Competing schools of thought Macroeconomic Theory

Macroeconomic theory is a set a views about the way the economy operates.

Models are developed to illustrate how the economy works Economists differ in what they believe is the “correct model” of the economy leads to disagreement about the role and conduct of policy

Two main schools of thought 1. Classical 2. Keynesian

Old Classical (1776 – 1930s) An Inquiry into the Nature and Causes of the Wealth of Nations by Adam Smith (1776) Invisible hand theorem laissez –faire economics Say’s law

Invisible hand theorem states that if each consumer is allowed to choose freely what to buy and each producer is allowed to choose freely what to sell and how to produce it, the market will settle on a product distribution and prices that are beneficial to all the individual members of a community, and hence to the community as a whole. The reason for this is that self-interest drives economic actors to beneficial behaviour. Video

laissez –faire economics The Invisible hand theorem leads to the concept of laissez- faire economics. An approach to economics that emphasizes an environment in which transactions between economic agents are free from government intervention, including regulations, taxes, tariffs and enforced monopolies.

Say’s Law “Supply creates its own demand” John Baptiste Say No possibility of overproduction and underproduction.

The classical view was the predominant view of the period from the late 18 th century until the Great Depression in the 1930s.

The Great Depression 1929 – early 1940s Worldwide economic depression began on October 29 th, 1929 with a stock market crash…panic struck! Unemployment rates spiked and persisted (33% in Canada; 25% in U.S.) The Classical view did not explain the persistent levels of high unemployment.

John Maynard Keynes There is no invisible hand channeling self interest towards a social optimum. Keynes proposed a new approach in his “General Theory of Employment, Interest and Money”

The Keynesian Revolution! Took hold in 1930s The great depression was a result of a lack of demand, not a lack of supply. The dawn of Keynesian economics is marked by the acceptance of the idea than changes in AD drive the business cycles.

Keynesian economics Advocates wide use of stabilization policy. Post WWII, all advanced democratic societies adopted Keynesian policies Policies that manage the demand side of the economy Unemployment remained low until 1973.

Key concepts of Keynesian economics Market failure Involuntary unemployment Stabilization policy

1970s High inflation! Rising unemployment! Low economic growth! Led to questioning of Keynesian economics

The reign of Keynesianism came to a halt No one school of thought has dominated since that time.

Other important schools of thought 1. Monetarist school (Milton Friedman) Quantity theory of money Expectations augmented Phillips curve 2. New Classical School Real business cycle theory

3. New Keynesian Economics Adapted micro to macro theory Micro foundations 4. Austrian School Free markets, invisible hand, emphasis on individuals 5. Post Keynesian Importance of uncertainty