Monetarism and Keynesianism Compared – HL Ahuja (Macroeconomics)

• The old monetarists such as Irving Fisher advanced the quantity theory of money, which stated that changes in money supply have a direct and proportional effect on the price level.

• Modern monetarists, led by Milton Friedman, developed an alternative macroeconomic framework to Keynesian theory, explaining not only changes in prices but also fluctuations in output and employment.

• Monetarists argue that money supply is the primary determinant of nominal GNP in the short run and of the price level in the long run.

• The central difference between monetarists and Keynesians lies in their explanation of aggregate demand: Keynesians view it as influenced by multiple factors such as consumption, investment, government expenditure, taxes and exports, whereas monetarists consider changes in money supply as the dominant force.

• Monetarists believe the private market economy is inherently stable and, if left free, will automatically adjust to the full-employment level of output.

• They contend that economic instability largely results from discretionary fiscal and monetary interventions by the Government and monetary authorities.

• In contrast, Keynesians regard the private economy as inherently unstable and emphasize the need for active government intervention through discretionary fiscal and monetary policies to achieve stability and growth.

• In recent years, however, the differences between the two approaches have narrowed, with some convergence in views regarding the roles of monetary and fiscal policies.

Two Different Approaches to Aggregate Demand

• Keynesians define aggregate demand as the sum of consumption, investment, government expenditure and net exports, expressed symbolically as AD = C + I + G + (X − M), and equilibrium national income is determined where C + I + G + (X − M) = Y.

• In this framework, Y represents national income or GNP, and aggregate demand is influenced by multiple real and policy variables such as fiscal measures, investment decisions and foreign trade.

• In contrast, monetarists focus on money supply as the primary determinant of aggregate demand, using the equation of exchange MV = PQ.

• In this equation, M denotes quantity of money, V is velocity of circulation, P is general price level and Q is real output, so MV represents aggregate expenditure while PQ represents nominal income or nominal GNP.

• Since monetarists assume velocity (V) to be stable and predictable, they argue that changes in money supply directly cause changes in nominal GNP.

• When money supply increases, individuals hold excess money balances and increase spending on goods and services, raising aggregate demand and thereby increasing PQ.

• Although aggregate demand in both approaches ultimately equals national income, the key difference lies in its conception: Keynesians view it as C + I + G + (X − M), while monetarists interpret it simply as MV.

• The central debate concerns which framework better explains the determination of income, employment and prices, and which provides a more reliable basis for economic policy.

Money Supply as the Prime Determinant of Nominal GNP

• A central principle of monetarism is that “only money matters,” as aggregate demand is defined as MV, and with stable velocity (V), changes in money supply are the main force affecting nominal income (PQ).

• From the equation MV = PQ, if V is constant, variations in nominal GNP arise primarily from changes in M, making money the dominant determinant of output, employment and prices in the macroeconomy.

• Monetarists argue that while fiscal policy may influence resource allocation between defence, consumption or investment, key macroeconomic variables such as national output and price level are largely determined by money supply.

• Empirical evidence presented by Milton Friedman and Anna Schwartz in A Monetary History of the United States (1867–1960) supports the view that monetary policy significantly influenced nominal GDP and explained major fluctuations in U.S. output.

• In contrast, Keynesians define aggregate demand as C + I + G + (X − M) and see money as only one indirect influence on income and employment.

• In the Keynesian framework, an increase in money supply lowers the interest rate, which stimulates investment; through the multiplier process this raises aggregate demand, output and employment, especially during depression with idle capacity.

• Early Keynesians believed monetary policy was relatively weak in deep recessions due to a flat liquidity preference curve and interest-inelastic investment demand, limiting its effectiveness.

• However, modern Keynesians accept that changes in money supply can affect output and employment, though they maintain that the transmission operates indirectly through interest rates and investment, unlike the direct impact emphasized by monetarists.