A shortage in aggregate demand: a Keynesian-Monetarist contest in the sources for additional demand

In a framework of stimulus measures for the economy, the elephant in the room would not be efficiency, but time-efficiency.
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Central Office
on December 23, 2023
on December 23, 2023
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John Maynard Keynes (left) and Milton Friedman (right), two of the most remarkable economic figures of the 20th century.


Human society is perceived as more economic than human. At least, this is the perception of the Austrian School, which is based on the concept of a rational economic agent, or `homo-economicus`. Based on its Walrasian roots, consumers are always found at the informational limits of what is happening in the economic society, they do not make erroneous decisions in understanding the economic climate and thus are perfect optimizers situated in an enduring equilibrium (Hoover, 1984). But consumers are not always rational economic agents. As the spiritual father of the German social market economy, Wilhelm Röpke once said, ''the ordinary man is not just a homo economicus [...] The motives which drive people towards economic success are as varied as the human soul itself'' (Gregg, 2010). Since rational expectations cannot be self-fulfilling prophecies in economic relations, the idea that the economic planning environment of human societies might create imbalances in decision-making, induces the possibility that – at least from time to time – the economy might be suffering from insufficient aggregate demand and its departure from meeting output at potential level.

The present paper starts from the premise of the existence of economic imbalances between two aggregates: present demand and potential output and depicts two conceptual approaches regarding the source of demand fluctuations in order to advance a way of acquiring additional demand to correct the inter-aggregate imbalance. Based on the circular flow of income - income creates product demand which in turn increases output and the level of income - the Keynesian revolution of the inter-war period and the Monetarist counter-revolution of the late 1960s will be closely analyzed as economic schools aimed to correct deficits of demand through different equations of exchange, as well as divergent transmission mechanisms (fiscal or monetary policy). The conclusion of the paper intends to highlight which economic school would be more admissible, if not efficient, in stimulating the aggregate demand based on the debate between efficiency and time-efficiency.

The Keynesian revolution: we consume what we invest in our income

In the 1920-1930s, Keynesianism (based on the teachings of the British economist, John Meynard Keyes), was the first to advance the possibility of deficit aggregate demand and the fact that, left to itself, capitalism cannot provide for effective demand (Hansen, 1946). The economic environment of the Keynesian revolution was one of high levels of unemployment contrary to previous Classical perceptions of human society as a full employment economic society. The increase in unemployment rates was seen by Keynes as the most pressing social issue tied closely to a demand which was below its potential level (Johnson, 1971). The main reason for an ineffective demand or current income below full employment income was the over-existence of sclerosis at the investment level. It is important to remember the circular flow of income: the income in a society is spent on goods and services and the demand for the product increases the income of investors who will increase the investment levels in terms of output expansion and demand for labor force soon to be translated into raises in income subsequently spent on goods and services. Accordingly, unemployment is introduced, according to this cycle, by the lack of investment caused by an imbalance between demand and output. According to Keynes, there can be no demand for labor without demand for products and vice versa as the fall of one pulls the other after it. Consequently, the Keynesian solution was to boost output and investments through a corresponding adjustment of demand, and this could be achieved through an increase in consumer incomes with the help of the latest Keynesian breakthrough, the consumption function: C=a+bY, where C is consumption, a is autonomous consumption (the consumption level below income since even with no income an individual must consume with saved or borrowed money), b is the marginal propensity to consume (also known as induced consumption when the change in income affects the change in consumption), and Y noted as the available income (Hansen, 1946). Once consumption is properly determined, the level of product demand can be positively adjusted to increase the output and investment levels (labor demand) and inject additional income into society. According to Milton Friedman in his ``Monetary trends in the United States and United Kingdom: their relation to income, prices, and interest rates, 1867-1975``, Keynes saw the fluctuations of income ''as a dance of investment, rather than of the dollar'' (Friedman and Schwartz, 1982). The chosen channel to accomplish this endeavor was expansionary fiscal policy (an increase in public spending or reduction in taxes) aimed to boost what Keynes termed as the `liquidity preference`, an increase in liquid assets (cash) to be spent immediately on product demand. Keynesian mechanisms for transmitting fiscal policies into inter-aggregate equilibrium between demand and output was possible through the Keynesian equation of exchange: Y=C+G+I+(X-IM), where Y is income, C is consumption, G is governmental public spending, I is investment and X-IM is the net export (the difference between exports and imports) (Baumol and Blinder, 2015). Leaving the last variable aside since our example model is of a closed economy, an increase in income given by the inter-aggregate equilibrium between demand and output can be achieved either directly through an increase in G (through more public spending), or indirectly through an increase in C (through a reduction in taxes) and I (with the help of the consumption function through which the marginal propensity to consume can be shaped by both increases in public spending and decreases in taxes). Regardless of the choice of fiscal policy, the concept of government intervention thus becomes the in posse Keynesian recipe for inter-aggregate equilibrium.

