Classical economic theory assumed that a ‘free-market’ economy is a ‘self-regulating’ system that continually tends toward a full-employment equilibrium, with optimum economic benefits for everyone. Therefore, the best government economic policy is to ‘excuse itself’ and give utmost freedom to individual enterprise. A key element of the ‘Keynesian revolution’ was its demonstration that these basic assumptions are false, both in theory and practice, and its assertion that, therefore, the most appropriate government macro-economic policy is to view the whole economy as if it were a single huge business enterprise which needs to be managed as one.
In any individual business enterprise, a basic tool of management is the accounting system, which enables management to analyze its operation and performance.
Keynes rejected the view, (Adam Smith) that if left alone the ‘invisible hand’ will work on it’s own accord. Instead he argued that “in a barter economy, in a monetary economy, decisions to demand and decisions to supply were made by different persons-they are unlinked,” (Walker). Thus they might not be the same. There is a need for management of the decisions, and there might be a management failure that could result in excess supply.
Keynes saw the possibility of this arising from circular cycle such as this, where demand depends upon income. But income in turn depends upon expenditure. Thus, income is expenditure: in our market economy, every dollar of income comes from somebody’s spending. But expenditure in turn depends on demand. Thus he imposed that this might tentatively account for depressions whereas: “low income produces low demand produces low expenditure produces low income.” This sounds like circular interpretation, but Keynes argued that it is the causation that is circular. Keynes plan was to explain unemployment in terms of circular cycle: “from income to expenditure and back to income.” Thus, Keynes’ theory is a model of equilibrium income and expenditure–model of ‘income-expenditure.’ But as in every great achievement, there is always opposition.
From the late 1950s, a group of economists known as the Monetarists successfully engaged their Keynesian opponents in a macroeconomic statistical race. Subsequently, faith in competition rose, while faith in Keynesian economics fell. “Although, one can argue that it did little more than open the door through which the true counter-revolutionaries, the New Classicals slipped in,” (Will). Amazingly, some of its adversaries that challenged the intellectual claims of the Monetarist controversy – bearing in mind, it were these experimental issues opposed to the theoretical issues, which divided Monetarists from Keynesians. Nevertheless, the biggest guns of Keynesian macroeconomics (Robert Solow, James Tobin, and many more) that came out to combat a single man with some very compelling ideas, Milton Friedman. Despite the fact that, at this time it would be hard to find any single economist, who did not have an opinion on theories.
Monetarism is acknowledged as a Neoclassical “counter-revolution” to the prevailing Keynesian Revolution. Friedman ‘s model explores the ‘internal’ logic of these developments by examining the sociology of economic knowledge construction and destruction. From here Monetarism was a powerful intellectual revolution, which has left an indelible imprint on macroeconomics and economic policy forever. Or was it just a fad? Whatever your conclusion, there can be no doubt that the “Monetarist counter-revolution” that raged in economics has been one of the most fervently contested battles in ‘modern’ economics.
The great “counter-revolutionary” contribution was the introduction of the natural rate hypothesis by Friedman and Phelps. More specifically, it led to the interpretation of other ‘anti-Keynesian’ contributions by the Monetarists, such as the Phillips Curve and the “St. Louis” equations. It is these contradictions to Keynesian equations used to analyze macroeconomic policy, such as the money-income dilemma, money supply model, the development of the Phillips Curve, and the advocacy of a disinflation policy, that were acutely precarious for Keynesian theory. On the other hand it has been mentioned, that without the natural rate hypothesis that this would be inconsequential. Above all it was the Monetarist’s natural rate hypothesis that served as the barrel pillory for the Neo-Keynesian system; and it is from this that the modern classical economics was born, and by this held together.
Keynes Income Expenditure Model had great opposition; the Monetarist devoted their entirety to disproving this Keynesian theory. The Keynes’ basic income-expenditure model suggests that it is the key to understanding macroeconomic problems in the market for goods and services, but when analyzed this model completely ignores other crucial aspects of economics. It is these basic characteristics that deliberation of policies arose:
1.“Keynesians believe that the interest rate, largely, if not wholly, a monetary phenomenon, is determined by the supply of and demand for money. Monetarists believe that the interest rate, largely a real phenomenon, is determined by the supply of and demand for loanable funds, a market, which faithfully reflects actual opportunities and constraints in the investment sector.
2.In the Keynesian vision, a change in the interest rate has little effect on (aggregate) investment; in the Monetarist vision, a change in the interest rate has a substantial effect on (aggregate) investment. This difference reflects, in large part, the short-run orientation of Keynesians and the long-run orientation of Monetarists.
3.Keynesians conceive of a narrowly channeled mechanism through which monetary policy affects national income. Specifically, money creation lowers the interest rate, which stimulates investment and hence employment, which, in turn, give rise to multiple rounds of increased spending and increased real income. Whereas the Monetarists conceive of an extremely broad-based market mechanism through which money creation stimulates spending in all directions-on old as well as new investment goods, on real as well as financial assets, on consumption goods as well as investment goods.
4.Keynesians believe that long-run expectations, which have no basis in reality in any case, are subject to unexpected change. Economic prosperity is based on baseless optimism; economic depression, on baseless pessimism. Monetarists believe that profit expectations reflect, by and large, consumer preferences, resource constraints, and technological factors as they actually exist.
5.Keynesians believe that economic downturns are attributable to instabilities characteristic of a market economy. A sudden collapse in the demand for investment funds, triggered by an irrational and unexplainable loss of confidence in the business community, is followed by multiple rounds of decreased spending and income. Monetarists believe that economic downturns are attributable to inept or misguided monetary policy. And unprovoked monetary reduction puts downward pressure on incomes and on the level of output.
6.Keynesians believe that in conditions of economy-wide unemployment, idle factories, and unsold merchandise, price and wages will not adjust downward to their market-clearing levels-or that they will not adjust quickly enough. Monetarists believe that prices and wages can and will adjust to market conditions, and leading the Monetarists’ to advocating for no governmental intervention. A market process that adjusts prices and wages to existing market conditions is preferable to a government policy that attempts to adjust market conditions to existing prices and wages,” (Walker).
Within the context of this income-expenditure analysis, it is appropriate to think of Friedman’s Monetarism as being directly opposed to Keynesians. Although both Keynesians and Monetarists accept the same high level of aggregation, they have sharp disagreements about the nature of the relationships among these macroeconomic issues.
Walker, Ken. Walker, Marcus, ed. A Crucial Review of Economic Theory. New York: Terian Publishers, 1991.
Will, Jeremy. Analysis of Historical Economic Policies. New York: Free Press, 1988.