Progress in Economics

1. Progress in Economics As elusive as soap in the bath?

2. The issue of social science • Pure science includes subjects such as Physics and Chemistry • They have the ability to use laboratory experiments to test theories and examine the world • Social sciences have no laboratory, there can be no experiments, just observation.

4. No lab, so what do you do? • There are two ways to approach a problem when you can’t experiment • 1. Observe the world and see if you can see a pattern • 2. Think about the world and form a theory which you then test against reality

5. No lab, so what do you do? • The first is called Induction or the inductive method • The second Deduction or the deductive method • The problem is the first is logical nonsense and the second may never work!

6. Induction • The process of induction • Observe the data – an empirical study • Form a theory (hypothesis) from those observations • Usually works in the hard sciences. Repeat experiments, get the same results time and time again and you are probably on safe ground

7. Induction • Social sciences have a problem • No matter how many observations are made there is no inevitability that future observations will support the same theory.

8. Induction • I observe only white swans • I induce that all swans are white • But a black one might be out there

10. Deduction • Start with axioms which are taken to be true • Apply deductive logic and form a theory • Then test against reality (the data)

11. Deduction • Axiom: Consumers try to maximise their satisfaction through rational decisions • Logic: Consumers will try to get the best value for money from their income when deciding what to buy • Theory: If the price of a good rises Consumers will buy less of it

12. Deduction • Problems for Economics • Consumers may not be rational • More than just price may change at the same time • So price may rise and people buy more of a good – maybe incomes changed, people judge quality by price, a good consumed with it got cheaper

13. Deduction • So economics must make the assumption of Ceteris Paribus – All other things stay the same – for the theory to make sense • Also the assumptions may be wrong.

14. Hypothetico-Deductive Method • Science requires a theory to produce a set of predictions which have the potential to be falsified by the evidence. • So Economists favour the hypothetico-deductive method of reasoning as induction and deduction seem inadequate

15. Hypothetico-Deductive Method Hypothesis Revised hypothesis Deduction Induction Proposition Empirical testing

16. Hypothetico-Deductive Method Hypothesis There is a relationship between the Level of unemployment and wage rises Revised hypothesis Deduction When unemployment is low Unions can ask for higher wages Induction Proposition Inflation is caused by ‘wage-push’ factors Empirical testing

17. The Phillips Curve

18. Hypothetico-Deductive Method Revised hypothesis Inflation is caused by cost factors and highest during low unemployment Hypothesis Deduction Induction There is a trade-off between Unemployment and inflation Proposition Empirical testing

19. Phillips curve It turned out to be wrong!

20. The Reality • Economists debate – argue with each other to make progress • The problem is that when forming the hypothesis they will rely on selecting axioms • And the economists core belief will guide that choice

21. Progress through debate • Since the start of Economics as a distinct subject (1776) economists have argued their point • One of the oldest debates in economics is the one about the cause of recessions.

22. Progress through debate • There are two fundamental schools of thought: • Those who believe that the economy is essentially self regulating • Those who believe that the economy can fail to employ everyone and growth is not assured

25. What causes recessions? • This debate has been an active one since the 18th Century • We will concentrate on its latest incarnation the Keynesian – Monetarist debate

26. How debates proceed • One side lays out their theory. They state their assumptions and put forward their predictions • They appeal to the data to support their theory • The other side put forward their objections and may state a theory of their own

27. Keynesian thinking • Keynes reignited this old debate in his ‘General Theory’ in 1936. His aim was to explain the ‘Great Depression’ of 1930 to 33. • His axiom is that the economy is not self-regulating • His hypothesis is that it is possible for expenditure in the economy to be less than the total level of output

28. Keynesian thinking Hypothesis It is possible for effective demand to be less than total output Revised hypothesis Deduction This will lead to a ‘surplus’ level of output and so workers will be released by firms Induction Proposition Without government action to boost demand the situation persists Empirical testing

29. Keynesian thinking Hypothesis Revised Hypothesis Governments should Manage the economy Deduction Induction If effective demand rises the recession will end Proposition Empirical testing The Great Depression 1930 To 1933

30. Keynesian thinking • The Keynesian view was very persuasive in the wake of the experience of the 1930s • Governments after 1945 followed a policy of managing the level of economic activity by manipulating the level of demand. • They did this by varying their own spending and taxation levels

31. Monetarist thinking • Monetarists represent the type of thinking that dominated economics prior to the Great Depression • There axiom was that the economy is essentially self-regulating, but cyclical • Their hypothesis was that prolonged recessions must be caused by some sort of intervention in the normal process

32. Monetarist thinking • For the Monetarists, led by Milton Friedman and the Chicago School the problem was the quantity of money in circulation

33. Monetarist thinking Hypothesis Effective demand is determined by the quantity of money in circulation Revised hypothesis Deduction A fall in the money supply will lead to a fall in demand and so output Induction Proposition The Central Bank should maintain a stable money supply Empirical testing

34. Monetarist thinking Hypothesis Revised Hypothesis Central Banks should adopt a ‘Money Supply Rule’ Deduction Induction The Great Depression was caused by the Federal Reserve Bank Proposition Empirical testing During Great Depression the Federal Reserve allowed the US money supply to fall by a third

35. Monetarist thinking • After the failure of Keynesian policy in the 1970s the Monetarist view became the norm • This developed into the ‘New Classical’ approach as Monetarism is essentially a ‘one problem’ theory.

36. The debate • In the 1970s Keynesians and Monetarists debated how the economy worked with passion • The debate was often difficult as each side talked at cross-purposes • This was because their axioms – which were based on their core beliefs - conflicted

37. The debate • But as time wore on progress was made. • Keynesians (now called Post-Keynesians and New-Keynesians) accepted that ‘money does matter’ • Milton Friedman discussed the Monetarist case in the format of the Keynesian IS/LM model

38. The debate • By the 1990s a consensus was reached. • Inflation stability was prioritised but not by manipulating the money supply. Instead interest rates were used • Aggregate demand was monitored to smooth out the business cycle while not threatening the inflation target

39. The latest • The Global Financial Crisis was met by a massive Keynesian style stimulus to boost demand in the economy • No serious objections to this was raised by market economists recognising this was a major and unusual demand side shock • Monetary policy was changed to support an economic recovery

40. The latest • Sadly the debate now reignites • There is still disagreement on • 1. What caused the GFC • 2. How to design policy to recover from it after the initial shock

41. The latest • But that’s why economics is so interesting – it’s always changing