Simon Longhurst

4266683X

Level H International Macroeconomics Conor Okane

Outline the main theoretical approaches to managing the economy as put forward by the mainstream schools of macroeconomic thought
In this essay I will be examining and outlining the central beliefs and reasoning behind Keynesian views and those of the classical school. I will be looking at the key central points and comparing the different approaches each party has on the subject. Namely I will be examining the relationship between inflation and unemployment as they have a large impact on a countrys economy and we can trace the pitfalls that theorists have had over the history of a country and its economic recessions/booms. Finally I will provide a view on modern day policy makers and whether or not and if so how much, they depend on original economic schools of thought. As Sloman and Wride state: the classical theory predicted that, in the long run, equilibrium in the economy would be at virtually full employment, this meant that the classical models variables were, employment, real and nominal wages, price levels, interest rates and real output. Simply put, the classical theorist believed that the market would always correct itself back to equilibrium or, as Horwitz (undated) quotes Says Law, supply creates its own demand. This means that all income in the economy would have to be spent, causing investment to equal savings. Classical theory also holds that in the market for loanable funds, savings will equal investment, due to the increase in demand for investment/firms needing to purchase assets on finance; interest rates will rise on loans, making them less attractive. What follows is that, as interest rates rise on savings, customers will be more attracted to depositing in financial institutions. This can be illustrated using the following graph, which shows the equilibrium point where Savings equal Investment. The same can be illustrated for a countrys imports equaling its exports; using the balance of payments and the gold standard, which essentially meant that any deficit in the balance of payments (M>X) had to be paid for in gold from the countrys reserves. The UK was only part of the gold standard before 1914 and between 1925 and 1931. At this point, deep into the great depression, Britain left the gold standard and allowed the pound to depreciate.
Market for Loanable Funds. (Sloman and Wride, 2009, pg 457)

Inflation, under classical economists, was seen as equal to the supply of money in the economy, this meant that under classical economic theory, any reduction in money supply would reduce inflation and vice versa. The equation used to prove this was MV = PY, money supply x velocity of circulation (number of times per year a pound is spent on buying goods/services that contribute to GDP) = Prices x nominal value of GDP.

Simon Longhurst

4266683X

Level H International Macroeconomics Conor Okane

By the time of the Great Depression and the abandonment of the gold standard, it was clear that classical economic thought was contradicting itself; the market was not correcting and balancing itself (Sloman and Wride, 2009). Keynesian Theory

John Maynard Keynes is the founder of the Keynesian economic school of thought, he published a text in 1936 that questioned and opposed many classical theories and economists. Keynes believed that government intervention, or fiscal policy, was the answer to ensuring a stable and productive economy. In fact, according to Tobin (1981) Keynes "denies the existence of self-correcting market mechanisms which would eliminate excess supplies of labor and other productive resources...in a competitive economy....He does not say merely that this process may take a very long time; he says that it does not work at all". John Keynes and those that share or follow his theories on economic management believed that economies will frequently reach equilibrium below full employment. In this situation aggregate supply will most likely be price elastic and increases in aggregate demand will mainly affect output. Keynes argued the fact that workers are still consumers and that a fall in wage rates would cause consumers to spend (Sloman and Wride, 2009). This would shift the aggregate demand curve to the left, which would outrun the wage decrease, meaning that wage rates would not drop fast enough to clear the market and the recession would get worse. Keynes believed in a circular economic flow where government injections or expenditure would cause a disequilibrium that would cause firms to use more labour due to the increased demand. This in turn would increase the household income, which would increase household consumption and expenditure, which again, increases employment and output from firms. Keynes did not think that this would go on forever however, as incomes rise, so do taxes, savings increase, and imports increase. This was called the multiplier effect and could be applied whenever there was a new injection into the circular flow. When these withdrawals have risen far enough to equal injections, a new equilibrium will exist.
Demand Deficiency in the labour market. (Sloman and Wride, 2009, pg 462)

A withdrawal of income from the circular flow will lead to a downward multiplier effect. Therefore, whenever there is an increased withdrawal, such as a rise in savings, import spending or taxation, there is a potential downward multiplier effect on the rest of the economy (Economics Online, undated) Keynes believed that at this point it was necessary for government intervention through one of two main policies. Between 1945 and the mid 1970s both conservative and labour governments pursued Keynesian demand management policies in an attempt to stabilise the economy and avoid excess or deficient demand (Sloman and Wride). From 1946 until the mid-70s the increase in belief of Keynesian economics had a huge influence over the economy and increased the presence of government in the economy quite substantially. Private spending is much more volatile than government spending and so the increase of government spending reduced the business cycle volatility, which in turn prevented

Simon Longhurst

4266683X

Level H International Macroeconomics Conor Okane

increases in unemployment during times of recession. The usage of governmental intervention using increased spending and control over taxes is called fiscal policy (Farmer, R. 2011). On the other hand monetary policy has more of a relationship with the money supply, for example, lowering interest rates when a recession is looming to help stimulate private demand. Both approaches are Keynesian in essence, in that they promote government intervention or central bank intervention but that they also reject the classical theory of free-markets. W. H. Phillipss study of wage inflation and unemployment in the United Kingdom from 1861 to 1957 is a milestone in the development of macroeconomics. Phillips found a consistent inverse relationship: when unemployment was high, wages increased slowly; when unemployment was low, wages rose rapidly.

