02 December, 2008

Ezra Klein Watch: Keynesianism

Ezra kind of butchers the difference between Keynesian macroeconomics and Milton Friedman's monetarism:

The implications of this are that monetarists, the most prominent of which was Milton Friedman, reject the idea that the government should directly intervene in the economy. Rather, it should stand back and either expand or contract the money supply. It should restrict itself to monetary policy. Keynesians argue that monetary policy isn't enough because people can develop a liquidity preference, in which they prefer to hoard money and thus there is insufficient spending and thus insufficient demand. That's why the government needs to spend directly in order to induce demand.
Monetary policy and fiscal policy need to be separated here. What Friedman really cared about was that the government ensure a stable money supply. In particular, he wanted the Fed to institute a monetary rule by which the money supply (think the amount of currency plus overnight reserves held by banks at the Fed) would increase by a fixed percentage each year. Friedman was famous for saying that "inflation is always and everywhere a monetary phenomenon", the implication of which was that setting the rate of growth of the money supply also set the inflation rate. So he did want government intervention, in some sense, he was just against discretionary monetary policy: the government should intervene as long as it followed a transparent rule in doing so. (Nowadays money demand varies so much from day to day that fixing money supply would be disastrous, so instead we fix interest rates.) On the other hand, most Keynesians think that discretionary monetary policy has a large role to play in macroeconomic management.

Friedman was against fiscal policy mostly on libertarian grounds. But he also wrote a whole book attempting to show that the Great Depression was caused by the Fed's monetary blunders. If this was the case, fiscal policy was never necessary. Keynesians, on the other hand, see fiscal policy as an important (if blunt and only to be used as a backup) instrument for rescuing a receding economy.

Here's Greg Mankiw (one of the founders of New Keynesianism) expressing some healthy skepticism about the current state of macroeconomic knowledge and here's a great piece on Friedman's economics by none other that uber-Keynesian Paul Krugman.

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