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Inflation: The Monetarist versus New Classical Frameworks

Discuss the differences and similarities of the explanation of inflation found in the monetarist and new Classical frameworks. How does, for instance, the formation of expectations influence their respective analyses? Contrast how the structure of the theories shapes the effectiveness of fiscal and monetary policies.

The economic thought is rich in different theoretical frameworks that are likely to have both similar and distinct characteristics in regard to the same concepts. In particular, the monetarist and new classical theories can be a vivid example in this respect. The two economic models represent the theoretical challenges to Keynesianism with a slight difference in the time of their conceptualization. Nevertheless, even though the two theories have common roots in the classical economics, the ideas they represent are not inherently the same. In order to trace the correlation between the similarities and dissimilarities that the new classical model and monetarism possess, the essay utilizes the concept of inflation as the core for the analysis. Being an “important social and economic problem”, inflation has been a centerpiece of theorizing and policy-making, though it may involve varied methods of influence and recognition of the problem. In this respect, the paper explains the notion from the standpoint of both frameworks to show the depth and extent of the theorists’ approach to the phenomenon as a whole. Further, one takes account of the issue connected with the formation of expectations through the lens of these theoretical paradigms as another aspect of comparison-contrast synthesis. Additionally, the paper evaluates the theories’ relevance to formulation and implementation of fiscal and monetary policies. Finally, the essay draws conclusions of the conducted analysis.

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Key Ideas of Monetarism

In the scope of monetarism, inflation as a monetary phenomenon is linked to money supply. In particular, the representatives of this branch of the economic science are certain that the primary condition of its occurrence is increased money supply as compared to the rates of growth in the national income through increased price levels. As soon as inflation is supplemented with reduced money supply, it will diminish on its own. According to the conceptualist of the theory Milton Friedman, “the amount of money the public wants to hold not only will increase as wealth, that is, permanent income, increases, but it will increase more than in proportion to the increase in the stock of wealth”. Thus, the issue of inflation stems from and is mostly dependent on the quantity of money; thus, the assumption has been framed in a respective theory. As a result, a sufficient degree of control over the inflated economy can be maintained through the decrease in money inflows, namely anticipated options. With the established control over the money, the free market is likely to fix the consequences of inflation on its own. In this case, money is both source of inflation and means of handling the problem, though the process is predominantly based on free market conditions.

A Diversified Approach of New Classicals

In contrast, new classicals have broadened the scope of understanding economic phenomena, including inflation, and expanded the frameworks developed by monetarists. This approach is predominantly grounded on the work of John Muth in light of his proposition of the theory of rational expectations and theory of continuous market clearing. Similarly to monetarists’ one, this theory has heavily relied on the free-market conditions rather than governmental intervention as argued by Keynesians, which oppose the two models. However, this framework has not been solely focused on money supply as compared to monetarists’. Instead, the theorists have proposed several well-reasoned assumptions that effectively combined and refined classical and monetarist economies as a more thorough and complex approach to the issue of inflation.

The two models that have been positioned at the core of new classical economy have managed to address the theoretical saturation experienced because of inability of Keynesian and monetarist scholars and practitioners to fully explain the economic phenomena, especially inflation. Primarily, reference to rationalization allowed explaining the underpinning of prices fluctuations in economies in light of utilitarianism, or individual’s reasoning over the future of pricing, and thus, inflation, on the grounds of rational worldview, past experiences and availability of credible information. Similarly, as an extended version of self-sustained nature of the market that requires no governmental intervention, new-classics unified the Walrasian general equilibrium theory and efficient markets theory. Hence, this refined theoretical framework assumed the conditions of the market efficiency and supply-to-demand balance through the maintenance of equilibrium in pricing as a result of proper utilization of the relevant and credible information about the key market characteristics.

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One more notable implication of the new classical theory was a contribution by Lucas who presented a concept of business cycles that is favorable in comprehension of policy-centered decisions. According to this assumption, behavior within the market setting is rational when there is a continuous clearing in markets that happens in a Walrasian sense. For instance, in perfectly competitive markets, equilibrium prices will clear all the markets, which means that there will be no inflation. In this regard, the representatives of this school of thought explicated the significance of the information lag for individuals. Specifically, when the general price falls, entrepreneurs and workers of an industry think that only their own prices fall, and, therefore, reduce their supply of goods and labor respectively. As soon as these population segments understand the flawed nature of their initial assumption, they make adjustments in their pricing for both goods and labor. Thus, inflation occurs due to misinterpreted information from the market, not just because of increased money supply as stated by monetarists. While this suggestion is in line with the fundamentals of new classics, no empirical evidence has been found in support of such a naive behavior of the two aforementioned actors in the economy.

