A Test of Two Open-Economy Theories: The Case of Oil Price Rise and Venezuela

INTRODUCTION The Keynesian and monetarist theories dominate macro-economics, in general, and open-economies, in particular. The main goal of this study is to empirically discriminate between the two theories of open-economies. Keynesian and monetarist theories contain fundamentally different views about the long-run equilibrium state of the economy. Their views differ on the effectiveness of market forces in re-establishing the full-employment level of real income. Keynesian theory views market forces as being weak in re-establishing the full-employment level of income, so that, in the absence of government intervention, real income tends to remain below the full-employment level. Monetarist theory, on the other hand, views market forces as being strong enough to re-establish full-employment relatively quickly. For classic references to the Keynesian approach, see Fleming (1962) and Mundell (1963, 1964). For classic references to the monetary approach to balance of payments, see Frenkel and Johnson (1976) and Johnson (1972, 1976). This study, therefore, uses the different predictions implied by the two approaches with respect to the sharp increase in oil prices that took place in late 1973 to discriminate between them. The experience of Venezuela, as an oil-exporting country, is analyzed. The results support the monetarist view. For an exhaustive review of the theory and empirical evidence on the monetary approach to balance of payments and the limited ability of this literature in empirically discriminating between the Keynesian and monetary approaches, see Ardalan (2003, 2005a, 2005b, 2007, 2008). This study is organized in the following way. Section II discusses the conceptual basis used for the construction of an empirical test to discriminate between the monetarist and Keynesian theories. Section III empirically tests the experience of Venezuela with respect to a major real shock, i.e., the sharp increase in oil prices in late 1973. Section IV summarizes the major conclusions. CONCEPTUAL FRAMEWORK OF THE DISCRIMINATING TEST This section discusses the construction of a test that can discriminate between the two open-economy theories. The approach is based on the different views Keynesians and monetarists have about the role of stability (homeostasis). This difference is considered the basis for constructing the discriminatory test. For a classic discussion of the ideas separating Keynesians and Monetarists, see Mayor (1978), Chapter 1, pp. 1-46. This paper uses the model and the methodology of Ardalan (2013) and applies it to the data from Venezuela. The model and the methodology of Ardalan (2013) are provided here for the reader's convenience. The analysis concentrates on one of the fundamental issues separating monetarist and Keynesians--the effectiveness of market forces in re-establishing full-employment. In the monetary interpretation, market forces are strong and, in the long run, real income can be treated as though it were pre-determined. In Keynesian models, market forces are weak, and in the absence of government intervention, real income tends to remain below its full-employment level. If market forces tending to re-establish equilibrium are strong and effective, the monetarist assumption that income can be treated as exogenous is reasonable. In that case, open-economy adjustment for a small country under fixed exchange rates must take place through changes in the stock of money or relative prices rather than through changes in employment and output. If market forces are weak and there is persistent under-employment, then income becomes endogenous as the positive feedback of multiplier analysis dominates the market feedback assumed by monetarists. In that case, open-economy adjustment normally involves alterations in employment and output. Restated, monetarists believe that a country's response to an external real shock will be through an adjustment in relative prices with no long-run change in employment and output. …