Schools of Thought in Economics

Rabbia Javed & Wajiha Samreen

Classical EconomicsKeynesian EconomicsNeo-Classical Economics

Framework of Presentation

Known as the English School of Economic Thought

Originated during the late 18th century in Britain

Main Idea: “Invisible Hand”◦ The most effective market system is the market without

government intervention.

Classical Economics

Adam Smith (1776-1790), An Inquiry into the Nature and Causes of Wealth of Nations-1776

Jean Baptiste Say (1767-1832), A Treatise on Political Economy - 1803

David Ricardo (1772-1823), Principles of Political Economy and Taxation, 1817

John Stuart Mill (1806-1873), Principles of Political Economy, 1848

Famous Classical Economists

Full Employmen

t

Laissez-faire

Free trade

Wages are Flexible

Aggregate Supply

Self adjusting

Assumptions

Classical Aggregate Supply curve

• LRAS is vertical.• Increase in Aggregate Demand results in

increase in prices only.

“Supply creates its own demand”

Production creates demand for goods Price Level in the economy depends on the supply of money Saving investment equality Rate of interest as determinant factor support the laissez-faire belief that a capitalist economy will

naturally tend toward full employment and prosperity without government intervention

Say’s Law of Market

Wage Price Flexibility

• Decrease in demand for labor results in decrease in wage rates.

No tradeoff No Tradeoff Between Unemployment and Inflation

◦ Classical economists say that in the short term, you might be able to reduce unemployment below the natural rate by increasing AD.

◦ But, in the long-term, when wages adjust, unemployment will return to the natural rate, and there will be higher inflation. Therefore, there is no trade off in the long-run.

Full employment refers to that situation in which at a given level of real wage demand of labour is equal to the available supply of labour.

All those people get employment who are willing to work at prevailing wage rate

Demand of labour = Supply of labour

Full employment

Aggregate demand◦ The classical theory centers on the quantity

theory of moneyMV = PT (1)

With M = the quantity of Money in the circulation

V = the transaction velocity of money P = price level T = volume of transaction

Aggregate Demand

- Assume that T = Q (real output), with Q is fixed at the fully employed level. Also, the short run V is fixed.- Therefore,

A change in money supply only affects the price level.

Aggregate Demand

QPVM

◦ Money supply changes has not effect on current output, only affect price.

◦ Changes in government expenditure has no effect on current output.

◦ Changes in the overall level of taxation do not affect current output.

◦ Policy tools will not affect output and employment but add instability.

◦ Let market work properly is the best thing the government can do.

Implications of Classical Economics

The main critic of the classical school of thought was John Maynard Keynes.

In his book, “General Theory of Employment, Interest and Money”, he out rightly rejected the Say’s law of market that supply creates its own demand.

In addition, in his view, the idea of full employment in the economy is unrealistic.

Criticism to Classical School

During the Great Depression of the 1930s, existing economic theory was unable either to explain the causes of the severe worldwide economic collapse or to provide an adequate public policy solution to remove unemployment.

John Maynard Keynes

Govt Interventio

n

Under-employmen

t equilibrium

Trade Off

Wages are Inflexible

Money Illusion

Short Run

Assumptions

The Keynesian view of long run aggregate supply is different. They argue that the economy can be below full capacity in the long term. Therefore, a Keynesian plays greater emphasis on the role of aggregate demand in causing and overcoming a recession.

Aggregate Supply Curve

Effective demand refers to that level of aggregate demand where it is equal to aggregate supply.

He therefore suggested that unemployment could be removed by increasing the effective demand.

According to him aggregate demand comprised of demand for two types of goods: Demand for consumption good and Demand for investment goods

to remove unemployment and to achieve full employment, government interference is necessary

Aggregate demand

C + I = AD

Wages are ‘sticky downwards’. Workers resist nominal wage cuts. For example, if there was a fall in demand for labour, trade unions would reject

nominal wage cuts, therefore, in the Keynesian model it is easier for labour markets to have disequilibrium. Wages would stay at W1, and unemployment would result.

Wages inflexible

Y=f (N), OUTPUT (y) is the direct function of employment (N), NS=f (W), (Supply of labor (NS) IS the direct function of money wage (W). ND = f (W/P), (Demand for labor (ND) is the inverse function of real wage (W/P). Labor market will be in equilibrium when demand for labor is equal to its supply, NS=ND According to Keynes, money market will be in equilibrium when demand for money is equal to

supply of money, i.e. MS=MD I = S, KEYNES also assumed that in equilibrium, investment and saving will be equal I= f(r), investment is an inverse function of rate of interest (r), S=f (Y), saving is a direct function (f) of income. Saving increases with increase in income.

Keynesian Model

William Jevons (1835-1882) Carl Menger (1840-1921) Leon Walras (1834-1910) Alfred Marshall (1842-1924)

Proponents

Economic agents are rational in their behaviour People act independently on the basis of full

and relevant information. Consumers look to maximise utility Firms look to maximise profits. Focus on marginal values, such as marginal

cost and marginal utility Market equilibrium is achieved only when both

the customer and the company achieve their respective goals.

Assumptions