Keynesians and monetarists disagree on almost all issues related to money and its role. Their extreme positions can be summed up like this- the Keynesians hold the view that ‘money does not matter’ as an effective means of demand management; the monetarists, on the contrary, maintain that ‘only money matters’ as an effective means of demand management.
The disagreement is mainly attributable to the fundamental assumptions taken by these economists, (a) The classical economists believe that the economy moves quickly to full potential output with minimum level of unemployment. (b) The monetarists believe this as a long-run proposition but admit that deficiency of demand can cause unemployment in the short period, (c) The Keynesians believe that the short run can last a very long time.
The conflicting views of the Keynesians and the monetarists on the transmission mechanism (i.e., how changes in money supply affect the economic activity) and other theoretical and policy issues are discussed below:
A. Transmission Mechanism – Classical View:
Transmission mechanism or monetary mechanism deals with the problem of causality (causal role) of money. When we say that money plays a causal role, it means that changes in the money stock cause subsequent changes in the price level, nominal income or real variables. Transmission mechanism explains the channels through which money influences the price level, nominal income and the real sector.
The classical writers gave two distinct mechanisms through which changes in the money supply were transmitted to the price level- (a) direct mechanism and (b) indirect mechanism. In the direct mechanism, the classical writers (Hume and Cantillon) showed that whenever actual money balances exceeded those desired, both the money spending and the price level would increase proportionately, so that the level of real output remains unchanged.
In Figure 3, the excess money balances will shift aggregate demand curve from MV to M’V which indicates that the demand for goods and services has increased. This will ultimately result in the proportional rise in the price level from OP0 to OP1. The real output level will remain unchanged at OY level.
In the indirect mechanism, Thornton demonstrated that increase in money supply, by lowering the money- rate of interest relative to the real or natural rate, would create disparity between the actual and desired stock of real capital. This would lead to a higher rate of investment, an increase in money spending and ultimately a rise in the price level.
In Figure 4, the initial equilibrium indicates that the real or natural rate of interest is equal to the money rate of interest (in = im). The money supply is increased by increasing the excess reserves of the commercial banking system. This will increase the supply of loanable hinds from S + M curve to S + M’ curve.
As a result, the money rate of interest falls from im to i’m and there will be an excess of intended investment over intended saving (AB). This disequilibrium is reflected in the commodity market by a rise in aggregate demand from MV curve to M’V curve (as shown in Figure 3). The increase in aggregate demand will lead to a proportionate rise in prices, leaving real output level unchanged. Thus, both direct and indirect mechanism, as used by the classical writers, exerts a transitory effect on real variables and a permanent effect on the general level of prices.
B. Transmission Mechanism – Keynesian View:
In order to explain and compare the transmission process in the Keynesian and monetarist approaches, we start with the assumptions that- (a) the economy is in the initial equilibrium situation in which both money and goods markets are both in equilibrium; (b) this is less-than-full employment situation; and (c) the central bank carries out an open market purchase of securities in order to achieve the objective of full employment.
Keynes, in his book ‘The General Theory’, presented an indirect mechanism through which changes in money cause changes in the economy. Changes in the money supply via interest rate movements set in motion variations in investment expenditure, which are further amplified through the process of multiplier.
Later on, during 1950’s and 60’s, the neo-Keynesians, like W.L. Smith, J. Tobin, extensively refined the transmission mechanism in which more asset categories were added to the primitive money-bond portfolio model of Keynes.
Nevertheless, the original and basic nature of the Keynesian transmission mechanism remains unaffected. In the modern or neo-Keynesian approach, the effect of changes in money supply is transmitted to the real sector of the economy through- (a) initial effects and (b) secondary effects.
(a) Initial Effects:
The initial effects operate through the portfolio adjustment process.
The following initial effects can be identified:
(i) Immediate Effects:
There are two immediate effects of the open market purchase of securities by the central bank:
a. For the open market purchase to be carried out, the central bank has to bid up the price of the securities. Thus, the price of the securities will increase and its yield (the interest rate) will fall.
b. The liquidity position of whoever sells the securities, whether it be the public or the commercial banks, will increase.
(ii) Substitution Effects:
The sellers of securities to the central bank now possess excess money balances, i.e., they hold more money than they desire. As a result, they try to readjust their asset portfolios in order to reduce their surplus money balances.
