ASSIGNMENT ON INTERMEDIATE MACROECONOMIC (ECN 304)

Question 1: Compare and contrast Classical theory of interest rate and Keynesian theory of interest Question2: Highlight all the controversies between Keynesian, Monetarist, and the Classical

QUESTION 1:

COMPARE AND CONTRAST CLASSICAL THEORY OF INTEREST RATE AND KEYNESIAN THEORY OF INTEREST

Meaning of Interest Rate: An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for deferring the use of funds and instead lending it to the borrower. Interest rates are normally expressed as a percentage of the principal for a period of one year. Interest rates targets are also a vital tool of monetary policy and are taken into account when dealing with variables like investment, inflation, and unemployment. Theories of Interest Rate Determination There are four (4) basic theories on the determination of interest rates. They are: 1. The Classical theory of interest rate 2. Keynesian theory of interest rate 3. The loanable funds theory 4. The Modern theory of interest Having given these four theories, I will limit my exposition to compare and contrast the Classical theory of interest rate and Keynesian theory of interest 1.1. THE CLASSICAL THEORY OF INTEREST RATE

The fundamental principle of the classical theory is that the economy is self-regulating. Classical economists maintain that the economy is always capable of achieving the natural level of real GDP or output, which is the level of real GDP that is obtained when the economy's resources are fully employed. While circumstances arise from time to time that cause the economy to fall below or to exceed the natural level of real GDP, self-adjustment mechanisms exist within the market system that work to bring the economy back to the natural level of real GDP. Therefore, to the Classical Economists, rate of interest is determined by the supply and demand of capital. The supply of capital is governed by the time preference and demand for capital by the expected productivity of capital. Both time preference and productivity of capital depend upon waiting or saving or thrift. The theory is, therefore, also known as the supply and demand theory of saving. In other words, the theory holds the proposition based on the general equilibrium theory that the rate of interest is determined by the intersection of the demand for and supply of capital. Thus, an equilibrium rate of interest is determined at a point at which the demand for capital equals its supply. Demand for capital stems from investment decisions of the entrepreneur class. Investment demand schedule, thus, reflects the demand for capital, while the supply of capital results from savings in the community. Savings schedule, thus, represents the supply of capital. It follows that savings and investment are the two real factors
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determining the rate of interest. In technical jargon, the rate of interest is determined by the intersection of investment demand schedule and the savings schedule. At the equilibrium rate of interest, total investment and total savings are equal. It should be noted that the theory assumes real savings and real investment. Real savings refer to those parts of real incomes which are left unconsumed to provide resources for investment purposes. Reinvestment implies use of resources in producing new capital assets like machines, factory plants, tools and equipment, etc. It means investment in capital goods industries, in real terms. 1.1.0. Demand for Capital: Demand for capital comes from entrepreneurs who wish to invest in capital goods industries. In fact, demand for capital implies the demand for savings. Investors agree to pay interest on those savings because the capital projects, which will be undertaken with the use of these funds, will be so productive that the returns on investment realized will be in excess of the cost of borrowing, i.e., interest. In short, capital is demanded because it is productive, i.e., it has the power to yield an income even after covering its cost, i.e., interest. The marginal productivity curve of capital, thus, determines the demand curve for capital. Indeed the marginal productivity curve is, after a point, a downward sloping curve. While deciding about an investment, the entrepreneur, however, compares the marginal productivity of capital with the prevailing market rate of interest. Marginal productivity of capital (MPK) = marginal physical product of capital (MPK) x the price of the product (P). Given marginal productivity, when the rate of interest falls, the entrepreneur will be induced to invest more till marginal productivity of capital is equal to the rate of interest. Thus, investment demand expands when the interest rate falls and it contracts when the interest rate rises. As such, investment demand is regarded as an inverse function of the rate of interest. In symbolic terms:I = f(r), in which I/r < 0 Where, I = investment demand, r = rate of interest, and f = functional relationship panel (a) illustrates an investment demand schedule in graphical terms. 1.1.1. Supply of Capital: Saving is the source of capital formation. Therefore, supply of capital depends basically on the availability of savings in the economy. Savings emerge out of the people's desire and capacity to save. To some classical economists like Senior, abstinence from consumption is essential for the act of saving while economists like Fisher stress that time preference is the basic consideration of the people who save. In both the views, rate of interest plays an important role in the determination of savings. The classical economists commonly hold that the rate of saving is the direct function of the rate of interest. That is, savings expand with the rise in the rate of interest and, when the rate of interest falls, savings contract. In symbolic terms, the saving function may be stated as follows: S = f (r), in which S/r > 0 Where, S = volume of savings, r = rate of interest, and stands for functional relationship. The saving-function or the supply of savings curve is an upward-sloping curve. It must be noted that savings and investment, referred to in the above functions, are in real terms. 1.1.2. Equilibrium Rate of Interest:

