Transcript keynesian economics

ECONOMICS
What Does It Mean To Me?
THEORIES OF
ECONOMICS
Qu i ck Ti me ™a nd a
TIF F (Un co mpre ss ed )d ec omp res so r
a re ne ed ed to s ee th i s pi c tu re.
Economists have
forecasted 9 of the last
5 recessions……..
QuickT ime ™an d a
TIFF ( Uncomp res sed) deco mpre ssor
ar e need ed to see this pictur e.
The major theorists in each area
are:
1) Neo-classical
Adam SMITH
David RICARDO
FISHER
Jean-Baptiste SAY
Irving
Thomas MALTHUS
2)Keynesian
John Maynard KEYNES
Richard HICKS
Sir Roy Forbes HARROD
3) Monetarist
Milton FRIEDMAN
Friedrich August Von HAYEK
Sir John
NEO-CLASSICAL THEORY
The term ‘classical’ refers to work done by
a group of economists in the 18th and 19th
centuries. Much of this work was
developing theories about the way markets
and market economies work. Much of this
work has subsequently been updated by
modern economists.
Adam SMITH (17231790)
*Father of Economics
*Developed much of the
theory about markets
that we regard as
standard theory now.
•Scottish
•Graduated from
Glasgow at the age of 17
•fellow at Oxford
•lecturer in Scotland.
Adam Smith argues that it
was market forces that
ensured the production of
the right goods and
services. This would
happen because
producers would want to
make profits by providing
them. Without government
intervention, thus forming
laissez-faire
environment, public wellbeing would increase from
competition organizing
production to suit the
This was
the basis of the free
public.
market economy.
COMPETITION would mean
that producers would try to
outsell each other and this
would bring prices down to
their lowest possible levels
(making minimal profit). If
there is not enough
competition, this would
mean that producers would
make more profit. This
would soon attract more
producers into the industry,
bringing prices down. All
this would end up benefiting
the consumer without
GOVERNMENT
INTERVENTION.
Smith also recognized the danger of monopolies:
“A monopoly granted either to an
individual or to a trading company has the
same effect as a secret in trade or
manufacturers. The monopolists, by
keeping the market constantly understocked, by never fully supplying the
effectual demand, sell their commodities
much above the natural price, and raise
their emoluments, whether they consist in
wages or profits, greatly above their
natural rate.”
These concepts developed by SMITH
are so fundamental that they are still
present in nearly all economics
courses.
(something to look forward to!!!!)
Thomas MALTHUS (17661834)
*Cambridge in mathematics
*widely considered to be
the founder of social
demography
*greater contribution in the
area of ecologicalevolutionary theory
*His essay, “The Principle of
Population,” points out that
our ability to produce
children will always outstrip
our ability to provide energy
for their survival.
Malthus believed that population growth was
continuously being checked--held down tto sustainable
levels--in all past, present, and future societies. He
described environmental constraints within which all
societies must exist, and these constraints were a
major obstacle to any real progress.
The constant effort towards population, which is found
to act even in the most vicious societies, increases the
number of people before the means of subsistence are
increased. The food previously divided between 7
million must now be divided between 8 million. The
poor consequently must live much worse, and many of
them reduced to severe distress.
The number of labourers also being above the
proportion of the work in the market, reduces the
price of labor while the price of provisions would, at
the same time, tend to rise. The labourer, therefore,
must work harder to earn the same as before.
During this season of distress, the discouragements
of marriage, and the difficulty of rearing a family are
so great that population is at a stand.
In the meantime, the cheapness of labor encourages
the cultivators to employ more labor and expand
production until the means of subsistence is in the
same proportion to the population.
Along with Malthus,
David RICARDO
(1772-1823), was
concerned about the
impact that rising
populations would have
on the economy. He
developed two key
theories still important
today:
1) Distribution Theory
2) International Trade
Theory
Distribution Theory
Ricardo argued that with more people, more
land would have to be cultivated. However,
the return from the land would not be
constant as the amount of capital available
would not grow at the same rate. In fact, the
land would suffer from DIMINISHING
RETURNS. Extra land that was brought into
cultivation would become more and more
marginal in terms of profitability, and
eventually returns would not be enough to
attract any further capital. At this point, the
maximum level of ECONOMIC RENT would
have been earned.