Thus, there will be a tendency to replace the newly acquired non-interest-earning asset (i.e., money) with other interest-earning assets (e.g., stock and bonds). This process of portfolio substitution (i.e., increase in the financial assets) will further increase the prices of securities and reduce their interest rates in general.
(iii) Wealth Effects:
According to the Keynesians, no direct wealth effect is involved in the central bank’s open market purchase of securities because such a purchase merely exchanges one asset (money) for another (bonds). However, the open market operation does involve an indirect wealth effect. When the central bank purchases the securities, it leads to a decline in the market interest rates.
This produces a wealth effect which results from the fact that at a lower interest rate the present or capitalised value of the expected income stream of financial or real capital assets will increase. As the people feel wealthier, they tend to buy more of all assets in their portfolios and also increase their purchase of consumer durables.
(iv) Credit Availability Effects:
When the central bank purchases the securities from the commercial banks, it causes an increase in the total reserves and excess reserves of these banks. The creation of excess reserves has the potential for multiple credit expansion. The expansion of bank credit results in an increase in the money supply.
(b) Secondary Effects:
The initial impact of the monetary policy (i.e., substitution effects, wealth effects and credit availability effects) will generate secondary effects in the real sector. The lower rate of interest and the greater availability of bank credit will increase the level of investment spending, depending upon the interest elasticity of marginal efficiency of investment curve. The increase in investment spending, through multiplier process, will generate higher levels of income and induce consumption expenditure in the economy.
C. Transmission Mechanism – Monetarist View:
According to the monetarists, the transmission mechanism initiated by an increase in money supply involves wealth and substitution effects.
These effects are discussed below:
I. Immediate Effects:
As far as the immediate effect of open market operation is concerned, there is no difference between the Keynesians and the monetarists.
The immediate effect of the open market purchase of securities by the central bank is two-fold:
(a) It raises the security price and lowers the rate of interest;
(b) It increases the liquidity of those who sell the securities.
The difference between the two schools arises in wealth and substitution effects.
II. Wealth Effects:
According to the monetarists, the open market operation may produce two types of wealth effects:
(a) Direct wealth effect and
(b) Indirect wealth effect.
An open market operation which exchanges money for securities increases the nominal wealth of society. This is direct wealth effect. A fall in the rate of interest raises the market value of the existing capital stock, thereby raising the nominal wealth of the society.
This is indirect wealth effect. As a result of both these wealth effects, net nominal wealth causes increase in investment and consumption spending.
III. Substitution Effect:
The increase in the nominal wealth of the society leads to the adjustments in the total portfolio of assets, i.e., to the rearrangement of real as well as financial assets. In other words, people with greater nominal wealth tend to purchase all types of assets. The first impact may be on goods rather than on securities.
People with greater wealth and influenced by the change in the relative prices of the assets, first tend to increase their money expenditures on consumption and investment. As the prices of financial assets rise due to the fall in the rate of interest, real assets become more attractive because of their relatively lower prices. Thus, the households will spend their excess money expenditures on consumer goods and the businessmen on capital goods.
As a consequence of increase in demand for existing real assets, their prices rise and they become expensive relative to new real assets. There is thus generated an increase in demand for new real assets. This, in turn, stimulates investment and production of new goods. Thus, the substitution into real assets is the result of the fact that yields on financial assets have fallen relative to the expected yields on real assets.
Views on Transmission Mechanism Compared:
The Keynesian view and the monetarist view on transmission mechanism are compared in the following chart:
In the Keynesian analysis, the open market purchase of securities by the central bank reduces the rate of interest and increases the liquidity, with the sellers of securities. Attempts to rearrange portfolios further reduce the rate of interest.
This decline in the interest rate leads to increase in investment spending which ultimately leads to further increase in aggregate spending for both consumption and investment. Increases in the availability of bank credit and the supply of money, due to increase in bank liquidity, serve to support and reinforce the upward expansion started by the initial increase in investment spending.
In the monetarist analysis, the initial fall in the interest rate and increase in general liquidity, as a result of open market purchase of securities by the central bank, leads to the readjustment of real as well as financial assets depending upon change in relative prices of the assets.
