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Schools of Economic Thought

Subject in STC - III

Michael Ungar

on 13 July 2018

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Transcript of Schools of Economic Thought

Schools of Economic Thought
- prior to Adam Smith
consideration of economics was all just off-the-
cuff intuition and policy proposals by a myriad of
merchants, government officials & journalists, principally in Britain.

Not a coherent school of thought, but a bunch of varying ideas about improving tax revenues, the value & movements of gold and how nations competed for international commerce & colonies. Mostly protectionist, 'war-minded', and all haphazardly argued. Zero-sum gain - one's nation benefits
at the expense of another
Classical School -- The Enlightenment era
(mid-1700s) in Europe. Following Newton's lead
thinkers began trying to discover the "laws" of human
interaction, to explain how human society operates.
The economy - exchange, prices, markets - seemed
amenable to scientific inquiry, where there might be
'laws' to be discovered in how markets operate.

French and Scottish Enlightenment thinkers were
dissatisfied with the Mercantilist approach and its

The first serious attempt to systematically study and look for "laws" in the marketplace was the Scottish philosopher Adam Smith in his
Wealth of Nations (1776)

It is for this reason Adam Smith is commonly regarded
as the "father of economics".
Emphasized the mutual benefits of trade & efficiencies of
the marketplace and specialization
The main idea of the Classical school was that
markets work best when they are left alone, and that there is nothing but the smallest role for government = laissez-faire & faith in the efficiency of free markets to generate economic development.

Markets should be left to work because the price mechanism acts as a powerful 'invisible hand' to allocate resources to where they are best employed.

Theory of Value - determined mainly by scarcity and costs of production.
In terms of the macro-economy, the Classical economists assumed that the economy would always return to the full-employment level of real output through an automatic self-adjustment mechanism.
Neo-classical - a wide ranging school of ideas from which modern economic theory evolved. The method is clearly scientific, with assumptions, hypotheses and attempts to derive general rules or principles about the behavior of firms and consumers.

Neo-classical economics assumes that economic agents are rational in their behavior, and that consumers look to maximize utility and firms look to maximize profits. The contrasting objectives of maximizing utility and profits forms the basis of demand and supply theory. Neo-classical economists focus on marginal values, such as marginal cost and marginal utility.

Keynesian economists broadly follow the main macro-economic ideas of British economist John Maynard Keynes. Keynes is widely regarded as the most important economist of the 20th Century, despite falling out of favor during the 1970s and 1980s following the rise of new classical economics.

In essence, Keynesian economists are skeptical that, if left alone, free markets will inevitably move towards a full- employment equilibrium.
Classical View >> The downsloping aggregate demand curve is stable and is the sole determinant of the price level.
Aggregate supply curve is a vertical line & is located at the full-employment level of real GDP, Qf .

The economy will operate at its potential level of output b/c

(1) Say's Law = the very act of producing goods generates
income equal to the value of the goods produced.
The production of any output automatically provides the
income needed to buy that output. Supply creates its own demand.

(2) responsive, flexible prices and wages. With flexible wages
and other input prices, costs will move up and down with prices and leave real rewards and real output constant.

A change in the price level will not cause the economy to stray from full employment.
Keynesian view = product prices & wages are downwardly
inflexible over very long time periods. Aggregate demand is
subject to periodic changes caused by changes in the
determinants of aggregate demand.
very short run
Monetarism focuses on the money supply holds that markets are highly competitive, and that a competitive market system gives
the economy a high degree of macroeconomic
Price & wage flexibility in competitive markets causes
fluctuations in aggregate demand to alter product and
resource prices rather than output and employment.

The problem, as monetarists see it, is that government has promoted downward wage
inflexibility through the minimum-wage law, pro-union legislation, guaranteed
prices for certain farm products, pro-business monopoly legislation, and so forth.

The free-market system is capable of providing macroeconomic stability, but, despite good intentions, government interference has undermined that capability.
The fundamental equation of monetarism is the equation of exchange
M is the supply of money

V is the velocity of money >>the average number of times per year a
dollar is spent on final goods and services

P is the price level or the average price at which each unit
of physical output is sold

Q is the physical volume of all goods and services produced
Change in
Monetary Policy
Change in Money Supply
Change in Interest Rates
Change in Investment
Change in Aggregate Demand
Change in Prices, RGDP and Employment
Keynesian Monetary Chain
Change in
Monetary Policy
Change in Money Supply
Change in Aggregate Demand
Change in Prices, RGDP & Employment
Monetary Policy
Supply-side economics came into vogue in the early 1980s
Supply-siders mantra was to cut tax rates, government spending, and government regulation.

The object of supply-siders is to raise aggregate supply
Many of the undesirable effects of high marginal tax rates
are the work effect, the savings and investment effect,
and the elimination of productive market exchanges.

Supply-Side Economics
The Monetarists

(Patron Saint) Milton Friedman did exhaustive studies of the relationship between the rate of growth of the money supply concluded that
the United States has never had a serious inflation that was not accompanied by rapid monetary growth.

When the money supply grew
slowly, the country had no

Building on the quantity theory of money, the monetarists agree with the classicals that when the money supply grows, the price level rises, albeit not at exactly the same rate

Recessions are caused when the Federal Reserve increases the money supply at less than the rate needed by business – say, anything less than 3 percent a year.

By and large the facts have borne out the monetarists’ analysis

Mainstream economists view the instability of
investment as the main cause of the economy’s
instability. Monetary policy is a stabilizing factor.

Changes in the money supply raise or lower interest
rates as needed, smooth out swings in investment,
and thus reduce macroeconomic instability.

Why Is the Money Supply Important?

1. Interest Rate Effect - An increase in the supply of money causes lower interest rates, which spurs investment

2. ,Wealth Effect: Putting more money in the hands of consumers, making them feel wealthier stimulates spending.

3. Business firms respond to increased sales by ordering more raw materials and increasing production. The spread of business activity increases the demand for labor and raises the demand for capital goods.

4. As PL increases, firms can generate more profits -->> produce more
Why the Quantity Theory of Money is Faulty
Changes in the money supply are the dominant forces that change nominal GDP (P × Y). It is not surprising, therefore, that monetarists view control of the money supply as the key variable in stabilizing the economy.
Real-Business-Cycle Theory

Business fluctuations result from significant changes in technology
& resource availability. Those changes affect productivity and thus the long-run growth trend of aggregate supply.
Ramifications of supply-shock - oil prices spike = fall in output (too
expensive) AD shifts to left >> people need less money b/c buying
fewer goods & demand for money falls
Business need to borrow less from banks & reduce supply even more
Decline in money supply reduces aggregate demand.
Macro instability arises on the aggregate supply side of
the economy, not on the aggregate demand side,
as mainstream economists and monetarists usually claim.
Reverse Scenario based on jump in production based on innovation
Full transcript