THEORIES OF ECONOMICS

1. ECONOMICS What Does It Mean To Me? THEORIES OF ECONOMICS

2. Economists have forecasted 9 of the last 5 recessions……..

3. The major theorists in each area are: 1) Neo-classical Adam SMITH Jean-Baptiste SAY David RICARDO Irving FISHER Thomas MALTHUS 2)Keynesian John Maynard KEYNES Sir John Richard HICKS Sir Roy Forbes HARROD 3) Monetarist Milton FRIEDMAN Friedrich August Von HAYEK

4. NEO-CLASSICAL THEORY 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.

5. Adam 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.

6. 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-faire environment, public well-being would increase from competition organizing production to suit the public. This was the basis of the free market economy.

7. COMPETITION 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 GOVERNMENT INTERVENTION.

8. 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.”

9. These concepts developed by SMITH are so fundamental that they are still present in nearly all economics courses. (something to look forward to!!!!)

10. Thomas 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.

11. 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.

12. 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.

13. Along with Malthus, David 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

14. 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 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 RENT would have been earned.

15. International Trade Theory (COMPARATIVE 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) 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.

16. If all countries specialized where they had a comparative advantage, then the level of world welfare should increase.

17. Jean-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 OF PRODUCTION into Land (all natural resources, Labor (all human resources, and Capital (man-made resources to aid production)

18. Say was also responsible for introducing the concept of ENTREPRENEUR into economics. However, he is best known for his “LAW OF MARKETS” or Say’s Law, which states: “Supply creates it’s own demand.”

19. 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 (supply) will lead to an increase in expenditure to buy those goods and services (demand). There will not be any shortage of demand and there will always be jobs for all workers (Full Employment). 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.

20. Irving 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 EXCHANGE.

21. 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 level T is the number of transactions taking place

22. MV = PT This 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 EXPENDITURE.

23. 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. inflation)

24. 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 ECONOMICS.

25. John 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).

26. Keynes argued that an economic slump was not a long-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-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.

27. 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 we are all dead.”

28. So his theory was that the government should actively intervene in the economy to manage the level of demand. These policies are often known as DEMAND MANAGEMENT POLICIES, aptly named since the idea of them is to manage the level of aggregate demand. If you want to impress your teacher with your astute knowledge of Keynesian economics, you could call these policies COUNTER-CYCLICAL DEMAND MANAGEMENT POLICIES. They are called this because the government should be doing the exact opposite to the trade cycle.

29. We can see these policies in the graph below: PRICES AD4 AD3 AD2 AD1 Q1 Q2 Q3 Q4 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.

30. We can see these policies in the graph below: PRICES AD4 AD3 AD2 AD1 Q1 Q2 Q3 Q4 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.

31. Sir 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.

32. 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.

33. MULTIPLIER/ACCELERATOR INTERACTION 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.

34. 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.

35. Sir John Richard HICKS (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.

36. 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. Rate of Interest LM curve IS curve Output 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.

37. MONETARIST THEORY This school of thought, suggested by Milton Friedman, stressing the importance of stable monetary growth to control inflation and stimulate long-term growth. The FEDERAL RESERVE SYSTEM conducts monetary policy in the United States. Federal Reserve: Dallas

38. MONETARIEST THEORY Monetarists are a group of economists so named because of their preoccupation with money and its effects. Federal Reserve: Minneapolis Their view that the main cause of changes in aggregate output and the price level are fluctuations in the money supply. The FEDERAL RESERVE is responsible for monetary policy in the United States.

39. Milton 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.

40. 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 policy to control inflation and supply-side policies to make markets work better and reduce unemployment.

41. 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 circulation V is the velocity of circulation of that money P is the average price level T is the number of transactions taking place

42. 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?

43. 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!

44. 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 X Y 8% V W 5% U Pe=8% Pe=5% Pe=0% Unemployment

45. 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. LRPC Inflation X Y 8% V W 5% U Pe=8% Pe=5% Pe=0% Unemployment 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.

46. 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.

47. 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.

48. Timeline of Famous Economists

49. THE END Compiled from internet sources by Virginia Meachum, Economics Teacher, Coral Springs High School