The Monetarist counter-revolution: inflation is always a monetary phenomenon

Monetarism rose in rank towards the end of the 1960s as a counter-response to inflationary-biased Keynesianism, precisely Keynesian tendencies to trade off high rates of inflation for low levels of unemployment and succeeded as an economic response to Keynes in the 1970s during `stagflationary` times of both high levels of inflation and unemployment (Johnson, 1971). Under the work of Milton Friedman, Monetarism replaced unemployment with inflation as the most urgent social issue and advanced an economic agenda distinct from Keynes, both as components of a new equation of exchange, and as transmission mechanisms in order to obtain an equilibrium between aggregate demand and output. If for Keynes the liquidity preference was about cash being spent as part of the circular flow of income on raising output, employment and income, with little effects on the general price level and the interest rate, for Monetarism, money, or more precisely, the demand function for money (in contrast to the Keynesian consumption function) could affect real GDP, prices and interest rates throughout the economy: Md=f(Y,P,Ir), where Md is the money demand, Y is the real GDP , P is the price level and Ir is the interest rate. According to Monetarists, there is a positive relationship between the demand for money and real GDP and prices, and a negative one in relation to interest rates. Following this lead, when the economy booms and prices and wages increase, the need for more money to satisfy new spending transactions increases, whereas a decrease in interest rates may induce an increase in the demand for money for speculative reasons once investors decide to hold cash balances for better days or to be soon invested in other markets with higher rates of returns. Leaving aside the contrast between the Keynesian consumption function and the Monetarist demand for money function, Monetarism advances the importance of velocity as the ratio of income to the quantity of money. While Keynes does not at all minimize the importance of velocity, on the contrary - on the grounds of the improbability of determining the velocity as the speed at which money circulates, Keynes lays the foundations of his consumption function based on active fiscal policy - Monetarists consider velocity to be predictable and thus a stable component in the determination of nominal GDP. Therefore, in contraposition to Keynes, Monetarism uses MxV=PxY (where M is money supply, V is velocity, and PxY is the nominal GDP as a result of prices (P) multiplied by income (Y)), as their equation of exchange and a better model for determining the aggregate demand to the limit of pushing it towards equilibrium with aggregate output (Baumol and Blinder, 2015). Introducing the money demand function into the equation and considering that financial markets are in equilibrium (money supply=money demand / M=Md), Monetarism recognizes that -velocity being constant- there is a correlation between the expected inflation rate and the money demand/supplied, a relationship that Keynes did not follow (for Keynes, money does not matter) (Laidler, 1981). Consequently, any change in money supply is reflected in a proportional change in prices: P=Mx(V/Y), and since M=Md, the money demand could be calculated as Md=(PxY)/V.

