SCHOOLS OF THOUGHT

The two dominant schools of thought in economics are the Classicalists and the Keynesians.
While there are schools within these schools of thought and many extensions of these schools,
this Unit will focus on the more general differences between the Classicalists and Keynesians.
KEYNESIAN SCHOOL OF THOUGHT
The Keynesian School of Thought is more short run oriented with emphasis on trying to fix
problems with various government policies. They believe that our market system can be unstable
and have serious problems that sometimes cannot be easily fixed. These problems might include
external shocks (weather shocks, labor strikes, political problems, corporate fraud, terrorism),
international economic problems (serious economic problems in other countries that are
impacting us), or business cycle problems (rising inflation or rising unemployment). They
believe that Fiscal, Monetary, and Regulatory Policies can be helpful in solving or at least
reducing the problems.
The Keynesian School of Thought tends to focus more on social issues such as poverty,
unemployment problems, and income and wealth distribution. They favor balance between
economic growth and the environment and policies impacting the rich versus the poor.
CLASSICALIST SCHOOL OF THOUGHT
The Classicalist School of Thought generally believes there is a limited role for government.
This belief is based on the idea that the market system and economy are generally stable and
self-correcting. They believe we might experience problems from time to time (those mentioned
above). However, they will gradually diminish through corrections made by firms, individuals,
and the market mechanism (supply and demand). They believe that the government often does
more harm than good with its policies. This does not mean that government policy adjustments
aren't sometimes necessary but generally they favor letting the business cycle problems correct
themselves. Their policies generally tend to be long run. They do not favor responding to the
short run business cycle (rising unemployment or rising inflation) but rather favor policies that
will help the economy over the long run (lower taxes, less government involvement).
The Classicalists are often referred to as supply-siders, and the Keynesians are often referred to
as demand-siders. I will address the reasons for this in the Units on Short Run Economics
(demand side) and Long Run Economics (supply side).
Most economists and most followers of the economy are not extreme Keynesians or extreme
Classicalists. Rather they incorporate a part of each in their economic thinking. The most
extreme Classicalists would be against all forms of government that relates to economic policies.
This would include the Federal Reserve System, the FDIC, the SEC, and other government
agencies. However, most Classicalists favor these government agencies but possibly believe their
influence should be felt to a lesser degree (compared to a Keynesian). The most extreme
Keynesian would favor strong government controls and even more centralized (government)
decision making. However, very few American economists believe in this kind of role for the
government.
PROPER ROLE OF GOVERNMENT
What is the proper role of government in our economy? How large should the government sector
be relative to the private sector? What kind of a tax system should we use? How high should
taxes be? Is it okay to run budget deficits or should we always balance the budget? These are the
kind of general questions our policy makers have to address on a regular basis. Depending on
your Social Welfare Function and your School of Thought, there will be different answers to
these questions. Certainly there are different answers to these questions in the European Union
than in the United States. There are different answers in the Democratic Party than in the
Republican Party.
SHORT RUN MODEL
The Keynesians generally follow the Short Run Model. This focuses on the business cycle as the
economy sometimes falls below its potential GDP growth rate. If this becomes severe enough, it
will lead to the contraction phase of the business cycle and a recession. On the other hand,
sometimes the economy becomes overheated or too strong. This can lead to increasing inflation
and interest rates. The problems of a weakening economy (growing unemployment, falling
profitability for firms, falling confidence) or a strengthening economy (falling unemployment,
rising profitability for firm, rising confidence) that can lead to higher inflation need to be
addressed by government policies. While these problems might take care of themselves over
time, the Keynesian approach is to address the problem now and shorten this period of time.
MONETARY POLICY
One of the government approaches is to use Monetary Policy. Our Federal Reserve is in charge
of Monetary Policy. To learn more about the Federal Reserve, please go to the Federal Reserve's
Website (www.federalreserve.gov (Links to an external site.)). Please read (1) "Structure of the
Fed" (Go to "About the Fed" and then click on "Structure of the Fed"), and (2) "Monetary
Policy." You should learn about the Board of Governors, the Federal Open Market Committee,
the Board of Directors for the Regional Banks, Open Market Operations, the Federal Funds Rate,
and the Discount Rate.