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The equilibrium rate of interest is determined at that point at which both demand for and supply of capital are equal. In other words, at the point at which investment equals savings, the equilibrium rate of interest is determined. Indeed, the demand for capital is influenced by the productivity of capital and the supply of capital. In turn, savings are conditioned by the thrift habits of the community. Thus, the classical theory of interest implies that the real factor, thrift and productivity in the economy, are the fundamental determinants of the rate of interest.
Figure-1 Savings and Investments (Classical Equilibrium of Interest Rate)

In this diagram the amount of investment (or saving) I is measured vertically, and the rate of interest r horizontally. X1X1' is the first position of the investment demand-schedule, and X2X2' is a second position of this curve. The curve Y1 relates the amounts saved out of an income Y1 to various levels of the rate of interest, the curves Y2, Y3, etc., being the corresponding curves for levels of income Y2, Y3, etc. Let us suppose that the curve Y1 is the Ycurve consistent with an investment demandschedule X1X1' and a rate of interest r1. Now if the investment demand-schedule shifts from X1X1' to X2X2', income will, in general, shift also. But the above diagram does not contain enough data to tell us what its new value will be; and, therefore, not knowing which the appropriate Y-curve, we do not know at what point the new investment demand-schedule will cut it. If, however, we introduce the state of liquidity-preference and the quantity of money and these between them tell us that the rate of interest is r2, then the whole position becomes determinate. For the Y-curve which intersects X2X2' at the point vertically above r2, namely, the curve Y2, will be the appropriate curve. Thus the X-curve and the Y-curves tell us nothing about the rate of interest. They only tell us what income will be, if from some other source we can say what the rate of interest is. If nothing has happened to the state of liquidity-preference and the quantity of money, so that the rate of interest is unchanged, then the curve Y2' which intersects the new investment demand-schedule vertically below the point where the curve Y1 intersected the old investment demand-schedule will be the appropriate Y-curve, and Y2' will be the new level of income.

