Economics Online Tutor
Keynesian and Monetarist Points
of View
With an Introduction to the
Classical 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 all
about.  Learning the history behind the debate is probably the best way to learn what the debate is about.  
So this analysis begins with the historical background:

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:

The unemployment created by a recession would mean that an excess labor supply exists in the
economy.  This excess labor supply would drive down the wage rates, and lower aggregate demand
would drive down the overall price level.  With lower prices, consumers would 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 would be no need for government
interference in the economy because the economy would 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 at
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 them 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, ever 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.  He 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 would redistribute wealth from the “idle” classes
to the “active” classes, including businesses.  This would ensure 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 in any way anti-capitalist or socialist.  He believed
strongly in capitalism.  He just 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.

That brings us to the current debate between the Keynesian philosophy and the Monetarist philosophy.  
The basic difference is already mentioned above, but what follows is a look at some of the details of the
differences in points of view:

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

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

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.
Economic Schools of

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17, 2012
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