Readers Questions: Could you please explain the comparison between the Keynesianism & monetarism?
Keynesian approach
Keynesianism emphasises the role that fiscal policy can play in stabilising the economy. In particular Keynesian theory suggests that higher government spending in a recession can help to enable a quicker economic recovery. Keynesians say it is a mistake to wait for markets to clear as classical economic theory suggests.
They believe that in a liquidity trap, monetary policy is ineffective because interest rates cannot fall far enough to stimulate borrowing. Keynesians accept that deficits may rise during recessions and see this as a necessary stabilisation tool.
Monetarist approach
Monetarism emphasises the importance of controlling the money supply to control inflation. Monetarists argue that inflation is “always and everywhere a monetary phenomenon,” resulting from excessive growth in the money supply. Monetarists are generally critical of expansionary fiscal policy, arguing that it will cause just inflation or crowding out and therefore not helpful.
Monetarists tend to believe markets are more efficient and self-correcting, so government spending is often seen as distortionary, crowding out private investment. Monetarists prefer predictable, rules-based monetary policy—such as steady growth of the money supply—and view fiscal policy as slow, political, and largely ineffective. They argue that inflation is controlled primarily through interest rates and central bank credibility, not through government demand management.
Principles of Keynesianism
Classic Keynesian view of spare capacity – increasing AD can increase GDP without inflation.
- 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 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
Monetarist view of Long run aggregate supply (LRAS) – higher demand causes just inflation.
- 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)
Convergence of Keynesianism and Monetarism
The distinction between Keynesian and monetarists positions is a bit more blurred. For example, many ‘Keynesian’ economists have taken on board ideas of a natural rate of unemployment, in addition to demand deficient unemployment. ‘New Classical’ economists are more likely to accept ideas of rigidities in prices and wages.
Who is Right – Monetarists or Keynesians?
The Keynesian approach is most useful in deep recessions, liquidity traps and times of collapsing confidence. In 2008–09 and 2020, interest rates hit zero and monetary policy alone could not revive demand. Fiscal stimulus, furlough schemes, and large-scale government spending prevented far worse recessions.
In 2009/10, UK government borrowing increased as they pursued expansionary fiscal policy.
In 1932, the US embarked on the New Deal – expansionary government spending on public works. This helped unemployment come down.
Empirical studies of the Great Depression also show that recovery only really began once governments increased spending. When private sector demand disappears, Keynesianism explains the world very well.
When Monetarists tend to be right:
Monetarist ideas are strongest when dealing with inflation, credibility, and monetary stability. The high inflation of the 1970s seemed to cause stagflation – both inflation and low growth. There was not a simple Keynesian response.
The high inflation didn’t end until central banks tightened monetary policy. Arguably, fiscal stimulus during this period mostly caused more inflation. Nevertheless, the UK’s monetarist experiment 1979-84 was effectively abandoned when the link between the money supply and inflation was proved to be unreliable, with many economists saying the economy was too severely depressed by overly tight monetary policy
Friedman’s view—that inflation ultimately depends on the money supply and central bank policy—fits the evidence from the inflation-targeting era (1990s–2010s), when stable monetary policy kept inflation low despite governments running various fiscal policies. However, the great credit crunch of 2008 and subsequent deep recession saw Keynesianism come back in vogue.
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