International Trade Theory
(COMPARATIVE ADVANTAGE)
Ricardo’s theory focused on
comparative costs and looked at
how a country could gain from
trade when it had relatively lower
costs (I.e. comparative advantage)
The original example focused on the trade in wine
and cloth between England and Portugal. Ricardo
showed that if one country produced a good at a
lower opportunity cost than another country, then it
should specialize in that good. The other country
would therefore specialize in the other good, and the
two countries could then trade.
If all countries
specialized where they
had a comparative
advantage, then the level
of world welfare should
increase.
Jean-Baptiste SAY
(1776-1832) was a French
businessman, which
explains why he was
responsible for introducing
the work of Adam Smith to
Europe. Say can take credit
for the way in which we
tend to divide the
FACTORS OF
PRODUCTION into Land
(all natural resources,
Labor (all human resources,
and Capital (man-made
resources to aid
production)
Say was also responsible for introducing the
concept of ENTREPRENEUR into
economics. However, he is best known for his
“LAW OF MARKETS” or Say’s Law, which
states:
“Supply creates it’s own demand.”
Say’s Law provides justification for the
Classical view that the economy will tend
towards full employment. This is because,
according to this law, any increase in
output of goods and services (supply) will
lead to an increase in expenditure to buy
those goods and services (demand).
There will not be any shortage of demand
and there will always be jobs for all
workers (Full Employment). If there was
any unemployment it would simply be
temporary as the pattern of demand
shifted. However, equilibrium would soon
be restored by the same process.
Irving FISHER (1867-1947)
graduated from Yale
specializing in mathematics.
One area he developed was
index numbers. Index numbers
that we use today include the
FTSE index to measure share
values and the RPI to measure
inflation. He also wrote about
and campaigned for world
peace, healthy eating and
healthy lifestyle. Much of the
Classical and Monetarist theory
of inflation is based on Fisher’s
EQUATION of EXCHANGE.
Equation of Exchange
The Fisher equation appears in various guises,
but perhaps the most common is:
MV=PT
Where:
M
V
P
T
is the amount of money in circulation
is the velocity of circulation of that money
is the average price level
is the number of transactions taking place
MV = PT
This equation is in fact an identity as it will always
be true.
At its simplest level you could imagine an economy
that has a good money supply of $5m. If this $5m
is on average used 20 times a year, it will have
generated $100m of spending. In the Fisher
equation above M would be equal to $5m, V would
be equal to 20, and PT would be equal to $100m.
This $100m could be made up of, say 100
transactions of $1m each. PT can therefore be
though of as equivalent to NATIONAL
EXPENDITURE.
Classical economists then tried to
show that V and T would be stable in
the long-term, thus implying that any
increases in the money supply (M)
would cause prices (P) to rise-- (i.e.
inflation)
KEYNESIAN THEORY
Keynesian economics is a theory
suggested by John Maynard
Keynes in which government
spending and taxation is used to
stimulate the economy. This theory
is also called fiscal policies or
DEMAND-SIDE ECONOMICS.
John Maynard KEYNES
(1883-1946) is perhaps one of
the best known economists. His
work changed the whole face of
post-World War II economic
policy.
*graduate of Cambridge --studied
Classics and Math.
His reputation does not rest
solely on the General Theory of
Employment, Interest and Money
(1936), which initiated the socalled Keynesian Revolution, but
also on his other writings, most
notably A Treatise on Probability
(1921) and A Treatise on Money
(1930).
Keynes argued that an economic slump was not
a long-run phenomenon that we should all get
depressed about and leave the markets to sort
out. (Remember that Smith felt that government should
always stay out of economic policy---laissez-faire)
Keynes felt that a slump (or trough) was a shortrun problem stemming from a lack of demand.
If the private sector was not prepared to spend
to boost demand, then the government should
do it instead by running a budget deficit. When
times were good again and the private sector
was spending again, the government could trim
its spending and pay off the debts they had
accumulated during the slump.
The idea, according to
Keynes, was to balance
your budget in the
medium term, not in the
short-run.
One of his best known
quotes summarizes this
focus on the short-run
policies:
“In the long-run we
are all dead.”
So his theory was that the
government
should actively intervene in the
economy to manage the level of
demand.
