THEORIES OF ECONOMICS

ECONOMICSECONOMICSWhat Does It Mean To Me?

Economists have forecasted 9 of the

last 5 recessions……..

QuickTime™ and aTIFF (Uncompressed) decompressorare needed to see this picture.

QuickTime™ and aTIFF (Uncompressed) decompressorare needed to see this picture.

The major theorists in each The major theorists in each area are:area are:

1) Neo-classical

2)Keynesian

3) Monetarist

Adam SMITH Jean-Baptiste SAY

David RICARDO Irving FISHER

Thomas MALTHUSJohn Maynard KEYNES Sir John Richard HICKS

Sir Roy Forbes HARROD

Milton FRIEDMAN

Friedrich August Von HAYEK

The term ‘classical’ refers to work done by a group of economists in the 18th and 19th centuries. Much of this work was developing theories about the way markets and market economies work. Much of this work has subsequently been updated by modern economists.

NEO-CLASSICAL THEORY

Adam SMITHAdam SMITH (1723-1790)

*Father of Economics

*Developed much of the theory about markets that we

regard as standard theory now.

•Scottish

•Graduated from Glasgow at the age

of 17

•fellow at Oxford

•lecturer in Scotland.

Adam Smith argues that it was market forces that ensured the production of the

right goods and services. This would

happen because producers would want to make profits by providing them.

Without government intervention, thus forming laissez-laissez-fairefaire environment, public well-being would increase from

competitioncompetition organizing production to suit the public.

This was the basis of the free market economy.free market economy.

COMPETITIONCOMPETITION would mean that producers would try to outsell each other and this would bring prices down to their lowest possible levels (making minimal profit). If there is not enough competition, this would mean that producers would make more profit. This

would soon attract more producers into the industry, bringing

prices down. All this would end up benefiting the consumer without without

GOVERNMENT GOVERNMENT INTERVENTION.INTERVENTION.

Smith also recognized the danger of monopolies:

“A monopoly granted either to an individual or to a trading

company has the same effect as a secret in trade or manufacturers. The monopolists, by keeping the market constantly under-stocked, by never fully supplying the effectual demand, sell their commodities much above the

natural price, and raise their emoluments, whether they consist in wages or profits, greatly above their natural rate.”

These concepts developed by SMITH are so fundamental that they are still present in nearly all economics

courses.

(something to look forward to!!!!)

Thomas MALTHUSThomas MALTHUS (1766-1834)

*Cambridge in mathematics

*widely considered to be the founder of social demography

*greater contribution in the area of ecological-

evolutionary theory

*His essay, “The Principle of

Population,” points out that our ability to produce children will always outstrip our ability to provide

energy for their survival.

Malthus believed that population growth was continuously being checked--held down tto sustainable levels--in all past, present,

and future societies. He described environmental constraints within which all societies must exist, and these constraints were a major obstacle to any real progress.

The constant effort towards population, which is found to act even in the most

vicious societies, increases the number of people before the means of subsistence are increased. The food previously divided between 7 million must now be divided

between 8 million. The poor consequently must live much worse, and many of them

reduced to severe distress.

The number of labourers also being above the proportion of the work in the market, reduces the price of labor while the price of provisions would, at the same time, tend to rise. The labourer, therefore, must work harder to earn the same as

before.

During this season of distress, the discouragements of marriage, and the difficulty of rearing a family are so great that population is at a stand.

In the meantime, the cheapness of labor encourages the cultivators to employ more labor and expand production until the means of subsistence is in the same

proportion to the population.

Along with Malthus, David RICARDODavid RICARDO

(1772-1823), was concerned about the impact that rising populations would

have on the economy. He developed two key theories still important today:

1) Distribution Theory

2) International Trade Theory

Distribution Theory

Ricardo argued that with more people, more land would have to be cultivated. However, the return

from the land would not be constant as the amount of capital available would not grow at the same rate. In fact, the land would suffer from

DIMINISHING RETURNSDIMINISHING RETURNS. Extra land that was brought into cultivation would become more and more marginal

in terms of profitability, and eventually returns would not be enough to attract any further

capital. At this point, the maximum level of ECONOMIC RENTECONOMIC RENT would have

been earned.

The original example focused on the trade in wine and cloth between England and Portugal. Ricardo showed that if one country produced a good at a lower

opportunity cost than another country, then it should specialize in that good.

The other country would therefore specialize in the other good, and the two

countries could then trade.

