Abstract
The use and interpretation of economic policies are fundamental to the formulation of strategic plans and courses of action. Economists and policy makers play a vital role in executing this important analytic and interpretive task. Keynesian and monetary schools of thoughts are some of the important alternatives applied in making economic decisions.
Monetarists believe that government involvement in controlling the level of aggregate demand in the economy is counterproductive in the long run. In its stead, they propose that the best way the government can control unemployment and inflation levels is by the use of monetary policies. Monetary policies are acts that allow the government to control the amount of money circulating in the economy. When the government seeks to reduce the rate of inflation, according to monetarists, the supply of money is reduced (Lucas, 2013). They are of the view that wages are flexible, and a reduction in the money supply will lead to a corresponding reduction in nominal wages with no impact on the real wages. Where the government has got control of the money in circulation, by ways such as wage control, a decrease in wages leads to a decrease in aggregate demand, reduced production, increased unemployment and low inflation rates. The real value of money, however, is unaffected by such a move.
Keynesians, on the other hand, stress the role the government plays in controlling unemployment levels and inflation rate. They propose for the use of fiscal policies, which are tools the government utilizes to control the aggregate level of demand. In the case of unemployment, Keynesians propose the use of government spending to induce the aggregate demand for goods thus increasing employment. They reject the monetarist’s position on wage flexibility by holding that in a recession, wages may be ‘sticky downward’ due to the resistance of unions in having wages adjusted downwards (Beetsma, 2004). By use of fiscal policy, the government controls the allocation between private and collective goods demand. For instance, a reduction in taxation increases the amount of money the households have, subsequently increasing saving and private spending, spurring production, increases employment opportunities, while also raising the inflation levels.
The IS-LM model (i) LM IS2 IS1 (y) Where: IS investment/ savings curve
LM liquidity preference/ money supply curve
(i) Interest rates
(y) GDP/ real economy
Application of the IS-LM model to the Keynesian model (the goods and services market)
When the Keynesian principles are applied to the model, an increase in government spending will induce an increase in investment to meet the increased demand triggered by increased government spending. Further, government spending also increases the rate of saving among households, in the case that government is engaged in domestic borrowing to fund its spending. Reduced interest rate motivates households to prefer holding cash rather than save due to the reduced interest it would earn. Holding cash amongst the households triggers spending, thus increasing the aggregate demand for goods and services. In the short term, increased demand would reduce unemployment rates while triggering inflation. The GDP would grow positively in the through such a measure (Lucas, 2013).
Application of the IS-LM model to the money market
The government would also have the option of manipulating the money markets to reduce inflation, by increasing the interest rates, or by reducing the real wages. An increase in the interest rates would result in reduced borrowing and subsequent shrunken money supply. This has the effect of reducing aggregate supply, increasing inflation in the process (Krugman, 2012). The value of investment would reduce, and households would prefer saving rather than spending. This has the effect of further reducing money in the economy, thus reducing the level of inflation. This measure would lead to a shrunken GDP due to reduced production.
Keynesian policies are more effective than monetarist policies.
The Keynesian model is favourable as it involves the government in the active determination of economic welfare by proactively contributing to it. The role government plays in an economy is invaluable in case of a growing, receding economy since it has the potential to large scale spending and lending capabilities. The participation of the government, therefore, expands the economy rather than constrict it. The monetary approach would be suitable for a developed economy which seeks to protect the value of its currency by checking inflation; it would find little use in a government that seeks to expand its economy, since it goes the opposite direction of constricting it.
References
Beetsma, R. M. (2004) Monetary policy, fiscal policies, and labour markets Macroeconomic policymaking in the EMU. Cambridge, UK: Cambridge University Press.
Krugman, P R, Obstfeld, M, & Melitz, M J (2012) International economics: Theory & policy Boston: Pearson Addison-Wesley
Lucas, R. E, & Gillman, M (2013) Collected papers on monetary theory Cambridge, Mass Harvard University Press