Formation of Expectations

At the same time, the two theories introduced distinct paradigms for considering the formation of expectations of the market performance. On the one hand, due to the fact that monetarists majorly focused on money supply, the one-sided approach narrowed the understanding of inflation and projected expectations in this context. Specifically, these theorists linked expectations to a short-run success only. The assumption is based on the notion of adaptive expectations as it stems from relation to past experiences and is bound by time constraints.

On the other hand, new classicals referred to the factor of rationality and provided a more weighted rationale for future-oriented expectations. In particular, the method entails efficient use of information from the past experiences along with taking into account utility matters. The model extends the previous monetarist assumption grounded on past experiences mostly. This issue is justified by the fact that the economic environment and its characteristics change with time. In general, new classicals offer a more comprehensive and rationalized explanation of monetary/ inflation surprises since they focus on the changing environmental factors rather than defining the expectations on the basis of prior experiences as monetarists. As a result, being related to the compared framework, the neo-classical economy entails a more broad-scope analytic account of the issue.

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Fiscal and Monetary Policies

With a reference to fiscal and monetary policies, the compared models also offer specific explanations. Lucas emphasized that parameters of “the usual functions of consumption, investment, demand for money, etc.” cannot be applied as a given in the context of economic policies as they will be doomed to failure. In other words, the monetary policies seem to be of the fragmented character in the neoclassical framework if considered as a single option because the approach itself is multicomponent in contrast to monetarism. Nevertheless, the fiscal policies should not concentrate on the previous evidence with respect to any of the economic phenomenon they address. Specifically, if the rates and key characteristics of inflation in the 2000s are thoroughly analyzed by the scholars and the main attributes of the process are identified accurately, the policies justified on this evidence most likely will be irrelevant today. Mostly, workers and employees habituated to the today’s economic and social circumstances due to the fact that “economic agents adjust their expectations and their behavior in general with regard to the new political environment”. In this context, new classicals have explicated a crucial role of focusing on the aggregate supply, not the aggregate demand specificities. The assumption is based on the verge of workers’ labor and employers’ service/product outputs that are set as the centerpiece of pricing strategies. Hence, in-depth awareness of policy-makers about the current state of these factors will provide them with relevant information for development of efficient policies. The strategies developed in this respect should take into account several factors at a time, and this feature shows a rather complex nature of the theory in contrast to monetarism with the issue relating to policy efforts.

While new classicals somehow revised and reversed the significance of operationalization of the Phillips curve for inflation-centered policies, monetarists paid notable attention to the model. The supporters of this branch in the economic discipline are rather critical regarding the fiscal policies’ capacities, though they stay optimistic with respect to monetary initiatives. The framework inversely related inflation and unemployment by asserting that monetary measures can have short-term effects on either side. Contrary to new classicals, monetarists ascertained that aggregated demand is what matters in this context. In other words, if there is increased demand for products or services, workers are likely to increase their labor input into the working process.

Moreover, the factor of awareness about the likelihood of the increased real wage is important as employers will have increased real wage as a stimulus for higher-level output. Thus, due to the increased output from these two sides of supply and primarily on the basis of increased aggregate demand, the market will experience short-term adjustment in unemployment. As long as the focus of monetary policy control is on money flow and employee wage, the inflation rates are likely to be relatively low and controllable. Thus, both theories organized their rationale in regard to correlation between aggregate demand versus aggregate supply. However, new classicals reversed the approach proposed by monetarists that constitutes another distinct factor between the frameworks in question. To be more precise, the latter define the relation between price and wage as rigid that also distinguishes this model from its relatively close theoretical framework.

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Summarizing the findings of the paper, it is evident that new classical and monetarist theories have both common and rather distinct assumptions. The issue of inflation as an important economic phenomenon was analyzed in order to trace these connections. As a result, the analysis showed that the two models have diversified key ideas on the problem. In particular, monetarism has overly emphasis on the primary role of money supply as a potential source of inflation. On the other hand, new classicals attributed occurrence of the discussed phenomenon to a more complex process of intertwined factors. Specifically, the theorists asserted that inflation is likely to appear on the grounds of tripled factors, including rationalization of individual preferences, analysis of past experiences, and availability and utilization of the accurate information about the market characteristics. Therefore, in spite of the fact that the two theories commonly oppose the governmental intervention into the economies, their approach to understanding the market realia differs to a sufficient degree. For instance, the analysis of formulation of expectation and approaching the development of monetary and market policies varies significantly. In this regard, new classics managed to create a more expanded framework for analysis, though this theory cannot be considered as a one-size-fits-all model.