Module 2: Keynesian versus Monetary view of unemployment and inflation (contd)

We have introduced the Keynesian view of unemployment and Inflation. We have also studied the relationship
between unemployment and inflation using the Phillip’s Curve.

The next two units will examine the Monetarist view and then compare it with the Keynesians view of inflation
and unemployment.

Unit 3: The concept of Monetarism

Unit 4: Monetarism Vs Keynesian Economics

Objectives

At the end of this module, students should;

1. Understand the core principles of monetarism

2. Differentiate between the key targets of monetary policy

3. Compare monetarism and Keynesianism in fiscal policy, wage flexibility, inflation, and unemployment
views.

UNIT 3: What Is Monetarism?

Monetarism is a macroeconomic theory which states that governments can foster economic stability by
targeting the growth rate of the money supply. The money supply is the sum total of all of the currency and
other liquid assets in a country's economy on the date measured. The money supply includes all cash in
circulation and all bank deposits that the account holder can easily convert to cash.

Essentially, the Monetarist belief that the total amount of money in an economy is the primary determinant of
economic growth.

Monetarism is an economic school of thought which states that the supply of money in an economy is the
primary driver of economic growth. As the availability of money in the system increases, aggregate demand for
goods and services goes up. An increase in aggregate demand encourages job creation, which reduces the rate
of unemployment and stimulates economic growth.

Monetary policy, an economic tool used in monetarism, is implemented to adjust interest rates that, in turn,
control the money supply. When interest rates are increased, people have more of an incentive to save than to
spend, thereby reducing or contracting the money supply. Contrarily, when interest rates are lowered following
an expansionary monetary scheme, the cost of borrowing decreases, which means people can borrow more and
spend more, thereby stimulating the economy.

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Milton Friedman and Monetarism
Monetarism is closely associated with economist Milton Friedman, who argued, based on the quantity theory
of money, that the government should keep the money supply fairly steady, expanding it slightly each year to
allow for the natural growth of the economy. Due to the inflationary effects that can be brought about by the
excessive expansion of the money supply, Friedman, who formulated the theory of monetarism, asserted that
monetary policy should be done by targeting the growth rate of the money supply to maintain economic and
price stability.

Targets of Monetary Policy

There are three target variables for monetary policy. They are the money supply, availability of credit, and
interest rates.

1. Money Supply: So far monetary policy is concerned, the central bank cannot directly control output and
prices. So it selects the growth rate of money supply as an intermediate target. If fact, it select an
operating target‘ which it considers to be closely linked to its intermediate target‘. Friedman suggests
that the money supply should be allowed to grow steadily at the rate of 3 to 4 per cent per year for a
smooth growth of the economy and to avoid inflationary and recessionary tendencies.

2. Availability of Credit and Interest Rates: availability of credit and interest rate are the other two
target variables of monetary policy. Economists call them money market conditions‘ which refers to
short-term interest rates and the banking system‘s free reserves (that is excess reserves minus borrowed
reserves). The monetary authority can influence the short term interest rates. It can change credit
conditions and affect economic activity by rationing of credit or other means. The monetary authority
influences economic activity by following an easy or expansionary monetary policy through low
and/or falling short term interest rates and a tight or contractionary monetary policy through high
and/or rising short-term interest rates.

Its Limitations:

The use of interest rates and credit availability as target variables are beset with a number of difficulties.

a. No doubt interest rates and the supply of credit influence spending, but it cannot be predicted with
definiteness about the size and timing of the effects of any change in them.
b. So far as interest rates are concerned, it is the real interest rate that matters and not the nominal interest rate.
It is possible to control and observe the movements in the nominal interest rate and not in the real interest
rate because it is difficult to measure the expected rate of price inflation.

Monetarism is an economic theory that emphasises the role of the money supply in determining economic
activity and prices.

The key ideas behind monetarism include:

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 1. Quantity of money matters: Monetarists believe that the money supply is the most important
determinant of economic activity and prices. They argue that changes in the money supply lead to
changes in economic activity, inflation, and interest rates.

