Two Hundred Years of Economic Thought

1. Two Hundred Years of Economic Thought (in one class period) (borrowed from Ulrich Kleinschmidt)

2. Classical Economics 1776-1930s, 1980s to present • Also known as: new classical, supply-side, trickle down economics, monetary • Key people: Adam Smith, J.B. Say, David Ricardo (comparative advantage), A. Marshall (graphs), Hayek, and Milton Friedman

3. Fundamentals of Classicalism • Say’s Law • Say built on Smith’s theory • If suppliers overproduce, they correct the surplus by cutting production and lowering prices • The economy then rebalances because wages are lower, but so are prices • If suppliers under produce, they correct for the shortage by increasing production and raising prices • The economy will rebalance because wages are higher, but so are prices • Thus, “Supply creates its won Demand” Say’s Law • Competition causes businesses to always improve product to win the market • Competition causes businesses to lower their prices • This effect is called the Invisible Hand • In the end, consumers get products that are better and cheaper • Inefficient companies leave or disappear from the market • New companies will have to be more efficient in order to compete

4. Role of Government in the Classical World • Gaovernment ensures that compeition occurs • Government must stop monopolies or unions because they prevent competition • Classical economists want to lower taxes to reduce government interference; real income reduces the role of government • In the long run, the economy will balance near Full Production (in other words, stay out of way and keep markets level)

5. Keynesian Economics: 1930s to present • Key people: J.M. Keynes, Krugman • Fundamental idea is that competition is GOOD, but flawed

6. Keynesianism • Prices can also increase easily, but not decrease. This is known as the Ratchett Effect • Markets can reach efficiency and full employment, but Keynesians assume that they will soon become inefficient or recessionay • Recession, in Keynes world, will probably become the economic norm • Government must now step in and correct Aggregate Demand • In the Short Run, Smith’s Invisible Hand will always have companies that are inefficient • Say’s Law is a myth because businesses can’t really lower prices at will because production costs are fixed (known as sticky prices) • Consumers will also be paid by businesses, but will save some of the income, thus undercutting production • This will cause a constant leakage or loss of income

7. Role of Government in Keynes world • During recessions • Congress should cut taxes, and raise government spending (deficits occur) • During inflation • Congress should raise taxes and cut government spending (creating a surplus) • Congress also has automatic stabilizers to keep economy from crashing too much • Unemployment insurance • Social Security • Progressive taxes • Congress will represent the interests of the people by using taxes and spending to prevent recessions • Congress can’t wait of the potential Long Run because workers need help • “In the Long Run we are all dead”

8. Monetary School Economics: (1913), 1970 to the Present • Also known as: Federal Reserve Policy, Central Bank Policy • Current US Chairman of the system: Volcker, Greenspan, Bernanke

9. Monetary School • Competition is Good, but needs fine tuning. • The average recession lasts about 14 months in the US • We only know a recession has started after at least 6 or more months have passed • Even if Congress aagrees on a policy, it can take many more months to enact • By the time the policy comes into force, the recession may have already ended naturally • Congress may be able to cut taxes during recessions, but they will never have the will to raise taxes to fight inflation

10. Monetary School continued • Therefore, the best way to correct economic flaws is to have the Federal Reserve act quickly • Plus, the Federal Reserve can focus on stable prices that helps control demand pull inflation • They can also focus on long run growth with realistic growth around 2-3% • This means that the government, through this nonpolitical and independent agency can control national growth by manipulating interest rates and the money supply (which is also why Ron Paul doesn’t like the FED) • This will keep inflation under control and healthy for businesses and other borrowers • When recessions threaten, lower interest rates on borrowing. • When inflation threatens, the FED will raise interest rates on borrowing • The FED is typically better at controlling inflation than preventing recessions

11. Now for A Quiz