The Monetarist Revolution and the Great Depression. In their monumental was it possible to argue that the demand for money was stable, and that a decline in money with the enthu- siasm accorded Banquo at Macbeth's feast. the relationship between money and GNP is subject to lags of variable and. 2According to. In the aggregate demand and aggregate supply model of the economy, the classical . Monetarists argue that the amount of money the public will want to hold . A) there is a tight relationship between the money supply and nominal GDP. relationship between the exogenous macroeconomic variable and the specific para? .. gated. Considering the monetarists' argument that the instability of the . regression model of Fama and MacBeth , whose procedure is related to a.
Although any projection, be it quantitative or qualitative, must be viewed with care and skepticism, one may ask whether this criticism is not beginning to cause damage to the research and application of quantitative methods in general? The disillusionment with the two analytical tools most widely used in manpower planning has lead to the development of combinations of qualitative and quantitative methods.
This has been advocated by Dougherty He argues for the systematic use of all available information as feedback for planning. Such a system should be pragmatic and eclectic through using previously neglected or nonexistent types of labourmarket information: Such a system should be monitored by manpower planners on a continuous basis. He gives the name 'cybernetic' to such an approach.
He is not, however, very fond of models and projections. This is surprising given that the Oxford Dictionary definition of the word 'cybernetic' is ' the study of system of control and communications in animals and electrically operated devices such as calculating machines'.
Despite the obvious merits of Dougherty's rather inaptly named cybernetic approach, a worrisome aspect is that it appears to lead to a lack of precision in exactly what the system should be and what forms of data should be collected, and then what to do with them once they have been collected. Perhaps what Dougherty really means is an 'heuristic' approach to employment and manpower planning.
A 'heuristic', again using the Oxford Dictionary definition, is 'a system to discover; a system of education under which the pupil is trained to find out things for himself". The heuristic approach has a number of advantages over other approaches. First, it helps to organise existing data; second it focuses attention on the labour market and the need for new research in that area; third, it focuses attention on precisely that data required to understand the labour market; and last the experiments with the system are performed in terms of scenario analysis.
Thus the system avoids point estimates through giving a range of estimates that depend on a number of supply and demand scenarios. The results are presented in graphical form allowing a dialogue to be maintained with even the most numerically illiterate policy maker. The system is easy to use and to develop and relatively inexperienced professionals can be quickly trained to use the system.
The system is heuristic because it produces results quickly, provokes discussion on the results emanating from the scenarios and leads the inquisitive into the search for new data sources, and better ways of understanding the labour market. The system can be used as a simple tool for continually monitoring what is happening in the labour market. The system applied in Ecuador had a number of weaknesses. These largely stemmed from the short amount of time three months spent on data collection, estimation and modelling.
Other than the data weaknesses reported upon in Hopkins, the model lacked a complete specification of labour demand it simply used projected output levels and multiplied them by projected productivity levels to obtain projected employment. Further, output growth was exogoneous to the model. These two weaknesses, therefore, did not help to greatly advance the MRA approach.
Additions, not tried in the Ecuador model and that have mitigated these weaknesses a little, are described more fully in Chapter IV. In a nutshell the two main improvments have been first, to link output growth to investment and second, to introduce substitution mechanisms so that labour demand is more responsive to market mechanisms. Key informants Large scale statistical systems with regular monthly or quarterly surveys of labour market phenomena are essential for LMIS's.
Except in a very few rich countries such systems hardly exist in the world and this is particularly so for the developing world. Richter has suggested an innovative scheme to provide labour market information through the use of key informants. The idea is to collect selected communitylevel data through key informants using the local knowledge of particular categories of respondents public officials, teachers, businessmen, large farmers etc.
This is much simpler and cheaper than a household survey and vastly cheaper than a census. Once reliable key informants have been identified the informants are questioned on a panel basis.
The information includes both generalpurpose questions about the overall situation and longerterm trends of labour markets plus specific questions related to shortterm movements and fluctuations in labour supply and demand. The overriding conclusion to these tests, unsurprisingly, was that key informant's information was found to be more or less reliable on community level variables such as village characteristics, the problems preventing or impeding the growth of employment like the lack of finance or energy supplies or inadequate transport.
