How do new classical economists differ from Keynesian economists in their assump

timer Asked: Jul 29th, 2014
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How do new classical economists differ from Keynesian economists in their assumptions about how government borrowing affects household consumption and borrowing patterns?

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Khali R
School: UT Austin

Keynesian economics is a theory of total spending in the economy (called aggregate demand) and of its effects on output and inflation. Although the term is used (and abused) to describe many things, six principal tenets seem central to Keynesianism. The first three describe how the economy works.

1. A Keynesian believes that aggregate demand is influenced by a host of economic decisions—both public and private—and sometimes behaves erratically. The public decisions include, most prominently, those on monetary and fiscal (i.e., spending and tax) policy. Some decades ago, economists heatedly debated the relative strengths of monetary and fiscal policy, with some Keynesians arguing that monetary policy is powerless, and some monetarists arguing that fiscal policy is powerless. Both of these are essentially dead issues today. Nearly all Keynesians and monetarists now believe that both fiscal and monetary policy affect aggregate demand. A few economists, however, believe in what is called debt neutrality—the doctrine that substitutions of government borrowing for taxes have no effects on total demand (more on this below).

2. According to Keynesian theory, changes in aggregate demand, whether anticipated or unanticipated, have their greatest short-run impact on real output and employment, not on prices. This idea is portrayed, for example, in Phillips curves that show inflation changing only slowly when unemployment changes. Keynesians believe the short run lasts long enough to matter. They often quote Keynes's famous statement "In the long run, we are all dead" to make the point.

Anticipated monetary policy (that is, policies that people expect in advance) can produce real effects on output and employment only if some prices are rigid—if nominal wages (wages in dollars, not in real purchasing power), for example, do not adjust instantly. Otherwise, an injection of new money would change all prices by the same percentage. So Keynesian models generally either assume or try to explain rigid prices or wages. Rationalizing rigid prices is hard to do because, according to standard microeconomic theory, real supplies and demands do not change if all nominal prices rise or fall proportionally.

But Keynesians believe that, because prices are somewhat rigid, fluctuations in any component of spending—consumption, investment,

or government expenditures—cause output to fluctuate. If government spending increases, for example, and all other components of spending remain constant, then output will increase. Keynesian models of economic activity also include a so-called multiplier effect. That is, output increases by a multiple of the original change in spending that caused it. Thus, a $10 billion increase in government spending could cause total output to rise by $15 billion (a multiplier of 1.5) or by $5 billion (a multiplier of 0.5). Contrary to what many people believe, Keynesian analysis does not require that the multiplier exceed 1.0. For Keynesian economics to work, however, the multiplier must be greater than zero.

3. Keynesians believe that prices and, especially, wages respond slowly to changes in supply and demand, resulting in shortages and surpluses, especially of labor. Even though monetarists are more confident than Keynesians in the ability of markets to adjust to changes in supply and demand, many monetarists accept the Keynesian position on this matter. Milton Friedman, for example, the most prominent monetarist, has written: "Under any conceivable institutional arrangements, and certainly under those that now prevail in the United States, there is only a limited amount of flexibility in prices and wages." In current parlance, that would certainly be called a Keynesian position.

No policy prescriptions follow from these three beliefs alone. And many economists who do not call themselves Keynesian—including most monetarists—would, nevertheless, accept the entire list. What distinguishes Keynesians from other economists is their belief in the following three tenets about economic policy.

4. Keynesians do not think that the typical level of unemployment is ideal—partly because unemployment is subject to the caprice of aggregate demand, and partly because they believe that prices adjust only gradually. In fact, Keynesians typically see unemployment as both too high on average and too variable, although they know that rigorous theoretical justification for these positions is hard to come by. Keynesians also feel certain that periods of recession or depression are economic maladies, not efficient market responses to unattractive opportunities. (Monetarists, as already noted, have a deeper belief in the invisible hand.)

5. Many, but not all, Keynesians advocate activist stabilization policy to reduce the amplitude of the business cycle, which they rank among the most important of all economic problems. Here Keynesians and monetarists (and even some conservative Keynesians) part company by doubting either the efficacy of stabilization policy or the wisdom of attempting it.

This does not mean that Keynesians advocate what used to be called fine-tuning—adjusting government spending, taxes, and the money supply every few months to keep the economy at full employment. Almost all economists, including most Keynesians, now believe that the

government simply cannot know enough soon enough to fine-tune successfully. Three lags make it unlikely that fine-tuning will work. First, there is a lag between the time that a change in policy is required and the time that the government recognizes this. Second, there is a lag between when the government recognizes that a change in policy is required and when it takes action. In the United States, this lag is often very long for fiscal policy because Congress and the administration must first agree on most changes in spending and taxes. The third lag comes between the time that policy is changed and when the changes affect the economy. This, too, can be many months. Yet many Keynesians still believe that more modest goals for stabilization policy— coarse-tuning, if you will—are not only defensible, but sensible. For example, an economist need not have detailed quantitative knowledge of lags to prescribe a dose of expansionary monetary policy when the unemployment rate is 10 percent or more—as it was in many leading industrial countries in the eighties.

6. Finally, and even less unanimously, many Keynesians are more concerned about combating unemployment than about conquering inflation. They have concluded from the evidence that the costs of low inflation are small. However, there are plenty of anti-inflation Keynesians. Most of the world's current and past central bankers, for example, merit this title whether they like it or not. Needless to say, views on the relative importance of unemployment and inflation heavily influence the policy advice that economists give and that policymakers accept. Keynesians typically advocate more aggressively expansionist policies than non-Keynesians.

Keynesians' belief in aggressive government action to stabilize the economy is based on value judgments and on the beliefs that (a) macroeconomic fluctuations significantly reduce economic well-being, (b) the government is knowledgeable and capable enough to improve upon the free market, and (c) unemployment is a more important problem than inflation.

The long, and to some extent, continuing battle between Keynesians and monetarists has been fought primarily over (b) and (c).

In contrast, the briefer and more recent debate between Keynesians and new classical economists has been fought primarily over (a) and over the first three tenets of Keynesianism—tenets that the monetarists had accepted. New classicals believe that anticipated changes in the money supply do not affect real output; that markets, even the labor market, adjust quickly to eliminate shortages and surpluses; and that business cycles may be efficient. For reasons that will be made clear below, I believe that the "objective" scientific evidence on these matters points strongly in the Keynesian direction. 

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