Model Answer
0 min readIntroduction
The debate between Monetarists and Keynesians has been central to macroeconomic policy for decades. While often caricatured, the statement that Monetarists believe “only money matters” and Keynesians believe “money does not matter at all” captures the essence of their divergent perspectives. This stems from fundamentally different understandings of how the economy functions, particularly regarding the stability of the private sector and the effectiveness of government intervention. Milton Friedman, a leading Monetarist, championed the primacy of monetary policy, while John Maynard Keynes, the founder of Keynesian economics, emphasized the role of aggregate demand and fiscal policy in stabilizing economies, especially during recessions. This answer will explore the reasoning behind these seemingly extreme positions.
The Monetarist View: “Only Money Matters”
Monetarists, led by Milton Friedman, argued that changes in the money supply are the primary driver of nominal GDP (and therefore inflation). Their reasoning rested on the Quantity Theory of Money, expressed as MV = PT, where M is the money supply, V is the velocity of money, P is the price level, and T is the volume of transactions. Monetarists believed that V and T are relatively stable in the short run. Therefore, changes in M directly translate into changes in P.
- Stable Velocity of Money: Monetarists assumed that the velocity of money – the rate at which money changes hands – is predictable and relatively constant. This assumption allowed them to focus solely on controlling the money supply.
- Natural Rate of Unemployment: They posited the existence of a “natural rate of unemployment” to which the economy tends to return regardless of monetary policy in the long run. Attempts to push unemployment below this rate through expansionary monetary policy would only lead to inflation.
- Limited Role for Fiscal Policy: Monetarists believed that fiscal policy (government spending and taxation) is largely ineffective. They argued that government spending either “crowds out” private investment or is offset by changes in monetary policy.
- Emphasis on Long-Run Effects: Monetarism focused on the long-run effects of monetary policy, arguing that short-run fluctuations are less important than maintaining price stability.
Friedman’s analysis of the Great Depression, for example, attributed the severity of the crisis not to a lack of aggregate demand (as Keynes argued) but to a contraction in the money supply caused by the Federal Reserve’s inaction. He argued that a more active monetary policy could have mitigated the Depression’s impact.
The Keynesian View: “Money Does Not Matter at All” (in the short run)
Keynesians, in contrast, argued that aggregate demand – the total spending in the economy – is the primary determinant of output and employment, especially in the short run. They believed that the economy can remain stuck in a recessionary equilibrium for extended periods due to “animal spirits” – psychological factors that influence investment decisions. While acknowledging the importance of money in the long run, Keynesians argued that in the short run, changes in the money supply may not necessarily translate into changes in aggregate demand.
- Liquidity Trap: Keynesians introduced the concept of a “liquidity trap,” where interest rates are so low that people prefer to hold cash rather than invest, rendering monetary policy ineffective.
- Sticky Prices and Wages: They argued that prices and wages are “sticky” – they do not adjust quickly to changes in supply and demand – which prevents the economy from self-correcting during recessions.
- Multiplier Effect: Keynesians emphasized the “multiplier effect,” where an initial increase in government spending or investment leads to a larger increase in overall economic activity.
- Active Role for Fiscal Policy: They advocated for active fiscal policy to stabilize the economy, particularly during recessions. Government spending and tax cuts can directly boost aggregate demand and stimulate economic growth.
The response to the 2008 financial crisis exemplified Keynesian principles. Governments around the world implemented large-scale fiscal stimulus packages to counteract the sharp decline in aggregate demand and prevent a deeper recession. The focus was on directly boosting spending, rather than relying solely on monetary policy.
Comparing the Two Schools of Thought
| Feature | Monetarism | Keynesianism |
|---|---|---|
| Primary Driver of Economic Activity | Money Supply | Aggregate Demand |
| Role of Government | Limited; focus on monetary policy | Active; fiscal policy crucial |
| Price and Wage Flexibility | Flexible | Sticky |
| Time Horizon | Long-run | Short-run |
| Effectiveness of Monetary Policy | Highly Effective | Limited, especially in liquidity traps |
It’s important to note that the “extreme” characterization is a simplification. Modern macroeconomic thought often incorporates elements of both Monetarism and Keynesianism. For example, the concept of inflation targeting, adopted by many central banks, reflects a Monetarist concern with price stability while acknowledging the need for some degree of monetary policy flexibility.
Conclusion
The contrasting views of Monetarists and Keynesians stem from differing assumptions about the stability of the private sector and the effectiveness of government intervention. While Monetarists prioritized controlling the money supply to ensure long-run price stability, Keynesians emphasized managing aggregate demand to address short-run economic fluctuations. The debate continues to inform macroeconomic policy today, with policymakers often adopting a pragmatic approach that combines insights from both schools of thought. Understanding the reasoning behind these seemingly extreme positions is crucial for analyzing economic issues and evaluating policy options.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.