1.1.3. Criticisms of the Classical Theory Of Interest Rate: The pure or the real theory of interest of the Classical as enunciated by A. Marshall and A.C. Pigou has been severely criticized by J.M. Keynes. Major criticisms leveled against the classical theory are as follows: 1) Income not constant but variable 2) Saving-investment schedules not independent 3) Neglect the effects of investment on Income 4) Indeterminate theory 5) Neglects other sources of savings 6) Unrealistic assumption of full employment 7) Neglect monetary factors 8) No automatic equality between equilibrium and market rates of interest 9) Different over the definition of interest Income not constant but variable: one of the serious defects of the classical theory is that it assumes the level of income to be given and regards interest as an equilibrating mechanism between the demand for
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investible funds and the supply of funds through savings. According to Keynes, income is a variable and not a constant and the equality between saving and investment is brought about by changes in income and not by variations in the rate of interest. Saving-investment schedules not independent: In this theory the two determinants of interest rate, the demand and supply curves of saving are treated as independent of one another. It means that if there is change in demand, the demand curve for savings can shift up or below the I-curve without causing a change in the supply curve. But according to Keynes, the two curves are not independent of one another. If, for instance, an investment shifts the investment curve upward, income will rise and it will rise and it will lead to higher savings and thus shift the supply curve too. Similarly, a shift in the supply curve will bring a change in the demand curve. Neglect the effects of investment on Income: The Classical theory neglects the effect of investment on the level of income. A rise in the rate of interest, for instance, will bring a decline in investment by making it less profitable. This will mean decline in output, employment and income. The latter will, in turn, lead to reduced savings a fact contrary to the classical assertion that saving is a direct function of the rate of interest. On the other hand, low rate of interest encourages investment activity, increase output, employment, income and savings. But Keynes does not believe that investment depends on the rate of interest. It depends on the marginal efficiency of capital. Even if the rate of interest were to fall to zero, Keynes argues, investment will not take place if business expectations for profits are at low level, as is the case in depression. Indeterminate theory: Since savings depend upon the level of income, it is not possible to know the rate of interest unless the income level is known beforehand. And the income level itself cannot be known without already knowing the rate of interest. A lower rate of interest will increase investment, output, employment, income and savings. So, for each income level a separate saving curve will have to be drawn. This is all circular reasoning and offers no solution to the problem of interest. That is why Keynes characterized the classical theory of interest as indeterminate. Unrealistic assumption of full employment: The classical theory is based on the unrealistic assumption of full employment. In a fully employed economy interest as a reward for saving, waiting or abstinence is necessary to induce people to save. But according to Keynes, underemployment and not full employment is the rule and where resources are unemployed, interest is not essentially an inducement to savings. Neglects other sources of savings: The propounders of this theory include savings out of current in the supply schedule of savings which makes it inadequate. Considering the supply of capital to be interestelastic, people might lend their past savings with the rise in the rate of interest and so increase the supply of capital. Banks lend more during periods of slow business activity. The classical theory remains incomplete when it neglects these in the supply schedule of capital. Neglect monetary factors: The classical theory is a pure or real theory of interest which takes into consideration the real factors like the time preference and the marginal productivity of capital. It completely neglects the influence of monetary factors on the determination of the rate of interest. The classical economists regarded money as a veil a medium of exchange over goods and services. They failed to consider it as a store of value. Keynes, on the other hand, laid emphasis in explaining the determination of the rate of interest as a monetary phenomenon. No automatic equality between equilibrium and market rates of interest: According to the classical view, the market and the equilibrium (natural) rates of interest are always equal. Any discrepancy between the two is only a temporary phenomenon which would disappear in the long run. Keynes, however, does not regard the discrepancy between the two as accidental and temporary. It can be due to the contraction or expansion of bank credit. An expansion of bank credit by increasing the supply of loanable fund brings about fall in the market rate of interest below the equilibrium rate, and vice versa. Thus there is no automatic mechanism for the equality of the market and equilibrium interest rate. Different over the definition of interest: Keynes differs with the classical economists even over the definition and determination of the rate of interest. According to him, it is the reward of not hoarding but the reward of parting with liquidity for a specified period. It is the price which equilibrates demand for money with the available quantity of money. He does not agree that it is determined by the demand for and supply of capital

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Thus, Keynes dismisses the Classical theory of interest as absolutely wrong and inadequate. 1.2. KEYNES LIQUIDITY PREFERENCE THEORY OF INTEREST

