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Journal number 4 ∘ Malkhaz Chikobava
Comparative analysis of Keynesian and monetarist theories

Expanded Summary

In the 30s of the 20th century, the economies of Western countries had a historically unprecedented, deepest economic crisis, which led to the practical need to find means that would allow dynamic economic reproduction without deep fluctuations. The first who developed a paradigm of state regulation based on the theory of “regulated capitalism” was John Maynard Keynes.

The main factor of economic development, according to Keynes, is “effective demand”, which consists of personal and industrial consumption. This choice of factors affecting the dynamics of economic development is not accidental. In the mid-thirties of the 20th century, Western economies tried to overcome the worst crisis. As is known, the economic crisis during capitalism is a crisis of overproduction of goods, capital and labor, that is, superiority of aggregate supply over aggregate demand.

Criticizing the concept of the classical school that supply automatically generates demand, Keynes suggested that it is necessary to generate income by stimulating demand in order to influence the factors that shape effective demand and determine the growth of national income. As noted above, one of the components of effective demand is personal consumption. The latter, first of all, depends on the level of employment, and therefore unemployment is one of the factors that impedes effective demand.

Keynes rejected the postulates of neoclassical economic theory, according to which employment depends on the marginal productivity of labor and the volume of labor expressed in real wages. In his opinion, the level of employment depends on the expected level of consumption and investment. He noted that the level of consumption increases with increasing income, but not as fast as income. This is due to the so-called "Basic psychological law", the essence of which is that people tend to increase consumption, but not in such a size as their income increases. With these, a natural propensity to save is revealed.

It should be noted that Keynes explained reality in his own way. The share of consumption in national income decreases as national income grows. This occurs in the form of extensive economic growth and the formation of the main industry. In addition, according to Keynes, the richer the society, the higher the savings and the less propensity to consume. This leads to a decrease in production and employment. So the crux of the problem is how to combine full employment and economic growth.

The answer to this question is based on determining the functional relationship between employment, consumption and investment. Given that employment is a function of consumption and investment, Keynes suggested that consumption is stable, and therefore the focus of government should be to encourage investment.

Thus, insufficient demand of population, which lags behind the income must be compensated for the increase in investment demand. The amount of investment depends on two factors: the expected return and the real interest rate. This implies monetary and fiscal instruments for regulating investment demand. What is the role of these tools in stimulating growth and investment growth?

The rate of return and demand can be increased by lowering nominal wages. This concept was a classic theory. Reducing wages leads to lower prices and reallocation of real income in favor of the rentier. In general, this redistribution reduces the propensity to consume. However, this increases the marginal efficiency of capital investments. In addition, lower prices and cash income, in turn, reduces the demand for cash, which leads to lower interest rates and encourage investment.

This method, known as the flexible wage policy, is to change the amount of money expressed in nominal wages. Its practical implementation is very problematic in a democratic society. Only in an authoritarian society can the wage be regulated. Uniform regulation in a market economy system and, moreover, a reduction in money wages is impossible. The gradual reduction of wages by individual entrepreneurs is a struggle against trade unions. In addition, the result of flexible wage policies can be “extreme price uncertainty, perhaps the most significant volatility, after which any business calculations will be completely meaningless.” Ultimately, this has a negative impact on investment demand.

A flexible monetary policy can be avoided by the negative results of a flexible wage policy. The change of money supply in the open market through monetary credit operations, regulation of discount rates and required reserves, according to Keynes, in public administration. Increasing the amount of money expressed by a unit of wages without reducing the latter will lead to a decrease in the interest rate and an increase in the marginal efficiency of investments. All this will stimulate investment demand and employment growth. In addition, lower interest rates on deposits will contribute to an increase in consumption, since deposits in banks are less attractive.

However, all these measures may not be sufficient to achieve effective demand and full employment. In order to increase demand and employment, Keynes proposes an active fiscal policy.

Budgetary expansion of demand is one of the decisive factors in reducing unemployment and, besides solving economic problems, contributes to the elimination of social resistance. Moreover, Keynes developed a theory of "multiplier" in terms of the efficiency of public expenditure towards Increasing production, income and employment.

The concept of Keynes laid the basis of many years of practice of state regulation, the parameters and directions of which have their own characteristics in different countries and were changed by the objective trend of social development.

In our opinion, the Keynesian model does not take into account one important point: under capitalism it is even theoretically impossible to achieve equality of aggregate supply and demand. Consider the following example: suppose that the entire capital of a country is combined into a large firm in the form of aggregate capital that produces final goods. At the same time, the company produces the means of production, raw materials, energy, materials and components. The price of final goods produced by this company is determined by the formula: price = wages + profit. Therefore, the company buys only one resource - labor. The rest creates its internal divisions. There is no rent and interests for the firm. In this company, everything is covered. Suppose a firm buys labor, pays a salary of 10 billion lari a year and plans to earn 20% of the profits. The company supplies goods and services in the amount of 12 billion lari. This is a aggregate supply.

But consumers are households. They can spend no more than 10 billion GEL, which is the disposable income they receive. Thus, real goods of 2 billion GEL cannot be realized. There is a “traffic jam” in the circulation of capital - an excess of supply. The problem is further exacerbated by the fact that households do not fully consume their wages from current consumption, but rather save part of it. If the latter is 10% of the income, then the value of the "traffic jam" will increase to 30 billion GEL.