It was found to be less good on statistical items concerning the size of the population or the labour force or manpower surpluses and shortages. For most items there was a positive relationship between the quality of the data supplied and the education, age and working experience of the key informants. In reviewing this experience, Rodgers a noted five major objections. First, there is a major problem of bias in the selection of respondents since these tend to come from the richer better educated strata of the population.
It is likely, therefore, that these key informants will give insufficient stress to the problems of the less rich community and the needs of the poor. Second, the questions asked tended to be rather simple yet they were addressed to rather complex problems e. Clearly better questions can be formulated and this is not such a major objection to the principle of key informants. Third, one objective of key informants is rapid feedback to local policy decisions.
However, the broad problems raised skill shortage, unemployment etc. They are partly, if not mainly, problems of the macroeconomy. On the other hand Central Governments would be interested in the broad problems raised and, therein, lies another danger. That Central Governments would act on the basis of incomplete, partial and incorrect assessments.
Further, local assessments are not likely to be randomly representative and the likelihood of considerable statistical bias could seriously mislead policy makers. Fourth, the key informant approach is likely to work when the labour market is fairly closed, and thus small enough that individuals can encompass it. This may work in relatively isolated villages, but cannot be easily applied in large urban areas nor where there is close interaction between a village and a large market e.
Fifth, as a local system for challenging problems to higher level authority, the key informants system is probably redundant. This is because local elected officials, key businessmen or government employees are in constant contact with the elites of their regions, from which they often themselves come.
Emphasizing these channels through key informants therefore seems to be redundant. In conclusion it would appear that key informants are of limited usefulness to the LMIS. There is not much doubt that random sample household surveys are a cheaper and more robust alternative to censuses. The literature on surveys is burdgeoning again Rodgers discusses some of these and there are quicker and cheaper ways of collecting and processing survey information - but see Chapter VII where a key informants survey is reported upon and its advantages and limitations discussed in a practical situation.
Labor market signaling For short-term assessment of training needs labor market signaling LMS is recommended as a tool that could both help, and improve, training centers' ability to respond quickly to changes in market circumstances and, thereby, reduce inefficiencies see Middleton, The reasons relate to the quality of occupational statistics, the effect of technology on the concept of an occupation, and the practical link between academic specialization and occupational placements.
Particularly revealing is the emphasis on education and training qualifications rather than occupations. However, nowhere in the Bank work is a list of skills defined that can be used as a basis for analysis.
This lacuna means that no real alternative to an occupational classification has been suggested. Obviously, a fixed occupational classification over the years will ignore technological changes, however there is no reason why these can not be factored in - this is what the most advanced country, the USA, does in practice.
Nevertheless, labor market signaling is a useful adjunct to traditional forms of manpower analysis in that it advocates the need for wage and employment trends not only to guide schooling and training decisions but also to evaluate how well labor markets are functioning. The objective of signaling, again according to Middleton et.
Planners can monitor labor market conditions and evaluate training programs and can also focus upon skills that are of strategic importance to economic development and that take a long time to acquire. The main indicators or labor market signals required are: Part and parcel of the labor market signaling technique is the need to identify the types of skills that are required in the labor market. It is felt that the demand for occupations is a poor predictor of future labor market requirements for qualified labor, simply because the types of occupation change rapidly with new technologies.
However, any forecasting technique can compensate through the use of scenario analysis i. Closely linked to the question of labour market signalling is how to define training needs of a given economy. A first approximation to defining training needs i. The main problem with these lists is that they go out of date rapidly as new occupations develop web designers and older ones decline steam engine drivers, punch card operators.
One often hears that training needs cannot be assessed and therefore the best bet is to go and talk to a few enterprises to see what they want. This begs the question of which enterprises, what questions to ask them and how to classify their responses. It also assumes that enterprises know exactly the sorts of occupations that will be in demand after a gestation period of 3 to 5 years - the time taken to place information gleaned from enterprises to policy makers who then determine the types of courses to run in training schools and for this to be put into practice through training teachers, attracting and then training students.
