A capitalist economy system is comparable to a multifaceted machine that entails numerous capitalists firms and individuals, all making uncoordinated decisions in the economy.
The many devices of this machine do not mechanically fit together. For example, when individuals resort to save a portion of their income, it does not imply that they will find people to borrow and invest it.
The decisions made by individuals in the capitalist economy thus rely on the institutional framework in which they operate. If the institutional framework fail, the devises of the machine do not mesh, resulting in an economic crisis, as one witnessed in the 1970s (Reuss 1).
Some economists in the U.S. have referred to this phenomenon as a social structure of accumulation, where capital accumulation is seen as a process where individuals and capitalist companies reinvest their profits to enlarge their operations in the economy.
If these economic agents (individuals and firms) fail to reinvest, factories will close down, resulting to massive unemployment. This phenomenon is what we call economic crisis (Reuss 2).
During the 1970 crisis, the United States’ economy experienced declining productivity, high energy prices, rising international competition and a high unemployment and inflation rates.
Between 1973 and 1974, the price of fuel increased four-fold, resulting to high energy costs for both businesses and consumers. The annual rate of inflation rose to over 9.9% in 1974 while the annual unemployment rate was over 8.1% in 1975 (Reuss 12).
The economy appeared to be ensnared in stagflation, a phenomenon that is characterized by an amalgamation of low economic growth and soaring unemployment rates, coupled with high rates of inflation (Reuss 13).
The economic downturn of the 1970s added to momentous changes in the institutional structures of the U.S. economic system. During the early stages of the crisis, the government implemented several expansionary fiscal policies to regulate economic activities.
Labour unions were also active during this period. Later on, the economic crisis ushered in the neoliberal capitalism era that was characterized by weakened roles of the government and labour unions (Reuss 3).
The Neoclassical (mainstream) economists often posit that if a capitalist economy is run on the precepts of static universal principles and that any infringement on the principles of the market- expansionary fiscal policies, labour union roles, industrial policies and government macroeconomic interventions- certainly implies disaster.
However, the performance of the United States’ economy from 1940s to mid 1970s, a period called the ‘Golden Age’ contradicts this premise (Reuss 5).
Historical data suggests that the U.S. economic performance was superior during the Golden Age when compared to other periods. Between early 1940 to mid 1970s, the annual economic growth was approximately 3.9%.
The annual inflation rate was less than 1.9% for nearly half of the Golden age epoch and only exceeded the 5.9% mark while unemployment rate was about 5.8%. Moreover, the real pay per hour in many industrial companies was added to up to an average rate of 2.1% per annum.
The economic crisis of 1970s emphasized the need for fiscal policies to stabilize the economy, alleviate recessions and sustain full employment. For example, the U.S. government expenditure on consumption and investments was about 22% of Gross Domestic Product (GDP) in 1970s compared to previous periods (less than 20%).
A number of key business sectors, such as communications, transportation, and banking and insurance were extremely regulated. Furthermore, the unionization rate rose to over 34.9% of the labour force and stabilized at 25.2% in the 1970s (Reuss 6).
Rational Expectation Approach verses Modigliani’s Approach
Franco Modigliani was one of the principal inventors of the neoclassical synthesis between the orthodox theory of value and the Keynesian’s principle of effective demand that dominated macroeconomic thoughts until the 1970s (Mongiovi 1).
Many of his works reflected a distinctive sensitivity to the complexities of striking a balance between the roles of the state as an instrument of progressive reform and its capability for repression.
The Modigliani approach for instance queried the conventional proposals concerning the impact of technological change on employment His approach rejected the argument that workers dislodged by technological changes in the economy would be re-employed immediately due to subsequent wage reduction and the growth of the investment goods sector (Mongiovi 3).
Modigliani criticized the problems of capital deficiency that were overlooked in the standard discourses. He also censured the prospect of destructive recursive effects of the rationality theory of wage reductions on employment and aggregate demand (Mongiovi 4).
As a remedial measure, his approach advocated for the theory of marginal productivity that would allow a partial substitution between labour and capital, resulting to the closest approximation to fiscal reality that is possible on the basis of rational expectation theory of a market economy (Mongiovi 4).
On the contrary, the Rational Expectations Model proposes that economic agents employ the best possible economic theory to predict unemployment levels, price and wages.
