WEBSITES RELEVANT TO CHAPTERS 14 AND 15
16.4 THE MONETARIST–KEYNESIAN DEBATE
Stagflation A term used in the 1970s to refer to the combination of stagnation (low growth and high unemployment) and high inflation.
Definition
Figure 16.9 The monetarist version of the long-run Phillips curve
monetarists). In the short run, higher aggregate demand will reduce unemployment below the natural level, but in the long run, once expectations have adjusted, all the extra demand is absorbed in higher inflation. Unemployment thus rises back to the natural rate.
If unemployment is to be reduced in the long run, there- fore, this vertical Phillips curve must be shifted to the left.
This will be achieved by a reduction in the natural (equilib- rium) rate of unemployment (Un), not by an increase in demand. To reduce the natural rate, argued the monet- arists, supply-side policies would be needed.
Give some examples of supply-side policies that would help to reduce the natural rate of unemployment.
Government policies
Governments up to the late 1970s responded to rising unemployment by boosting aggregate demand (the balance of payments permitting). This, however, as the monetarists predicted, led only to more inflation, fuelled by rising ex- pectations of inflation.
When governments eventually did curb the growth in aggregate demand, as the Thatcher government did after 1979, it took time for expectations to adjust downwards.
In the meantime, there was a further temporary rise in unemployment due to wage rises being slow to moderate.
Nevertheless the pursuit of these policies did, accord- ing to monetarists, lead to a dramatic fall in the rate of inflation, and eventually the rise in unemployment was reversed.
The other crucial aspect of government policy in the 1980s, in both the UK and the USA, and increasingly in other countries, was increased reliance on the market.
Policies of privatisation and deregulation were pursued;
union power was curbed; and tax rates were cut. Controls over the financial system were reduced, as we shall see in Chapter 18, with banks given much more freedom to expand their activities. This ‘supply-side’ revolution was designed to increase incentives to work, to invest and to innovate. We explore these market-orientated supply-side policies in Chapter 23.
The Keynesian response
Keynesians agreed with monetarists on one point. If demand is expanded too fast and for too long, inflation will result – and there will be a certain amount of unemploy- ment of labour (and other resources too) that cannot be eliminated simply by expanding aggregate demand.
In other respects, Keynesians differed markedly from monetarists.
Inflation
Inflation, they claimed, was not just a problem of excess demand (caused by too much money). It was also caused by
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increased cost-push pressures: the increasing concentra- tion of economic power in large multinational companies and large trade unions, and the large oil price increases of 1973/4 and 1978/9.
Also, workers had come to expect real wage increases each year, which could simply not be met from real increases in national income. The problem here for the long term was not so much the expectations of price increases, but rather the expectations of increases in real living standards.
Unemployment
Keynesians blamed a deficiency of aggregate demand for the massive rise in unemployment in the 1980s. Aggregate supply was highly elastic downwards in response to a reduction in aggregate demand. Firms responded to falling demand by producing less and employing fewer people.
This was further aggravated by firms running down stocks to try to reduce costs and maintain profits.
Expectations are relevant here. But, when aggregate demand is reduced, it is not so much the expectation of lower inflation that reduces inflation (as monetarists claim);
rather it is the expectation of lower sales that reduces production, investment and employment. The problem is not merely a short-term difficulty that markets will soon correct. Unless the government adopts a deliberate policy of reflation, the problem may continue. Business confidence may not return. Mass unemployment and recession may persist.
But why, when the world economy boomed in the late 1980s, did unemployment not return to the low levels of the 1970s? In the late 1980s there was little or no deficiency of demand, and yet unemployment fell only slightly. Now the problem was not one of stagflation (a stagnant eco- nomy with high inflation). Now the problem was one of a booming economy but with persistently high unemploy- ment. Keynesians typically offered two explanations of the persistence of unemployment.
Structural problems. The 1980s saw an acceleration in the decline of certain industries, a large-scale shift away from labour-intensive processes in manufacturing, an informa- tion technology revolution, a programme of privatisation, a more openly competitive world economy and campaigns by both governments and firms against overstaffing.
The result was a large increase in equilibrium (structural) unemployment.
Hysteresis. The huge rise in unemployment in the early 1980s throughout the industrialised world, although largely caused by a lack of demand, could not simply be reversed by a rise in demand. The recession had itself caused higher levels of unemployment to become embedded in the economy.
Many people had become deskilled and firms had become more cautious about taking on workers, preferring to manage with a smaller, more efficient workforce. What
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is more, people who remained employed (the insiders) were often able, through their unions or close relationships with their employers, or because of the possession of specific skills, to secure wage increases for themselves, and prevent the unemployed (the outsiders) from competing wages down. The insiders preferred to secure higher wages for themselves, rather than to have a larger number employed but with everyone on lower wages.
This continuation of high unemployment is known as hysteresis. This term, used in physics, refers to the lagging or persistence of an effect, even when the initial cause has been removed. In our context, it refers to the persistence of unemployment even when the initial demand deficiency no longer exists.
Keynesian criticisms of monetarism
Keynesians criticised monetarists for putting too much reliance on markets. The problems of inflation, unemploy- ment and industrial decline were much too deep-seated and complex to be rectified by a simple reliance on control- ling the money supply and then leaving private enterprise and labour to respond to unregulated market forces.
Free markets are often highly imperfect and will not lead to an optimum allocation of resources. What is more, markets frequently reflect short-term speculative move- ments of demand and supply, and do not give a clear indi- cation of long-term costs and benefits. In particular, the stock market, the money market and the foreign exchange market can respond quite violently to short-term pressures.
