A Comparison of Keynesian, Austrian, and Monetarist theories on Inflation and the Business Cycle

A Comparison of Keynesian, Austrian, and Monetarist theories on Inflation and the Business Cycle Elizabeth DalzenUniversity of WisconsinSuperiorOutlineKeynesian TheoriesMoney Illusion/Animal spiritsKeynes on Says LawLiquidity TrapNon-keynesianAustrian economicsAustrian Business Cycle TheoryClassicalClassical vs. KeynesMonetarismQuantity Theory of MoneyInflation and Side EffectsGovernment Spending

Money Illusion and animal spiritsPeople think in nominal terms, not real termsDeflationprice level, nominal wages, real wagesprice level, nominal wages, real wages surplusInvoluntary unemploymentAnimal spirits:A spontaneous urge to action rather than inaction*Decisions are made in the short-run, In the long run, we are all dead.**Confidence

*Keynes, The General Theory of Employment, Interest, and Money**Keynes, A Tract on Monetary Reform2 deflation scenarios:Dynamic market equilibriums do not determine wage-rates for Keynes 3Keynes and Says LawSays Law: People produce in order to consumeNo general glutsWhat if suppliers dont spend?Hoarding (saving without investing)AD unemployment AD RecessionUnemployed dont buy as much.Why hoard?4Liquidity TrapAs the interest rate approaches zero, stronger liquidity preferenceIndividuals dont save (invest), banks dont lendFlat LM curveImpotent monetary policyConfidenceConfidence low, wont invest even if i rate just very low (not 0)In midst of recession,*immediate* future bleak, low conf contributes to Liquidity Trap

5Keynesian EconIfMoney illusionGlut of unemploymentLow interest ratesDeflationLow consumer and business confidenceHoarding/Liquidity TrapDearth of investmentThenIncrease national income by shifting IS curve, increasing ADGovt. should spend, spend, SPEND!Austrian Business Cycle TheoryExpansion of credit by banksA central bank is necessary for banks to expand creditif banks were truly competitive, any expansion of credit by one bank would quickly pile up the debts of that bank in its competitors, and its competitors would quickly call upon the expanding bank for redemption in cash*

*Rothbard, Economic Depressions: Their Cause and Cure JMKeynes was neither first nor only economist to develop thry of Bus CycleThe central bank allows banks to expand credit in concert, creating inflation.

7A.B.C. TheoryCredit expansion Inflationary BoomDomestic prices bid up importsGold flows out of the country as payment for importsAs banks gold stores dwindle, panic!Fractional reserve bankingBanks call in loans, Money supply (deflation)Economy contractsBalance of payments reversesShift balance of payments, Austrians differ over bal or payments being only in gold8A.B.C. TheoryInterest rate artificially depressedMalinvestmentLow i rate is only temporaryOverinvestment in capital goodsNot enough savings to buy all producers goodsCapital is heterogeneous

Not only does the expansion of credit create inflation, it artificially depresses the interest rate as well. Businesses make malinvestments (something unprofitable at 10% suddenly looks profitable at 2%). Dont realize its only temp decrease i rate. Businessmen, believing there are increased savings, overinvest in capital goods relative to consumer goods. (But, workers arent saving any more, time pref have not actually changed) Capital is het. Not all of it will be automatically picked up by surviving bus, some thrown away 9A.B.C. TheoryGold StandardMoney supply shouldnt increase, even if the population or supply of goods increasesDeflation problemsGovernment sanctioned M counterfeitingAs well see, this is very much in conflict with the Monetarist school10Classical EconomicsSmallest decision making unit: the individualHomo economicusRationalSelf-interestedUtility maximizingAssume perfect informationClassical vs. KeynesMoney illusion/stickinessExample: DeflationWorkers resist nominal wagesBusinesses have 2 options:Raise prices cost-push inflationLay off wokersWorkers seek new jobsBusinesses offer wages that reflect workers real worth (if no minimum wage laws, labor unions, etc.)Stickiness due to:Time lags with change in price levelContract lengthLabor unionsWhy Keynes is wrong if people are rational, self-interested and utility maximizing.Subtitle: why Keynes is wrong if people are rational, self-interested and utility maximizing. businesses will offer wages that reflect what workers are worth in real terms. Workers may initially hold out for higher nominal wages, but theres only so long that people can hold out before they have to accept lower nominal wages simply to survive. There may be glut of unemployment for a short time, but unless the market is being distorted by wage restrictions, over time the market will find a clearing price. 12Keynes refutation of Says LawMisrepresentation of Says LawSay never said that depressions and unemployment are impossibleSays Law: supply creates its own demand, so no general glutsrequires flexible, self-correcting marketsA temporary glut in the labor market is not a general glutHoarding: why?