The Keynesians believe Monetary Policy affecting the federal funds rate and discount rate can
effectively counter the business cycle. When the economy is weakening (recessionary
conditions), the FOMC should buy Treasury Securities to increase the money supply and cause
the federal funds rate to fall (the FOMC actually lowers their target for the federal funds rate).
The Fed usually keeps the discount rate 50 basis points below the federal funds rate. This means
that if they lower the federal funds rate, they will also lower the discount rate. This lowering of
interest rates will cause other interest rates to fall (prime rate, other borrowing rates, bond
yields). The lower interest rates will then lead (this is the key) to more borrowing to buy cars,
houses, appliances, etc. The FOMC lowered the federal funds rate and discount rate a dozen
times from 2000-2003 trying to fight the slowing and troubled economy. Monetary Policy can be
a very important tool but it can't solve all the problems. The biggest challenge the Fed has
experienced is that falling interest rates cannot offset the impact of terrorism, world crises, and
corporate corruption. However, Wall Street tends to generally take a favorable view when the
Federal Reserve is aggressively fighting economic problems.
The Federal Reserve can lower interest rates (by increasing the money supply) but they have to
be careful not to increase the money supply too much or it could cause higher inflation sometime
down the road. So when the Federal Reserve is lowering the interest rate in the short run to fight
short run recession, they also are aware they have to be careful about long term inflation. This
has not been a problem from 2000-2003 as our inflation rate has stayed at a very low and
acceptable rate.
FISCAL POLICY
Fiscal Policy uses Government Spending and Taxes to affect the business cycle. If the economy
enters (or threatens to enter) the contraction phase, the Government can either increase spending
(Military, Roads, Education) or lower taxes (personal income tax, corporate income tax), to
quickly stimulate the economy. The Government spending or the tax decrease will cause more
spending to take place in the economy. This extra spending will lift up the economy. If the
economy becomes too strong, then effective Fiscal Policy would result in a Government
Spending decrease or a tax increase to slow the economy.
While Fiscal Policy can be effective, it is sometime slow to be implemented. For example a
change in policy will often times be debated in Congress for a lengthy period of time, causing it
to be less effective. On the other hand, Monetary Policy can change policy quickly (FOMC
Meeting). This is one of the advantages that Monetary Policy has over Fiscal Policy (speed and
flexibility). Just like Monetary Policy, Fiscal Policy can't solve every problem but it can be
useful in addressing various economic problems.
The President of the United States and Congress analyze the federal budget position every year.
The Federal Budget Position weights the tax revenues generated versus government spending. If
Government spending (education, roads, military, social programs) is greater than the tax
revenues, then the federal government is experiencing a federal budget deficit. If Government
spending is less than the tax revenues, then the federal government is experiencing a budget
surplus.
When the government runs a deficit they have to borrow. They borrow by selling Treasury
Securities (Bills, Notes, and Bonds). They then have to service this debt over its lifetime. A
deficit causes the national debt to grow. When there is a growing national debt, the government
has to use a larger percentage of its spending to service the debt. Since the late 60s, most years
have resulted in deficit spending. The exception to this was the late 90s where we had three
straight years of surplus.
The biggest cause of a growing deficit is a weakening economy. As the economy weakens, the
stock market falls, unemployment rises, and firm earnings fall. This results in a major fall in tax
revenues collected by our federal government causing deficits to grow.
One other issue is the treatment of Social Security Taxes. There is a separate Social Security
Trust Fund where Social Security Taxes are kept. However, quite a few years ago Congress
started to combine the Social Security Trust Fund (which has been running huge surpluses) with
the General Budget. The funds in the Social Security Trust Fund would be combined with the
General Budget to use for immediate spending. Congress would then place an IOU (the General
Budget owes the Social Security Trust Fund) each year in the trust fund. This puts the Social
Security Trust Fund at risk but helps our government budget look better.
