The two most prominent theories of macroeconomics to emerge during the 20th century are the Keynesian Theory of Money and the Monetarism Theory. Keynesian thought traces back to the early part of the century as a response to the Panic of 1914 and World War I. Monetarist theory arose later, in the decades following the Great Depression and World War II.
Each theory attempts to explain the fundamental drivers of the economic cycle and to prescribe the best policies to restore growth during recessions or depressions. While both theories may aim to achieve the same goal, they each focus on fundamentally different economic phenomena.
Keynesian Theory of Money
At the core of the Keynesian Theory of Money is consumption, or aggregate demand in economic jargon. Keynesians believe that the key to both a healthy economy and correcting recessions and depressions is doing whatever it takes to entice consumers to continue spending.
A thought experiment can help to see the logic. If a recession was spreading across the country and you are concerned that you will lose your job in the next six months, would you be more likely to increase your savings or more likely to increase your spending?
Economist John Maynard Keynes hypothesized that in this situation, most households would prioritize saving over spending. This is a rational but problematic choice. If households across the economy all start spending less and saving more, that has the effect of making the recession even worse as businesses lose sales, profits drop, and production contracts. Soon, those businesses are forced to cut jobs to survive, creating more fear and worsening this painful, self-fulfilling cycle.
To break the cycle, Keynesian economists think that the government should increase its spending to compensate for the slowdown in aggregate demand. Government spending would help to boost productivity and therefore protect jobs, which in turn will help to drive more consumption, or spending, by consumers.
Monetarist Theory
Second, we have Monetarist Theory, which was created by economist Milton Friedman, among others, as a criticism to what was seen as the shortcomings of the Keynesian Theory. The primary flaw, in Monetarist thinking, is the effectiveness of government spending to drive aggregate demand.
Instead, Friedman and Monetarist economists focus on keeping inflation low and stable by controlling the money supply. In their view, the greatest danger to an economy is when the money supply falls either too low or rises too high for the given economic environment.
For example, in times when inflation is too high, the money supply should be decreased. With less money circulating, supply and demand principles will bring inflation back down to lower levels. In the opposite scenario, like in the instance of a liquidity crisis, Monetarists think the monetary base should be expanded to prevent a damaging deflationary spiral. As a result in both cases, interest rates will move to appropriate levels to either encourage or discourage borrowing, keeping aggregate supply and aggregate demand in balance.
The key difference at the core of both theories is that Monetarists do not think that government spending is the best path to economic stability. Instead, they emphasize inflation.
Keynesian and Monetarist theories are not mutually exclusive
In the 1930's, Franklin Roosevelt introduced his plan for a "New Deal" to lower unemployment and increase aggregate demand. Government spending dramatically increased in line with the Keynesian prescription. Simultaneously though, the economy was experiencing a massive deflationary period. Roosevelt's policies had the effect of increasing the money supply, battling back against the deflationary pressure as a Monetarist would predict, even before Monetarism was invented. History books today view the New Deal, which included both Keynesian and Monetarist policies, as a success and a significant driver of America's eventual recovery from the Great Depression.
Likewise, in the great recession of 2008 and 2009, Presidents Bush and Obama, along with the Federal Reserve, implemented policies that both increased government spending and increased the money supply. There were the government's interventions into the liquidity crisis that nearly collapsed the financial system, as well as the Fed's quantitative easing and near-zero interest rate policies to keep inflation above 0%. Congress passed and Presidents Bush and then Obama signed two government spending packages, first for $152 billion in 2008 and then another for $787 billion in 2009. As in the Great Depression nearly 80 years before, elements from both theories were applied to bring the nation's economy back from the brink.
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