In fact the simple-minded statement posed at the beginning of this paragraph summarizes exactly what enterprise surveys of training needs try and establish see Chapter VIIand what labour market signalling tries to put into practice.
We should also note that enterprises work in their own best interests and tend to have a very short-term perspective. Therefore, information collected about enterprises perspectives need to be supplemented with other information.
A tracer survey of graduates helps to assess the efficiency of the training school and also to estimate the placement of graduates in jobs. This sort of survey again see Chapter VII is very difficult and expensive to carry out but is an effective way of judging the efficiency of training school courses to meet the training needs of the society.
Another way to introduce more qualitative and perhaps speculative ideas on the future development of training needs is to ask the practitioners themselves, through a key informants survey as mentioned above.
In the rows are given 'Types of Individuals' and these correspond to the population and labour supply. The total, of course, sums to the total population of the nation. Next, households are grouped in columns under 'Types of Households' to allow the construction of socioeconomic groups that have relevance with respect to economic and social policy issues.
There is quite a range of criteria to describe households and to group them. For some purposes characteristics of the household as a unit are appropriate, such as race or ethnic background, ownership of productive inputs, income level, household size and composition, dependency condition of the household etc.
As an alternative, or jointly with household characteristics, some features of the household head or main income earner can be used to describe the household, viz. Most censuses will allow the construction of such a block. The second building block describes the basic economic status of the individual members of the population. Under the heading 'Productive Activities' a first major dividing line could be whether or not an activity results in economic output, i.
It is possible, of course, to deviate from the UN guidelines to include all nonmarket activities the UN only includes selected nonmarket activities. To turn the LAM into a manpower matrix individuals could be further divided into educational or occupational categories. The LAM is then a manpower matrix because it indicates the number or number of hours that each type of person is, on the average, available for work.
The matrix of activities can either be a supply or a demand for labour statement and shows the numbers each type of individual spends being engaged in productive activities and the number of hours that are lost due to unemployment.
These could be relocated under the heading of 'productive activities' should it be so desired. Note that the left hand side of the matrix 'Types of Individuals' provides a number of difficulties for the allocations in 'Productive or Other Activities'.
Under 'productive activities' the seasonality dimension could be added to the labour force matrices. It could be available as both a head count table and a table with number of hours, this set of tables would permit the analysis of the seasonal pattern of job availability. It could give information about hours of work during peak and slack seasons which is useful to estimate the opportunity cost of time. To do this we need to add a number of other items to the matrix.
The remaining factors of production, land and capital goods need to be introduced. Since these factors are not only owned by households, but also by firms and by the government, columns for these institutions need to be added to the accounting scheme. Again the accounting can be accomplished in headcount, hours worked or value. To complete a LAM to a full SAM, links with the rest of the world, transfers within and across institutions, demand for commodities, an inputoutput table and current and capital accounts must be added.
He describes how, using a SAM in a comparative statics framework, an exogoneous change in the distribution of income can be shown to affect employment and output.
The first step in developing a SAMmodel is to separate the endogoneous accounts from the exogoneous ones so that the impact of the latter on the former can be measured. The endogenous accounts generally comprise the factor accounts, the accounts for households and companies the endogoneous institutions and the accounts for the production activities.
The exogoneous accounts include the government account, the investment account, the accounts for indirect taxes and international transactions. The classification is set out in Figure 1 below. Exogoneous and endogoneous submatrices Source: Vandemoortele based on Pyatt and Roe et. The northwest submatrix constitutes the matrix of transactions between the endogoneous accounts, and the southeast submatrix is the transaction matrix of the exogoneous accounts.
The northeast submatrix is the injection matrix while the southwest submatrix is the matrix of leakages.
The accounts are normalised, just like inputoutput analysis, by dividing the matrix elements by the column totals. The application of LAMs to the manpower planning problem is not widespread probably because of the use of fixed coefficients so that the allocation of labour by economic sector, for instance, is carried out in the same way as the discarded manpower planning approach.