International Trade Theory

(COMPARATIVE ADVANTAGECOMPARATIVE ADVANTAGE)

Ricardo’s theory focused on comparative costs and looked at how a country

could gain from trade when it had relatively lower costs (I.e. comparative

advantage)

If all countries specialized where

they had a comparative

advantage, then the level of world welfare should

increase.

Jean-Baptiste SAYJean-Baptiste SAY (1776-1832) was a French businessman, which explains why he was responsible for introducing the work of Adam Smith to

Europe. Say can take credit for the way in

which we tend to divide the FACTORS FACTORS OF PRODUCTIONOF PRODUCTION into Land (all natural

resources, Labor (all human resources, and Capital (man-made resources to aid

production)

Say was also responsible for introducing the concept of ENTREPRENEURENTREPRENEUR into economics. However, he is best known for his “LAW OF MARKETS” or Say’s Law, which states:

“Supply creates it’s own demand.”

Say’s Law provides justification for the Classical view that the economy will tend towards full employment. This is because, according to this law, any

increase in output of goods and services (supplysupply) will lead to an increase in expenditure to buy

those goods and services (demanddemand). There will not be any shortage of demand and there will always be

jobs for all workers (Full Full EmploymentEmployment). If there was any unemployment it would simply be

temporary as the pattern of demand shifted. However, equilibrium

would soon be restored by the same process.

Irving FISHERIrving FISHER (1867-1947) graduated from Yale

specializing in mathematics. One area he

developed was index numbers. Index numbers that we use today include the FTSE index to measure share values and the RPI to measure inflation. He

also wrote about and campaigned for world

peace, healthy eating and healthy lifestyle. Much of the Classical and Monetarist theory of inflation is based on Fisher’s EQUATION of EQUATION of

EXCHANGEEXCHANGE.

Equation of Exchange

The Fisher equation appears in various guises, but perhaps the most common is:

MV=PT

Where:

M is the amount of money in circulation

V is the velocity of circulation of that money

P is the average price levelT is the number of transactions taking place

MV = PTThis equation is in fact an identity as

it will always be true.

At its simplest level you could imagine an economy that has a good money supply of $5m. If this $5m is on average used 20 times a year, it will have generated

$100m of spending. In the Fisher equation above M would be equal to $5m, V would be equal to 20, and PT would be

equal to $100m.

This $100m could be made up of, say 100 transactions of $1m each. PT can

therefore be though of as equivalent to NATIONAL EXPENDITURENATIONAL EXPENDITURE.

Classical economists then

tried to show that V and T would be stable in the long-term, thus implying that any increases in the money supply

(M) would cause prices (P) to rise-- (i.e. inflationinflation)

KEYNESIAN THEORY

Keynesian economics is a theory suggested by John Maynard Keynes in which government spending and taxation is used to

stimulate the economy. This theory is also called fiscal

policies or DEMAND-SIDE DEMAND-SIDE ECONOMICSECONOMICS.

John Maynard KEYNESJohn Maynard KEYNES (1883-1946) is perhaps one of the best known economists. His work

changed the whole face of post-World War II economic

policy.

*graduate of Cambridge --studied Classics and Math.

His reputation does not rest solely on the General

Theory of Employment, Interest and Money (1936), which initiated the so-

called Keynesian Revolution, but also on his other writings, most notably A Treatise on

Probability (1921) and A Treatise on Money (1930).

Keynes argued that an economic slump was not a long-runlong-run phenomenon that we should all get depressed about and leave the markets to sort out.

(Remember that Smith felt that government should always stay out of economic policy---laissez-faire) Keynes felt that a slump (or trough) was a short-runshort-run problem stemming from a lack of demand.

If the private sector was not prepared to spend to boost demand, then the government should do it instead by

running a budget deficit. When times were good again and the private sector was spending again, the government

could trim its spending and pay off the debts they had accumulated during the

slump.

The idea, according to Keynes, was to balance your budget in the medium term, not in the short-

run.

One of his best known quotes

summarizes this focus on the short-

run policies:

““In the long-run In the long-run we are all dead.”we are all dead.”

So his theory was that the the governmentgovernment should actively should actively intervene in the economy to intervene in the economy to manage the level of demand.manage the level of demand.

These policies are often known as These policies are often known as DEMAND DEMAND MANAGEMENT POLICIESMANAGEMENT POLICIES, aptly named since , aptly named since the idea of them is to manage the level the idea of them is to manage the level

of of aggregate demandaggregate demand..