Such fluctuations can be very damaging to investment. For example, violent swings in exchange rates, as experienced between the euro and the dollar in the early 2000s (see Box 25.5), can dissuade firms from making long-term invest- ment decisions to develop export markets. A sudden rise in exchange rates may make it impossible to compete abroad, even though at a lower exchange rate an exporter could have made a large profit.
The fluctuations inherent in free markets cause un- certainty about future demand, supply and prices. This uncertainty reduces investment and hence reduces growth.
Government, therefore, should intervene much more to stimulate growth and investment.
Keynesian policy proposals
Keynesians generally favour a much more interventionist approach to policy than do monetarists. The following policies are typical of those favoured by Keynesians.
Maintaining a high and stable level of aggregate demand. A substantial increase in demand may be necessary if the economy is in danger of falling into deep recession, as was the case in 2008/9. The best way of achieving this is for the government to increase its expenditure on public works such as roads and housing, since these projects have a relatively low import content and therefore increased expenditure does not lead to balance of payments prob- lems. Thereafter the government should maintain a high and stable demand, by appropriate demand-management policies. This should keep unemployment down and set the environment for long-term investment and growth.
Stabilising exchange rates. To reduce uncertainties, the cen- tral bank should intervene in foreign exchange markets to prevent excessive short-term fluctuations in exchange rates.
This might involve international co-operation between central banks. More stable rates will encourage investment and growth.
Greater co-operation between government and industry. To promote long-term growth and to avoid the uncertainties of the market, the government should work much more closely with industry. This might involve the govern- ment helping to co-ordinate the plans of interdependent sectors of industry (such as the power and transport indus- tries) and channelling finance to the more promising industries.
Structural policies. To reduce structural unemployment the government should pursue regional and urban policies through grants, tax relief and direct infrastructure invest- ment in areas of high unemployment. This, it is argued, will encourage firms to move to such areas. Also, the gov- ernment should pursue retraining policies to encourage greater occupational mobility of labour.
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Insiders Those in employment who can use their privileged position (either as members of unions or because of specific skills) to secure pay rises despite an excess supply of labour (unemployment).
OutsidersThose out of work or employed on a casual, part-time or short-term basis, who have little or no power to influence wages or employment.
HysteresisThe persistence of an effect even when the initial cause has ceased to operate. In economics, it refers to the persistence of unemployment even when the demand deficiency that caused it no longer exists.
Definitions
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Section summary
1. Monetarists argued that there is a close correlation between the rate of growth of the money supply and the rate of inflation. Increases in money supply cause increases in aggregate demand, which in turn cause inflation. Along with the classical economists, they argued that output and employment are determined independently of money supply (at least in the long run). This means that a deflationary policy to cure inflation will notin the long run cause a fall in output or a rise in unemployment.
2. Monetarists thus argued that the long-run Phillips curve is vertical. Its position along the horizontal axis will depend on the level of equilibrium or ‘natural’
unemployment.
3. Keynesians rejected the notion of a totally vertical Phillips curve, but did accept that demand-side policies alone cannot cure unemployment completely.
Keynesians blamed the combination of high inflation and high unemployment on a number of factors, each of which has the effect of shifting the Phillips curve to the right. These factors include cost-push and
demand-shift pressures on inflation, and government attempts to cure inflation by continually pursuing deflationary policies.
4. Unemployment caused initially by a recession (a deficiency of demand) may persist even when the economy is recovering. This ‘hysteresis’ may be due to the deskilling of labour, a decline in firms’ capacity, insiders preventing outsiders from bidding down the wage rate, or firms being cautious about taking on extra labour when the recovery does come.
5. Keynesians argued that markets do not clear rapidly and that in the meantime expectations of output and employment changes can have major effects on investment plans.
6. Whereas monetarists generally favoured policies of freeing up markets (within the framework of strict government control over money supply), Keynesians favoured a much more interventionist approach by the government. Central to this is the control of aggregate demand so as to retain actual income as close as possible to its potential level.
A range of views
From the monetarist–Keynesian debates of the 1970s and 1980s has emerged a degree of consensus among many economists that draws on insights from both schools. This is not to suggest, however, that all economists agree. In fact, a whole range of views can be identified.
One simple way of classifying these differing views is to see them falling along a spectrum. At the one end are those who see the free market as working well and who generally blame macroeconomic problems on excessive government intervention. At the other are those who see the free market as fundamentally flawed. Let us identify different views along this spectrum, starting with the pro-free-market end.
The new classical/rational expectations school
The new classical schoolis like an extreme form of monet- arism. New classicists maintain that markets clear very quickly and expectations adjust virtually instantaneously to new situations. These expectations are based on firms’
and workers’ rational assessment of what is happening in
the economy and in their particular sector of it. They may be wrong, but they are just as likely to overpredict as to underpredict the rate of inflation and hence the equilib- rium price in their particular market. On average, they will guess it about right.
Expanding money supply will virtually instantaneously lead to higher expectations of inflation. Therefore it can only cause inflation; it cannot reduce unemployment. The short-run Phillips curve is vertical, as is the long-run one.
Likewise tight monetary policy reduces inflation; it does not increase unemployment. Rising unemployment is entirely due to a rise in the natural rate of unemployment.
If changes in aggregate demand cannot affect output and employment, how do the new classical economists explain the business cycle of booms and recessions? The answer they give is that these cyclical changes in output and employment are the result of shifts in the aggregate supplycurve. These in turn are the result of cycles in tech- nological progress and labour productivity. The theory is therefore known as real business cycle theory. We examine this in section 21.3.