Schools of Economic Thought Flashcards
School of Economic Thought
Group of economists collectively share a perspective on the way economy works: Often shaped by personal experiences
Classical Economics
The idea of division of labour as a way of increasing productivity where the value of the service/ good depends on the cost of production (determined by factors of production)
- Flourished in Britain in late 18th century
- Accepts Say’s Law of Markets (production is a source of demand)
- It’s downturns are led by lack of demand being impossible
- Market is able to adjust on its own without government intervention.
- Unemployment is voluntary therefore deficit budgeting is forbidden.
Classical Dichotomy
Separates the Classical Economists:
- Real Variables: determined on the basis the aggregate supply relationship measured in physical units (GDP).
- Nominal Variables: Neutrality of money- changes in money supply affects monetary units measured in monetary units (money supply which changes the price levels)
Keynesian Macroeconomics
Keynes who defines output (GDP) as the sum of consumption, gov spending etc, places emphasis on aggregate demand where recessions and depressions come as a result of lack of effective demand in the economy.
- Unlike CE, increased gov spending to increase aggregate demand and employment to lift the economy.
- Individual isnt rational, therefore consumers and investors are subject to emotional fluctuations
Neoclassical Synthesis
Individual is rational therefore, unemployment can persist and not be voluntary.
- Through fiscal and monetary policies, the gov can manage the economy, markets for goods and labour are competitive, externalities are absent and information is perfect.
- Classical dichotomy fails and nominal variables (like money supply) can effect real variables (unemployment or GDP)
- Nominal wages adjust to equate supply and demand
Monetarists
Coined by Milton Freidman- father of the theory of consumption (rose in mid-20th century). Believed the economy was very limited and questioned the motives of the gov in improving macroeconomic outcomes
Keynesians vs. Monetarists
Debated over:
1. The effectiveness of monetary vs. fiscal policy
2. The Phillips Curve
3. The Role of Policy
- Effectiveness of Monetary vs. Fiscal Policy
Friedman challenged the view that fiscal policy could affect output faster and more reliable that monetary.
- 1963, F published book with Anna Schwartz - monetary was very powerful and movements in money explained most fluctuations in output.
- The Great Depression was caused by a major mistake in monetary policy
- The Phillips Curve
F and Edmund Phelps argued that trade-ff btw unemployment and inflation (what the PC shows) would vanish if policy makers actually tried to exploit it
- By mid-1970s it was agreed that there wasn’t a long-run trade-off between inflation and unemployment.
- The Role of Policy
F believed that political pressures for mild problems do more harm than good.
- Argued in favour for simple rules such as steady money growth.
Anti-Keynesian
Argue that Keynesian approach is incorrect and based off a flawed doctrine.
- Emerged by Robert Lucas, Thomas Sargent and Robert Barro
Robert Lucas and Thomas Sargent
Believed in 3 implications of rational expectation which went against Keynesian ideas:
1. Existing macro couldn’t be used to design policies
2. With rational expectations, only unanticipated changes in money could affect output
3. Game Theory was the right tool to design policy rather than optimal control in Keynesian Model
Efficient-Market Hypothesis
Financial Markets price assets precisely at their intrinsic worth given all publicly available information
The New Classical (from 1980s)
Edward Prescott lead ‘New Classical Theory’ aimed to explain fluctuations as the effect of shocks in competitive markets with fully flexible prices and wages.
- RBC = output is always at its natural level and fluctuations are movements of the natural level of output, usually caused by technological progression
RBC vs Keynesian Model
- RBC is in general equilibrium based on sold micro-foundations with consumer preferences and firm PF vs. KM is a equilibrium model with postulates behaviour
- KM is static taking capital stock as its given vs. RBC: business cycles evolve over time its better to look at a dynamic model of the economy
- RBC looks at productivity shocks and how utility maximising consumers respond to these shocks in terms of consumption
- RBC, there are no market failures, individual response is optimal (known as Pareto efficient, any force in the economy to chose diff allocation would cause reduction in welfare
- RBC = no need for gov intervention