As prices of financial assets rise due to the fall in the interest rate, the demand for real assets increases because they become cheaper. Thus, increase in general liquidity or money balances, as a result of sale of securities to the central bank, increases the nominal wealth of the society, which in turn increases the expenditures on consumption and investment.
To sum up, the basic difference between the Keynesian approach and the monetarist approach is that while in the Keynesian approach the initial interest rate adjustment is essentially a financial one which then leads to an increase in investment and aggregate spending, in the monetarist approach, the adjustment process essentially takes place simultaneously in both the money market and the goods market.
Figure-5A illustrates graphically the Keynesian approach to the transmission mechanism. E0 is the initial equilibrium point, indicating OY0 income level and Oi0 rate of interest. As money supply increases, it causes a rightward shift in the LM curve (from LM0 to LM1).
As a result of portfolio adjustment process in the money market, the rate of interest falls, which leads to an increase in investment spending, given the interest elasticity of marginal efficiency of investment schedule. This is indicated by a movement down and along the IS curve from point E0 to E1.
The change from initial equilibrium E0 to the final equilibrium E1 is thus the joint result of the rightward shift of the LM curve (money market liquidity effect indicating an increase in money supply and decline in interest rate) and the movement along the IS curve (goods market income effect indicating an increase in investment and income). Ultimately, the income level increases from OY0 to OY1 and the rate of interest falls from OI0 to OI1.
What happens to the rate of interest? If we assume that immediately after the increase in money supply the income level will remain unchanged and the increased money supply will lead only to a reduction in the rate of interest, then the economy will move from E0 to E’1 and the rate of interest will initially fall from Oi0 to Oi’1.
Now point E’1 does not represent an equilibrium position. Although it is on the LM curve where money demand equals money supply, but it is not on the IS curve and hence investment is not equal to saving.
The fall in the interest rate means that desired investment is greater than saving. As a result income will increase and the interest rate will rise and the economy will move up along the new LM1 curve from E’1 to E1.
Thus, according to the Keynesians the initial decline in the rate of interest (from Oi0 to Oi’1) will be sharper than the ultimate response (the final equilibrium rate Oi’1). However, the negative slope of the IS curve indicates that in the traditional Keynesian model the equilibrium rate after an increase in money supply (Oi1) must be below the old rate (Oi0). In other words, the income effect of reduced interest rate cannot fully offset the liquidity effect of the increased money supply.
In Figure-5B, movement from E0 to E1 summarises the monetarist approach. The impact of an open market purchase of securities and an increase in the supply of money not only involves a rightward shift of the LM curve from LM0 to LM1 but also an induced shift in the IS curve from IS0 to IS1. The LM curve has shifted to the right, just as it did in the Keynesian analysis.
But the monetary disturbance ‘spills over’ into the goods market and induces a right ward shift in the IS curve too. Thus, there is simultaneous rightward shift in both LM and IS curves. This leads to a greater increase in income in the monetarist adjustment process (Y0Y1) than that expected through the Keynesian adjustment process (Y0 Y1).
Issues Related to Transmission Mechanism:
Keynesian and Monetarist views on the various specific issues related to the transmission mechanism are given below:
I. Effect of Excess Balance:
The public may hold more money than it wants to hold. These excess money balances may be caused- (a) by the increase in money supply by the central bank; or (b) by the increase in the velocity of money; or (c) by the increase in the determinants of the quantity of money demanded; or (d) by the increase in all the three. What the public will do with these excess money balances?
According to the Keynesians, the excess money balances lead the public initially to increase the purchase of financial assets (such as stocks and bonds). This increased purchase will increase the prices of such assets and lower their yields (interest rate).
Lower interest rates increase the quantity of money demanded for speculative purposes. This process will continue until the money stock and the quantity of money demanded are equated. Fall in the interest rates also increases investment. To the extent that interest rates fall and to the extent that the investment is responsive to the decline in the interest rates, the excess money balances can affect aggregate demand, and thereby increase national income, and the demand for money for transaction and precautionary purchases.
According to the monetarists, the excess balances can be spent directly on real assets. The households will spend on consumer goods and the businesses on the capital goods. These expenditures on the real assets cause national income to rise and demand for money for transaction and precautionary motives to increase. This process will continue until the stock of money and the quantity of money demanded are equated.