Market prices are expected to have all pertinent information needed to forecast and to make decisions. Each economic agent has his own forecast, which may differ from the actual prices. However, forecasted prices and wages will be spread around the actual prices and wages (Bortis 2).
A significant facet of the Rational Expectations Model and the neoclassical model is that savings are invested. The market for new capital stocks creates equilibrium between savings and investment at full employment level via variation of the interest rate.
The Walrasian model undeniably mirrors an absolutely self-governing economy, suggesting that there exists a strong inclination towards equilibrium. Employment and output are usually given at full employment levels such that a natural rate of unemployment- structural and voluntary-exists.
Equilibrium is thus achieved through a market that functions efficiently. On the macroeconomic echelon, the demand curve depends on the real balance effect while the supply curve mirrors scarcity of resources.
With a given amount of money, the macroeconomic demand rises when prices decline in the event of excess supply and vice versa. The Rational Expectation Approach is thus based on the assumption that a competitive market economy is constantly in equilibrium (Bortis 2).
Neoclassical-Keynesian verses Rational Expectation Approach
One of the major developments in economic theory during the economic crisis in 1970s was the emergence of the rational expectations approach to macroeconomic analysis.
This theory is based on two fundamental premises: expectations are formed rationally; and that total supply is inelastic to the anticipated changes in the aggregate price level. The second hypothesis, postulates that a shift in total demand will influence output only and that the ensuing price levels diverges from the expected price.
The implication of the rational expectations theory is that fiscal and monetary policies cannot methodically stimulate expectation errors by the producers (McCallum 418).
Therefore, on the basis of the second hypothesis, authorities are unable to design monetary and fiscal policies that can systematically influence unemployment and output rates.
As a matter of fact, authorities can neither sustain high output permanently nor decrease the magnitude of output fluctuations around capacity levels. Although a rare output inflation trade-off exists due to unanticipated shocks, authorities cannot utilize this trade-off in any constructive manner (McCallum 419).
In spite of the logical rigour and elegance of the Rational Expectations Approach, the Neoclassical-Keynesian school has generally rejected its policy implications.
One of the key reasons relates to the prevalent belief that the pace of price-level changes needed in the rational expectations approach is much greater than one witnessed in real economies. A significant outline of this disapproval focuses on the market-clearing facet of the rational expectations approach.
For example, in the Sargent Wallace model, prices are assumed to be absolutely flexible such that aggregate demand and supply are adjusted to maintain equilibrium in each period.
However, according to Neoclassical-Keynesian theory, prices adjustment is too slow to create equilibrium between demand and supply in each period (McCallum 419). However, some critics (neoclassical-Keynesian school) argue that the assumptions of the rationality approach are highly credible.
The critics of the rationality approach point to the assumption that endows the private economic agents with perfect information about the monetary authority’s policy decisions and the economic structures. However, this account is not necessary to give way to the conclusion that monetary policy cannot be used as a
stabilizing instrument. It is reasonable to make an assumption that expectations are created so that there is no systematic connection between the economic agent’s (firms and individual households) expectations errors and the information required by the authorities to be used to control the money stock (McCallum 432).
Neoclassical-Keynesians verses Monetarist
According to Modigliani, there are no apparent differences between the Neoclassical-Keynesians and Monetarists on fundamental macroeconomic issues.
The Neo-Keynesian paradigm is quite consistent with key revolutionary macroeconomics theories developed in the past decades. A number of the main tenets of neoclassical-Keynesian school include: first, inelasticity of prices is a major impediment the major function of monetary policy.
It also brings about the short run non-neutrality of money. Given that some prices are partially elastic, inflationary pressure stimulates relative price changes that have impact on welfare; second, the abrasions that exist in relatively profound monetary economies are second in the order of merit (Williamson &Wright 13).
These frictions encompass precise descriptions of specialization that creates information asymmetry in the market, thus giving credence to media as a platform for exchanging information; third, there exist a short-run Philips curve swap between output and inflation (or unemployment).
Monetary policy can stimulate a short run rise in the aggregate output by raising the rate of inflation; finally, the central bank is seen as the institution that can set up short term nominal interest rate with respect to macroeconomic conditions (Williamson &Wright 13).