Keynes defines the rate of interest as the reward for parting with liquidity for a specified period of time. According to him, the rate of interest is determined by the demand for and supply of money. In the words of Keynes interest is a monetary phenomenon. Liquidity means the convenience of holding cash. Liquidity preference means desire to hold cash. This is inherent in human nature. Everyone in this world likes to have money with him for a number of purposes. This constitutes his demand for money to hold. 1.2.1. Demand for Money: Liquidity preference means the desire of the public to hold cash. According to Keynes, there are three motives behind the desire of the public to hold liquid cash: 1) Transactions Motive 2) Precautionary motive 3) Speculative Motive Transactions Motive: The transactions motive relates to the demand for money or the need of cash for the current transactions of individual and business exchanges. Individuals hold cash in order to bridge the gap between the receipt of income and its expenditure. This is called the income motive. The businessmen also need to hold ready cash in order to meet their current needs like payments for raw materials, transport, wages etc. This is called the business motive. Precautionary motive: Precautionary motive for holding money refers to the desire to hold cash balances for unforeseen contingencies. Individuals hold some cash to provide for illness, accidents, unemployment and other unforeseen contingencies. Similarly, businessmen keep cash in reserve to tide over unfavorable conditions or to gain from unexpected deals. Keynes holds that the transaction and precautionary motives are relatively interest inelastic, but are highly income elastic. The amount of money held under these two motives (M1) is a function (L1) of the level of income (Y) and is expressed as M1 = L1 (Y) Speculative Motive: The speculative motive relates to the desire to hold ones resources in liquid form to take advantage of future changes in the rate of interest or bond prices. Bond prices and the rate of interest are inversely related to each other. If bond prices are expected to rise, i.e., the rate of interest is expected to fall, people will buy bonds to sell when the price later actually rises. If, however, bond prices are expected to fall, i.e., the rate of interest is expected to rise, people will sell bonds to avoid losses. According to Keynes, the higher the rate of interest, the lower the speculative demand for money, and lower the rate of interest, the higher the speculative demand for money. Algebraically, Keynes expressed the speculative demand for money as M2 = L2 (r) Where, L2 is the speculative demand for money, and r is the rate of interest. Geometrically, it is a smooth curve which slopes downward from left to right. Now, if the total liquid money is denoted by M, the transactions plus precautionary motives by M1 and the speculative motive by M2, then M = M1 + M2. Since M1 = L1 (Y) and M2 = L2 (r), the total liquidity preference function is expressed as M = L (Y, r). 1.2.2. Supply of Money:

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The supply of money refers to the total quantity of money in the country. Though the supply of money is a function of the rate of interest to a certain degree, yet it is considered to be fixed by the monetary authorities. Hence the supply curve of money is taken as perfectly inelastic represented by a vertical straight line. The total demand for money is obtained by summating the transactions, precautionary and speculative demands. Represented graphically, it is sometimes called the liquidity preference curve and is inversely related to the rate of interest. The Demand for Money and the Rate of Interest

Money Demand and Increases in Real GDP Consider a period of sustained economic growth in the economy. Rising real incomes and increasing numbers of people employed will increase the demand for money at each rate of interest. Therefore higher real national income causes an outward shift in the demand for money. This is shown in the diagram below.

Financial Innovation and the Demand for Money The pace of change in financial markets is rapid and this affects our demand for money balances in order to finance our purchases. In recent years the demand for cash balances (M0) has declined relative to the demand for interest-bearing deposit accounts. Most people can finance their purchases using debit cards and credit cards rather than carrying around large amounts of cash. Financial innovation has reduced the demand for cash balances at each rate of interest - represented by an inward shift in the money demand curve.

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1.2.3. Determination of the Rate of Interest: Like the price of any product, the rate of interest is determined at the level where the demand for money equals the supply of money. In the following figure, the vertical line QM represents the supply of money and L the total demand for money curve. Both the curves intersect at E2 where the equilibrium rate of interest OR is established. If there is any deviation from this equilibrium position an adjustment will take place through the rate of interest, and equilibrium E2will be reestablished. At the point E1 the supply of money OM is greater than the demand for money OM1. Consequently, the rate of interest will start declining from OR1 till the equilibrium rate of interest OR is reached. Similarly at OR2 level of interest rate, the demand for money OM2 is greater than the supply of money OM. As a result, the rate of interest OR2 will start rising till it reaches the equilibrium rate OR. It may be noted that, if the supply of money is increased by the monetary authorities, but the liquidity preference curve L remains the same, the rate of interest will fall. If the demand for money increases and the liquidity preference curve sifts upward, given the supply of money, the rate of interest will rise. 1.1.4. Criticisms of the Keynesian Theory Of Interest Rate:

Keynes theory of interest has been criticized on the following grounds: 1. It has been pointed out that the rate of interest is not purely a monetary phenomenon. Real forces like productivity of capital and thriftiness or saving by the people also play an important role in the determination of the rate of interest. 2. Liquidity preference is not the only factor governing the rate of interest. There are several other factors which influence the rate of interest by affecting the demand for and supply of investible funds. 3. The liquidity preference theory does not explain the existence of different rates of interest prevailing in the market at the same time. 4. Keynes ignores saving or waiting as a means or source of investible fund. To part with liquidity without there being any saving is meaningless. 5. The Keynesian theory only explains interest in the short-run. It gives no clue to the rates of interest in the long run.

