3.2.10 Assumptions and implications of the monetarist/new classical and Keynesian models Notes

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:

1. Cost-push inflation (cause by a leftward shift in SRAS) occurs when the costs of production increase (wages, raw materials...).
2. In response, firms in the technology sector made workers redundant to reduce costs.
3. The loss of income for these workers reduced aggregate demand (AD) by reducing consumer spending (C), which helped counter the inflationary pressures.
4. This adjustment aligns with the monetarist belief that profit-maximizing firms drive market self-correction.

So?:

1. The market corrected itself without requiring government intervention, consistent with the monetarist model.
2. The reduction in aggregate demand helped stabilise price levels over time, as the economy moved toward long-run equilibrium.
3. 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:

1. During the COVID-19 pandemic, lockdowns and restrictions significantly limited spending opportunities, leading to increased household savings.
2. Governments introduced stimulus measures (e.g., direct payments, unemployment benefits) to revive economic activity during the downturn.
3. Once restrictions were lifted, pent-up demand and surplus savings caused a sharp rise in consumption, increasing aggregate demand (AD).

How:

1. Relaxation of restrictions: as people returned to normal activities, they began spending saved income on goods and services.
2. Government stimulus: fiscal measures boosted consumer purchasing power, further amplifying demand.
3. 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.

Keynesian model: persistence of deflationary gaps

When: 2008

Where: Global, with significant impacts on the United States

What: The 2008 financial crisis (Global Financial Crisis) marked a severe global economic downturn triggered by the collapse of the U.S. housing market and a subsequent banking crisis.

Why:

1. The crisis began with the bursting of the U.S. housing bubble, leading to a wave of mortgage defaults.
2. This destabilized major financial institutions, froze credit markets, and caused widespread financial instability.
3. The resulting drop in consumer and business confidence caused a sharp decline in spending and investment, creating a global recession.

How:

1. Deflationary Gap: The crisis led to significant underutilization of resources, high unemployment, and reduced economic activity, shifting the economy far below its potential output.
2. Horizontal AS Curve: From a Keynesian perspective, the global economy operated on the flat portion of the aggregate supply curve, where increases in aggregate demand (AD) did not trigger inflation.
3. Policy Measures: Efforts to stimulate AD through monetary policy, such as lowering interest rates, were insufficient on their own to close the gap. Fiscal policy interventions were necessary to stimulate demand and address widespread unemployment.

So?

1. The 2008 financial crisis highlights how deflationary gaps can persist over long periods, even with attempts to increase AD.
2. It demonstrates that in severe recessions, increases in AD do not always result in inflation, as underutilized resources and excess capacity absorb the demand.
3. The crisis underscores the importance of Keynesian principles in addressing economic stagnation, emphasizing the need for coordinated fiscal policy alongside monetary measures to restore full employment and economic stability.