2. Long-run relationship between money and prices: Monetarists believe that in the long run, the money
supply and prices are positively related. They argue that increasing the money supply will lead to
inflation, while decreasing it will lead to deflation.

3. Monetary policy should focus on controlling the money supply: Monetarists advocate that monetary
policy should focus on controlling the money supply rather than on trying to stabilize the economy or
manage the business cycle. They believe that controlling the money supply is the most effective way to
control inflation in the long run.

4. Money supply targeting: Monetarists argue that the central bank should target a specific rate of growth
for the money supply and use monetary policy tools to achieve that target. This will help to achieve a
predictable monetary environment, with a low and stable inflation rate.

5. Ineffectiveness of fiscal policy: Monetarists generally argue that fiscal policy (taxation and government
spending) is relatively ineffective in managing the economy and that instead monetary policy is the best
tool for achieving stability and growth.

6. Natural rate of unemployment: Monetarists argue that there is a natural rate of unemployment below
which inflation will rise and above which there will be a fall in inflation. A central bank should focus on
controlling inflation rather than unemployment, as trying to bring unemployment below the natural rate
will result in higher inflation. The natural rate of unemployment is the unemployment rate that occurs
when the market is at equilibrium. That is when demand equals supply in the labour market. The
natural rate of unemployment only includes frictional and structural unemployment. Review your
previous notes for structural and frictional unemployment.

UNIT 4: Monetarism vs Keynesianism

Concepts of Keynesianism

• In a recession/liquidity trap, government intervention can stimulate aggregate demand and real output
through government borrowing and higher government spending. Therefore Keynesians
advocate expansionary fiscal policy in a recession.

• Keynesians reject the theory of crowding out presented by Monetarists. Keynesians say that if there is
a sharp rise in private sector saving (and fall in spending), government spending can offset this decline
in private sector spending.

• Paradox of thrift. A key element in Keynesian theory is the idea of a ‘glut’ of savings. Keynes argued
in a recession, people responded to the threat of unemployment by increasing saving and reducing their

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 spending. This was a rational choice, but it contributes to an even bigger decline in AD and GDP. This is
why government intervention may be needed.

• Keynesians usually believe there is a degree of wage rigidity. In a recession, Keynes said wages might
be ‘sticky downward’ as unions resist nominal wage cuts, and this can lead to real wage unemployment.

• In a recession, when an economy has spare capacity, increasing aggregate demand (AD) will have an
impact on real output and only minimal effect on the price level.

• Keynesians believe there is often a multiplier effect. This means an initial injection into the circular
flow can lead to a bigger final increase in real GDP.

• Generally, Keynesians are more likely to stress the importance of reducing unemployment rather than
inflation.

• Keynesians reject real business cycle theories (an idea that the government can have no influence over
the economic cycle)

Monetarism

• Monetarists are more critical of the ability of fiscal policy to stimulate economic growth.
• Monetarists /classical economists believe wages are more flexible and likely to adjust downwards to
prevent real wage unemployment.
• Monetarists stress the importance of controlling the money supply to keep inflation low.
• Monetarists more likely to place emphasis on reducing inflation than keeping unemployment low.
• Monetarists stress the role of the natural rate of unemployment. (supply side unemployment)

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Real-World Examples of Monetarism and Keynesian

When Margaret Thatcher was elected prime minister in 1979, she also implemented a set of monetarist policies
to combat the rising prices in the country. By 1983, inflation in Britain had been halved, from 10% to 5%.

However, the popularity of monetarism was relatively brief. In the 1980s and 1990s, the link between the
money supply and nominal GDP broke down; the quantity theory of money, the backbone of monetarism, was
called into question and many economists who had recommended the policies of monetarism in the 1970s
abandoned the approach.

In Nigeria, liquidity injection of 3.6 trillion (2.4 percent of GDP) into the banking system, including N100
billion to support the health sector, N2 trillion to the manufacturing sector, and N1.5 trillion to the real sector to
impacted industries.