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6. Keynes theory of interest, like the classical and loanable funds theories, is indeterminate. We cannot know how much money will be available for the speculative demand for money unless we know how much the transaction demand for money is. 1.3. Comparison between Classical and Keynesian Theories of Interest

The Keynesian theory of interest is an improvement over the classical theory in that the former considers interest as a monetary phenomenon as a link between the present and the future while the classical theory ignores this dynamic role of money as a store of value and wealth and conceives of interest as a nonmonetary phenomenon. Thus, the classicists made the serious error of ignoring the monetary element in formulating the theory of interest a monetary theory. Thus, the classical theory of interest in comparison with Keynes' liquidity preference theory has several weaknesses. They are as under: 1. The classical theory treated interest as the price for not spending, for saving, while, in fact, as the liquidity theory points out, it is price paid for not hoarding i.e. parting with liquidity. 2. The classical theory views the demand for money exclusively in terms of investment. It fails to consider the fact that the demand for money might also arise from the demand for hoarding, i.e., holding idle cash balances on account of the liquidity preferences. It is the Keynesian theory of interest that recognizes the important role of liquidity preference in the determination of the interest rate. 3. The classical theory is narrow in scope as it ignores the borrowing motives like hoarding or the purpose of consumption and concentrates only on savings demanded for productive purposes, i.e., real investment demand. 4. Classical economists did not pay any attention to the money supply and bank credit which can never be ignored as a determinant of the rate of interest. Keynes does pay attention to the quantity of money as a factor determining the rate of interest. 5. The classical theory is rather ambiguous and indefinite. It ignores the fact that saving is a function of income but regards it as a function of the interest rate. This is wrong; Keynes argued that when the rate of interest goes up level of income will be less since investment will decline so savings will be less. Keynes thus stressed the fact that saving is a function of income rather than that of the interest rate. 6. The main weakness of the classical theory is, therefore, that it assumes the level of income to be always given. This is because it assumes full-employment equilibrium. The theory is, therefore, rejected by Keynes because it is applicable only to a case when income is fixed at a point corresponding to the level of full employment. Keynesian theory, on the other hand, is more realistic as it considers the economies of less than full employment also. 7. In fine, an important distinction between the Keynesian and classical theories of interest is that the former theory is completely stock theory whereas the latter is a completely flow theory. 8. In some respects, the Keynesian theory is narrower in scope, compared with the classical theory. Keynes' liquidity preference theory applies to the supply and demand for money savings or money capital only whereas the classical theory applies to non-monetary capital also. 9. Moreover, the liquidity preference theory assumes that a person should lend capital to somebody to get interest; for then alone can one say that he has parted with liquidity and that interest is assumed to be a reward for parting with liquidity as such. According to the classical theory, on the other hand, even if a person does not necessarily part with his savings but uses them in his own productive activity (real investment), interest will arise. 1.4. Conclusion:

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Nevertheless, we may conclude that Keynesian theory is superior to the classical theory of interest since the former is concerned with equilibrium in the real sector. Thus, in the money economy of the present world, the Keynesian theory is more realistic than the classical theory of interest.