Consequently, of the total gross supply of 12 billion lari, 30 billion lari remains unrealized - supply exceeds demand by 25%. If the joint capital company reduces the volume and employment of the company, the amount of wages paid will be reduced, and, consequently, the total demand will still be reduced. Thus, the crisis of overproduction becomes even stronger.

The problem of imbalance in the turnover of capital according to Keynes is as follows: potential money will be transferred to wage labor, but only through exchange. In other words, the potential cash income is changed to labor, which is used in the investment process and does not participate in current production. For this, there are also the necessary financial resources, that is, 1 billion lari, which is concentrated in savings. In addition, it should be noted that the hired worker always promotes capital with his own labor. Labor in investments is labor that turns potential cash flow into tangible capital, namely, building structures, equipment, materials, energy. Labor in the investment for the company is not involved in the current production of profits, which in this case suffers from the problem of overproduction. Employment in investments does not bring any profit to a particular investor of a company, as the company invests money only for the sake of profit in the future.

However, this does not mean that labor in investments does not create a surplus product. The transformation of the surplus product into profit is delayed while the new material capital will not participate in the production of the final product. And this discrepancy over time creates the illusion that aggregate demand is equal to aggregate supply and the overproduction crisis is being overcome. But the fact is that the newly created material capital will participate in the creation of a new value added, that is, the creation of a new product and the discrepancy between aggregate supply and demand will be even greater. After this, the “overcoming” of this discrepancy in time still continues with the scenario described above. However, as we have seen, this will not only overcome the crisis of overproduction, but only postpones this crisis for a certain period of time, which will aggravate this crisis in the future. Consequently, according to Keynesian theory, it is impossible to establish an equality between aggregate supply and demand.

With the widespread use of the monetary regulation of the Keynesian approach, the problem of accelerating inflation has appeared. Ultimately, the agenda raised the question of the need to create conditions for long-term non-inflationary economic development.

According to the monetarist theory, the long-term non-inflationary development of the economy can be achieved by observing the monetarist equation, which looks like this:


where  shows long-term growth of the money supply,  - long-term growth of real GDP and ∏e - the expected inflation rate. This equation is called the monetarist or Friedman’s equation. Monetarists believe that the long-term equilibrium in the money market is reflected in compliance with the basic monetary law, in accordance with which a link is established between the growth rates of the real money supply and production volumes.

The goal of a long-term monetary policy is to stabilize inflation and turn it into a process when it is completely exposed to accurate forecasting. As monetarists consider, economic policy, which is aimed at the long-term trend of changes in the economic situation, is the best way to ensure optimal growth of economic growth.

Of course, all countries will strive for rapid economic growth, full employment and price stability. This raises the question: what does price stability mean? What is the most desirable long-term price trend? Economists point to a relatively low and stable advantage in the field of inflation. Stable inflation, the annual rate of which is about 3%, has been observed for almost half a century in the United States, in particular since the Second World War, if we do not take into account the stages of stagnation of the 70s of the last century and periods of global economic crisis starting from 2008.

It is noteworthy that economists say that macroeconomic policies should take a step forward and ensure absolute price stability or zero inflation. However, a significant part of macroeconomists holds a different opinion. They point out that zero inflation is just a matter of an ideal economy. Modern economic life is not characterized by stability. According to economists, such instability is the struggle of workers for lowering their nominal wages. To ensure the stability of the average wage level, it would probably be necessary to increase wages for one category of workers and lower them for others. However, no company or employee will agree to categorically reduce their wages.

In accordance with macroeconomic laws, stable prices and wages provide a more stable level of unemployment and lower output than when inflation rises by about 2–4%. Despite the fact that economists disagree about the optimal level of inflation, they are quite consistent that predictable and moderate price increases are most desirable for healthy economic growth.

The latter idea is dictated by the ideologists of monetarism, whose philosophy we have shown above from the point of view of the monetarist Friedmann's rule. Therefore, for prices to remain stable (which does not mean zero inflation), the Central Bank must choose the average annual growth rate of the money supply, which ensures a moderate, say, annual inflation rate of 2-4%. It is in this way that monetarists are trying to overcome the inflationary character of Keynesian monetary regulation.

Is this really possible with the help of a monetarist equation? In response to this question, we consider what the results of the Friedmann equation are for the long term. Suppose that the inflation target is at most 4%, and the average annual growth rate of production is due to new technologies and production factors - 3%. Then the central bank can only do everything to ensure a maximum of 7% of the annual money supply. In this case, the inflation rate will be saved. But in practice, if the long-term regulation of the money market is actually monetarist in practice, then the country's economy will face an inevitable crisis after decades, due to the accelerated growth of the money masses compared to the physical economy. Over time, the growing amount of money in the economy will accumulate more and more, from which there will be no other way out other than the explosion of inflation.

We believe that this small note is not without reason regarding the monetarist equation. Indeed, analysts believe that one of the causes of the global economic crisis is the excessive emission of the US dollar, which, as we have argued, may indeed occur in the practical implementation of Friedman’s monetarist regulation concept. Finally, we believe that the long-term monetarist approach does not ensure non-inflationary economic development. Moreover, this ideology in the current global crisis, as they say, has the lion’s share.

Based on the above, it can be said that during the current global financial and economic crisis, both Keynesian and monetarist paradigms turned out to be untenable and the question of the need to create a new paradigm that will be able to overcome the current systemic economic crisis is put on the agenda.