In fact the LAM is simply a formalisation of the data from a manpower planning exercise into a set of accounts.
I: Employment and manpower planning techniques
This is useful in itself as a way of organising data but still does not escape the aforementioned limitations. Concluding remarks The chapter has covered the main manpower planning techniques - manpower requirements, rate of return, labour market information systems, pragmatic, key informants, labour market signalling and LAMs. There are, of course, overlaps between each of the techniques suggested but none of the approaches has come to dominate in practice. Despite the lack of consensus on technique to be used, the demand for manpower projections runs unabated.
This experience is described in the last chapter where it can be seen that a mixture of most of the techniques described in this chapter were used depending on the precise question addressed.
The Practice of Manpower Forecasting: Guidelines for the development of employment and manpower information programmes in developing countries: Income distribution, structure of economy and employment London, Croom Helm, Social accounting for development planning ILO, Geneva, Planning techniques for a better future Geneva, ILO, Labour force participation and development Geneva, ILO, 2nd ed.
Planning for Basic Needs: A Modelling ApproachGower, London, Forecasting Skilled Manpower Needs: Introduction Manpower planning has, at its core, the problem of mismatch between labour supply and demand i. Consequently, a better understanding of the manpower planning problem can be helped by examining theories about the determination of unemployment. Therefore, this chapter overviews some of the leading strands of thought that have attempted to explain, among other things, the economic causes of unemployment.
This is an ambitious undertaking since the field is vast and, therefore, the approach taken has been eclectic and does not pretend to be exhaustive. The main choice has been to include those theories, and theoreticians, that have focussed upon unemployment rather than economic theory per se. Moreover, the discourse has been hampered because economists rarely agree among themselves on what is the most appropriate theory. Clearly, these causes are interrelated and so the emphasis of theory on a number of problems at once is not altogether surprising.
The word 'overview' has been used since it is difficult, if not impossible, to describe adequately all theories, thus the chapter's main purpose is to identify what the different theories say about the causes of unemployment as a forerunner to the presentation of a simulation model of the labour market in later chapters.
Theories have been considered that apply both to developing and to developed countries because, while countries at different stages of development have different settings for their common problems, theory transcends these boundaries. However, this should not imply that there is, or ever will be, a unique theory that can be applied everywhere or at different stages of development. Planning an economic system is not like visiting a supermarket where on the shelves can be found the various components of the mechanism incorporating the advantageous qualities of all systems.
On another there is full employment as it has been nowadays as was realised in Eastern Europe. On a third shelf is an equality of income and purpose such as found in Mao's China. On a fourth is economic growth free of recession, on a fifth price stability, etc.
Theory can help in setting guidelines and has a perverse affect in entering decision making hence carrying out Lord Keynes' dictum that present day policy makers, unbeknown to them, are carrying out the theories of some defunct economist! In this chapter theories dealing with the labour market will be discussed in temporal order. They have been arranged into seven main groups in order to preserve some common factors, namely classical theories Smith, Ricardo, Malthus, Mill, Marx ; neo-classical Say, Marshall, Schumpeter, Pigou, Hayek, Wicksell, Walras, Solow, Harrod, Domar, Schultz, Stiglitz ; social reformers Keynes, Lenin, Kornai ; latter-day development economists Lewis, Fei, Ranis, Prebisch, Hirschman ; monetarists Friedman ; more recent development economists who are institutionalist in persuasion such as the segmentation theorists Carnoy, Harris, Todaro ; and, finally, recent views of the labour market Krugman, Fine.
In this list there are gaps and overlaps between the different schools. Many would say that there exist today, at the most, two main schools of theory: But this is an oversimplification, because there are theories or ideas from one school that can be applied in the other.
For example, at different times Keynes could have been considered a classical, neoclassical, Marxist or even monetarist scholar since there are strands of each school in his writings.