These policies are often known as DEMAND
MANAGEMENT POLICIES, aptly named since the
idea of them is to manage the level of aggregate
demand.
If you want to impress your teacher with your astute
knowledge of Keynesian economics, you could call
these policies COUNTER-CYCLICAL DEMAND
MANAGEMENT POLICIES. They are called this
because the government should be doing the exact
opposite to the trade cycle.
We can see these policies in the graph below:
P
R
I
C
E
S
AD4
AD3
AD2
AD1
Q
1
Q Q Q4
OUTPUT
2
3
If aggregate demand is low (AD1), then government
should pursue Reflationary policies, such as cutting
taxes or boosting government spending to push AD
higher and boost employment and output.
We can see these policies in the graph below:
P
R
I
C
E
S
AD4
AD3
AD2
AD1
Q
1
Q Q Q4
OUTPUT
2
3
However, if aggregate demand is high (AD4), causing
demand-pull inflation, then government should
pursue Deflationary policies, such as increasing
taxes or cutting government spending to reduce
demand.
Sir Roy HARROD (19001978)
*graduate of Oxford
University
*greatest contributions
were trying to look at
growth not as simple static
equilibrium, but as a
changing dynamic situation
* also brought together in a
mathematical framework
the Multiplier and the
Accelerator.
Harrod brought together theory
about the multiplier and
accelerator to show
mathematically how they may
interact to change the pattern
of growth, and exaggerate the
trade cycle.
MULTIPLIER/ACCELERATOR
INTERACTION
The ACCELERATOR THEORY suggests that a
net investment depends on the rate of change of
output. This means that if there is an increase in
government expenditure this will boost through
the multiplier. This will, in turn, boost
investment through the accelerator. Then,
because of the increase in investment, the
multiplier takes over again. As growth reaches
its peak, the accelerator kicks in reverse and
investment then falls. This has a multiplied
effect and the same process begins but heading
downward this time!! The interaction of the
multiplier and accelerator serves to create some
of the cyclical fluctuations.
HARROD-DOMAR MODEL
This model is a model of long-term growth
which tends to show that there will be no
natural tendency for the economy to have a
balanced rate of growth. Growth is split into
different types and analyzed accordingly.
The overall conclusion of the model is that
the economy does NOT naturally find
a full-employment equilibrium.
The policy implication of the conclusion is
that the government has to intervene to try to
manage the level of output with its policies.
Sir John Richard
HICKS (1904-1989)
*Nobel prize winner in
Economics
*graduate of Balloil
College Oxford
*lectured at the London
School of Economics.
Much of his work was
done in microeconomics
and the analytical tool of
indifference curve
analysis.
Hicks looked at the role of the
accelerator theory in affecting
growth and income and came
to conclusions similar to those
of Harrod…..that the
accelerator may induce
various fluctuations in the
level of output.
He also developed the IS-LM
model. This is a way of
modeling equilibrium in the
economy by looking at
equilibrium in the goods and
service markets (IS curve) and
equilibrium in the money
markets (LM curve). Where
both these markets are in
equilibrium will be the
equilibrium level of
output. The IS-LM model
Rate of
Interest
LM curve
IS curve
Output
Hicks used this model to
explore the assumptions
concerned with investment,
savings, and the supply and
demand for money.
It has become a widely
accepted alternative framework
to standard Keynesian
analysis.
MONETARIST THEORY
This school of
thought, suggested by
Milton Friedman,
stressing the
importance of stable
monetary growth to
control inflation and
stimulate long-term
growth. The
FEDERAL
RESERVE SYSTEM
Federal Reserve: Dallas
conducts monetary
policy in the United
MONETARIEST
THEORY
Monetarists are a
group of economists
so named because of
their preoccupation
with money and its
effects.
Federal Reserve:
Minneapolis
Their view that the main cause of changes in aggregate
output and the price level are fluctuations in the money
supply. The FEDERAL RESERVE is responsible for
monetary policy in the United States.
Milton FRIEDMAN
(1912- ) is the best
known monetarist. He
is one of the select elite
in our Virtual economy
who has won a Nobel
Prize in economics
(1976). He was born in
New York and has
worked for the
government, Columbia
University, and
University of Chicago.
His best-known work is
often called the
“Chicago school” of
Monetarists.