QUESTION 2:

HIGHLIGHT ALL THE CONTROVERSIES BETWEEN KEYNESIAN, MONETARIST AND THE CLASSICAL ECONOMIC

2.0. Introduction: Over the years, macroeconomists from different schools of thought have had a divergent view on what really drives economic growth for an economy in achieving the macroeconomic. In this case, I will limit my idea to the controversies and the divergent view between Keynesian, Monetarist and the Classical economic theory. 2.1. The Controversies:

The primary phenomena and controversies among these three (3) schools of thought investigated are: 1. 2. 3. 4. 5. 6. 7. 8. 9. The proposed Structure and Stabilization Policies of the Economy Macroeconomics Thought on Demand for Money Macroeconomics Thought on Inflation Macroeconomics Thought on Growth Macroeconomics Thought on Unemployment Macroeconomics Thought on Business cycles Macroeconomics Thought on Balance of Payment Macroeconomics Thought on Wage Price Stickiness Macroeconomics Thought on Consumption

The proposed Structure and Stabilization Policies of the Economy: The fundamental message of the Keynesian is that the private enterprise needs to be stabilized, and therefore should be stabilized by appropriate monetary and fiscal policies. Monetarists by contrast take the view that there is no serious need to stabilize the economy; that even if there were a need it should not be done since stabilization policies would be more likely to increase than to decrease instability. To the Classical, which uses the Passive Strategy approach that assumes that the self-correcting mechanisms will work well, if not stifled by unnecessary meddling by policymakers. They Classical believe that erratic, improperly timed activist policies are actually a source of economic instability, and that economy would be better off if it maintain stable, predictable fiscal and monetary policy during all phases of the business cycle. Therefore, to monetarists there is no active role for stabilization policy, and to Keynesians there is. Classical, assumes selfcorrecting mechanisms. Macroeconomics Thought on Demand for Money (Quantity Theory of Money): The Classical economists assumed that the velocity of the money was constant. They believed the institutional, structural and customary conditions determined the velocity. P is the general price level. It is an average of prices of all those final goods and services provided and exchanged in the economy over the time period chosen for observation. The classical macroeconomists assumed that, because of full employment and flexibility of price, wage and interest, physical output would be constant. As a result, a change in the amount of money supply will cause a proportional change in the general price level-1. Modern Quantity Theory expressed in its most basic form, the simple quantity theory of money makes the demand for nominal money balances
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depend only on the nominal income level: M = P f{Y). The Keynesian theory adds the interest rate as a determinant to give us a different function: M = P f(Y,r).During the post-Keynesian period, another theory was developed. Its creator, Milton Friedman who championed the Monetarist sees the modern quantity theory as a restatement of the old one, whereas others see it as an elaborate statement of Keynesian theory. One way of expressing the demand for money in the simple quantity theory is M = k(PY), where k is a constant. Macroeconomics Thought on Inflation: In order to explain inflation, the Keynesians tend to argue that the long-run Phillips curve is not vertical and that the government needs to, pursue an unemployment target via discretionary demand management policies. Such policies will involve inflation owing to the trade-off between unemployment and inflation and believe that the long-run Phillips curve can be shifted downward by the adoption of a prices and incomes policy.
Fig-3: Keynesian Inflationary Gap. Using the Keynesian model is the relation between equilibrium and full