Classical economists These economists, working in the mid-nineteenth century, were greatly concerned with the interactions between labour, capital and land. Adam Smith in The Wealth of Nations, first published inwas concerned with the principles of free competition and the 'invisible hand' of the open market. Few economists would disagree with Smith that markets work when one important condition holds namely, actors in the market have equal weight in terms of size of firm, information, human and physical capital.
Imperfections or unbalances in these initial conditions in the real world have lead to the enormous and burgeoning economic literature of today and the attempts to resolve these overriding qualifications have led to the growth of economics as a science. In the long run he believed that population growth was regulated by the funds available for human sustenance. Consequently, the wage rate plays a crucial role in determining population size. The limiting wage was that which was neither sufficiently high to permit an increase in numbers, nor sufficiently low to force a shrinkage of the population base.
Smith called this rate 'the subsistence wage', one which is consistent with a constant population. Smith argued that in a purely competitive market, if the wage rate fell temporarily below what was necessary to maintain labour demand and supply in balance, the pressure of demand would act to raise it. Conversely, should wages be above the equilibrium level, then the excess supply resulting from too rapid a growth of population would soon lower the remuneration of labour.
But what determines the demand for labour? These funds are of two kinds: It relates the employment of labour to the size of the revolving fund destined for the maintenance of the labour force. Demand and supply curves for labour The demand and supply curves for labour intersect at full employment E, at a wage of WO and a quantity of labour LO i.
The dotted line S1S1 indicates a more inelastic labour supply function. Both Adam Smith followers and Keynesians disagreed with Malthus. The former because prices would adjust through the magical hand of the market and people would change their behaviour after seeing that the production of children led to their impoverishment. Today, as environmentalists vigorously argue for the reduction of the use of non-renewable resources, Malthus has again come back into fashion.
Marx's 'reserve army of the unemployed' - as shown by AB in Figure 2 - need not depress real wages from Wx to the mm minimum subsistence level. With perfect competition it can only depress wages from A to E. If labour supply became so abundant that SS intersected dd at mm, the wage would be at a minimum level, as in many underdeveloped regions.
But institutional or legal changes can do little when marginal productivity is so low.
Keynesian and Monetarist Views on Monetary Policy
That open unemployment has remained around the per cent level in many developing nations over the past 20 to 30 years suggests that these simplistic diagrams cannot totally be relied upon. This is discussed later in the section on segmented labour markets SLMs. One was that wages could only increase with rises in the accumulation of capital. The second principle was that the landowning class contributed a growing social weight whose power could be reduced only through free imports of agricultural products.
Ricardo's production function, like Adam Smith's, postulated the existence of three factors - land, capital and labour. As a result the marginal productivity not only of land itself but also of capital and labour, declines as cultivation is increased.
As many have remarked, a great weakness here is that Ricardo underrated the possibility of technological advance in agriculture. Ricardo's notion of population and labour supply was similar to that of Smith, except that he believed that, because of capital accumulation, the market wage could rise above subsistence level.
Yet, if labour supply exceeded labour demand, the market wage would fall to subsistence level so that labour demand would eventually equal supply. Karl Marx's provided the first major critique of capitalism based upon his observations of the labour market in nineteenth - century England.
Marx identified two main classes - capitalists and workers - and believed that the owners of capital would always seek to maximise profit or surplus value as he called it while paying workers a subsistence wage. These wages would allow labour to reproduce itself in order to maintain a reserve army of unemployed.
Capitalists could, therefore dictate both employment and wage levels. To analyse capitalism, Marx introduced the labour theory of value. Marx defined surplus value as the unpaid work of the workers. The total product of nation, called the social product P was equal to the sum of constant capital C [depreciation, raw materials used in production, and energy inputs], variable capital V [paid salaries] and surplus value Mi.
Marx did not indicate clearly what principles governed the distribution of surplus value between consumption and accumulation by the capitalist class. Considering that each capitalist simply struggled to increase surplus value, Marx did not much care about the conflicts within the capitalist class. This would come about because the capitalist mode of production produced a progressive relative decrease of variable capital as compared to constant capital so leading to a progressive fall in the rate of profit.
