KEYNESIAN ECONOMICS

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ECONOMICS
What Does It Mean To Me?
THEORIES OF ECONOMICS
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Economists have forecasted 9 of the last 5
recessions..
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The major theorists in each area are
1) Neo-classical
Adam SMITH Jean-Baptiste SAY David
RICARDO Irving FISHER Thomas MALTHUS
2)Keynesian
John Maynard KEYNES Sir John Richard HICKS Sir
Roy Forbes HARROD
3) Monetarist
Milton FRIEDMAN Friedrich August Von HAYEK
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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.
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• Adam SMITH (1723-1790)
• 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.

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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 well-being
would increase from competition organizing
production to suit the public.
This was the basis of the free market economy.
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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.
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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
under-stocked, 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.
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These concepts developed by SMITH are so
fundamental that they are still present in nearly
all economics courses. (something to look
forward to!!!!)
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Thomas MALTHUS (1766-1834) Cambridge in
mathematics widely considered to be the founder
of social demography greater contribution in
the area of ecological-evolutionary 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.
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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.
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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.
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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
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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.
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International Trade Theory (COMPARATIVE
ADVANTAGE) Ricardos 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.
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If all countries specialized where they had a
comparative advantage, then the level of world
welfare should increase.
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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)
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Say was also responsible for introducing the
concept of ENTREPRENEUR into economics. However,
he is best known for his LAW OF MARKETS or
Says Law, which states Supply creates its own
demand.
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Says 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.
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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 Fishers EQUATION of
EXCHANGE.
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Equation of Exchange The Fisher equation appears
in various guises, but perhaps the most common
is MVPT 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
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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.
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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)
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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.
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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 so-called Keynesian
Revolution, but also on his other writings, most
notably A Treatise on Probability (1921) and A
Treatise on Money (1930).
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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 short-run 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.
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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.
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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.
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We can see these policies in the graph below
PRICES
AD4
AD3
AD2
AD1
Q1
Q2
Q3
Q4
OUTPUT
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.
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We can see these policies in the graph below
PRICES
AD4
AD3
AD2
AD1
Q1
Q2
Q3
Q4
OUTPUT
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.
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Sir Roy HARROD (1900-1978) 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.
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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.
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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.
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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.
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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.
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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 looks at output against the rate of
interest.
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.
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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 conducts monetary policy
in the United States.
Federal Reserve Dallas
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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.
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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.
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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.
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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
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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
long-run. 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?
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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!
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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
Y
X
8
V
W
5
U
Pe8
Pe5
Pe0
Unemployment
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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.
LRPC
Inflation
Y
X
8
V
W
5
U
Pe8
Pe5
Pe0
Unemployment
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.
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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.
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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.
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Timeline of Famous Economists
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THE END
Compiled from internet sources by Virginia
Meachum, Economics Teacher, Coral Springs High
School