Schools of Economic Thought

(Neo-)Classical Theory - Introduction

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 and they are generally termed neo-
classical economists, the word neo meaning 'new'.

Classical economists were not renowned for being a happy, optimistic bunch of economists (in terms of
their economic thinking!). Some believed that population growth would be too rapid for the resources
available (Malthus was a particular exponent of this view). If this wasn't enough to depress the rate of
long-term growth (and the rest of the population along with it!) then diminishing returns would cause
further problems for growth.

They believed that the government should not intervene to try to correct this as it would only make
things worse and so the only way to encourage growth was to allow free trade and free markets. This
approach is known as a 'laissez-faire' approach. Essentially this approach places total reliance on
markets and anything that prevent markets clearing properly should be done away with.

Much of Adam Smith's early work was on this theme, and he introduced the notion of an invisible hand
that guided economic activity and led to the optimum equilibrium. Many people see him as the
founding father of modern economics.

The Victorian period of rapid expansion worldwide seemed to cheer the Classical economists up a little
and they became a bit more optimistic, but still maintained their total faith in the role of markets.

Classical theories revolved mainly around the role of markets in the economy. If markets worked freely
and nothing prevented their rapid clearing then the economy would prosper. Any imperfections in the
market that prevented this process should be dealt with by government. The main roles of government
are therefore to ensure the free workings of markets using 'supply-side policies' and to ensure a
balanced budget. The main theories used to justify this view were:

 Free market theory

 Say's Law
 Quantity Theory of Money

Free market theory

The Classical economists assumed that if the economy was left to itself, then it would tend to full
employment equilibrium. This would happen if the labour market worked properly. If there was any
unemployment, then the following would happen:

unemployment (a surplus of increased demand for equilibrium restored at full

fall in wages
labour) labour employment

This can be shown on a diagram of the labour market. Wages are initially too high and there is
unemployment of ab. This causes wage rates to fall and employment increases as a result from Q1 to
Q2. Any unemployment left in the economy would be purely voluntary unemployment - people who
have chosen not to work at the going wage rate.

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The same would also be true in the 'market for loanable funds' . If there was any discrepancy
between savings and investment the equilibrium would change in the market. This would again
require a free market and flexible prices. In this market the price is the rate of interest . Say, for
example, investment increased, then the following process would occur to restore equilibrium:

increase in increased demand increased rate of increased savings as borrowers are attracted equilibrium is
investment for money interest by higher rates of interest restored

Say's Law

Say's Law is imaginatively named after an economist called Say. Jean Baptiste Say was an economist
of the early nineteenth century. His law says (excuse the pun!) that:

'Supply creates its own demand.'

This once again provides a justification for the Classical view that the economy will tend to 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 as shown above.

Quantity Theory of Money

The classical economists view of inflation revolved around the Quantity Theory of Money, and this
theory was in turn derived from the Fisher Equation of Exchange . This equation says 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 and
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. Therefore they came to the conclusion that:

M P

In other words, increases in the money supply would lead to inflation. The message was simple: control
the money supply to control inflation.

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We have seen that Classical economists had complete faith in markets. They believed that the economy
would always settle - automatically - at the full employment equilibrium in the long-run. However,
they did acknowledge that there might be a slightly different reaction in the short run as the economy
adjusted to its new long-run equilibrium. We can illustrate these changes with AS & AD analysis:

Short-run

Any increase in aggregate demand in the short-run will lead to an increase in output (Q1 to Q2), but
will also lead to prices increasing. This will happen as firms suffer from diminishing returns and are
forced to increase the prices of their product to cover the higher level of costs. Increases in aggregate
demand may come about for a variety of reasons including:

 Increases in the money supply

 Lower levels of taxation
 Increased government expenditure

Long-run

In the long-run, however, the situation will be different. The economy will have tended towards full
employment on its own, and so any further increases in demand will simply be inflationary. The shape
of the long-run aggregate supply curve will therefore be vertical:

The long-run aggregate supply curve is vertical at the full employment level of output (Qfe), and any
increase in aggregate demand leads to prices increasing, but no increase in output.