This would lead, from equation 1 above, to a reduction in surplus value and hence reduction in the accumulation of capital. This process continues until capitalism collapses because of massive unemployment and social unrest. Capitalists could try and prevent this by a more intense exploitation of the workers through reducing wages, b exporting capital to the colonies, c swelling accumulation in order to raise the quantity of profit.
For the 'crisis' to occur, there would have to be persistent insufficiency in effective demand. A number of 'crises' have indeed occurred in capitalist economies over the past years. These have been characterised by a sharp increase in unemployment coupled with a slow-down or reduction in production. To date, governments in industrialised countries have bought their way out of crises through two main measures: Hence Marx's crisis of capitalism has been avoided through positive Government intervention on behalf of the workers and thus changed the relation between the accumulation of capital and unemployment.
In the United Kingdom - Marx's nineteenth-century model - the major depression of the s was finally resolved as war intervened, stepping up public works and preventing another crisis.
The war was followed by an intensive social security effort to compensate workers in unemployment. The labour movement in the United Kingdom steadily increased its power but channelled its major efforts into the formation of a political party - the Labour Party - which was elected into office for the first time in the s. The introduction of benefits for workers has propped up the British economy and dampened social unrest up to the present day. Marxist theories provided an essential and useful critique of capitalism.
The ideas of Marx were taken up by Lenin and gave the world Marxist-Leninist thought. This was applied in Eastern European countries under Soviet leadership, all of which were successful in providing full employment.
However two main aspects eventually led to its demise. First the standard of living remained low compared with Western economies and second, a high degree of repression of human rights was required to preserve the command economy. Neo-classical economists These theories underline the importance of market forces in bringing systems into equilibrium.
Their main addendum to classical economic theory is their focus on the regulatory role of prices, i. That markets for goods or labour do not clear, they believe, is a matter of distortions in the price system. Unemployment occurs because the price of labour wages relative to the price of capital interest rate is too high. If labour reduces its price it will be absorbed. This view can be attributed to any number of economists but perhaps Marshall was the forerunner.
All product markets are cleared through price adjustments to a 'Walrasian equilibrium'; the model therefore assumes full employment. There is no mechanism to introduce demand. It demands considerable political skill to manipulate it, however. The Monetarist Position on Monetary Policy: Monetarists differ from Keynesians in that they believe in the direct transmission mechanism.
When money supply is increased, people hold more money in their hands than they want to hold. So they spend the surplus money on securities, goods and services, thereby increasing aggregate effective demand. The theoretical underpinning for this is given by the theory of portfolio balance.
This theory states that people hold their wealth in a variety of assets—bills, bonds, shares or physical assets such as cars and houses. If money supply with the public expands, their portfolio balance is disturbed. The result is a change in the yields of bonds and securities as well as physical goods. The extra money will be used to purchase near money and liquid assets as a result of which their prices in the market go up. The mechanism has been criticised by Keynesians.
They doubt whether the mechanism operates so nicely in the short period and in this direct manner. In the first case, it is the working of fiscal policy and in the second case there is an inevitable time lag in the effects of monetary policy. So the process must depend upon the indirect mechanism. Monetarists also see monetary policy operating through the indirect mechanism.
They hold that this mechanism is more powerful than the traditional Keynesians believe it to be. This is because they have different assumptions: As a result, the effect of monetary policy on aggregate demand is much greater than the Keynesians perceived. Monetarists argue that, in an open economy with free, floating exchange rates, the effect of an increase in money supply is stronger still.
Any fall in interest rates will have such a strong effect on international capital flows and the exchange rate that the rise in money supply will be transmitted relatively quickly to aggregate demand. This should be clear from the Figure The indirect mechanism operates from stage I to stage IV where the fall in the rate of interest from r1 to r2 ends up in increase of national income by Y1 Y2.
Monetarists admit that the interest rates and yields on securities do fall in the short run as a result of the fall in the velocity of money V.
People may well hold larger money balances when the yields on non-money assets fall.
