Download tma07 - john p birchall

J.P.BIRCHALL P0194869/A/94
TMA 07
6/9/94
The two great traditions of economic theory during the last 60 years,
Keyesianism and monetarism, have generated endless debate and often antipathy
because of their widely divergent policy proposals. Surprisingly the differences
emerge in spite of using an identical analytical tool; the aggregate supply and
demand model.
Aggregate demand is the total, or sum, of all the money people plan, or
wish, to spend on goods and services produced in the domestic economy. It
comprises household consumption, the investment of firms, government
expenditure and exports, but because it is concerned with production in the
domestic economy it excludes imports. It is usually expressed as:e = c + i + g + (x - h)
The demand schedule is derived from the link between the goods and the
money markets. In the goods market, consumption depends on national income,
interest rates and the real stock of money and investment depends on interest rates
and the expectations of decision makers. These are expressed as:c = f (y , r, M/P) where M is the nominal money stock and P the price level
i = f (r , expectations)
In the money markets the demand for money depends on the national
income and interest rates:mD = f (y , r)
At equilibrium:mD = (M/P)D
The demand for money increasing as national income increases and more
money is required to support increased activity; but decreasing when interest rates
rise as high interest rates encourage people to hold bonds. Fig 1 shows the
relationship.
The links between the goods and money markets can now be understood and
the AD curve developed. If prices fall real money balances increase and
consumption is directly increased as people hold larger stocks of real money.
Investment and consumption will also increase as larger money stocks reduce
interest rates. Thus aggregate demand increases both directly through higher
money stocks and indirectly through lower interest rates. Thus as prices fall the
AD curve will slope down to the right. The lower the price level the higher
aggregate demand. The AD curve is shown in fig 2.
The AD curve assumes that, apart from price level, several of the other
important determinants of aggregate demand are held constant, namely; elements
of consumption, investment and imports which are independent of national income
or 'autonomous', government spending, taxation, exports, propensities to consume
and import, and the nominal money stock. Any change in these will shift the AD
curve.
It should be noted that the original theory of Keynes considered only the
goods market and assumed the consumption function depended only on income
and that investment was dominated by animal spirit expectations. Thus the AD
curve would not be affected by price level and would be vertical.
Aggregate supply is a more contentious issue and is usually assumed to be
dominated by the labour market and is defined as the total output domestic firms
wish, or plan, to produce.
The key to the derivation of the aggregate supply curve is the assumption
that is made about the behaviour of the costs facing the producing firms
(particularly labour costs) and the reality that such costs will be reflected in the
prices they charge for their products. In the AD/AS model that is used for analysis
it is short term costs that are considered and, therefore, capital stock and
technology are assumed constant.
It is usual to consider three possible shapes for the AS curve. The first
assumes the cost of labour does not change as output increases providing firms are
operating below capacity and the labour market is below full employment. At full
employment bottlenecks appear as labour cannot be recruited and output will not
increase whatever the price and the AS curve becomes vertical. This is shown as
AS1 in fig 3.
The second possibility assumes that costs do rise as output increases, this
would be the case if recruiting extra labour could only be done by offering higher
wages. In this case the AS curve would slope up to the right and would still retain
the vertical character when full employment is reached. AS2 reflects this scenario.
Thirdly it is possible that firms are geared up to produce at a specific output
level and their production cannot be increased in the short term and is therefore
independent of price. In this case the AS3 curve will be vertical.
It is the shape of the AS curves which highlights the differences between
Keynesian and monetarist theories. The shapes depend on the assumption about the
production function faced by the firms, as this determines the marginal product of
labour and the demand for labour; and the assumption about how wages behave
with output and how this affects labour supply.
Most Keynesians now assume an AS2 type curve, with price rises resulting
in a decline in real wages and an increase in the demand for labour as firms wish to
supply more output. This will continue until the full employment bottleneck and
the curve will slope up to the right and become vertical. Again it is assumed other
determinants of supply are constant, namely; capital, technology, raw material
prices, population size, leisure preferences, replacement ratios and money wages. It
is changes in these determinants of supply which will shift the AS curve.
Fig 4 puts the AD and AS curves together and illustrates the basis of the
Keynesian theory of demand management.
The derivation of the AD curve assumed several determinants of demand
were held constant and any changes in these would shift the curve. Thus changes in
taxation, money supply and government spending can be deliberately used to as
policy instruments to shift the demand curve in an attempt to increase national
output. This is the basis of Keynesian demand management.
If demand management policies were to increase government spending and
increase the money supply and reduce taxation, each would shift AD to the right,
to AD1. From fig 4 it can be seen that such a shift would result in firms increasing
prices from p to p1, real wages would fall more labour would be demanded to
produce more output at y1.
It is clear that with an upward sloping AS curve price levels would rise but
with an AS1 (inverted L curve fig 3) the output gain would be achieved without a
price rise on the horizontal part of the curve. This is why the shape of the AS curve
is so important. The original Keynesian theory assumed that there would be no
price rise.
The original theory ignored the money market and this omission exposed the
main weakness of demand management; it led to increases in price level and
inflation. There were also technical difficulties with the timing of policy changes
and the interaction of the policy instruments together with a lack of reliable
information about the economy. However it was the monetarists who pointed to
fundamental weaknesses in the theory.
The monetarists concentrated on the supply side of the economy and the
issues of real production efficiency and competitive market forces. Their
contention was that demand manipulation was impotent in the long term because
any fiscal or monetary expansion merely displaced, diverted or 'crowded out'
private sector activity. Output was determined by real factors and monetary change
simply resulted in a change in price level.
The monetarist theory criticised the derivation of the AS curve which
assumed that as the price level rose real wages declined and this triggered output
increases. The monetarists suggested that price rises and reduced real wages would
trigger a reduction in the supply of labour. This is the classical view that the supply
of labour depends on the real wage rate. Fig 5 shows the supply and demand
curves for labour, crucially the supply of labour reduces as wages fall. The
resulting employment level e when real wages are at W/P can be related to output y
by reference to the firms production function. If output is determined in this way
from the labour market and the production function a change in real wages will
shift the supply function.
Fig 6 shows the monetarist approach and how changes in demand can affect
supply and shift the supply curve.
As AD shifts to AD1 following expansionary demand management the
original supply curve AS may result in a short term increase in output to y1 but as
real wages decline as prices move to p1 less labour is available at current wage
rates and output cannot be maintained. The supply curve will shift to AS1 as firms
must raise prices to p2 simply to maintain real wages and the original output y.
From this analysis expansionary fiscal and monetary policy has only shifted prices,
output remains the same. Further repetition of expansionary demand will further
escalate prices with no effect on output.
Thus monetarist theory suggests the AS curve is independent of price level
and is the vertical AS3 line. This leaves the policy options for increasing output
confined to shifting AS right by looking to the supply side determinants which the
original theory derivation assumed to be constant, namely; capital, technology, raw
material prices, population size, leisure preferences, replacement ratios and money
wages. It is changes in these determinants of supply which will shift the AS curve.
The monetarists supply side policy would keep price levels stable by
controlling the money supply and focus efforts on work incentives, more capital
and investment, better technology and organisation, better quality of education,
training and management; in short focus on the underlying realities of competitive
efficient production.
Inevitably, even if there is an emerging consensus that supply side policies
are wanted, there is no agreement on what form they should take. The long running
differences of opinion on how best to achieve efficiency will plague supply side
policy for some years to come! Is it through planning or through markets? Even if
markets are accepted as the most efficient there will continue to be controversy
over their lack of compassion!