Economic Theories: Classical, Keynesian, Monetarist, and More
Historical Evolution of Economic Thought
Classical Economics (Ricardo, Mill, and Say)
Classical economists believed in an “invisible hand” without state intervention in the market. They posited that market forces (supply and demand) would maximize the production of goods and services and prevent unemployment.
Keynesian Economics
Keynes advocated for state intervention in the economy. He developed a theoretical framework to explain the Great Depression, arguing that waves of pessimism could negatively affect investment, leading to lower levels of economic activity, production, and employment.
Monetarism (Milton Friedman)
Monetarists, led by Milton Friedman, were key opponents of Keynesianism. They believed the economy was self-regulating and that the secret to economic stability was a stable money supply.
New Classical Economics (Robert Lucas, Thomas Sargent, and Robert Barro)
New Classical economists also believed in a self-regulating economy. They introduced the concept of rational expectations, suggesting that families and businesses rationally adjust prices and wages.
New Keynesian Economics (Oliver Blanchard and Gregory Mankiw)
New Keynesians seek to explain why markets can fail, making room for public policy. They argue that even if individuals are concerned only with their self-interest, the market may not self-regulate.
Real Business Cycle Theory
This theory posits that Keynesians and Monetarists are wrong. It suggests that technological shocks, rather than demand shocks or policy, explain economic fluctuations.
Categories of Unemployment
- Involuntary
- Voluntary
- Frictional
Classical economists disagreed with Keynes regarding involuntary unemployment.
Assumptions of the Classical Model
Classical theorists assumed that involuntary unemployment was temporary and that full employment would prevail. They believed that demand is created by production (Say’s Law).
Factors Ensuring Full Employment
- Free market
- Free mobility of resources
- Full knowledge of the market
- Passive role of money
- Flexibility in the interest rate
The Free Market (Laissez-Faire) and Pigou’s Comprehensive Competition
This concept involves the absence of state intervention in private business (economic liberalism). Wages would decrease under the pressure of unemployment until full occupancy is reached. A decrease in savings would lead to a reduction in interest rates, a reduction in the prices of consumer goods, and an increase in the production of capital goods. Therefore, savings are invested in production goods.
Keynes and Say’s Law
The essence of Say’s Law is that supply creates its own demand. If a product is created, it generates a market value equal to it. Therefore, involuntary unemployment cannot be caused by a deficiency in aggregate demand.
Validity of Say’s Law
- Barter economy
- Money as a simple medium of exchange
- Demand equals supply; money is not borrowed but spent
Implications of Say’s Law
- Full employment
- Appeal to reversed wages and profits
- Government spending does not interfere with final demand
- No general overproduction crisis
- Capital accumulation (investment) is a function of profits
Keynes and the Principle of Effective Demand
Keynes argued that aggregate demand is crucial and commands production and employment. Aggregate supply and aggregate demand determine the volume of employment. The equilibrium level of aggregate supply depends on the propensity to consume and investment (the essence of the general theory of employment). Aggregate demand determines the quantity that will be produced, limited by the availability of resources. Excessive aggregate demand leads to inflation. The propensity to consume curve is stable because it is determined by certain psychological characteristics. Only under abnormal conditions does consumption increase.
The Multiplier
The multiplier is a coefficient that indicates the change in income (production) in monetary units, given a change in investment. It is based on the marginal propensity to consume (MPC) when income increases as a consequence of an increase in investment. The multiplier (K) is the ratio between the change in income (?Y) and the change in investment (?I): ?Y / ?I = 1 / (1 – MPC). The multiplier decreases during expansion and increases during a depression because the MPC falls during expansion and rises during a depression. The marginal propensity to save (MPS) is ?S / ?Y, and MPS = 1 – MPC.
Marginal Efficiency of Capital (MEC)
Keynes defined the marginal efficiency of capital as the discount rate that would make the present value of the flow of expected returns from capital throughout its existence exactly equal to its supply price. It is the expected profit rate of a new capital asset. The MEC is the proportion between the expected flow of returns from a new capital good and its supply price. The supply price is the price that would induce a manufacturer to produce a new unit of capital (replacement cost). The demand price is the sum of the expected returns minus the interest rate. The liquidity preference curve shows that the lower the interest rate, the greater the preference for money. The preference for money is influenced by three factors: transaction, speculation, and precaution.
Demand for Goods and Services
Z = C + I + G + (X – M); Y = Co + C1(Y – T) + I + G; Private Savings (Sp) = -Co + (1 – C1)(Y – T); I = S = Sp + Sg; I = -Co + (1 – C1)(Y – T) + (T – G)
Paradox of Thrift
When people attempt to save more, the product decreases, and the equilibrium savings remain unchanged (determined by G, T, and I). National income falls, and savings remain equal to investment (I = S). So = (To – G – Tr) + T1Y. The relationship between the change in the level of product spending and investment is known as the accelerator principle. The capital-product ratio, ?, is known as the accelerator. Imports depend on domestic income (Y) and the real exchange rate (?). An increase in domestic income favors imports, while an increase in the real exchange rate inhibits imports. An increase in foreign income (Y*) leads to an increase in exports, and an increase in the real exchange rate positively changes expenditures, leading to an increase in exports. An increase in government spending leads to an increase in the product and a worsening of the trade balance. The increase in the product is greater than the increase in government spending due to the multiplier effect. The trade balance is NX = X – M.
Determinants of Employment
The volume of employment depends on effective demand, consumption expenditure, and investment expenditure. Net consumption depends on income and the MPC of consumers. Investment depends on the MEC and the interest rate. How can the propensity to consume be increased? Through a reduction in income inequality and wealth redistribution using taxation and transfers. The MPC falls during expansion and rises during a depression.
Yield of Bonds
Yield (R) = Gain from the bond / Price of the bond. An increase in GDP leads to an increase in interest rates, which in turn leads to a decrease in GDP. A decrease in GDP leads to a decrease in T1. The nominal exchange rate is e = R$ / US$. The real exchange rate is E = (eP* / P). Open market operations involve the buying and selling of government bonds. The price of a bond is PB = $100 / (1 + i), where i is the yield.
Dependent and Independent Variables
Dependent variables include the volume of employment and national income. Independent (explanatory) variables include the propensity to consume, the marginal efficiency of capital, and the interest rate.
Keynesian Critique of Classical Theory
Practical Sense: Wages are not very flexible; they are rigid. This prevents wages from falling even when there is an excess supply of labor due to labor unions. Keynes argued that even if wages were flexible, unemployment could still occur if effective demand were low.
Theoretical Sense: Unemployment occurs due to a lack of investment (demand) and the inflexibility of the interest rate. Employers lack full knowledge of the future (uncertainty), leading to unstable and generally insufficient investment.
Absolute Income
As aggregate income increases, the fraction of income spent on consumption declines.
Relative Income
The demonstration effect suggests that consumption spending increases if a neighbor’s income increases.
Permanent Income
This concept involves transitory consumption, which can be positive or negative.