If you want to impress your teacher with If you want to impress your teacher with your astute knowledge of Keynesian your astute knowledge of Keynesian

economics, you could call these policies economics, you could call these policies COUNTER-CYCLICAL DEMAND MANAGEMENT COUNTER-CYCLICAL DEMAND MANAGEMENT

POLICIESPOLICIES. They are called this because . They are called this because the government should be doing the exact the government should be doing the exact

opposite to the trade cycle.opposite to the trade cycle.

We can see these policies in the graph below:

AD1

AD2

AD3

AD4

Q1 Q2 Q3 Q4

PRICES

OUTPUT

If aggregate demand is low (AD1), then government should pursue Reflationary policies, such as cutting taxes or

boosting government spending to push AD higher and boost employment and output.

We can see these policies in the graph below:

AD1

AD2

AD3

AD4

Q1 Q2 Q3 Q4

PRICES

OUTPUT

However, if aggregate demand is high (AD4), causing demand-pull inflation, then

government should pursue Deflationary policies, such as increasing taxes or cutting government spending to reduce

demand.

Sir Roy HARRODSir Roy HARROD (1900-1978)

*graduate of Oxford University

*greatest contributions were trying to look at

growth not as simple static equilibrium, but as a changing dynamic situation

* also brought together in a

mathematical framework the Multiplier and the

Accelerator.

Harrod brought together theory about the multiplier and

accelerator to show mathematically how they may interact to change the pattern of growth,

and exaggerate the trade cycle.

MULTIPLIER/ACCELERATOR MULTIPLIER/ACCELERATOR INTERACTIONINTERACTION

The ACCELERATOR THEORY suggests that a net investment depends on the rate of change of output. This means that if there is an increase in government expenditure this will boost through the multiplier. This will, in turn,

boost investment through the accelerator. Then, because of the

increase in investment, the multiplier takes over again. As growth reaches its peak, the accelerator kicks in

reverse and investment then falls. This has a multiplied effect and the

same process begins but heading downward this time!! The interaction of the multiplier and accelerator

serves to create some of the cyclical fluctuations.

HARROD-DOMAR MODEL

This model is a model of long-term growth which tends to show that there will be no natural tendency for the economy to have a balanced rate of growth. Growth is split into different types and analyzed

accordingly.

The overall conclusion of the model is that the economy does NOT naturally find a full-employment equilibrium.

The policy implication of the conclusion is that the government has to intervene to try to manage

the level of output with its policies.

Sir John Richard Sir John Richard HICKSHICKS (1904-1989) *Nobel prize winner

in Economics*graduate of Balloil

College Oxford*lectured at the London School of

Economics.

Much of his work was done in

microeconomics and the analytical tool of indifference curve analysis.

Hicks looked at the role of the accelerator theory in affecting

growth and income and came to conclusions similar to those of Harrod…..that the

accelerator may induce various fluctuations in the level of output.

He also developed the IS-LM model. This is a

way of modeling equilibrium in the

economy by looking at equilibrium in the goods and service markets (IS curve) and equilibrium in the money markets (LM curve). Where

both these markets are in equilibrium will be

the equilibrium level of output. The IS-LM model looks at output against the rate of

interest.

LM curve

IS curve

Output

Rate of Interes

t

Hicks used this model to explore the assumptions

concerned with investment, savings, and the supply and demand for

money.

It has become a widely accepted alternative framework to standard Keynesian analysis.

MONETARIST THEORYMONETARIST THEORY

This school of This school of thought, suggested thought, suggested

by Milton by Milton Friedman, Friedman,

stressing the stressing the importance of importance of stable monetary stable monetary growth to control growth to control inflation and inflation and stimulate long-stimulate long-term growth. The term growth. The FEDERAL RESERVE FEDERAL RESERVE SYSTEMSYSTEM conducts conducts

monetary policy in monetary policy in the United States.the United States.

Federal Reserve: Dallas

MONETARIEST THEORY

Monetarists are a group of

economists so named because of

their preoccupation with

money and its effects. Their view that the main cause of changes in

aggregate output and the price level are fluctuations in the money supply. The

FEDERAL RESERVEFEDERAL RESERVE is responsible for monetary policy in the United States.

