Schools of Thought and Policy Implications

Question 1

The Neo-Classical Approach

Hint: 4 assumptions

Answer 1

• economists who assume economic agents are rational and have perfect information to make maximising decisions
• argue no imperfect implications in the economy and so the economy will always self correct itself
• believe that the economy is always operating at full capacity so the LRAS is perfectly inelastic
• believe in the free market so there is no need for gov intervention

Question 2

What do neoclassical economists believe happens during a recession?

Answer 2

1. Believe that the LRAS is perfectly inelastic as economy is always operating at full capacity
2. If the economy is going through a recession: people spend less, AD decreases, price decreases, output decreases, real GDP decreases, derived demand for labour decreases, unemployment increases
3. Assume economic agents are rational and have perfect info
4. Believe in the free market so there is no welfare state and no benefits, so when unemployment is high, unemployed workers willing to look for work for lower wages to get back into work and maintain their lifestyle
5. Since they have perfect info they are aware there is a lot of competition so willing to take any job
6. Workers are willing to work for less, firms cop decreases, SRAS shifts, prices decreases and return back to full employment, at lower inflation.

Question 3

What is the neoclassical school of thought often referred to as?

Answer 3

referred to as laissez-faire
(let people do as they choose)
- markets work best when they are left and there is no government intervention
- they do not believe in any demand side policies
- no room for fiscal or monetayry policy

Question 4

The impact of fiscal policy using the neoclassical approach

Answer 4

1. In the short term, can operate beyond full capacity by working overtime and have capital work for longer
2. However, this is only sustainable in the short term as people get tired and machinery can depreciate
3. As a result of AD increasing, prices increase so there is inflation
4. In a neo-classical world, consumers will have perfect info so they would demand higher wages as they want their nominal wage to reflect their real wage
5. Firms cost of production increases so SRAS shifts to the left and prices increase even more
6. Return back to fully employment but this is purely inflationary as prices have increased

Question 5

What do neoclassical economist believe is the appropriate policy intervention?

Answer 5

Supply-side Polices
- only way to improve the economy as it improves productive capacity in the long run
- decreases costs of production
- improves quality and quantity of FOP so less scarce resources

Question 6

The keynesian approach

Answer 6

• free markets are volatile and not self-correcting so economy does not always get back to full employment
• people won’t invest or consume when exogenous shocks occur due to low confidence
• not always perfect information so workers won’t know inflation has fallen so won’t accept lower wages
• harder for wages to decrease as they are sticky downwards, and in the UK there has been an increasing trade unions and regulation

Question 7

Keynesian aggregate supply curve

Answer 7

1. Keynesian section
- idle labour, spare capacity and FOP
- if AD increases it is non-inflationary

2. Intermediate section
- factors of production becoming more scarce
- if AD increases there is an increase in competition of FOP so prices increases

3. Neoclassical section
- perfectly inelastic, no spare capacity or FOP
- can no longer increase output or else purely inflationary

Question 8

What did keynes argue about markets?

Answer 8

• markets are not self correcting
• in a recession firms and households are not confident, so the government gets involved and provides a fiscal stimulus to promise economic recovery

Question 9

What is the importance of fiscal stimulus strengthed by?

Answer 9

The existence of the multiplier effect
- an initial injection into the eocnomy in the form of increased government spending will continuously increase AD

Question 10

When is fiscal policy most likely to be effective?

Answer 10

When you are in a recession and there is lots of spare capacity as can have non-inflationary growth

Question 11

How should expenditure be financed?

Answer 11

Financed by borrowing
- In the long term there is more growth and the government could collect more tax revenue so they can pay it back

Question 12

The quantity theory of money

Answer 12

Used by neoclassical economist to further evidence the harms of demand side management of the economy

Question 13

The fisher equation of exchange

Answer 13

MV = PY

- M = money supplied
- V = velocity of circulation
- the number of times money changes hand in an economy
- the number of transactions that take place with a given amount of money

- P = avergae price level of goods
- Y = quantity of goods

Question 14

Why is V and Y fixed?

Answer 14

1. V is fixed as it is determined by institutional factors
- how often worksers get paid

2. Y if fixed as neoclassical economists believe the economy is always going to be at full capacity
- LRAS is perfectly inelastic

Question 15

What powerful implications does it have about the impact of increases in the money supply?

Answer 15

If money supply increases there is a directly proportional increase in inflation
- as more people have money they are going to spend more on goods and services
- more money is chasing the same number of goods which is purely inflationary

Question 16

What does the supply of money only ever increase by?

Answer 16

The amount of how much the productive capacity increases
- the extent to which long run economic growth increases
- increasing goods and service while increasing price so price levels would stay stable

Question 17

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Why does this provide a powerful critique for the effectiveness of quantitive easing?

Answer 17

• should not implement quantitative easing as it it pureply inflationary and there is no change in output

Question 18

What weaknesses do the keynesians point out?

Answer 18

• Y is not fixed as can operate below full employment meaning an increase in money supply does not always lead to an increase in price level
• V is not fixed as dependent on when people get paid
• people on zero hour contracts means they get paid infrequently
• does not take into account other external factors that could impact inflation
• If the government printing out more money and implementing QE shows that the economy is struggling so people may become loss averse and less confident so consumption falls