Introduction
Various instruments of macro-economic policy affect a country’s economy and the global economy at large. They include monetary policy, fiscal policy, and the supply side policy. Monetary policy is when the government decides to use the interest rates and the money in the economy to control the economy (Griffiths & Wall, 2012). This can be applied during recession to expand the economy, or during boom to restrict the economy. Fiscal Policy is used to direct the economy by deciding the expenditure of the government, the resources, and the taxation. The supply side policy is used to change the economic structure and to improve the market performance. To explain these instruments, various theories and approaches have been postulated. Some of the approaches include the Keynesian, the Monetarist and the supply-side approach. Keynesian approach suggests that, in order to eliminate the deflationary and inflationary gaps and to flatten the cyclical fluctuation effects in the national income, governments should properly manage the aggregate demand level. On the other hand, Monetarist approach suggests that the governments are not supposed to engage in these policies, since the policies are ineffective at best, and destabilizing at worst. The UK’s Conservative government and the Labour government both pursued the demand management policy thought the nineteen sixties and nineteen seventies until UK economy was gripped by stagflation (Krugman, 2009; Skidelsky, 2001). Thatcher then opted for the Monetarist approach which was the basis for the economic policy of UK throughout the 1980s and the 1990s (Skidelsky, 2001). This paper compares and contrasts the Keynesian, Monetarist and the supply-side approaches in the management of an economy.
The Keynesian approach
Keynesian approach advocates for a mixed economy. It postulates that ineffective macroeconomic outcomes sometimes result from private sector decisions. Therefore, the public sector, through the fiscal policy regulations of the government and the central bank, must provide active policy responses, especially the monetary policy responses, so that the output of the business cycle can be stabilized (Le Grand et al., 1992; Keynes, 2007). According to this approach, the private sector is predominant; however, both the public sector and the government have very significant roles.
This approach explains the cyclical fluctuation of economy in two parts. The first part stresses on the variations in investment which is caused by the business cycle, and emphasizes on the non-monetary causes of the variations (Lipsey and Chrystal, 2007; Le Grand et al., 1992). When explaining the cycles, both the monetary and the non-monetary forces are important. Keynesian acknowledges that serious monetary mismanagement is one of the potential sources of fluctuations in an economy; however, it is not the major cause, neither is it the only cause of the fluctuations (Keynes, 2007; Griffiths & Wall, 2012). Thus, government policy does not induce the fluctuations in the demand curve, rather the private sector and the desire to spend. Also, lack of strong natural mechanisms for correcting the economy is another cause of the fluctuations. As the price level increases quickly and eliminates inflammatory gaps, the wages and prices fall slowly to the recessionary gaps (Lipsey and Chrystal, 2007). Therefore, unless eliminated by active stabilization policy, recessionary gaps are most likely to persist for longer periods.
The second part stresses on the correlation between the changes in the economic activity level and the money supply changes (Lipsey and Chrystal, 2007). According to this approach, monetary supply changes are often caused by the changes in economic activity level. The GDP fluctuations are mostly caused by autonomous expenditure fluctuations. Besides, it is the GDP fluctuations that cause the money supply fluctuations (Keynes, 2007). The approach acknowledges that deliberate changes in the monetary policy are most likely to cause a change in GDP; however, it is not the main cause. Therefore a rigid policy rule should be implemented. Keynesians believe that the most important factor is the fluctuation in the private sector investment, which can easily be offset by the authorities.
The monetarist approach
Monetarist approach emphasizes on the role of the government in regulating the money in circulation (Le Grand et al., 1992). According to this approach, the national output and the price level are highly influenced by the variations in money supply (Griffiths & Wall, 2012). Besides, the monetary policy objectives are best achieved by targeting the monetary supply growth rate.
Monetarism is theoretically a challenge to the Keynesian economics. This challenge strengthened during the stagflation that followed the oil shocks in 1973 and 1979 (Le Grand et al., 1992; Griffiths & Wall, 2012). The Keynesian approach had no substantial policy responses to the crisis. Inflation was extremely high and Friedman convincingly argued that rapid increase in money supply was the main cause of high inflation rates. He further reasoned that the economy might be complicated; however, stabilization policy is not needed (Le Grand et al., 1992). Therefore, the key is to control the money supply.
This approach postulates that there is inherent stability in the economy due to the fact that the functions of the private sector expenditure are comparatively stable and the price adjustment brings the economy back to the potential output (Lipsey and Chrystal, 2007). As well, aggregate demand curve shifts result from the induced changes in the money supply policy. Business cycles result from the monetary causes and there is a strong correlation between the economic activity changes and the money supply changes. The approach further postulates that minor recessions are associated with the slow increase in money supply below the long-term trend, while major recessions are associated with the absolute declines in monetary supply (Lipsey and Chrystal, 2007). Changes in the business activity are caused by changes in money supply. In addition, fluctuations in the GDP are caused by fluctuations in money supply.
