The Keynesian-Monetarist Controversy in International Economics: Discriminatory Power of Long-Run Empirical Tests

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ABSTRACT

Two major theories in the area of balance of payments are the Keynesian and monetarist theories. There have been many long-run tests of the monetary approach to the balance of payments and the evidence has been used to support the monetary approach. This paper argues that most of the existing empirical work does not have any discriminatory power. Long-run empirical models can discriminate between a simple Keynesian cross and a monetarist approach, but they cannot discriminate between a monetarist and a standard IS-LM model because the monetary equation is the LM schedule in an IS-LM model. This paper recommends that Keynesian and monetarist views about the transmission mechanism and the homeostatic mechanism are fundamentally different and provide bases for discriminatory tests.

INTRODUCTION

Keynesian and monetarist theories dominate macro-economics in general and balance of payments theories in particular. There have been many long-run tests of the monetary approach to the balance of payments and the evidence has been used to support the monetary approach. This paper argues that most of the existing empirical work does not have any discriminatory power.

Ardalan (2003, 2005a, 2005b) has reviewed three alternative theories of balance of payments adjustments. They are the elasticity and absorption approaches (associated with Keynesian theory), and the monetary approach. In the elasticities and absorption approaches the focus of attention is on the trade balance with unemployed resources. The elasticities approach emphasizes the role of the relative prices (or exchange rate) in balance of payments adjustments by considering imports and exports as being dependent on relative prices (through the exchange rate). The absorption approach emphasizes the role of income (or expenditure) in balance of payments adjustments by considering the change in expenditure relative to income resulting from a change in exports and/or imports. In the monetary approach, on the other hand, the focus of attention is on the balance of payments (or the money account) with full employment. The monetary approach emphasizes the role of the demand for and supply of money in the economy.

Ardalan (2003, 2005a) has comprehensively reviewed the relevant empirical work dealing with the monetary approach. Empirical work on the monetary approach to the balance of payments can be divided into two different approaches; one tests the theory in long-run equilibrium, the other considers the adjustment mechanism and the channels through which equilibrium is reached. The first approach is based on the reserve flow equation developed by Johnson (1972). Testing was undertaken by Zecher (1976) and others (See Ardalan 2005a). The second approach is based on theoretical work of Prais (1977), with corresponding empirical work undertaken by Rhomberg (1977) and others (See Ardalan 2003).

This paper is based on Ardalan (2003, 2005a, 2005b) and it argues that most of the existing empirical work in the long-run framework has no discriminatory power because Keynesian and monetarist approaches yield similar implications when Keynesian models contain a monetary sector. The standard monetary equation may be used to discriminate between the monetary approach and simple Keynesian multiplier theory, but it cannot discriminate between the monetary approach and the Keynesian IS-LM models because the monetary equation is the LM schedule in an IS-LM model.

The next section explores the existing empirical work on the long-run monetary approach to the balance of payments to see if it can discriminate between the differing views of Keynesian and monetarist economists.

QUESTION OF DISCRIMINATORY POWER

The main goal of this section is to show that existing empirical work on the long-run monetary approach to balance of payments does not discriminate between Keynesian (IS-LM) and monetarist theories of the balance of payments. …