Modifications That Were Made to Keynes' Approach Essay

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Modifications That Were Made to Keynes' Approach by the Neo-Keynesians and the Implications for the Scope of Fiscal and Monetary Policies

The objective of this work is to examine the key modifications that were made to Keynes' Approach by the Neo-Keynesians and the Implications for the Scope of Fiscal and Monetary Policies. Keynesian economics is reported in the work of Chick (1983) to be understood as a certain set of policy prescriptions, yet in the General Theory; very little space is devoted to the implications of the theory for government policy." (p.316) The Keynesian doctrine held that the economy "could be stabilized and growth encouraged by policies -- mostly variations of government expenditure and taxation -- designed to alter the level of aggregate demand, while monetary policy was dismissed as impotent, not just in the particular circumstances of the 1930s and later 1940s but generally 'money did not matter'." (Chick, 1983, p.316) The alleviation of unemployment was also a primary aspect of Keynesian policy as Keyes was attempting to solve a futuristic problem and specifically that of "unemployment high for over a decade and showing no sign of improvement, entrepreneurs discouraged, great excess capacity yet the economy generally undercapitalized: a condition where there is a shortage of houses, but where nevertheless no one can afford to live in the houses there are." (Chick, 1983, p.317) Modigliani states that money, in the free capitalistic economy serves two purposes: (1) it is a medium of exchange; and (2) it is a form of holding assets. (p.49) Two sources of demand for money exist: (1) the transaction demand for money; and (2) the demand for money as an asset. (p.48) Keynes argues that classical theory is only applicable to special rather that general cases and that the assumption is made in the situation "which is assumes being a limiting point of the possible positions of equilibrium." (p.3) In addition Keynes holds that the characteristics of the special case assumed by the classical theory happen not to be those of the economic society in which we actually live, with the result that its teaching is misleading and disastrous if we attempt to apply it to the facts of experience." (Keynes, 1964, p.3)

Pasinetti states that the principle of effective demand "may appear very simple; so simple in fact as to make one wonder why it has taken so long to emerge." (p.33) Keynes is stated to have been forced "by the very logic of his system, to look for a new theory of the rate of interest. He claims that, for a series of reasons including transactions, precautionary and speculative motives that there is certain quantity of money that people are willing to hold at each level of the rate of interest. This quantity of money -- the demand for money is inversely related to the rate of interest and tends to infinity before the rate of interest reaches zero." (Pasinetti, 1974, p.37) This means that the rate of interest is determined by the money quantity that the Central Authority issues. The IS-LM model holds that monetary policy is not as strong as fiscal policy "because it shifts the aggregate demand curve directly. Monetary policy influences aggregate demand through adjusting interest rates and money supply." (CLIENT'S REFERENCE) This is reported to take place through government bond sale or purchase with the money supply being fixed by the central bank and demand on money determination "through the liquidity preference and thus, the interest rate." (CLIENT'S REFERENCE) Depending on the balance and demand and the money supply the interest rate is adjusted affecting the money market and the quantity of goods as well as services and the price level of those services. A larger money supply decreases rates of interest and results in the stimulation of investment expenditure resulting in an increase in aggregate demand. (CLIENT'S REFERENCE)

In the classical system it is reported that the "suppliers of labor are supposed to behave rationally." (Modigliani, 1994, p.47) The supply of any commodity is stated to be dependent "on the relative price of the commodity so the supply of labor is taken to depend not on the money wage rate, but on the real wage rate." (Modigliani, 1974, p.47) However, the assumptions made by Keynes are different on the supply-of-labor schedule as the supply of labor "is assumed to be perfectly elastic at the historically ruling wage rate." (Modigliani, 1974, p. 47) The classical system was such that when there was no work for workers that the services of the workers could be procured at a price that was much lower than previously making it feasible to employ those workers. In the same vein, an unused plant or facility would be offered at lower prices to attract customers and competition would "force prices down and sales and production up." (Galbraith, 1984, p.80) Classical theory held that the flow of purchasing power would always be enough to purchase the goods at the established prices and specifically this is according to Say's Law, which is quite simplistic in nature however, the lesson of the 1930s showed differently.

According to Galbraith (1994) Say's Law "is not immutable. Income does not necessarily get spent of invested…in times of insecurity and doubt as to the future it will be hoarded in cash or in banks and the banks may be too frightened or pressed by bad loans to lend. Or they may be lacking in suitably solvent borrowers." (p.81) In addition, prices are stated to be such that do not necessarily accommodate to the reduced demand" as in the modern corporate economy they have a certain rigidity or stability, as do wage costs." (Galbraith, 1994, p.81) When demand is reduced production falls and workers are then laid off and the income, which is reduced or which no longer exists simply adds to the effect of depression. Say's Law is reported to be such that may be further rendered ineffective by unused purchasing power in large portions that are held by individuals who have not immediate need to spend or to invest. However, individuals with only moderate or with small incomes will continue to spend for survival. The belief during the depression that it was automatic that there would be a return to the full use of plant facilities and workers is reported by Galbraith to be based instead of on economic reality, on "political faith, hope and assurance…" (1994, p.82)

The underemployment equilibrium of the depression continued due to the banking crisis and the decentralized banking system in the U.S. However, as history shows the Hoover years served to push public works spending and there was an increase in the federal deficit as the government spent money to provide stimulation to the economy. As history shows however, this monetary policy is not sound and this was evidenced in the 1970's when Keynesian concepts resulted in terrible failure. These concepts have once again been invoked in today's economy and have been used for putting off issues that should be addressed resulting in only short-term economic relief through creating deficits in the budget and resulting in monetary inflation. Keynes does not acknowledge that government management is inefficient and appears to have confidence in the capacity of government established and administered systems of economics. Keynes believed that the government should control interest rates, direct flows of investment and redistribute the country's wealth and that the government should manage the business activities of major corporations. Keynes is in agreement with Marx that the entrepreneur is not a necessity and that the capitalist system when stimulated will result in capital assets being generated making these assets other than scarce. However, the entrepreneur is the lifeblood of the capitalist economy and monetary policy that avoids support of the entrepreneur results in government owned and controlled assets becoming predominant in the economic system. Monetary policy is the "manipulation of the money supply with the objective of affecting macroeconomic outcomes such as GDP growth, inflation, unemployment, and exchange rates" (Monetary Policy, nd, p.1)

The policy of Monetarists is such that holds monetary policy is that which affects prices but that it does not affect GDP or unemployment. Therefore the impact of monetary policy is expressed using the 'equation of exchange' or "MV=PQ" and where M. is the quantity of money in circulation, V is the velocity of money, P is the price level and Q. is real GEDP, then the assumption is made that V is stable then the change in the money supply must result in changes to the price level or the GDP therefore, total spending changes regardless of interest rates. The Keynesian train of thought would be to decrease the supply of money so that interest rates would increase, spending would decrease as well as would prices and real output however it is the position of monetarists that in the case of high inflation, that interest rates are already high therefore, a decrease in the supply of money would result in falling interest rates due…

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