II. Effect on Rate of Interest:
What is the effect of change in the money supply on the rate of interest? The Keynesian and the monetarist replies to this question are explained through Figure- 6A & B. According to the Keynesians, the interest rate varies inversely with money supply changes; an increase in money supply reduces interest rate and vice versa.
In Figure-6A, an increase in money supply from M to M’ provides additional liquidity and the interest rate falls from Oi to Oi1.
The monetarists accept the Keynesian view only as a short period explanation. In the long run, however, an increase in the money supply leads to an increase in the demand for money. As the additional money is spent on goods and services, national income rises and the higher national income level causes an increase in the demand for money for transactions and precautionary purposes.
Thus, in the long run, the nominal interest rate will rise back to its previous level. In Figure-6 B, an excess in the money supply from M to M’ in the short run may reduce the rate of interest from Oi to Oi1, given the demand for money (L). But, in the long run, the demand for money also rises from L to L’ because of increase in nominal income. Thus, eventually, the interest rate rises to its former level Oi.
3. Effect of Government Expenditure:
Keynesians maintain that an increase in government spending (e.g. financed by borrowing from public) causes an expansion in the national income and employment. Increased borrowing will increase the interest rate which, in turn, will reduce the demand for money for speculative purpose and thus permit increased spending.
Monetarists, on the other hand, believe that the net effect of the government spending financed by borrowing will be very small. Higher interest rates, as a result of public borrowing crowd out private investment and consumption, and thus there will be slight or no effect on income and employment.
4. Wealth Effect:
In the Keynesian approach, open market purchase of securities has no direct wealth effect. It only produces a wealth effect indirectly through a fall in the interest rate. In the monetarist approach, the open market purchase produces a direct wealth effect by increasing the nominal wealth of the society.
5. Multiplier Effect:
In the Keynesian approach, the new investment spending on either producer or consumer durables, as a result of a fall in the interest rates, produces via the multiplier process a rise in disposable income. This in turn increases spending on consumer non-durable goods.
In the monetarist approach, there is no mention of the multiplier process. Moreover, consumer spending on non-durables may precede spending on producer and consumer durables, depending upon how the money supply is increased.
6. Demand for Money:
In the Keynesian approach, money is demanded for transaction, precautionary and speculative motives. In the monetarist approach, money is demanded because it is an asset. Money is considered as a commodity which, like any other commodity, provides utility to its holder.
7. Nature of Transmission Mechanism:
In the Keynesian approach, the transmission mechanism (i.e., the mechanism explain how money is supposed to work out its influence) can be described in a detailed and systematic manner.
The monetarists, on the other hand believe that the transmission mechanism is so complicated as a to make its detailed description impossible. Whether the reaction of increase in money balances is manifested sooner in investment expenditures or in consumption expenditures, whether the major quantitative effect is on one or the other, whether the effect is mostly in prices or quantities, what the initial and subsequent impacts are on the interest rates.
All these matters depend upon- (a) the speed with which the economic participants react; (b) the technical problems involved in readjusting various categories of expenditures; and (c) the state of supply conditions.
8. Usefulness of IS-LM Curves:
The Keynesians and the monetarists also differ on the usefulness of IS-LM curves in explaining transmission mechanism. So long as the substitution effect alone is considered (as is done in the Keynesian analysis), IS-LM curves can be used to describe the transmission mechanism because these curves remain independent of each other.
But, once wealth effect is considered (as is done in the monetarist analysis), the transmission mechanism becomes too complex to be explained by the IS-LM curves. These curves do not remain independent; shifts in the LM curve induces shifts in the IS curve.
Other Theoretical Issues:
The Keynesians and the monetarists also differ on some other fundamental theoretical issues:
1. Proportionality between Money and Prices:
In the classical view, there exists a long run proportional relationship between the money Stock and the price level. Changes in the money supply will ultimately produce a proportionate change in the general level of commodity prices.
This proportional relationship is based on the assumption that- (a) the ratio of real balances to the volume of transaction is relatively constant, and (b) there is no link between the interest rate and the demand for money.
The Keynesian analysis, which deals with the short run, finds that the price level does not vary in strict proportionality to the money stock. According to the Keynesians, if we begin with the initial position of less-than-full employment equilibrium, a given change in the supply of money will affect real output, prices and velocity through its influence on the rate of interest.