So, Classical economists are of the view that the economy is self-adjusting. We can therefore sum up
their policy recommendations in a variation on a well-known phrase

'Don't just do something, sit there!'

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Of course, taking this too literally would be unfair on Classical economists, but it would be true to say
that because the economy tends to full-employment, there is no need to actively intervene in the
economy. In fact intervention may simply be destabilising and inflationary. The key to long-term
stable growth is therefore:

 Ensure free markets with no imperfections (through supply-side policies )

 Control the growth of the money supply to ensure low inflation

Supply-side policies

Supply-side policies can be used to reduce market imperfections. This should have the effect of
increasing the capacity of the economy to produce (in other words the long-run aggregate supply ). If
the level of aggregate supply increases then Say's Law (the work of Jean Baptiste Say) predicts that
demand will also increase. This will be the only non-inflationary way to get increases in output.

Using supply-side policies has increased the level of output from Qfe1 to Qfe2, but the price level has
remained stable. Supply-side policies as we have said are ones that reduce market imperfections. They
may include:

 Improving education & training to make the work-force more occupationally mobile
 Reducing the level of benefits to increase the incentive for people to work
 Reducing taxation to encourage enterprise and encourage hard work
 Policies to make people more geographically mobile (scrapping rent controls, simplifying house buying
to speed it up)
 Reducing the power of trade unions to allow wages to be more flexible
 Getting rid of any capital controls
 Removing unnecessary regulations


Money supply policies

The other area that Classical economists felt was important, is to control monetary growth. In this way
(as predicted by the Quantity Theory of Money) they would be able to maintain low inflation. Policies
might include:

 Open-market operations
 Funding
 Monetary-base control
 Interest rate control

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Keynesians - Introduction

Keynesian economists are, not surprisingly, so named because they are advocates of the work of John
Maynard Keynes. Much of his work took place at the time of the Great Depression in the 1930s, and
perhaps his best known work was the 'General Theory of Employment, Interest & Money' which was
published in 1936.

Keynes didn't agree with the Classical economists!! In fact the easiest way to look at Keynesian theory
is to see the arguments he gave for Classical theory being wrong. In essence Keynes argued that
markets would not automatically lead to full-employment equilibrium, but in fact the economy could
settle in equilibrium at any level of unemployment. This meant that Classical policies of non-
intervention would not work. The economy would need prodding if it was to head in the right direction,
and this meant active intervention by the government to manage the level of demand.

Keynesian beliefs can be illustrated in terms of the circular flow of income. If there was disequilibrium
between leakages and injections, then classical economists believed that prices would adjust to restore
the equilibrium. Keynes, however, believed that the level of output (in other words National Income)
would adjust. Say, for example, that there was for some reason an increase in injections (perhaps an
increase in government expenditure). This would mean an imbalance between leakages and injections.
As a result of the extra aggregate demand firms would employ more people. This would mean more
income in the economy some of which would be spent and some saved (or paid in tax). The extra
spending would prompt the firms in the economy to produce even more, which leads to even more
employment and therefore even more income. This process would go on, and on, and on, and on until
it stopped! It would eventually stop because each time income increased, the level of leakages
(savings, tax and imports) also increased. Once leakages and injections were equal again, equilibrium
was restored. This process is called the Multiplier effect.

Keynesians - Theories

Keynes argued that relying on markets to get to full employment was not a good idea. He believed that
the economy could settle at any equilibrium and that there would not be automatic changes in markets
to correct this situation. The main Keynesian theories used to justify this view were:

 The labour market

 The market for loanable funds (money market)
 The Multiplier
 Keynesian inflation theory

The labour market

Keynes didn't have the same confidence in the labour market as Classical economists. He argued that
wages would be 'sticky downwards'. In other words workers would not be happy about taking wage
cuts and would resist this. This would mean that wages would not necessarily fall enough to clear the
market and unemployment would linger. We can see this in the diagram below:

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When the demand for labour falls from D1 to D2 (maybe due to the onset of a recession), the wage
rate should fall, so that the market clears. However, Keynes argued that because wages were sticky
downwards, this would not happen and unemployment of ab would persist. This unemployment he
termed demand deficient unemployment.