Federal Reserve: Minneapolis

Milton FRIEDMANMilton FRIEDMAN (1912- ) is the

best known monetarist. He is one of the select

elite in our Virtual economy who has won a Nobel

Prize in economics (1976). He was born in New York and has worked for the government,

Columbia University, and University of

Chicago. His best-known work is often called the “Chicago

school” of Monetarists.

Friedman is a great believer in the power of

the free market and much of his work has been based on

this.

It was his work that persuaded Mrs. Thatcher to adopt Monetarist policies in 1979 in Great Britain.

Friedman has made two particularly fundamental contributions to the

economic policy debate:

1) Quantity Theory of Money

2) Expectations-augmented Phillips Curve

He has also been a darling of right-wing governments throughout the world helping them

to justify their particular brand of ‘laissez-faire’ economics. In his view, any attempt to manage the level of demand (as in

Keynesian economics) would simply be de-stabilizing and make things worse. The role of government is simply to use its monetary policymonetary policy to control

inflation and supply-side policiessupply-side policies to make markets work better and reduce

unemployment.

QUANTITY THEORY OF MONEY

This theory is based of the Fisher Equation of Exchange, which states

that:

MV = PT

Where:M is the amount of money in circulationV is the velocity of circulation of that moneyP is the average price levelT is the number of transactions taking place

Classical economists suggested that V would be relatively stable and T

would always tend to full employment. Friedman developed this and tested it further, coming to the conclusion

that V and T were both independently determined in the long-run. The conclusion from this was that:

M P If the money supply grew faster than the underlying growth rate of output there would be

inflation. Inflation would be bad for the economy because of the uncertainty it created. This uncertainty could limit spending and also limit the level of investment. Higher inflation

may also damage our international competitiveness. Who will want to buy UK goods

when our prices are going up faster than theirs?

Expectations-augmented Phillips Curve

The Phillips Curve showed a trade-off between unemployment and inflation.

However, the problem that emerged with it in the 1970s was its total inability to explain unemployment and inflation going up together - stagflation. According to the Phillips

Curve they weren't supposed to do that, but throughout the 1970s they did. Friedman then put his mind to whether the Phillips Curve could be adapted to show why stagflation was occurring, and the explanation he came up

with was to include the role of expectations in the Phillips Curve - hence the name 'expectations-augmented' Phillips Curve. Once again the supreme logic of economics

comes to the fore!

Friedman argued that there were a series of different Phillips Curves for each level of

expected inflation. If people expected inflation to occur then they would anticipate and expect a correspondingly higher wage rise. Friedman was therefore assuming no 'money illusion' - people would anticipate inflation and account for it. We therefore got the situation shown below: LRPC

Inflation

Unemployment

8%

5%

Pe=8%Pe=0% Pe=5%

V

U

W

YX

LRPCInflati

on

Unemployment

8%

5%

Pe=8%Pe=0% Pe=5%

V

U

W

YX

So having moved along the Phillips Curve from U to V, the firms now begin to lay people off once again and unemployment moves back to W. Next time

around the firms and consumers are ready for this, and anticipate the inflation. If the government insist on trying again the economy will do the same thing (W to

X to Y), but this time at a higher level of inflation.

Any attempt to reduce inflation below the level at U will simply be inflationary. For this reason the rate U is often known as the natural rate of unemployment.

Say the economy starts at point U, and the government decides

that it wants to lower the level of unemployment because it is too

high. It therefore decide to boost demand by 5%. The

increase in demand for goods and services will fairly soon

begin to lead to inflation, and so any increase in employment will quickly be wiped out as people realize that there hasn't been a

real increase in demand.

Friedrich August von HAYEK (1899-

1992)

*born in Vienna, was a great believer in free

markets

*Nobel Prize in Economics.

*passionate opponent to Socialism and along with another economist

called Ludwig von Mises formed the Mont Pelerin Society. This society was pledged to give individual the

freedom to make their own economic choices

and campaigned to make people aware of the

dangers of Socialism.

Hayek did a considerable amount of work on the trade-cycle theories that

were developed by his friend von Mises and combined them with theories on capital. He

looked at how real wages will usually fall in a

recession causing firms to switch to more labour-intensive

methods of production. This in turn will lead investment to fall. In a

boom time the opposite will occur.

Hayek also argued like Friedman that the growth of the money supply should

be restricted, even if that led to high unemployment, as it was the only way

to control inflation.

Timeline of Famous Economist

s

THE END

Compiled from internet sources by Virginia Meachum, Economics Teacher, Coral Springs

High School