The extent to which commodity prices will change in this situation will depend upon what happens to per-unit costs. The per-unit costs tend to rise at an increasing rate as we get closer to full employment. This is because of the sharply diminishing productivity of labour.
The ultimate impact of the change in the money supply on the price level also depends on- (a) how this change is introduced into the system (i.e., through gold sales, open market operations, etc.) and (b) which sectors experience the monetary-induced change in demand.
Thus, in the Keynesian model, the price level is an endogenous variable. The nature of the production function and the state of the labour market are important determinants of the price level.
Under the condition of less-than-full employment, larger money supply will produce higher level of real output and a lower value of velocity on the one hand, and a higher price level on the other.
But, there is no strict proportionality between money supply and the price level. However, if the initial position is one of full employment, the increase in the money supply must ultimately produce a proportional increase in the commodity prices.
Like the Keynesians, the monetarists also hold that in the short run, the proportionality between money supply and the price level do not exist, and the short run changes in real output as a result of changes in money supply disturbs this proportional relationship. The monetarists give two reasons for the short- run non-proportionality between money supply and the price level.
(i) Friedman’s restatement of the quantity theory of money indicates that deviations in the short-run growth rate of money stock, by affecting interest rates or expectations, produce variations in the velocity.
(ii) Phillips curve indicates that deviations in the growth rate of the money stock can produce variations in real output to the extent that labour fails to perceive the associated price rise.
But, the similarity of Keynesian and monetarist view is only superficial. From the Keynesian viewpoint, the changes in the money supply produce permanent changes in velocity and output, while from the monetarist viewpoint, changes in velocity and output as a result of changes in money supply are only transitional and exist only for the period when the actual course of prices differs from that expected by labour.
In the long run, the monetarists believe that once the actual course of prices becomes fully anticipated, the transitory effect on real output and velocity vanishes and the short-run increase in the money supply serves only to raise commodity prices.
Friedman has summarised the monetarist viewpoint on the subject of proportionality between money supply and price level in the following seven propositions:
(i) There is a consistent though not precise relation between the rate of growth of the quantity of money and the rate of growth of national income.
(ii) This relationship is not obvious to the naked eye largely because it takes time for changes in monetary growth to affect income and how long it takes is itself variable.
(iii) On the average, a change in the monetary growth produces a change in the rate of growth of national income about six to nine months later. This is an average and does not hold in every individual case.
(iv) The changed rate of growth of nominal income typically shows up first in output and hardly at all in prices.
(v) On the average, the effect on prices comes about six to nine months after the effect on income and output, so the total delay between a change in monetary growth and a change in the rate of inflation averages like 12-18 months.
(vi) Even after allowance for the delay in the effect of monetary growth, the relation is far from perfect. There’s many a slip twixt the monetary change and the income change.
(vii) In the short run, which may be as much as five or ten years, monetary changes affect primary output, over decades, on the other hand, the rate of monetary growth affects primary prices.
2. Inflation and Deflation:
The classical economists gave a monetary theory of the price level. This implies that inflations and deflations are purely monetary phenomena. In other words, the non-monetary factors, such as changes in government spending or taxation, changes in the rate of investment or private spending in general, themselves alone exert no influence on the general level of prices.
According to the Keynesians, inflations and deflations may be non-monetary in nature. Changes in money supply, government spending and taxation, private expenditures and personal savings can all influence the price level. In their non-monetary (cost-push) theories of inflation, the Keynesians regarded changes in the per-unit labour cost or the profit mark- up as the major determinant of changes in price level.
The Keynesian non-monetary theory of the price level is summed up by Paul Samuelson in the following three propositions:
(i) Even when the money supply is held constant, any significant changes in thriftiness and the propensity to consume can be expected to have systematic independent effects on the money value of current output, affecting average prices or aggregate production or both.
(ii) Even when the money supply is held constant, an exogeneous burst of investment opportunities or animal spirits on the part of business can be expected to have systematic effects on total gross national product.
(iii) Even when the money supply is constant, increases in public expenditures or reductions in tax rates and even increases in public expenditures balanced by increases in taxation can be expected to have systematic effects on aggregate gross national product.