In the late 90s when the budget resulted in three straight years of surpluses, it looked like we
would start to run surpluses on a regular basis. The big issue became what to do with the
surpluses. Generally the Democrats wanted to spend the surplus on education, social security,
and other social programs. The Republicans wanted to give the surplus back to the people in the
form of a tax cut (this led to the Bush Tax Cut of 2000). The Clinton Administration was using
the surpluses to downsize the national debt (which was over six trillion dollars). However, the
surpluses have turned into growing deficits with a weak economy, the war against terrorism, and
a military buildup. This has caused the next Bush tax cut proposal to be less popular since it
could cause the growing deficits to be even larger. A tax cut could possibly help the weak
economy (Fiscal Policy) but could cause the federal budget deficit to grow.
If you would like to read more about federal budget deficits (and surpluses),
see www.cbo.gov (Links to an external site.). They have the budget position of our federal
government year by year along with projections for the future (with and without Social Security).
LONG RUN MODEL
The long run model (favored by the Classicalists) focuses on long term economic growth. This
policy looks at government regulations and taxation as a constraint on potential long-term
growth. Regulations and taxes should be reduced as much as possible to realize the maximum
long-term growth rate in the economy. With lower taxes and regulations, there is a greater
incentive to produce and invest in our economy. The expectation is that stronger economic
growth can solve many problems.
The economy naturally grows around 3% per year. The Classicalists believe that the money
supply should then increase by around 3% per year to cause spending (usually called Aggregate
Demand) growth to increase around 3% to match this natural growth.
This policy allows the economy to grow at its sustainable rate (roughly 3%) and puts enough
money in the economy to allow the new products to be purchased by consumers and businesses.
Notice that the money supply growth will stay constant at about 3% in the long run model. So
even if the economy strengthens or weakens, the policy should not be changed. The economy
will naturally grow over time if left alone. There will be times when the economy will deviate
from this 3%. However, this should be looked as a temporary disturbance, with the economy
over the long run (2-3 years) returning to the 3% rate of growth. In other words, the Classicalists
do not respond to every change in the business cycle. Rather they believe the economy will "self
correct" the problem and return to a normal state of 3% growth.
The Keynesians (short run model) use monetary policy to counteract the business cycle. They
want to lower interest rates when the economy weakens and raise interest rate when the economy
strengthens. However, the Classicalists (long run model) generally do not believe in
counteracting or fine-tuning the economy. Rather they believe that economy can self correct with
time.
The Classicalists also believe in long-term price stability. They believe that if we experience
high economic growth with price stability (low stable inflation rate), most economic problems
can be solved.
The Keynesians argue that the Classicalists want to reduce regulations (Federal Reserve, SEC,
EPA, FTC, and FDA) too much and it could cause an increase in fraud, a reduction in quality
standards, and a decrease in confidence and stability. They say the corporate fraud problem we
have experienced is a sign we need to toughen SEC regulations not reduce them. The Keynesians
argue that by managing these problems now, we will be better of in the long run.
The Keynesians also argue that the Classicalists do not pay enough attention to the differences
between the rich, middle class, and the poor. The Classicalists believe that if we maximize
economic growth everyone will benefit. The Keynesians argue that most Classicalist policies
favor the rich (Bush Tax Cut) and will cause the gap between the rich and poor to grow. The
Keynesians argue that tax cuts and other policies should have a balanced effect on the rich,
middle class, and poor.
Keynesians generally favor a progressive income tax (rich pay a higher percentage of income)
while the Classicalists favor a flat tax where everyone would pay the same percentage. The
Classicalists argue that the flat tax will give us a higher economic growth rate over time and it is
more consistent with their long-term model.
Monetary Policy makers use a combination of Keynesian and Classicalist policies. The FOMC
responds to changes in the economy with interest rate changes (consistent with Keynesian short-
term model). However, they are also very careful not to increase the money supply too much so
as to cause inflation (consistent with the Classicalist-long-term model).
Fiscal Policy depends more on the political party in power. The Republicans (usually more in
line with the Classicalists) will use more of the long run model. However, every administration
uses a combination of short run and long run policies. Possibly, balance between the short run
and long run is the best policy.