Obviously there will be a surplus in a market where the price is fixed at a level above the equilibrium price. In addition, a temporary glut in the market for labor does not a general glut make. Money hoarding: why? Fin sys collapse even low i rate better than nothing13Puzzling ParadoxKeynesian economic man:Ruled by animal spiritsDoesnt make decisions for the long-runIncapable of thinking in real termsBut somehow responds rationally to lower interest rates by investing less of his money?Monetarist EconomicsAlso has roots in classical economicsDisagree with both Keynesians and Austrians on inflation and the business cycleMilton FriedmanQuantity Theory of MoneyQuantity theory of money:M*V=P*QM=quantity of money in circulationV=velocity of moneyP=price levelQ=index of the real value of final expendituresKeynes: V is inherently unstableM, V move in opposite directionsFriedman: M, V move in the same direction

How to Avoid InflationInflation is always a monetary phenomenonM and P are not independentMPSince M*V=P*Q, we have M+V=P+QAssume velocity is stable (V=0)P=0 if and only if M=QTo avoid inflation, the growth rate of the money supply should be set equal to the growth rate of output Inflation and Side EffectsMonetarists want monetary policy that creates a stable frameworkReducing inflation is not technically difficult, but there are political barriersPossible side effects of reducing inflation:RecessionUnemploymentAlthough the high political barriers to reducing inflation may make it impossible to eliminate inflation, there are still steps that we can take towards a more stable monetary framework. Escalator clauses can be built into contracts using a price index so that contracts are made in real terms rather than nominal terms. This eliminates much of the risk involved with estimating future rates of inflation. Milton Friedman would like to see the government required to use escalator clauses in everything from personal taxes to corporate taxes to government securities (Friedman, 1991). Escalator clauses are already included in social security, retirement benefits to Federal employees, wages of many government employees, etc. Taxes that are expressed as a fixed percentage of price or other value base are escalated automatically. This would decrease the incentive for government to use implicit taxes via inflation. 18StimulusIn a liquidity trap:Even if the Fed increases M, banks hesitate to lend (low interest rates)Bypass the banks, give money directly to consumersAggregate Demand boosted without increasing government spendingGovernment SpendingWhere does the money come from?Increased tax revenueBorrowing from the private sectorGovernment spends money that otherwise would have been spent in the private sectorPrinting moneyImplicit tax on holders of dollar denominated assetsNo legislation involvedUnless one subscribes to Keynes notion that the private sector is made up of irrational people, while the government is presumably composed of benevolent souls that truly have only the publics interest at heart and are far more capable of efficiently and productively spending money than the people who earned it, there is no reason for the government to be allowed to take the money for government expenditures. The money has only changed hands; the same amount is spent whether by the public or private sector. The increase in government spending may also come from printing money. The creation of new money, when it causes inflation, acts as an implicit tax on holders of dollar denominated assets. There is no legislation involved in the creation of money, so this form of taxation is considered taxation without representation (Friedman, 1991). 20ReviewKeynesian TheoriesMoney Illusion/Animal spiritsKeynes on Says LawLiquidity TrapNon-keynesianAustrian economicsAustrian Business Cycle TheoryClassicalClassical vs. KeynesMonetarismQuantity Theory of MoneyInflation and Side EffectsGovernment Spending

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