The market for loanable funds (money market)

Classical economists were of the view that savings would need to be increased to provide more funds
for investment. Keynes disputed this assumption - once again because he had less faith in markets as
the economics 'miracle cure'. He argued that any increase in savings would mean that people spent
less. This would mean a decrease in aggregate demand. This would just make things worse and firms
would be even less inclined to invest because they would find the demand for their products
decreasing. He felt that investment depended much more on business expectations.

The Multiplier

Any increase in aggregate demand in the economy would result, according to Keynes, in an even
bigger increase in National Income. This process came about because any increase in demand would
lead to more people being employed. If more people were employed, then they would spend the extra
earnings. This in turn led to even more spending, which led to even more employment which led to
even more income which then led to even more spending which then led to , and thus the cycle
continues. The length of time this process went on for would depend on how much of the extra income
was spent each time. If the initial recipients of the extra income saved it all, then the process would
stop very quickly as no-one else would get their hands on the extra income. However, if they spent it
all the knock-on effects of the extra spending would carry on for some time.

Therefore the higher the level of leakages, the lower the Multiplier would be. The precise formula for
calculating the multiplier is:

1
Multiplier =
1 - Marginal propensity to consume

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Keynesian view of inflation

The key to the classical view of inflation was the Quantity Theory of Money. This theory revolved
around the Fisher Equation of Exchange:

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 and
T is the number of transactions taking place

Keynes once again rejected this theory. He argued that increases in the money supply would not
inevitably lead to increases in inflation. Increasing M may instead lead to a decrease in V. In other
words the average speed of circulation of money would fall because there was more of it about.

Alternatively, the increase in M may lead to an increased in T (number of transactions), because as we

have seen Keynes disputes the assumption that the economy will find its own equilibrium. It may be in
a position where there is insufficient demand for full-employment equilibrium, and in that case
increasing the money supply will fund extra demand and move the economy closer to full employment.

Keynesians tend to argue that inflation is more likely to be cost-push inflation or from excess levels of
demand. This is usually termed demand-pull inflation.

Keynes didn't distinguish between the short-run and the long-run as Classical economists tend to. He
argued that the economy could settle at any equilibrium level of income at any time, and it was the
government job to use appropriate policies to ensure that this equilibrium was a good one for the
economy. This can be illustrated on an aggregate supply and demand diagram:

The economy could settle at any of the 4 equilibria shown (Q1 - Q4). Clearly Q1 is not a very desirable
equilibrium as the level of output is very low and there would be high levels of unemployment.
Nevertheless this situation could, according to Keynes, persist in the long-term unless the government
did something to stimulate the economy. This something would have to be some sort of reflationary
policy, which boosted the level of aggregate demand. As aggregate demand grows so does the level of
output, but as the economy nears full employment the dark spectre of inflation emerges - in other
words the price level starts to increase! This inflation is due to an excess level of demand and so is
called demand-pull inflation. At the same time there will be increased pressure on the labour market as
nearly everyone has a job, and so wages will begin to rise as firms have to offer more to get the people
they want. This in turn will cause costs to increase, and result in cost-push inflation.

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Keynesians - Policies

The other sections about Keynesians show that they believe that the economy can settle at any
equilibrium. This means that they recommend that the government gets actively involved in the
economy to manage the level of demand. These policies are known as demand-management policies.

Demand management means adjusting the level of demand to try to ensure that the economy arrives
at full employment equilibrium. If there is a shortfall in demand, such as in a recession (a deflationary
gap), then the government will need to reflate the economy. If there is an excess of demand, such as
in a boom, then the government will need to deflate the economy.

