A Comparison of Keynesian,

Austrian, and Monetarist theories

on Inflation and the Business Cycle
Elizabeth Dalzen
University of Wisconsin
Superior

Outline

Keynesian Theories
Money Illusion/Animal spirits
Keynes on Says Law
Liquidity Trap

Non-keynesian
Austrian economics
Austrian Business Cycle Theory
Classical
Classical vs. Keynes

Monetarism
Quantity Theory of Money
Inflation and Side Effects
Government Spending

Money Illusion and animal spirits

People think in nominal terms, not real terms

Deflation
price level, nominal wages, real wages
price level, nominal wages, real wages surplus
Involuntary unemployment

Animal spirits:
A spontaneous urge to action rather than inaction*

Decisions are made in the short-run,

In the long run, we are all

dead.**
Confidence
*Keynes, The General Theory of Employment, Interest, and Money
**Keynes, A Tract on Monetary Reform

Keynes and Says Law

Says Law: People produce in order to

consume
No general gluts

What if suppliers dont spend?

Hoarding (saving without investing)
AD unemployment AD

Recession

Liquidity Trap

As the interest rate approaches zero,

stronger liquidity preference
Individuals dont save (invest), banks dont

lend

Flat LM curve
Impotent monetary policy

Confidence

Keynesian Econ

If
Money illusion
Glut of unemployment
Low interest rates
Deflation
Low consumer and business confidence
Hoarding/Liquidity Trap
Dearth of investment

Then
Increase national income by shifting IS curve,

increasing AD
Govt. should spend, spend, SPEND!

Austrian Business Cycle Theory

Expansion of credit by banks

A central bank is necessary for banks to expand
credit
if banks were truly competitive, any expansion of credit

by one bank would quickly pile up the debts of that bank

in its competitors, and its competitors would quickly call
upon the expanding bank for redemption in cash*

*Rothbard, Economic Depressions: Their Cause and Cure

A.B.C. Theory

Credit expansion Inflationary Boom

Domestic prices bid up imports
Gold flows out of the country as
payment for imports
As banks gold stores dwindle, panic!
Fractional reserve banking

Banks call in loans, Money supply

(deflation)
Economy contracts
Balance of payments reverses

A.B.C. Theory

Interest rate artificially depressed

Malinvestment
Low i rate is only temporary

Overinvestment in capital goods

Not enough savings to buy all producers

goods

Capital is heterogeneous

A.B.C. Theory

Gold Standard
Money supply shouldnt increase,
even if the population or supply of
goods increases
Deflation problems

Government sanctioned M
counterfeiting

Classical Economics

Smallest decision making unit: the

individual
Homo economicus
Rational
Self-interested
Utility maximizing

Assume perfect information

Classical
vs.
Keynes
Why Keynes is wrong if people are rational, self-interested and
utility maximizing.

Money illusion/stickiness
Example: Deflation
Workers resist nominal wages
Businesses have 2 options:
Raise prices cost-push inflation
Lay off wokers
Workers seek new jobs
Businesses offer wages that reflect workers real worth (if
no minimum wage laws, labor unions, etc.)

Stickiness due to:

Time lags with change in price level
Contract length
Labor unions

Keynes refutation of
Says Law

Misrepresentation of Says Law

Say never said that depressions and

unemployment are impossible

Says Law: supply creates its own

demand, so no general gluts
requires flexible, self-correcting markets
A temporary glut in the labor market is not a

general glut

Hoarding: why?

Puzzling Paradox

Keynesian economic man:

Ruled by animal spirits
Doesnt make decisions for the long-run
Incapable of thinking in real terms
But somehow responds rationally to lower

interest rates by investing less of his

money?

Monetarist Economics

Also has roots in classical economics

Disagree with both Keynesians and
Austrians on inflation and the
business cycle
Milton Friedman

Quantity Theory of Money

Quantity theory of money:

M*V=P*Q
M=quantity of money in circulation
V=velocity of money
P=price level
Q=index of the real value of final expenditures

Keynes: V is inherently unstable

M, V move in opposite directions

Friedman: M, V move in the same

direction

How to Avoid Inflation

Inflation is always a monetary

phenomenon
M and P are not independent
MP

Since M*V=P*Q, we have

M+V=P+Q
Assume velocity is stable (V=0)
P=0 if and only if M=Q
To avoid inflation, the growth rate of the

money supply should be set equal to the

growth rate of output

Inflation and Side Effects

Monetarists want monetary policy

that creates a stable framework
Reducing inflation is not technically
difficult, but there are political
barriers
Possible side effects of reducing
inflation:
Recession
Unemployment

Stimulus

In a liquidity trap:
Even if the Fed increases M, banks hesitate

to lend (low interest rates)

Bypass the banks, give money directly to
consumers
Aggregate Demand boosted without
increasing government spending

Government Spending

Where does the money come from?

Increased tax revenue

Borrowing from the private sector

Government spends money that otherwise
would have been spent in the private sector

Printing money
Implicit tax on holders of dollar denominated
assets
No legislation involved

Review

Keynesian Theories
Money Illusion/Animal spirits
Keynes on Says Law
Liquidity Trap

Non-keynesian
Austrian economics
Austrian Business Cycle Theory
Classical
Classical vs. Keynes

Monetarism
Quantity Theory of Money
Inflation and Side Effects
Government Spending

Questions?

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