The Philips Curve, Hoover (undated)

The problem came when Keynesian theory failed to explain how inflation was rising at the same time as unemployment was, called stagflation, the Philips curve began to break down, due to the fact that it couldnt account for the increase in both factors. Therefore economists abandoned Keynesian beliefs and turned to policies based on the classical theory, namely the monetary policy. Monetary Policy Since Milton Friedman wrote his famous "The role of monetary policy" article where he described advantages and applications of monetary policy and how it should be conducted, monetary approached have played a substantial part in policy making globally. Monetarists argued that inflation is damaging to the economy because it reduces certainty in the market, which creates uncertainty for businesses and therefore reduces investment. One of the main points that Milton revealed was that there could be an alteration of the generally accepted Philips cure to incorporate expectations for inflation. Friedman argued that there were a series of different Phillips Curves for each level of expected inflation. If people expected inflation to occur then they would anticipate and expect a correspondingly higher wage rise. Friedman was therefore assuming no 'money illusion' - people would anticipate inflation and account for it
Accelerationist theory of inflation, (Sloman and Wride, 2009, pg 620)

(Biz/Ed, undated ). The expectation augmented Philips graph also includes the monetarists view of the long run Philips curve, as shown. Monetarists argued that the natural rate of unemployment is a vertical line at equilibrium, meaning that, in the long run, once expectations have adjusted, all extra demand is absorbed in higher inflation, causing unemployment to rise back to its natural state (Sloman and Wride, 2009). When the government started implementing the monetarist policies, it seemed that the rise in unemployment was reversed eventually and lead to a big drop in inflation.

Simon Longhurst

4266683X

Level H International Macroeconomics Conor Okane

Keynesians were quick to have a response to the boom in faith in the monetarist policies, stating that inflation was not just a problem of excess demand but also an issue with an increased expectancy from workers for impossible real-wage increases. They evolved their take on unemployment to take into account expectancy, but insisted that it was not so much inflation expectancy, but the expectancy of production, investment, and employment. Keynesians insisted that the government would need to implement a policy of reflation in order for business confidence to return. In essence, the Keynesian school of thought followers believed that monetarists put too much faith in markets and their ability to control inflation. There are a number of rational reasons for this, namely that markets can respond to the smallest fluctuations, and these changes can affect the confidence of businesses with regards to long-term decisions. This just means that free markets are generally unpredictable and therefore unable to give a clear indication of long-term costs and benefits. (Sloman and Wride. 2009). Keynesian views would have the government having a strong intervention policy and expenditure on domestic infrastructure, since small projects such as roading and housing require little imports, with the result that aggregate demand will rise and the balance of payments wont be as affected. They also want to promote international agreements between central banks in order to stabilise exchange rates, improve relationships between government and industry, namely, providing finance to promising industries, and ensuring retraining schemes are put in place in order to minimise unemployment due to lack of skilled labour. Conclusion Having examined various different schools of thought, from the classical view of allowing markets to regulate themselves in a free-market economy, through to the Keynesian view that government expenditure into the economy is the way to control inflation and unemployment. There has naturally been a development of other schools of thought that go extreme in one direction, eg. The New Classical School, one that believes in a free market and that the only thing that tight money-supply control causes is a decrease in inflation, changes in unemployment are due to the natural rate of unemployment (Sloman and Wride, 2009). However it can be seen that over the developing year of macroeconomic theory there are areas that the different schools can agree on to a degree. Firstly it is clear to see that aggregate demand has a huge impact, a slump in demand needs to be countered by expansionary policies from the government, be they monetary or fiscal. Another clear development, mainly from the Keynesians in respect to the monetarists beliefs, is that expectations of the consumer/worker have a large effect on inflation and therefore on unemployment. If a consumer believes that a product is to get more expensive in the foreseeable future, they will naturally buy now, and vice versa, causing them to wait, thinking the product will get cheaper and therefore reducing injections. The general consensus between schools is also that government should refrain from allowing the money supply to grow too quickly lest it lead to inflation, but, contrary to basic Keynesian principles, most economists in the modern day can agree that interest rates are the easiest way to control inflation, and therefore most central banks around the globe have targets matched by interest rate alterations. Clearly, since the UK went into recession in 2008, there is not any one perfect way of managing the economy, this paper was written to outline the main schools of thought and consider the pros and cons of each. There is no general consensus on economic management at the moment but one final point that is important to all the schools is that globalisation is affecting the strength of any school of thought, and that as the distance between countries lessens, and capital can travel the globe more easily, there needs to be a development of international policies that can tackle global recessions. With ease of movement becoming more and more each day, there will need to be a global standard of

Simon Longhurst

4266683X

Level H International Macroeconomics Conor Okane

economic management as it will likely soon become counter-productive attempting to just manage a single countrys economy.

Bibliography
Biz/Ed. Undated. Milton Friedman Theories, Biz/Ed.com. Available from: http://www.bized.co.uk/virtual/economy/library/economists/friedmanth.htm [Last Accessed 5.12.12]

Simon Longhurst

4266683X

Level H International Macroeconomics Conor Okane

Economics Online. Undated. The Multiplier effect.Available from: http://www.economicsonline.co.uk/Managing_the_economy/The_multiplier_effect.html [last accessed 08.12.12] Farmer R. 2011. Economic Policy through the Lens of History. gilderlehrman.org. Available from:
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Hoover, K. Undated, Philips Curve. The Concise Encyclopaedia ofEconomics. Available from: http://www.econlib.org/library/Enc/PhillipsCurve.html [Last Accessed 6.12.12]
Horwitz, S. undated. Understanding Say's Law of Markets. FEE.org. Available from: http://www.fee.org/the_freeman/detail/understanding-says-law-of-markets/#axzz2Ed1KqKNJ [last accessed 08.12.12] Sloman, J, Wride, A., 2009. Economics. 7 . Edinburgh, UK. Pearson Education LTD.
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Tobin, J. 1981. Asset Accumulation and Economic Activity. Chicago, USA. University Press.