Class Lecture-2
Macroeconomics in Business (Econ-1202)
Keynesian Revolution
Classical and Neo-classical economists assumed that, full employment of labor and other resources are always prevailed in the economy. They explained that, how the resources were allocated to the production of various goods and services. They also explained that, how the relative prices of products and factors are determined. They concentrated on the problem of determination of prices, outputs and resources employments in the individual industries.
They believed that, if there were departures from full employments, a free market economy would automatically work in a way that would restore full employment of resources, if it works freely without interventions of trade unions and Governments.
They also believed that, the problem of deficiency of demand does not arise. Since Say’s law stated that, supply creates its own demand. So factors get rewards for supply and rewards create demand. For example –land, labor and capital get rent, wage and interest as rewards respectively.
But they could not provide adequate explanation about the huge unemployment during Great Depression in 1930s.
A.C.Pigou tried to solve the problem by cutting wage and increasing employment within the same budget.
J.M.Keynes challenged the classical viewpoints and said that, reduction in wage may expand employment in an individual industry but reduce the income of working class, thus reduces the aggregate demand.
J.M.Keynes made a genuine break from the Classical and Neo-classical economics and produced such a fundamental and drastic change in economic thinking through his book ‘A general theory of employment, interest ad money(1936), thus his macroeconomic analysis has earned the names ‘Keynesian Revolution and ‘New Economics’.
Post Keynesian development in Macroeconomics
- Monetarism
- Supply-side economics
- Rational expectations theory
1. Monetarism
American Nobel laureate economist Milton Friedman criticized the idea of .J.M.Keynes through his work (A monetary history of the United States) along with Anna Schwartz.
They argued that, monetary policy is the prime engine in causing fluctuations in economic activities by bringing about changes in aggregate demand while J.M.Keynes said that, monetary policy was quite ineffective instrument in bringing about economic stability.
He further argued that, the Great Depression in 1930s. did not show the failure of the free market system but the failure of Government’s interventionist policy. Moreover, it occurred mainly due to excessive contraction of money supply.
There are differences between the monetarists and Keynesian in respect of two important issues. First issue relates to the relationship between money supply and inflation. The second relates to the role of Government in the economy.
Monetarists led by Friedman believed that, inflation is always and everywhere a monetary phenomenon.Mreover, inflation is caused by the rapid expansion of money supply. It is also caused by the greater increase in money supply relative to growth of output. To control inflation, they suggest a constant growth rate of money supply.
Keynesian economists emphasized that, active role should be played by the Government to control Business cycle and achieve economic stability while monetarists opposed to this idea and said Government should pursue a policy of stable rate of growth of money supply.
Keynesian economists also emphasized on the adoption of discretionary fiscal and monetary policies. They argued that, expansion of money supply is not always cause of inflation but it also depends on the possibility of expansion in output.
Supply side economics
In the early 1970s and early eighties, the problem of stagflation appeared in which high inflation was accompanied by high rate oh unemployment. Keynesian economists were unable to solve this problem. if expansionary fiscal and monetary policies were taken to raise aggregate demand to remove stagnation or unemployment, it accelerated inflation further. On the other hand, if steps were taken to lower aggregate demand to lower the inflation rate, it would have further increased the already high unemployment rate.
Supply side economists pointed out that, it was caused by supply shock by reduction in oil supplies and increased in oil prices. They said that, if money supply decreases, then inflation increases but aggregate output and unemployment fall.
Advocates of supply side economics- for the expansion in aggregate in aggregate supply and there by increase in employment opportunities, incentives to work, more saving and investments were required to be promoted.
The increase in aggregate supply will lead to the increase in employment and thus reduce inflation. According to them, high rate of income taxes serve as disincentives to work, saving and investments. So to increase in aggregate supply, income tax should be reduced.
Reduction in income taxes increases the tax revenue and output; it was illustrated by the Laffer curve. Government budget deficit was also reduced by the increased tax revenue.
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