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September 2012 Policy Study, Number 12-9

   

A Short History of Economic Theory

   

War of Ideas: Economic Growth and Stabilization Policy

   

 

After the financial crash of 2007, all of the old debates about the role of government were resurrected. Should large financial institutions be “bailed out” by the government? Should it spend its way out of the recession? Can it afford to do nothing? There can be no question that the recent downturn has rekindled a smoldering war between various economic theories. As should be obvious to all the actors on the great stage of the American economy, we are still suffering from a severe recession, and as the crisis grinds on, the voices on every side grow louder. All parties claim to have the key to our economic salvation, if only we follow their policies to the letter. Various solutions to promote economic growth and stability can be found in Keynesian, Monetarist, and Neoclassical theories.

 

Advocated by John Maynard Keynes, Keynesian stimulus theory calls for government intervention to counteract business cycles. According to Keynes, there are three ways to neutralize a recession: an unexpected increase in business confidence, sticky wage adjustment, and governmental stimulus.[184] The last of these three options, governmental stimulation of the economy through deficit spending and low taxes, is the main Keynesian solution for an economy that is mired in a recession.[185] In the Rational Expectations model, repeated use of such spending to move out of a recession will cease to have any effect, epitomizing the idea of policy irrelevance, because the public will understand that deficit spending today must be financed by a tax tomorrow, and adjust their consumption habits accordingly.[186] The Real Business Cycle theory posits that Keynesian demand-side stimulus will do nothing to solve business cycles, since they are a product of drops in aggregate supply, not aggregate demand.[187] While Keynesian theory focuses on fiscal stimulus, Monetarists decry this position and support stabilizing the economy through the central bank.

 

As their name would suggest, Monetarists seek to use monetary policy, rather than fiscal, for countercyclical activities. Monetarism is closely linked to Classicism, from which Monetarism’s founder, Milton Friedman, drew his inspiration.[188] The central principles of Monetarism are adaptive expectations, the short-run effects of shocks to aggregate demand, and the idea that variations in the money supply are responsible for demand fluctuation.[189] Due to their belief that a vacillating money supply is responsible for business cycles, Monetarists seek to break the power of recessions by removing discretionary power from central banks and tying the growth of the money supply to the rate of economic growth, about 5 percent.[190] This model fits quite well within the Rational Expectations system, since it gives producers and consumers an absolutely reliable medium of exchange, stabilizing demand and supply.[191] Monetarism does not mesh well with Real Business Cycles, since they espouse different views of the source of business cycles: shocks to aggregate supply and shocks to the money supply, respectively.[192] While Monetarists sought a partial revival of Adam Smith’s ideas, Neoclassical theorists took Friedman’s work one step farther.

 

In a resurrection of the Classical laissez-faire model, Neoclassicists argue for a “hands off” economic system which embraces business cycles. Although it is a renewal of Classicism at the core, Neoclassical models expound the principles of free enterprise with analysis of microeconomics and the business cycle.[193] With its roots in The Wealth of Nations, Neoclassical stabilization policy is mainly concerned with preventing the government from intervening in the economy and crowding out the private sector; recoveries from recessions are driven by entrepreneurship and the profit motive.[194] Rational Expectations maintains the viewpoint that because producers and consumers understand the economy, they will not be fooled by government attempts at fiscal stimulus into consuming more; instead, they will merely save money for the inevitable taxation.[195] The Real Business Cycles theory holds that fluctuations in economic output, i.e. business cycles, are driven by “productivity shocks” which can come from changes in the cost of inputs, technology, and government taxation.[196] The defining feature of Neoclassical theory is that it views business cycles as efficient responses to changes in the “natural rate of output,” not the villains that Keynesian and Monetarist economists cast them as.[197] Neoclassical economic models work on the principle of a gyroscope-like economy that is self-correcting.

 

Neoclassical, Monetarist, and Keynesian theories offer different solutions to achieve economic stability and expansion. The debate is still unfinished. Will Keynes’s interventionist instincts, Friedman’s monetary focus, or Smith’s free-market principles win the day? As the war of ideas is waged from the political stage to the kitchen table, only one thing is clear: it’s going to be quite a fight.


   

 

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