt that the monetarists differed from them in believing that only money mattered. The debate was resolved by means of the IS-LM Keynes-ian-neoclassical synthesis, in which the monetarists assumed a highly inelastic LM curve and Keynesians assumed a highly elastic LM curve. Thus, at least in terms of the textbook presentation, monetarist and Keynesian analyses came together in the general neo-Keynesian IS-LM model, about which they differed slightly on some parameters.

Modern macroeconomics was a result of economists working through the neo-Keynesian model and discovering many problems, some purely theoretical, and some becoming apparent as neo-Keynesian policy failed.

Problems with IS-LM Analysis

IS-LM analysis remains part of most macroeconomists' toolbox; it provides the framework most economists initially use in tackling macroeconomic analysis. By the 1960s, however, it had been well explored in the literature and found wanting in several ways. First, it forced the analysis into a comparative static equilibrium framework. In the view of many economists, Keynes's analysis concerned—or should have concerned—speeds of adjustment. They believed that Keynes was arguing that the income adjustment mechanism (the multiplier) occurred faster than the price or interest rate adjustment mechanisms. Comparative static analysis lost that aspect of Keynes.

Second, in IS-LM analysis the interrelationship between the real and nominal sectors had to occur through the interest rate and could not occur through other channels. Monetarists were unhappy with this because they thought money could affect the economy through several channels. Many Keynesians were unhappy with the framework because it shed little light on the problem of inflation, which in the 1960s was beginning to be seen as a serious economic problem. Third, the demand for money analysis used to derive the LM curve was not based on a general equilibrium model; instead, it was assumed in a rather ad hoc fashion. It had not truly integrated the nominal and real sectors. Because it did not capture the true role of money and the financial sector, it trivialized their function. It made it seem as if a fall in the price level could bring about an equilibrium, when in fact most economists believed that a falling price level would make matters worse, not better. Nonetheless, the IS-LM model was adopted. It was neat, it served its pedagogical function well, it was a rough and ready tool, it provided generally correct insight into the economy, and it was the best model available. Dissatisfaction with existing analysis, however, led many macroeconomists to turn to other models in their research. This led to a dichotomy. While IS-LM analysis remained the key undergraduate model in the 1970s and 1980s, graduate research started to focus on quite different issues. By the early 1990s the change in focus was filtering down to undergraduate courses. Modern theoretical debates in macroeconomics have little to do with the shapes of the IS-LM curves. Instead, they approach macroeconomic issues from a microeco-nomic perspective, and they deal with issues such as the speeds of quantity and price adjustment. In a sense, many macroeconomic researchers in the 1970s and 1980s argued that we should skip the Keynesian IS-LM interval and return to the macroeconomic debate as it existed in the 1930s, when issues were framed in microeconomic terms. Thus, starting in the 1970s we saw a reaction against Keynesian economics.

The Rise of Modern Macroeconomics

Monetarism's focus on inflation brought it to the fore in the 1970s as inflation increased substantially. At this happened, Keynesian policies and theory lost favor. Fiscal policy proved politically too hard to implement; decisions on spending and taxation were made for reasons other than their macroeconomic consequences. Monetary policy became the only game in town, but the Keynesian models did not include the potential inflationary effects of monetary policy and so were not well suited to dealing with discussions of monetary policy. So there was a movement away from Keynesian economic models for formulating policy.

Simultaneously, there was a movement away from the Keynesian models on theoretical grounds. As economists tried to develop the microfoundations for those models, they found that they could not do so within the context of the standard general equilibrium microeconomic approach. This desire for micro-foundations deserves some comment, since it is important in understanding the movement away from neoclassical economics and into modern formalistic eclectic model-building economics.

Keynesian macroeconomics does not fit the neoclassical mold, and thus it can be seen as a step in the direction away from neoclassical and into the eclecticism that characterizes modern economics. It starts with analysis of interrelationships of aggregates rather than developing these relationships from first principles. Thus, it has always had a tenuous theoretical existence, its primary role being as a rough-and-ready guide to policy. Loose microfoundations were added to macroeconomics throughout the 1950s and 1960s where they seemed to fit, but no attempt was made to develop macroeconomics models from first principles. Macroeconomics was simply out there—a separate analysis with little direct connection to the Walrasian theory that was at the core of theoretical microeco­nomics.

The Microfoundations of Macroeconomics

In the 1970s, economists, in trying to fix this problem, began to lay the microfoundations of macroeconomics by attempting to fit the Keynesian models into the neoclassical general equilibrium model. They did this for two reasons: first, for theoretical completeness and, second, to be able to expand the model to include inflation in the analysis. As they did so, they discovered that Keynesian models broke down when normal neoclassical principles were applied to them. Keynesian macroeconomics, the traditional macroeconomics of the textbooks, was inconsistent with the microeconomics being taught.

The microeconomic foundations literature established new ways of looking at unemployment. Whereas Keynesian analysis pictured unemployment as an equilibrium phenomenon in which individuals could not find jobs, the micro-foundations literature pictured unemployment as a temporary phenomenon— the result of the interaction of a flow of workers leaving work and new workers entering. It argued that intersectoral flows were an important cause of unem­ployment and that these flows were the natural result of dynamic economic processes. For the new microfoundations approach to macroeconomics, unem­ployment was a microeconomic, not a macroeconomic, issue.

Microfoundations economists argued that to understand unemployment and inflation economists must look at individuals' and firms' microeconomic deci­sions and relate those decisions to macroeconomic phenomena. Search theory, the study of an individual's optimal choice under uncertainty, became a central topic of macroeconomics, as did a variety of new dynamic adjustment models. As researchers began focusing more and more on these models, they focused less and less on IS-LM models. The initial microfoundations models had been partial equilibrium models, but once the microfoundations box was opened, economists needed to derive some method of combining the various markets. The obvious choice was to use general equilibrium models. Thus, general equilibrium analysis, which we saw in Chapter 14 had become the central model of microeconomics, was ushered into macroeconomics along with microfoundations literature.

Microfoundations literature was cemented into the profession's consciousness in the early 1970s by its accurate prediction about inflation. Advocates of the microfoundations approach argued on theoretical grounds that the Phillips curve—a curve showing a tradeoff between inflation and unemployment—was only a short-term phenomenon and that, once the inflation became built into expectations, the unemployment-inflation tradeoff would disappear. The long-run Phillips curve would be close to vertical and the economy would gravitate toward a natural rate of unemployment.

The policy implications of the new microfoundations approach were rela­tively strong. Its analyses removed the potential for government to affect the natural rate of long-run unemployment through expansionary monetary and fiscal policy. Attempts to do so would work in the short run by temporarily fooling workers, but expansionary policy would simply cause inflation in the long run. According to the new microeconomics, government's attempt to reduce unemployment below its natural rate was the cause of inflation in the late 1970s.

Keynesian monetary and fiscal policies were not, however, completely ruled out. In theory, at least, they could still be used temporarily to smooth out cycles. Thus, in the early 1970s a compromise arose between Keynesians and the advocates of a microfoundations approach to macroeconomics economics: in the long run the classical .model is correct; the economy will gravitate to its natural rate. In the short run, however, because individuals are assumed to adjust their expectations slowly, Keynesian policies can have some effect.