Reflationary policies

Reflationary policies to boost the level of economic activity might include:

 Increasing the level of government expenditure

 Cutting taxation (either direct or indirect) to encourage spending
 Cutting interest rates to discourage saving and encourage spending
 Allowing some money supply growth

The first two policies would be considered expansionary fiscal policies, while the second two are
expansionary monetary policies. The impact of them should be to increase aggregate demand and
therefore the level of output. The diagram below shows this:

The reflationary policies have boosted the level of output from Q1 to Q2. The impact on the price level
has been small, though if demand increased any more it may well be inflationary.

Deflationary policies

Deflationary policies to dampen down the level of economic activity might include:

 Reducing the level of government expenditure

 Increasing taxation (either direct or indirect) to discourage spending
 Increasing interest rates to encourage saving and discourage spending
 Reducing money supply growth

The first two policies would be considered contractionary fiscal policies, while the second two are
contractionary monetary policies . The impact of them should be to reduce aggregate demand and
therefore the level of output. The diagram below shows this:

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The initial level of aggregate demand was inflationary - prices were increasing rapidly. However, the
deflationary policies have reduced demand to AD2 and thus reduced the level of inflation.

Monetarists - Introduction

Monetarists are a group of economists so named because of their preoccupation with money and its
effects. The most famous Monetarist is Milton Friedman who developed much of the Monetarist theory
we learn.

Monetarism is very closely allied with the classical school of thought. It is essentially an extension of
classical theory which was developed in the 1960s and 1970s to try to explain a new economic
phenomenon - stagflation. Stagflation was an expression coined to try to explain two simultaneous
economic problems - stagnation and inflation. Much of the Monetarists' work revolved around the role
of expectations in determining inflation, and a key part of their theory was the development of the
expectations-augmented Phillips Curve.

In their work Monetarists draw a lot on Classical economics. They re-evaluated the Quantity Theory of
Money and argued that increases in the money supply would cause inflation. This view was backed up
by a substantial body of empirical evidence. They would therefore argue that to reduce inflation, the
growth in the money supply needs to be controlled.

Monetarists vary in their precise beliefs on expectations. Some believe that expectations adjust so
quickly that any policy change will immediately be taken into account by people, and there will
therefore be no short-term adjustment. This school of Monetarism is known as 'rational expectations'.
More moderate Monetarists accept that there may be an adjustment period, and so policy changes may
have temporary or short-term effects on the level of output.

Perhaps one of the best known quotes from Friedman's work is that:

"Inflation is always and everywhere a monetary phenomenon"

This quote is perhaps the best indication of the reason why Monetarists are called Monetarists!

Monetarists - AS & AD

Moderate Monetarists would argue, as Classical economists do, that the economy may behave slightly
differently in the short run from in the long run.

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Short run

In the short run any increase in the money supply may lead to an increase in aggregate demand. This
may, in turn, lead to more employment, but before long people's expectations will catch up and as we
saw with the expectations augmented Phillips Curve the effects of the boost will only be short-lived.
Inflation picks up and wipes out any short-term gains. The following diagram shows this:

Output grows a bit, but inflation is pushed up and once the inflation is in the system people will begin
to anticipate it.

Long-run

In the long run, any attempts to reduce unemployment below its natural rate will result in inflation.
This means that there is no long-run trade-off between unemployment and inflation, and the long-run
aggregate supply curve will be vertical.

Monetarists - Policies

Since the work of Monetarists is mainly limited to their view of inflation, their policy recommendations
are pretty much on inflation only as well. They tend to believe that if you control inflation as the main
priority, then this will create stability and the economy will be able to grow at its optimum rate.

The key policy is therefore control of the money supply to control inflation. The government should
certainly not intervene to try to reduce unemployment as the economy will automatically tend to the
natural rate of unemployment. The only way to change the natural rate is through the use of supply-
side policies.

All of this makes Monetarists' policy recommendations pretty similar to those of the classical
economists.

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