Keynesian and Monetarist Views on Monetary Policy
Furthermore, the direct mechanism may take time to operate and V may fall in the meantime. Monetarists also recognise that the demand for money can shift unpredictably in the short run with changing expectations. For these reasons, monetarists conclude that monetary policy cannot be used for demand management in the short run.
Here at least there is a measure of agreement between Keynesians and monetarists. Monetarists do believe, however, in the long-run stability of V, firstly because the direct mechanism gets sufficient time to work through and secondly because of the effect of monetary expansion on inflation and interest rates.
The effect of inflation works as follows. When money supply is initially raised, both the interest rate and V fall. But if the money supply is increased continuously for some time, the rate of inflation goes up and so do the nominal rates of interest. In choosing between money and non-money assets, people consider the nominal rate of interest as the opportunity cost of holding up.
Since this opportunity cost goes up, people choose to hold less money and more of the interest-earning assets. As a consequence, V rises back again. So the velocity of money is fairly stable in the long run, and monetary policy serves as a potent tool of controlling aggregate demand.
For this reason, monetarists favour a longer-term approach to monetary policy including targets for the growth of money supply. Fiscal policy is considered by Keynesians as the prime instrument of controlling aggregate demand. If the economy is in a deep recession, aggregate demand can be boosted through tax cuts and increased government expenditure.
It is difficult to decide on the size of tax cuts and raising of public expenditure but the economy can get the economy moving.
The difficulty with this policy is that it can worsen the balance of payments position through larger imports. But all the same, fiscal policy can help to stabilise the economy. The main monetarist objection to the use of fiscal policy as a cure for recession is that it cannot operate to increase output in the long period.
Whichever the mode of financing the budget, the money supplies gets increased in the long run. In other words, fiscal policy cannot work to cure recessions in the long run without an accommodating monetary policy.
Inflation is inevitable in such a situation. This will directly fuel inflation by raising the prices of imports. On the opposite side, if the economy is under persistent demand-pull inflation associated with near-full employment, Keynesians argue that deflationary fiscal policy should be used. The persistently high inflation of the s was accompanied by rising unemployment. Keynesians explain this stagflation in terms of a left-ward shift in the aggregate supply curve as shown in the figure given below.
A reduction in aggregate demand under these circumstances may offset the inflationary effect. But this solution is highly unpopular politically because it entails further decline in output and a corresponding rise in unemployment.
What is more, there may be adverse supply-side effects of tax increase. It may reduce incentives and push up costs. Cuts in government expenditure may have serious effects on such socially-sensitive sectors as health, education and public transport. Damage to such infra-structure may damage the prospects of long-term growth. Thus, it is doubtful that deflation can squeeze out the inflation from the economy without causing a severe depression.
The advantages claimed for a stabilisation policy through fiscal measures are: The main problems with fine tuning the economy are the time lags in recognition of the situation, taking appropriate action and the lag in results of the policy.
Keynesians therefore advise continuous monitoring of the economy, forecasting of output and prices and taking of timely action. Monetarists make a clear distinction between pure fiscal policy where fiscal policy operates with no change in the money supply and a fiscal policy operating alongside a change in money supply.
Monetarists hold that a pure fiscal policy is unfit to be used for stabilisation of the economy. There is the problem of unexpected supply and demand shocks to the economy. So it cannot be used to control aggregate demand with any precision.
In the long-run, pure fiscal policy is totally ineffective as increases in public expenditure lead to corresponding decreases in private expenditure. This is known as the problem of crowding out of private investment when public investment is increased through fiscal policy. Fiscal policy has its monetary effects in the form of changes in interest rates. When public expenditure is increased either through public borrowing or through tax financing, money supply falls short of the increased demand for money and the market rate of interest goes up as is shown in the figures given below.
This causes crowding out of private investment. Just how much crowding out will occur when there is an expansionary fiscal policy but money supply is not allowed to be expanded, depends on two factors: The responsiveness elasticity of the demand for money to a change in the interest rate. Keynesians assume that the demand for money is relatively elastic and therefore an increase in demand i.