Friedman is a great believer in the
power of the free market and much
of his work has been based on
this.
It was his work that persuaded
Mrs. Thatcher to adopt Monetarist
policies in 1979 in Great Britain.
Friedman has made two particularly
fundamental contributions to the economic
policy debate:
1) Quantity Theory of Money
2) Expectations-augmented Phillips Curve
He has also been a darling of right-wing governments
throughout the world helping them to justify their
particular brand of ‘laissez-faire’ economics. In his view,
any attempt to manage the level of demand (as in
Keynesian economics) would simply be de-stabilizing and
make things worse. The role of government is
simply to use its monetary policy to control
inflation and supply-side policies to make
markets work better and reduce unemployment.
QUANTITY THEORY OF MONEY
This theory is based of the Fisher Equation of
Exchange, which states that:
MV = PT
Where:
M is the amount of money in circulation
V is the velocity of circulation of that money
P is the average price level
T is the number of transactions taking place
Classical economists suggested that V would be
relatively stable and T would always tend to full
employment. Friedman developed this and tested
it further, coming to the conclusion that V and T
were both independently determined in the longrun. The conclusion from this was that:
M
P
If the money supply grew faster than the underlying growth rate of
output there would be inflation. Inflation would be bad for the
economy because of the uncertainty it created. This uncertainty
could limit spending and also limit the level of investment. Higher
inflation may also damage our international competitiveness. Who
will want to buy UK goods when our prices are going up faster
than theirs?
Expectations-augmented Phillips Curve
The Phillips Curve showed a trade-off between
unemployment and inflation. However, the problem that
emerged with it in the 1970s was its total inability to explain
unemployment and inflation going up together - stagflation.
According to the Phillips Curve they weren't supposed to do
that, but throughout the 1970s they did. Friedman then put
his mind to whether the Phillips Curve could be adapted to
show why stagflation was occurring, and the explanation he
came up with was to include the role of expectations in the
Phillips Curve - hence the name 'expectations-augmented'
Phillips Curve. Once again the supreme logic of economics
comes to the fore!
Friedman argued that there were a series of different Phillips
Curves for each level of expected inflation. If people expected
inflation to occur then they would anticipate and expect a
correspondingly higher wage rise. Friedman was therefore
assuming no 'money illusion' - people would anticipate inflation
and account for it. We therefore got the situation shown below:
LRPC
Inflation
8%
5%
X
V
Y
W
U
Pe=8%
Pe=0% Pe=5%
Unemployment
LRPC
Inflation
8%
5%
X
V
Y
W
U
Pe=8%
Pe=0% Pe=5%
Unemployment
Say the economy starts at point
U, and the government decides
that it wants to lower the level
of unemployment because it is
too high. It therefore decide to
boost demand by 5%. The
increase in demand for goods
and services will fairly soon
begin to lead to inflation, and so
any increase in employment will
quickly be wiped out as people
realize that there hasn't been a
real increase in demand.
So having moved along the Phillips Curve from U to V, the firms now begin to
lay people off once again and unemployment moves back to W. Next time
around the firms and consumers are ready for this, and anticipate the inflation. If
the government insist on trying again the economy will do the same thing (W to
X to Y), but this time at a higher level of inflation.
Any attempt to reduce inflation below the level at U will simply be inflationary.
For this reason the rate U is often known as the natural rate of unemployment.
Friedrich August von
HAYEK (1899-1992)
*born in Vienna, was a great
believer in free markets
*Nobel Prize in Economics.
*passionate opponent to
Socialism and along with
another economist called
Ludwig von Mises formed the
Mont Pelerin Society. This
society was pledged to give
individual the freedom to make
their own economic choices
and campaigned to make
people aware of the dangers
of Socialism.
Hayek did a considerable amount of work on the
trade-cycle theories that were developed
by his friend von Mises and combined them
with theories on capital. He looked at how real
wages will usually fall in a recession causing
firms to switch to more labour-intensive
methods of production. This in turn will lead
investment to fall. In a boom time the opposite
will occur.
Hayek also argued like Friedman that the
growth of the money supply should be
restricted, even if that led to high
unemployment, as it was the only way to control
inflation.
Timeline of
Famous
Economists
THE END
Compiled from internet sources by Virginia
Meachum, Economics Teacher, Coral Springs High
School