Chapter 10 – Economic Theory 10.1 Classical Economics 10.2 Keynesian Economics 10.3 Monetarism 10.4 Supply Side Economics 10.5 The Global Financial Crisis

Classical Economics Pioneered by Adam Smith in The Wealth of Nations published in 1776. People acting in their own self-interest will often produce the best social outcome. Also known as laissez-faire economics which literally means “let it be” or “leave it alone”. Argues for “small government” which means very little government intervention. Adam Smith

The Classical View of Unemployment

The Classical View of Unemployment Individuals (households) supply labour. Supply curve is upward sloping because the higher the wage, the more attractive it is to work, therefore the more people will be willing to work. Firms demand labour. Demand for labour downward sloping because the higher the wage the more costly it is to hire employees, so firms hire less employees as the wage increases.

The Classical View of Unemployment Classical economists held the view that unemployment was either voluntary or frictional or the result of some short run shock. In the long run the economy should naturally move towards full employment (where demand and supply for labour are in equilibrium). Unemployed workers will compete for jobs and therefore drive down the cost of labour. This should result in an increase in hiring.

The Classical View of Unemployment Questions: What is meant by frictional unemployment? What is meant by structural unemployment?

The Great Depression The Great Depression was the worst recession or economic downturn in modern history. Nearly every country in the world affected during the 1930s. Unemployment in the USA was over 25% and over 20% in the UK, higher rates than have ever been seen since.

The Great Depression What caused the great depression?? What happens when people get worried about the economy?

Keynesian Economics The dramatic nature of the Great Depression and the hardships that were felt during it caused an economic re-think. The market, left to its own devices, had failed. John Maynard Keynes argued that the government should use fiscal and monetary policy to actively ward off recessions.

Keynesian Economics Keynes argued that simply waiting for the economy to tend towards full employment would take far too long. “In the long run, we are all dead” High rate of unemployment was the result of market failure and a deficiency in aggregate demand. The government could rectify the market failure by intervening and using expansionary fiscal policy to stimulate demand.

The Phillips Curve Inverse relationship between inflation and unemployment. The implication is that governments could control unemployment and inflation with monetary and fiscal policy. Government’s could trade-off increased inflation in order to lower unemployment, or trade-off lower inflation for some extra unemployment.

The Phillips Curve

Stagflation High unemployment and high inflation at the same time. In 1973 the first oil price shock contributed to this new phenomenon. Higher oil prices caused prices in general to rise, resulting in inflation. Higher oil prices also caused production costs to increase, lowering profits for firms, which slowed down world economies and increased unemployment.

Stagflation Keynesian theory was challenged by stagflation. Before the 1970’s inflation and unemployment were thought to be mutually exclusive. You could treat one at the expense of the other but not both at the same time.

Monetarism Gained popularity in the mid-1970s due to stagflation and the failure of Keynesian theory to deal with it. Argues that inflation is caused by excess money supply. Monetarists argued that tight control of the money supply would bring stability to inflation and the economy. The Federal Reserve implemented monetarist theory in the late 1970’s with little success. After a series of recessions the theory was discredited.

Supply Side Economics In the 1980s, after monetarism was discredited, governments began to follow a policy of economic rationalism or supply side economics. This meant smaller governments and more effective market mechanisms. In Australia, the Hawke government began the process of deregulation and microeconomic reform.

The Mid-1990s to 2007 — The Howard Years From the mid-1990s to 2008 most parts of the world and particularly Australia experienced a long period of fairly stable and healthy economic growth. Microeconomic reform seemed to be paying off. Many thought the business cycle had finally been conquered. Australian Economic Growth 1980-2008

The Global Financial Crisis Triggered by the collapse of the sub-prime mortgage market in the USA. The US housing market price bubble burst in late 2006. Widespread loan defaults meant banks took ownership of nearly worthless houses, leaving them at a loss. As a result, the banking market collapsed.

The Global Financial Crisis Banks became reluctant to lend both to the public and to each other for fear of not being paid back. This is known as a credit crunch. During 2008 the credit crunch ballooned into a financial crisis where: Hundreds of billions in mortgage related investments went bad. Leading investment banks went bankrupt. Share markets crashed globally.

The Impact on Australia Relatively small on a global scale due to: Rudd Government’s stimulus package RBA slashing the cash rate Strength of the Australian economy Resilience of the Chinese economy

Post-GFC What is the solution? What is meant by austerity measures? Keynesian economics argued that during the crisis governments should increase spending to boost economic growth, so that is what they did. Central banks slashed interest rates to boost consumers spending. This resulted in governments going into huge amounts of debt. Which is what has caused the current European debt crisis. What is the solution? What is meant by austerity measures?