Keynesian economics in a crisis – policy examples in Nigeria

1. Immediate injections of extra spending into public health care

The Federal Government adopted a revised budget for 2020 in response to the COVID-19 shock. A N500
billion (0.3 percent of GDP) COVID-19 intervention fund is included in the revised budget to channel resources
to additional health-related current and capital spending (tests, supplies and facilities) and public works
programs to support the incomes of the vulnerable, including N7.5 billion to Nigeria's Center for Disease
Control and grant of N10 billion to Lagos State.

2. Wage subsidies to maintain employment (including the self-employed)

The coverage of the conditional cash transfer program has been broadened and an allocation of N150 billion to
support state and local governments' spending needs has been made available through the budget.

⚫ In USA stimulus package injects money directly into millions of household budgets

Real life Situation

Is Cyclical unemployment likely to rise in Nigeria in 2023?

Cyclical unemployment is involuntary unemployment due to lack of aggregate demand for goods and
services. This is also known as Keynesian Unemployment or demand deficient unemployment.

Inflation rose marginally to 23% in June from 22.4% in the previous month fuelled by both food (25%) and
core inflation rates (20%). The rise was primarily due to the increases in food and transport costs by 2.4%
respectively.
Real income still under pressure as inflation (23% as of June 2023) continues to accelerate and wages remain
static. This will lead to decline in real consumer spending
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Falling Aggregate Demand cause many firms to scale back job hiring, and many businesses will make
redundances to control their costs.

According to NESG Macroeconomic Outlook for 2023,the unemployment rate will increase with about 37% in
2023.

Conflicts in Policy Objectives

Conflicts of policy objectives occur when, in attempting to achieve one objective, another objective is
sacrificed. There are numerous potential policy conflicts, including:

1. Full employment vs low inflation: The conflict between employment and prices is the most widely
studied in economics. If policy makers attempt to undertake job creation by injecting demand into the
economy, by expansionary fiscal or monetary policy, there is a danger that prices will be driven up. This
conflict is best explained by reference to the Phillips Curve. It is likely that the trade-off still exists, for
example despite the UK economy approaching full employment and prices still remaining stable in
recent years.

2. Economic growth vs stable prices: This conflict is similar to the unemployment-inflation trade-off, and
can be understood through the Phillips Curve and the AD/AS model. If, through a fiscal or monetary
stimulus of aggregate demand, the economy grows too quickly, aggregate supply may not be able to
respond and prices may be driven up.

3. Economic growth vs a balance of payments: As an economy grows, import spending is stimulated

relative to export revenue. Policy makers have to be aware that a dash for growth‘ could lead to balance
of payments problems.

4. Economic growth vs negative externalities: Sustainable growth is defined in terms of the extent to
which current economic growth rates do not cause unnecessary damage to the environment, especially in
the future. Economic growth does, of course, generate both consumption and production externalities,
such as rising carbon emissions and global warming, excessive waste, and the depletion of global fish
stocks.

5. Crowding-out – public sector vs private sector: Crowding-out is another widely studied conflict. The
belief in the existence of crowding out has profoundly shaped economic policy over the last 20 years.
Crowding-out is essentially a conflict between the public and private sector. For example, public sector
borrowing to compensate for market failures and provide public and merit goods, might drive up long
term interest rates and crowd-out private sector investment. Hence, the desire to achieve short term
stability might put at risk the prospects for long term growth.

INSTRUCTION: Please take note of the keywords in bold for their definitions, you can also refer to the
previous note for the meaning of terms not defined here

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GROUP 3 ASSIGNMENT

1. Evaluate the economies policies that might be used to help reduce the rate of inflation in high inflation
countries
2. Why does an increase in public sector spending by the government decrease the amount the private
sector can spend?

QUESTIONS FOR REVIEW(everyone)

1. Discuss the three target for monetary policy in an economy.

2. How do monetarism and Keynesianism differ in terms of fiscal policy and views on inflation and
unemployment?

3. Provide examples of real-world situations where monetarist and Keynesian policies were used, and what
were the outcomes?

4. What are some common conflicts in policy objectives, and why are they important?