Three + 1 Primary Schools of Economic Thought

Classical Adam Smith David Ricardo Keynesian John Maynard Keynes Monetarist Milton Friedman

Founders of Classical Economics Adam Smith: 1723-1791 (Scotland) The father of modern economics, he saw the market system acting as an "invisible hand" which leads people to unintentionally promote society's interests while pursuing their own. Author “The Wealth of Nations” David Ricardo: 1772-1823 (England) His theory that landlords enriched themselves at the expense of society led him to campaign tirelessly in Parliament and in print for free trade. Also known as the father of comparative advantage and why nations trade. Thomas Malthus: 1766-1834 (England) A Classical economist, he startled early 19th century society with his pessimistic prediction that population growth would exceed food supply, condemning mankind to misery.

Primary Beliefs of Classical Economics People maximize: Households try to maximize their economic well-being and firms try to maximize profits. People are forward looking People use available information today (interest rates, stock prices, inflation, etc…) to form expectations about the future. Markets adjust All prices (including wages and FOP) are fully flexible so that buyers and sellers can make transactions The economy normally operates at its potential

View on Recessions and Booms (Expansions) Recessions and Booms (expansions) are often exaggerated. They are never as bad or good as they appear. They are simply “natural” adjustments to bring the economy back to its potential Wages and all prices are fully flexible and will always adjust with the market. (Major Difference)

Major Disagreement with the other Schools of Economic Thought Government and Central Bank (The Fed) actions often do more harm than good. Uncertainty about current and future market conditions interferes with the interaction between households and firms. The economy ALWAYS performs better when markets make decisions rather than governments or central banks.

Problems with Classical Economics The Great Depression Until 1929 (The Great Stock Market Crash), most policy makers and economists believed strongly in classical economics. When the economy did not recover from the beginnings of the Great Depression, many policy makers and economists abandoned the classical analysis. The question with classical economics is: How long will it take for the economy to recover?

Founder of Keynesian Economics John Maynard Keynes: 1883-1946 (England) Reacting to the severity of the worldwide depression, Keynes in 1936 broke from the Classical tradition with the publication of the General Theory of Employment, Interest, and Money. The Classical view assumed that in a recession, wages and prices would decline to restore full employment. Keynes held that the opposite was true. Falling prices and wages, by depressing people's incomes, would prevent a revival of spending. He insisted that direct government intervention was necessary to increase total spending. Keynes insisted that wages and the prices of FOP are “sticky”, they do not adjust with the market

Primary Beliefs of Keynesian Economics People are forward looking People use available information today (interest rates, stock prices, inflation, etc…) to form expectations about the future. Prices and wages are “sticky”. Prices do not adjust with the market because of “menu costs” and Wages do not adjust with the market because of negotiated wage contracts.

View on Recessions and Booms (Expansions) During a recession (high unemployment and falling GDP), the government must use expansionary fiscal policy to stimulate demand and employment. Without a stimulus, declining consumer spending (people are still unemployed) will only worsen the recession or create a downward spiral. During a boom, the government must use contractionary fiscal policy to slow inflation.

Problems with Keynesian Economics The stagflation of the 1970’s seemed to lesson the ideas of Keynesian Economics. Keynes believed in fiscal policy to control economic outcomes. The problem during the 1970’s was high unemployment and high inflation which Keynesians could not control. It appeared that the Phillips curve was disproven. Government actions lag behind the market, the effects of fiscal policy are often unpredictable, and fiscal policy often over corrects.

Founder of Monetarist Economics Milton Friedman: 1912-2006 (United States) Milton Friedman, recipient of the 1976 Nobel Memorial Prize for economic science, was a senior research fellow at the Hoover Institution from 1977 to 2006. He passed away on Nov. 16, 2006. He was also the Paul Snowden Russell Distinguished Service Professor Emeritus of Economics at the University of Chicago, where he taught from 1946 to 1976, and a member of the research staff of the National Bureau of Economic Research from 1937 to 1981. An American Economist who firmly believed that the economy is controlled by the money supply.

Primary Beliefs of Monetarist Monetarism is the view that growth in the money supply has major influences on the growth of real GDP and inflation. They also believe that recessions and booms are exaggerated . They argue that recessions and booms can be controlled by controlling the growth rate of the money supply.

View on Recessions and Booms (Expansions) During recessions, the Fed should use expansionary monetary policy to increase the money supply which will stimulate aggregate demand . During booms, the Fed should use contractionary monetary policy to decrease the money supply which will decrease aggregate demand.

Problems with Monetary Policy Monetary policy lags behind the market (not as much as fiscal policy) Monetary policy creates uncertainty for households and firms. Our economic fate is tied to what the future monetary policy will be.

What do Economists Agree On? There is no trade-off between inflation and unemployment in the long-run (only in the short-run) People are forward thinking and expectations about the economy matter. Monetary and Fiscal policy must be transparent to households and firms. Today, most economists believe in a hybrid of all three of the schools of economic thought.

(+1) Another School of Economic Thought Austrian Economics Friedrich Hayek: 1899-1992 (Austria). Wrote “The Road to Serfdom”-How central planning will make the common person poor Main Beliefs Only individuals choose Markets (interaction between households and firms) determine prices. The price system economizes information Private property (Enforced by the government) Money is nonneutral-an increase in the money supply will cause inflation Free Markets Rule (Adam Smith)

Hayek and Keynes Hayek was very critical of Keynes because he believed that fiscal and monetary policy created uncertainty and confusion for markets. Hayek concluded that expansionary fiscal and monetary policies drove down interest rates which created poor investment decisions (malinvestment) Expansionary policy creates inflation

Hayek and Keynes