The transmission mechanism of this equation of exchange termed by the Monetarists as the quantity theory of money once the predictability of velocity was fully accepted, was monetary policy (Baumol and Blinder, 2015). Contrary to Keynes preference for fiscal policy in the form of governmental public spending and tax cuts, Monetarism advanced the money supply - velocity being constant - as a more direct economic instrument for the determination of fluctuations in nominal GDP. The monetary version of the liquidity preferences, the demand function for money could be advanced through an expansionary monetary policy by increasing the money supply, and thus reducing the interest rates throughout the economy. With a fall in interest rates, the speculative demand for money increased (more liquidity) thus allowing for a proportional increase in prices and nominal GDP. The Monetarist trend of the circular flow of income will thus provide for more revenues from higher prices to be invested in output expansion and labor demand, thus raising income to be spent on product demand and restoring the equilibrium between aggregate demand and output without any governmental intervention in public spending and tax policy.

The rules of Monetarism: from the Keynesian political theory to the politically independent Classical Monetarism under Friedman

One should not see Monetarism as the monetary substitution of an excessively expansionary fiscal policy of income-expenditure under Keynes with an expansionary monetary policy of uncontrollably raising the money supply in establishing interest rates so low as to stimulate aggregate demand. Classical Monetarism, contrary to Keynesianism and Political Monetarism, has rules (Bradford De Long, 2000). The Keynesian politically intrusive income-expenditure theory did not allow any specific target-rules in how much public spending should be advanced or how far taxes should be cut, instead relying on its marginal propensity to consume and the multiplier to do their part in the government-enacted correction of an ineffective demand below its potential level. On its part, Political Monetarism, the politicized movement of the advancement of the quantity theory of money, had as part of its agenda the sole use of the money supply as the most accurate economic instrument for the determination of aggregate demand. According to this, any ineffective demand and disequilibrium in the economy is caused by the national Central Bank not raising the money supply enough to accommodate the macroeconomic inconsistencies (Bradford De Long, 2000). But Monetarism in the way it was presented in this paper should be the embodiment of Classical Monetarism under which money supply grows at constant x% every year and the Central Bank remains apolitical enough to ensure this. This Monetarism is best associated with Milton Friedman and his k-percent rule whereby the Central Bank must refrain from a counter-cyclical and unlimited monetary policy in the expansion of money supply in favor of constant increases in money stock based on the rate of growth of real GDP to meet cyclical demands (Bradford De Long, 2000) (Hoover, 1984). A rule-based monetary policy transmission mechanism for the correction of the aggregate demand was preferred at the expense of an alternative political monetary policy aimed to manipulate the demand and cyclical fluctuation to meet political needs in times of election (Bradford De Long, 2000). Moreover, based on the rational expectation hypothesis, economic agents will understand the implications of an active and limitless monetary policy in raising inflation, adjusting accordingly with their future expectations, and thus making inflation a self-fulfilling prophecy. The Miltonian Monetarism on the other hand uses the k-rule to assure economic agents of the limits of a disciplined monetary policy and the improbability of future inflation, whereas agents will immediately adjust to any rate of inflation produced as a consequence of the constant annual increase in money supply (Hoover, 1984).

Conclusion: efficiency or time efficiency?