employment. The relation between the inflationary gap and recessionary gap indicates which of the gaps, if either, might exist. In this particular example, full employment results with $9 trillion of aggregate production, which is less than the $12 trillion equilibrium level of aggregate production. The relation between equilibrium and full-employment aggregate production means the economy has an inflationary gap. The resulting inflationary gap is $3 trillion of aggregate production. In other words, aggregate production needs to decrease by $3 trillion to eliminate this gap. The Monetarists argue that inflation is essentially a monetary phenomenon propagated by excessive monetary growth. They accept that in the short run there may be a trade-off between inflation and unemployment but argue that once people have fully adjusted their inflationary expectations the trade-off disappears, resulting in a vertical long-run Phillips curve at the natural rate of unemployment. In short, monetarists advocate that discretionary demand management policies should be replaced by a monetary rule in order to avoid economic instability. New classical macroeconomics incorporates the monetarist view that inflation: is essentially a monetary phenomenon propagated by excessive monetary growth and can only be reduced by slowing down the rate of monetary expansion. Macroeconomics Thought on Growth: One growth theory relates the growth rate of the economy's aggregate output to that of its capital stock. In this approach, capital is the only factor of production explicitly considered and it is assumed that labor is combined with capital in fixed proportions. With regard to the rate at which capital accumulates, this theory is Keynesian in nature. Keynesian-based growth theory is commonly known as the Harrod-Domar theory. The Classical is based their idea on "subsistence level" to model their Growth Theory. They believed that if real GDP rose above this subsistence level of income that it would cause the population to increase and bring real GDP back down to the subsistence level. It was sort of like an equilibrium level that real GDP would always revert to in this theory. Alternatively, if the real GDP fell below this subsistence level, parts of the population would die off and real income would rise back to the subsistence level. Keynesian growth theory appears essentially a theory of the medium period, Classical a theory of the long period. The main differences between the two theories concern the formation of expectations with respect to factor prices and the behavior of capacity utilization. Basically monetarism views government roles in policy to ensure a stable equilibrium in the Money Market (supply and demand for money). This is known as Price Stability. Too much growth equals higher than normal levels of inflation. Too little growth and the economy may slow. Money is the

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only way to manage the "health" of the economy, as defined by stability fo economic variables (unemployment, inflation, output growth, etc.) Macroeconomics Thought on Unemployment: The Keynesian approach is usually associated with Keynesian AD-AS model. In terms of the IS-LM model the Keynesian position has been characterized by a relatively flat LM curve and a relatively steep IS curve. Fiscal policy is preferred as the main policy instrument to maintain the economy at a high and stable level of employment. In contrast to Keynesian beliefs, monetarists argue that capitalist economies are inherently stable and that when subjected to some disturbance the economy will return to equilibrium at the natural rate of unemployment. As such, they question the need for discretionary aggregate-demand management policies and tend to argue that such policies cannot stabilize the economy. Regarding fiscal policy, monetarists argue that while pure fiscal expansion can influence output and employment in the short run, and in the long run it will have no effect. Monetarists argue that if governments wish to reduce the natural rate of unemployment in order to achieve higher employment levels they should pursue microeconomic or what are referred to as supply side policies rather than macroeconomic policies. According to Classical, anticipated aggregate demand policies will be ineffective in influencing level of output and employment even in the short run, and that only random and unanticipated shocks to aggregate demand can temporarily affect output and employment. Any attempt to affect output and employment by random or non-systematic aggregate demand policies would, only increase the variation of output and employment. Macroeconomics Thought on Business cycles: The traditional Keynesian explanation of cyclical fluctuations in the economy has two parts. First, it emphasizes variations in investment as a cause of business cycles and stresses the non-monetary causes of such variations, such as expectations or, as Keynes put it, 'animal spirits. Keynesians reject the extreme Monetarist view that only money matters in explaining cyclical fluctuations. Many Keynesians believe that both monetary and non-monetary forces are important in explaining cycles. Although they accept serious monetary mismanagement as one potential source of economic fluctuations, they do not believe that it is the only, source of such fluctuations. Thus, they deny the monetary interpretation of business cycle given by Friedman and Schwartz. They believe that most fluctuations in the aggregate demand curve are due to variations in the desire to spend on the part of the private sector and are not induced by government policy. Keynesians also believe that the economy lacks strong natural corrective mechanisms that