Schools of Economic Thought

Question 1

School of Economic Thought

Answer 1

Group of economists collectively share a perspective on the way economy works: Often shaped by personal experiences

Question 2

Classical Economics

Answer 2

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.

Question 3

Classical Dichotomy

Answer 3

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)

Question 4

Keynesian Macroeconomics

Answer 4

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

Question 5

Neoclassical Synthesis

Answer 5

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

Question 6

Monetarists

Answer 6

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

Question 7

Keynesians vs. Monetarists

Answer 7

Debated over:
1. The effectiveness of monetary vs. fiscal policy
2. The Phillips Curve
3. The Role of Policy

Question 8

1. Effectiveness of Monetary vs. Fiscal Policy

Answer 8

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

Question 9

2. The Phillips Curve

Answer 9

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.

Question 10

3. The Role of Policy

Answer 10

F believed that political pressures for mild problems do more harm than good.
- Argued in favour for simple rules such as steady money growth.

Question 11

Anti-Keynesian

Answer 11

Argue that Keynesian approach is incorrect and based off a flawed doctrine.
- Emerged by Robert Lucas, Thomas Sargent and Robert Barro

Question 12

Robert Lucas and Thomas Sargent

Answer 12

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

Question 13

Efficient-Market Hypothesis

Answer 13

Financial Markets price assets precisely at their intrinsic worth given all publicly available information

Question 14

The New Classical (from 1980s)

Answer 14

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

Question 15

RBC vs Keynesian Model

Answer 15

• 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

Question 16

The New Keynesian (since 1980s)

Answer 16

Michael Woodford and Jordi Gali
- Provides microeconomic foundations for Keynesian economists, connect with:
1. Research in nominal wages and prices
2. Exploration of imperfections in credit markets

Question 17

The New Growth Theory (since 1980s)

Answer 17

Focuses on the determinants of technological progress in the long run, and the role of increasing returns to scale.