The monetarists do not seem to present a consistent theory of inflation. On the one hand. Friedman gives a monetary theory of price level and strongly asserts that “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be only by a more rapid increase in quantity of money than in output.”
On the other hand, the monetarists also hold the view that the price level is “a joint outcome of the monetary forces determining nominal income and the real forces determining real income.” They consider rate of interest as a determinant of velocity and therefore admit that changes in the real variables will exert influence on aggregate demand and the price level.
In spite of these inconsistencies, the monetarists in general have a largely monetary theory of the price level. The influence of rate interest as a determinant of velocity is held weak in Friedman’s works.
The Keynesian type of cost-push theory of inflation has also been completely rejected on the ground that the purpose of cost-push pressure is to restore equilibrium in the relationship between aggregate demand and the long-run supply schedule of output.
3. Neutrality of Money:
For the classical economists money was neutral and the neutrality of money meant that changes in money or its rate of growth could not produce changes in the equilibrium value of real variables, such as output and employment. The only lasting influence of money was on the general level of prices. The classical economists, however, admit short-run non-neutrality of money.
The Keynesians believe that in the short-run, under the conditions of unemployment, changes in the money supply will produce permanent non-neutral effects, i.e. will permanently change the rate of interest, the level of employment, the rate of capital formation etc. Thus, money is non-neutral in the short period and has permanent effect on real variables.
The monetarists believe that money is non-neutral in the short-run and the short run may be considerably long. However, such non-neutrality is essentially transitory depending upon the time it takes labour and lenders to perceive inflation and adjust to it.
The most important difference between the Keynesians and the monetarists arises over the policy implications of their theoretical systems and the role and effectiveness of monetary and fiscal policies.
1. Nature of Capitalist Economy:
The policy implications of the Keynesian and monetarist system arise from the two divergent positions taken by these groups regarding the nature of the capitalist economy and the source of business fluctuations. The Keynesian position is that the real economy is highly unstable and that monetary management has both little relevance to it and little control over it.
The Keynesian analysis implies that the IS curve is more fluctuating than the LM curve. This is either due to exogenous change in the profit expectations or due to the animal spirits of the business community. Moreover, small changes in investment, through multiplier and accelerator processes, produce much larger changes in output.
Thus, the broad policy implications of the Keynesian system can be summed up as follows:
(a) The capitalist economy is inherently unstable;
(b) This instability is mainly due to the variability of investment spending and produces violent business cycles; and
(c) Such an economy needs to stabilised and should be stabilised by appropriate monetary and fiscal measures.
The monetarist position is “that the real economy is inherently stable, but it can be destabilised by monetary developments, which therefore, need to be controlled as far as possible by intelligent monetary policy.”
Thus, according to the monetarists, the major instability and uncertainty in the economic process result from the behaviour of the government; they are due to the monetary, credit and fiscal policies of the government.
The board policy conclusions of the monetarist system are- (a) The capitalist economy is inherently stable; (b) much of the instability actually experienced since World War II has been the result of active fiscal and monetary policies, (c) there is no need to stabilise the economy; and (d) If there is need, it cannot be done because Stabilisation policies are more likely to increase than to decrease instability.
2. Key Policy Variable:
The Keynesian transmission mechanism indicates that the monetary policy works out its effect through changes in the interest rate and availability of credit. Thus, for the Keynesians, the key policy variable is free reserves of commercial banks. Free reserves are excess reserves less member bank borrowings.
By operating on free reserves, the central bank expects to affect the rate of interest and the availability of credit. The monetarist transmission mechanism, on the other hand, indicates that the monetary policy operates through changes in the money supply. Thus, the money supply is obviously the key policy variable.
According to the Keynesians, monetary policy is ineffective and less reliable because of the following reasons:
(a) Monetary policy is one of many factors that determine the level of nominal national income in the short-run.
(b) Changes is money supply lead to opposite changes in velocity, and thereby limit the effectiveness of the monetary policy,
(c) During recession, investment is unresponsive to interest rate changes.
Keynesians believe that the economy operates under liquidity trap range (horizontal LM curve). The IS curve is vertical or interest inelastic. It is a depression economy in which prices, income level, rate of interest and velocity of money are very low and speculative demand for money is very high.
