- The monetarist/new classical and Keynesian models come from 2 different economics schools of thought.
- Understanding their different assumptions and implications is crucial for analysing economic fluctuations and policy responses.
The monetarist/new classical model
Assumptions
- Flexible wages and prices:
- Wages and prices adjust to restore equilibrium.
- If AD falls, a decrease in price level causes wages to decrease, reducing production costs and increasing AS.
- Vertical long-run aggregate supply (LRAS) curve:
- The LRAS curve is vertical at the full employment level of output (potential output).
- Potential output is determined by the production possibilities of the economy, not the price level.
- Full employment as the norm:
- The economy naturally gravitates towards full employment.
- Any deviation is temporary and corrected by market forces.
- Need for minimal government intervention:
- Since the economy is self-regulating, government intervention is unnecessary, and it may be harmful if it alters the market self-correction mechanism.
- Policies should focus on long-term growth by expanding the production possibilities (supply-side policies).
The monetarist/new classical model emphasises the economy’s ability to self-correct through flexible wages and resource prices, assuming full employment is the natural state of the economy.
Implications
- Temporary output gaps:
- Inflationary or recessionary gaps are short-lived.
- Market forces restore equilibrium at full-employment in the long run.
- Ineffectiveness of demand-side policies:
- Fiscal and monetary policies (demand-side policies) aim to shift the AD curve.
- However, in the long run, shifts in AD only affect the price level, not potential output.
- Therefore, increasing AD beyond its full employment equilibrium only leads to inflation, not to increasing real output.
- This makes demand-side policies ineffective in the long-run.
- Focus on supply-side policies
- Long-term growth depends on improving the production possibilities of the economy.
- Policies should focus on the supply-side of the economy, driving growth in production possibilities.
Monetarist model: automatic self-correction
Who: Technology Industry
Where: United States
When: 2022-2023
What Happened: Mass layoffs occurred across major tech companies following a period of cost-push inflation.
Why: Rising production costs, particularly higher labor costs, led companies to reassess their expenses and reduce their workforce to maintain profitability.
How:
- Cost-push inflation (cause by a leftward shift in SRAS) occurs when the costs of production increase (wages, raw materials...).
- In response, firms in the technology sector made workers redundant to reduce costs.
- The loss of income for these workers reduced aggregate demand (AD) by reducing consumer spending (C), which helped counter the inflationary pressures.
- This adjustment aligns with the monetarist belief that profit-maximizing firms drive market self-correction.
So?:
- The market corrected itself without requiring government intervention, consistent with the monetarist model.
- The reduction in aggregate demand helped stabilise price levels over time, as the economy moved toward long-run equilibrium.
- This demonstrates the self-correcting mechanism of markets, where price and demand adjustments occur naturally through profit-driven decisions by firms, reflecting minimal government interference in the economy.
Monetarist model: Aggregate Demand increases are always inflationary
When: 2021-22
Where: United States
What: Post-COVID-19 economic recovery led to significant demand-pull inflation.
Why:
- During the COVID-19 pandemic, lockdowns and restrictions significantly limited spending opportunities, leading to increased household savings.
- Governments introduced stimulus measures (e.g., direct payments, unemployment benefits) to revive economic activity during the downturn.
- Once restrictions were lifted, pent-up demand and surplus savings caused a sharp rise in consumption, increasing aggregate demand (AD).
How:
- Relaxation of restrictions: as people returned to normal activities, they began spending saved income on goods and services.
- Government stimulus: fiscal measures boosted consumer purchasing power, further amplifying demand.
- Aggregate Demand surge: these factors combined to shift the AD curve to the right, leading to an increase in the price level and inflation.
So?:
- This case demonstrates how a sharp increase in AD, even from a deflationary gap (e.g., annual growth rate of -2% in 2020), can trigger inflation.
- It supports the monetarist principle that increases in AD are inherently inflationary when the economy nears or surpasses its productive capacity.
- While this AD increase contributed to economic recovery, it also led to inflationary pressures, highlighting the trade-off between growth and price stability in a demand-driven recovery.