Thus, the neoclassical-Keynesians support the current role of central banks with respect to instituting monetary policies to increase aggregate output. The clear similarity between the neoclassical-Keynesian school and monetarist is that they both support the role of central bank as an institution that can stimulate output through monetary policies.
According to Modigliani, both schools are in concurrence that achieving a low inflation rate should be the main focus of any monetary policy. Moreover, monetary policy is seen as a process that determines the volume of money in circulation.
The optimal monetary policy entails reducing the inconsistency in the growth of monetary aggregate. The two schools also agree that although sticky prices are important in producing short-run non-neutralities, they are irrelevant to monetary policy.
Moreover, inflation and inflation uncertainty bring about welfare losses in the economy. Both schools give credence to the existence of a short-run Philips curve trade off although the monetarists argue that the central bank should not attempt to utilize it (Williamson &Wright 14).
The Differences between Rational expectation approach Monetarist
One of the key facets of the neoclassical economics is that in order to find out the economic consequence of a theoretical change in government policy, such as tax cut, it is essential to consider the likelihood of individual households and businesses reacting to changes in government policy by making their own economic choices.
Thus, according to the neoclassical economic theory, expectations of households and businesses are designed in the most perfect way according to the information accessible to them.
This phenomenon is called rational expectations (Espinosa &Russell 18). However, the rational expectations approach has attracted criticism from the monetarist school since it requires unrealistically high level of economic information and exceptional forecasting abilities by firms and households (Espinosa & Russell 22).
On the other hand, the basic tenets of monetarism emerged from a conference at the Federal Reserve Bank of Minneapolis in 1970. Significant precursors to this school included Samuelson (1956), who presented a model of money in general equilibrium, and Lucas (1972), whose writings ignited the rational expectations rebellion and with it, a shift towards integrating vital macroeconomic theories.
The monetarist differ from the rational approach in a number of significant ways: first, since the rational approach ignores crucial elements of economic theory, their policy recommendations can be severely erroneous; the fiscal policy is vital for the effect of monetary policy; as opposed to the rational approach, monetary economics can utilize macroeconomic theory in other areas, such as public economics and finance (Williamson &Wright 14).
Friedman, who represented the old monetarist ideas, argued that although money was any object that could be employed as a medium of exchange, it was irrelevant with respect to the analysis of monetary policy (Williamson &Wright 13).
While old monetarist were critical of the role of the central bank on monetary policy, the rational expectations approach posited that the role of t central bank was necessary in order to institute a dynamic monetary policy to counterbalance aggregate instability rather than leaving it to the private sector (Fisher 213).
According to the rationality approach, the central bank’s ability to influence allocation of resources relies on its ability to influence real interest rates and therefore savings.
Expansionary monetary policy reduces the real interest rate by increasing the anticipated inflation rate (Fisher 215). On the contrary, the old monetarist stressed that monetary policy was non-neutral in the short-run and its utilization by central bank would increase inflation rate. Thus, the monetary policy should focus only on long run inflation (Williamson &Wright 14).
Bortis, Heinrich. Remarks on the use of Mathematics in economic Theory. The Example of the Appropriate Macroeconomic Foundations of Financial analysis. Switzerland: University of Fribourg, n.d. Espinosa, Marco, and Russell Steven. History and Theory of the NAIRU: A Critical Review. Atlanta: Federal Reserve Bank of Atlanta, 1997.
Fiher, Stanley. On Activist Monetary Policy with Rational Expectations. Chicago: University of Chicago Press, 1980.
McCallum, Bennet. “Price Level Adjustments and the Rational Expectations Approach to Macroeconomic Stabilization Policy.” Journal of Money, Credit, and Banking 10.4 (1978): 418-436.
Mongiovi, Gary. “Franco Modigliani and the socialist State.” New York’s: John’s University Jamaica. n.d. Reuss, Alejandro. “That ‘70s Crisis”. What can the crisis of U.S. capitalism in the 1970s teach us about the current crisis and its possible outcomes? Dollar & Sense. Web. May 1, 2011. November, 2009 <http://www.dollarsandsense.org/archives/2009/1109reuss.html>
Williamson, Stephen & Wright, Randall. “New Monetarist Economy”, Key Developments in Monetary Economics Conference. The Federal Reserve Board. Web. May 1, 2011. August 4, 2010. <http://www.federalreserve.gov/events/conferences/kdme2009/HTML/paper 2/index.html>