In such a situation (as shown in Figure-7A), monetary policy is ineffective. An increase in money supply does not shift the LM curve (LM0 = LM1) and therefore, there will no change in the income level (OY0) and the rate of interest (Oi0).
The monetarists consider the monetary policy to be effective at least in the short period. They have produced empirical evidence to show that changes in nominal national income, employment and the price level are more closely related to changes in the money stock than to changes in government expenditures and taxes.
Monetarists believe that the economy operates under the classical range (vertical LM curve). It is an inflationary situation when prices, income level, rate of interest and velocity of money are very high and speculative demand for money is at a minimum.
The IS curve slopes downward or is interest elastic. Under such condition (as shown in Figure-7B), monetary policy is fully effective. An increase in money supply will shift the LM curve from LM0 to LM1. This will reduce the rate of interest from Oi0 to Oi1, encourage investment and thus increase the income level from OY0 to OY1.
The Keynesians believe that fiscal policy is superior and more effective than monetary policy. Fiscal policy is superior because- (a) it bypasses the effect of interest rates; (b) it affects aggregate demand directly through changes in government expenditures and indirectly through changes in taxes which cause changes in the consumption and investment functions.
In Figure-8A, in the Keynesian trap range (i.e., horizontal LM curve), a shift in the IS curve from IS0 to IS1 due to an increase in government expenditure or reduction in tax rate increases the income level to the same extent (from OY0 to OY1). The interest rate does not rise at all (Oi0) and there is no crowding out (reduction) of private investment. Hence, fiscal policy is fully effective.
The monetarists doubt that fiscal policy is effective if the money supply is held constant. If government expenditures are financed by borrowings from public, interest rates will rise and some private investment and consumption expenditures will be crowded out.
In the vertical portion of the LM curve, increases in government expenditures are completely offset by reductions in investment and consumption; government expenditure multiplier is zero in this case.
In Figure-8B, an increase in government expenditure shifts the IS curve from IS0 to IS1. As a result, the real income increases from OY0 to OY1 and not from OY0 to OY1. Thus, some private investment (Y1 Y’1) is crowded out.
In the classical range of vertical LM curve, when, as a result of increase in government expenditure, the IS curve shifts from IS2 to IS3, the rate of interest rises from Oi2 = to Oi3 and the increase in government expenditure is totally offset by a decrease in private investment and consumption. In this case, there will be no change in the income level OY2 and there will be total or 100% crowding out.
5. Rules versus Discretion:
The main controversy between the Keynesians and the monetarists is not that the former prefer fiscal policy, while the latter prefer monetary policy. The real issue in the debate is that while the Keynesians are in favour of government intervention in the economy in order to stabilise it, the monetarists, on the other hand, are against government intervention.
The Keynesians prefer fiscal policy because they consider it a superior stabilising tool. On the same reasoning, they are even prepare to adopt monetary policy if it works. On the contrary, though the monetarists prefer monetary policy against fiscal policy, their true position is that monetary rule is better than discretionary monetary policy. The discretionary monetary policy or fine tuning of the economy through monetary policy may have destabilising effects on the economy.
In the modern times, the debate between the Keynesians and the monetarists has become irrelevant. Both the groups refrain from holding their traditional extreme positions and tend to adopt a compromising attitude.
The controversy between the Keynesians and the monetarists has shifted from the question whether monetary policy is important at all to the debate on the degree of importance of fiscal policy and on the appropriate response of monetary and fiscal policy to business fluctuations.
Whatever the outcome of the current debate may be, there is general agreement today- (a) that neither monetary policy alone nor fiscal policy alone can deliver goods and solve economic problems and (b) that the money supply is an important factor affecting interest rates, real income and prices.
The comparison of the extreme and modern positions of the Keynesians and the monetarists is given in the following charts:
Today, the basic difference among the Keynesians and the monetarists is empirical, and not theoretical. Time is not far off when the empirical research will bring the economists of the two opposite camps much closer and each side will be able to recognise and appreciate the view point of the other side.
One can conclude with a note of conciliatory optimism- “Perhaps the profession will really believe that the two sides have made an objective examination of their beliefs when Chicago produces a dissertation demonstrating that fiscal policy matters and Yale produces one showing that money matters.”