The main differences between Keynesian approach and Monetarist approach
Despite their convergence in various areas, there are substantial differences between Keynesian approach and Monetarist approach. First, Keynesian approach postulates that policy makers should use discretion when conducting the monetary policy. Monetarist approach, however, advocates for long term money growth rules, i.e. the monetary policy should be tied to the rules (Lipsey and Chrystal, 2007; Le Grand et al., 1992). Secondly, Keynesians view the fiscal policy as potentially important. Monetarists, however, believe that the fiscal policy is useless.
Considering the forces that operate on aggregate demand, the two approaches disagree. Monetarist approach views money supply as the sole factor that affects the aggregate demand. Therefore, there is reliable and stable impact of money on the aggregate demand. Besides, the autonomous spending changes or the fiscal policy must be accompanied by the monetary changes so that the effects on the output and prices can be significant. By contrast, Keynesians hold that money supply is not the only factor that affects aggregate demand. Other factors are equally important.
Finally, Keynesians have a general rule that Aggregate Supply curve is less vertical and more horizontal (flat slope) in the short run. Therefore, stabilization policy has large impacts on the output and employment. On the other hand, Monetarists have a general rule that the Aggregate Supply curve is more vertical and less horizontal (steep slope). Therefore, the discretionary stabilization policy is of negligible importance.
The supply-side approach
The supply-side approach postulates that by lowering the production and supply barriers, the economic growth is highly enhanced (Gwartney, 2008). These barriers include capital gains tax, income tax, and flexibility barriers such as regulations, among others. As a result, consumers are most likely to benefit from greater supply of products (goods and services) at highly reduced prices.
The approach was developed in response to the Keynesian approach due to the failure of the stabilization of the demand management during the stagflation and the oil crisis (Atkinson, 2006). Supply-side approach postulates that the key to economic prosperity is the supply (production). The demand (consumption) is basically a secondary impact. The similarity between the supply-side and the Keynesian approach is that the demand is effectively stimulated by the policy. The spending, the size of the fiscal deficit, and the taxation level are important for the economic incentives.
The main aim of this approach is to reduce the price level and increase the national income (Le Grand et al., 1992). This in turn leads to unemployment reduction and poverty eradication (SSAG Study). According to the monetarist approach, the supply side policies are supposed to be used in freeing up the market and reducing the government interventions such as deregulation, providing incentives, and encouraging the private enterprise. Keynesian approach also believes in the supply side policies; however, it emphasizes on more interventionalist nature policies such as regional grants and training schemes.
According to this approach, increased taxation results into a steady decrease in the economic trade between the participants and at the same time discourages investment (Lindsey, 1990). Taxes are trade barriers that make the economic participants regress to less effective means of needs satisfaction (Lindsey, 1990; Atkinson, 2006). Therefore, high taxation results in lower specialization levels, which consequently leads to low economic efficiency.
The approach also postulates that the price rule should form the basis of the monetary policy (Gwartney, 2008). Monetary policy should therefore target some specific money value regardless of the money quantity withdrawn or created by the central bank in order to achieve the target. This view contrasts with both the monetarist approach on the money quantity, and the Keynesian approach on the real aggregate demand. The difference is that: in monetarist approach, the money quantity is the sole determinant for the demand and supply of money; and in the Keynesian approach, money does not matter.
On tax revenue, the supply-side approach argues that the tax cut results in an overall increase in the revenue. This was more common in the 1980s when tax cuts led to significant increase in the revenue, thus economic growth.
Conclusion
Keynesian approach can be used by the government as an intervention tool to attain a suitable aggregate demand level and to achieve full employment, economic growth, balance of payments, and stable inflation level. When an economy faces a recession, monetary policy is used to lower the interest rates and ease the controls on bank lending. On the other hand, fiscal policy is used to increase the public spending and to cut the taxes. During an economic boom, the monetary policy is used to increase the interest rates and make the control on bank lending stricter. On the other hand, fiscal policy is used to decrease the public spending and to raise the taxes. Monetarist approach, however, suggests that increase in money supply is the main cause of inflation. Also, higher wage demands are caused by future expectations of increased inflation levels. This consequently increases the inflation. The government should therefore control its spending. Monetary policy is used to ensure a slow but steady growth in the money supply. It also stresses the importance of stabilizing the supply of money in the medium term. In order to change the economic structure and to improve the market performance, supply-side approach is considered.
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