The Keynesian revolution and the Monetarist counter-revolution to Keynes provide different equations of exchange and transmission mechanisms for the correction of an ineffective demand and its imbalance relative to potential output. But an analysis of the two macroeconomic models limited to which economic theory stimulates demand more efficiently than the other, misses the understanding of how the economic environment works: both affect demand but in different lags. Therefore, rather than the success of one macroeconomic model at the expense of the other in terms of better sources of additional demand that its equation of exchange can produce, a better approach would be to look at their transmission mechanisms and ask which one would be faster in this endeavor. In a framework of stimulus measures for the economy, the elephant in the room would not be efficiency, but time-efficiency. The Keynesian model emphasizes its marginal propensity to consume as an explanation for the way an economic agent will spend more once its income increases, thus moving the demand to the right. An increase in consumer income can be achieved either through a decrease in taxes or through an increase in government spending that will take over part of the daily expenses of households that would otherwise have occurred in its absence. Either through the components of the Keynesian equation, G or C, additional stimulus to the demand curve will be achieved. The question still remains, how quickly will these fiscal transmissions be seen in the real economy? Remembering Wilhelm Ropke mentioned in the introduction to this paper, "the ordinary man is not just a homo economicus [...] The motives which drive people towards economic success are as varied as the human soul itself" (Gregg, 2010). An agent might be indeed stimulated to consume more by the positive change in its income, but the same economic agent might be uncertain about the current economic climate as a tax cut might be perceived as a temporary measure which will make the agent save today's extra income for tomorrow's higher taxes (Baumol and Blinder, 2015). And even if this would not be unsafe at all, spending habits die hard. An agent who used to spend 20$ daily will not automatically spend 30$ the next day as a result of the increase in its income (Baumol and Blinder, 2015). The Keynesian propensity to consume is not automatic but adaptive. Furthermore, in terms of the transmission mechanism, the Keynesian demand is stimulated through fiscal policy. But in a democratic and multi-party world, taxation is a long battle to take. The annual budgets are quite rigid with minor changes over the fiscal year while the outcome is always contested and delayed by political debates (Baumol and Blinder, 2015). Consequently, the Keynesian income-expenditure theory will eventually change the position of the demand but given the time lap, it might not move it towards equilibrium. By the time the fiscal measures became effective, the economy might be in a different stance compared to the period when they were enacted, making the post-fiscal policy economy worse off.

On the other hand, the Monetarist approach is based on money supply as a component of the equation of exchange and on monetary policy as its transmission mechanism into aggregate demand. Just like the Keynesian C and G, the Monetarist M affects the changes in income of economic agents by lowering the interest rate and stimulating consumption and investments. But in the same Keynesian note, consumption stimulation is not outright, as like taxes, agents might perceive the low interest rate to be temporary while expecting it to rise in the future. Additionally, investments are even slower in reaction than consumers since it takes a lot of corporate bureaucracy to increase the company budget and come up with an expansion strategy (Baumol and Blinder, 2015). Just like the national budget being at the mercy of politicians, investments have their bureaucrats. But where the Monetarist model excels compared to Keynes is in the speed of its transmission mechanism. As the independence of the national Central Bank is considered the quintessence of Classical Monetarism (as advocated by Milton Friedman), its institutional capacity to come up with non-political and fast and periodic economic decisions in contrast to the rigid, contested and annual budget set politically by the national parliament, makes monetary policy a more reactive mechanism in the transmission of the Monetarist equation of exchange in the real economy than fiscal policy (Baumol and Blinder, 2015).



`Chapter 14` in Baumol J. William and Blinder S. Alan, 2015, Macroeconomics: principles and policy, Cengage Learning.

Bradford De Long, J., 2000 ‘The Triumph of Monetarism’, The Journal of Economic Perspectives, vol. 14, issue 1.

Chapter 12’ in Friedman, M. and Schwartz, A., 1982 Monetary Trends in the United States and United Kingdom: Their Relation to Income, Prices and Interest Rates, 1867–1975, University of Chicago Press.

Gregg, S., 2010 ‘Smith v Keynes: Economics and Political Economy in the Post-Crisis-Era’, Harvard Journal of Law & Public Policy, vol. 33, no. 2.

Hansen, A., 1946 ‘Keynes and the General Theory’, The Review of Economics and Statistics, vol. 28, no. 4.

Hoover, K., 1984 ‘Two Types of Monetarism’, Journal of Economic Literature, vol. 22, no. 1.

Johnson, H. G., 1971 ‘The Keynesian Revolution and the Monetarist Counter-Revolution’, The American Economic Review, vol. 61, no. 2.

Laidler, D., 1981 ‘Monetarism: An Interpretation and an Assessment’, The Economic Journal, vol. 91, no. 361.

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