will always force it easily and quickly back to full employment. They believe that, while the price level rises fairly quickly to eliminate inflationary gaps, prices and wages fall only slowly in response to recessionary gaps. As a result, Keynesians believe that recessionary gaps can sometimes persist for long periods of time unless they are eliminated by an active stabilization policy. Friedman and Schwartz maintained that changes in the money supply cause changes in business activity. The Classical approach to explaining business cycles has something in common with the monetarists, in that the shock that sets off the cycle is a change in the money supply. However, what happens in the Classical is different from traditional (monetarist or Keynesian) business cycle theory, because the New Classical school wanted a model in which markets were always in equilibrium. In the New Classical approach, cycles in real economic activity are triggered only by unexpected increases in the money supply. Macroeconomics Thought on Balance of Payment: The classical price-specie flow mechanism approach, associated especially with David Hume (1711-76), applied to the world of the gold standard. Current account balance of payments surpluses led to gold inflows which caused domestic prices to rise. The rise in domestic prices made domestic goods relatively expensive compared with foreign goods, so imports rose and exports fell. By this means, a balance of payments surplus would be eliminated. The monetary approach to the balance of payments approach is that excess demand or supply of money is important in explaining official reserve changes, under fixed exchange rates, and exchange rate changes, under floating. Professor Harry Johnson (1923-77) popularized this modern interpretation of the classical approach in the1970s. He reinterpreted the links between the money supply and the balance of payments to fit with modern monetary institutions. The result, that increases in the money supply lead to proportional
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currency depreciation and price-level increases, inconsistent with the monetary approach. However, one important insight of the monetary approach was that an economy that is growing faster than the rest of the world, but is subject to restricted domestic money creation, could have a sustained cur-rent account surplus under fixed exchange rates, or a continuing appreciation under floating exchange rates. Macroeconomics Thought on Wage Price Stickiness: Sticky prices lie at the very heart of Keynesian macroeconomics, and it explains quantity fluctuations in goods and labor markets as equilibrating movements arising because prices do not immediately change when aggregate demand shifts. The postulate of price flexibility lies at the center of new-classical economics. It has it that prices always move to equilibrate markets when demand shifts, but that individual agents, who are not fully informed about the behavior of all money prices in the economy, mistake money price changes in the markets for the goods they sell for relative price changes. Hence they respond by changing the quantities of goods they supply. In the aggregate, an unperceived demand increase which raises the general price level therefore causes an expansion of output along aggregate supply curve, and a fall of demand causes a contraction. Macroeconomics Thought on Consumption: The consumption function is the centerpiece of Keynes General Theory. Keynesians approach to consumption was Absolute income Hypothesis .One of the earliest attempt to derive a theory of consumption function in accord with the empirical discoveries was James Duesenberry's Relative Income Hypothesis (1949).A household's consumption depends not on its absolute income but on its relative income; relative that is to (1) the income of other households and (2) its own Previous income. Later Milton Friedman proposed the PIH to explain consumer behavior 2.3. Conclusion The mainstream schools of thoughts highlighted above carries different views on a specific given economic variable in discussing economic policy stabilization .The importance of such is that it gives the reader to appreciate different tools and techniques theories adopted to achieve economic policy stabilization. The drastic change that has occurred in economic theory has not been the result of ideological warfare. It has not resulted from divergent political beliefs or aims. It has responded almost entirely to the force of events: brute experience proved far more potent than the strongest of political or ideological preferences. (Friedman, 1977, p. 470)

References Leslie .D, Advanced Macro Economics(1993) L.Rosalind, R.Alexander, Macro Economics An Introduction to Keynesian Classical Controversies. (1982) Lipsey .R.G , Chrystal.K.A, An Introduction to Positive Economics(1989) Shapiro. Edward , Macro Economic Analysis .(2004) The New Classical contribution to Macro Economics Cross, Rod, ed. Unemployment, Hysteresis, and the Natural Rate Hypothesis. Oxford: Blackwell, 1988. Friedman, Milton. The Role of Monetary Policy. American Economic Review 58, no. 1 (1968): 117. Lucas, Robert E. Jr. Econometric Testing of the Natural Rate Hypothesis. In Otto Eckstein, ed., Phelps, Edmund S. Phillips Curves, Expectations of Inflation and Optimal Employment over Time. Economica, n.s., 34, no. 3 (1967): 254281. Phillips, A. W. H. The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 18611957.Economica, n.s., 25, no. 2 (1958): 283299. Samuelson, Paul A., and Robert M. Solow. Analytical Aspects of Anti-inflation Policy. American Economic Review 50, no. 2 (1960): 177194.

BERNARD OKPE

Reg. No./Group/Level: 272010497/B/300

Assignment on ECN 304

Page | 12