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Econ3142: HISTORY OF ECONOMIC THOUGHT II

CHAPTER 1: THE NEOCLASSICAL SCHOOL

The Neoclassical School- Pure Competition

 History of economic thought deals with different thinkers and theories in the subject that became political
economy and economics, from the ancient world to the present day.
 Encompasses many disparate schools of economic thought.
 Neoclassical (19th and early 20th century).
 Prominent founder is Alfred Marshall followed by John Gustav Knut Wicksell and Irving Fischer.

Neoclassical School
 Market economy with private property.
 Markets are fully competitive.
 Initially, there is no government.
 Two kinds of individual agents exist in this economy — firms and households.

Firms:
 Produce commodities
 Supply the commodities at the market price
 Demand labor, paying the market wage
 Undertake investment

Households:
 Consume (purchase) commodities at market prices)
 Supply labor at a wage
 Save

Neoclassical School
 There are three markets in this economy:
 Commodity Market
 Labor Market
 Capital Market

Alfred Marshall (1842-1924)

 Established the Royal Economic Society and was its first president.
 Founded the Economic Journal.
 Founded the Cambridge School of Economics.
 Introduced the diagrammatic methodology to economics.
 Legacy through Pigou, Robinson, Keynes.
 Assumed free competition, mobility of productive resources, rational pursuit of economic objectives.
 Tried to make his theoretical models realistic.
 Kept utility theory in the background.
 Expanded the concepts of supply and demand.
 Focused more on the firm than on the consumer or General Equilibrium.
 Favored partial equilibrium over general equilibrium.
 Credited with an attempt to put economics on a more mathematical footing.
 First professor of economics at the University of Cambridge, his 1890 work Principles of Economics
abandoned the term "political economy" for his favorite "economics".
 Viewed math as a way to simplify economic reasoning.
 Responsible for diagrammatic economics or the translation of economic concepts into simple graphs.
 Founder of partial equilibrium analysis.
 Most significant event of the 1890s was the publication of Alfred Marshall's Principles of Economics
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 Marshall derived his demand and supply functions on the presumption that the quantity demanded and the
quantity supplied of a specific good or service are functions of the price of that specific good or service.
 The prices of substitutes and complements for the specific good or service and a number of other factors also,
no doubt, influence the price, but Marshall for the sake of simplicity regarded all these distantly related
determinants of demand and supply as given and put them under the category of ceteris paribus assumptions.
 Marshall’s method is partial equilibrium method because he examined the determination of the price of a
specific good or service separately and ignored the interrelations of different markets.

Irving Fischer (1867 – 1947)

 Greatest economist America has produced.
 Made seminal and durable contributions on a wide range of economic science.
 Strongly promoting mathematical economics.
 Much of standard neoclassical theory today is Fisherian in origin, spirit and substance.
 Most modern models of capital and interest are essentially variations on Fisher's theme , the conjunction of
intertemporal choices and opportunities.
 His theory of money and prices is the foundation for much of contemporary monetary economics.
 Deeply involved with quantitative empirical research, index numbers and their properties (on which he was a
world authority), and other early econometric approaches.
 His ideas have frequently been rediscovered by others, e.g. distributed lag regression, life cycle saving theory,
the ‘Phillips curve’, ‘consumption tax’ rather than ‘income tax’, the modern quantity theory of money, real vs.
nominal interest rates, and many other standard tools in economists’ kits.

Piero – Sraffa (1898–1983)

 Came to England from Fascist Italy in the 1920s and a member of the Cambridge Circus.
 In 1960, published a small book called Production of Commodities by Means of Commodities.
 He explained how technological relationships are the basis for production of goods and services.
 Prices result from wage-profit tradeoffs, collective bargaining, labour and management conflict and the
intervention of government planning.
 Like Robinson, Sraffa was showing how the major force for price setting in the economy was not necessarily
market adjustments.

Edward Hastings Chamberlin (1899–1967)

 American economist.
 The "founding father" of the theory of monopolistic competition is Edward Hastings Chamberlin, who wrote a
pioneering book on the subject, Theory of Monopolistic Competition (1933).

Joan Robinson (1903–83)

 Keynes's pupils at Cambridge, a member of Keynes's Cambridge Circus.
 Contributed to the notion that competition is seldom perfect in a market, an indictment of the theory of markets
setting prices.
 In The Production Function and the Theory of Capital (1953) Robinson tackled what she saw to be some of
the circularity in orthodox economics.
 Neo-classicists assert that a competitive market forces producers to minimize the costs of production.
 Robinson said that costs of production are merely the prices of inputs, like capital.
 Capital goods get their value from the final products.
 And if the price of the final products determines the price of capital, then it is, utterly circular to say that the
price of capital determines the price of the final products.
 Goods cannot be priced until the costs of inputs are determined.
 This would not matter if everything in the economy happened instantaneously, but in the real world, price
setting takes time – goods are priced before they are sold.
 Since capital cannot be adequately valued in independently measurable units, how can one show that capital
earns a return equal to the contribution to production?
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Nicolson & Cambridge School

 At Cambridge, Henry Sidgwick and Alfred Marshall introduced him to economics.
 In 1877, Nicholson won the Cobden prize, with an essay that would become his first publication, the Effect of
Machinery of Wages.
 He completed his M.A. at London in 1878, winning the Gersternberg prize.
 In 1893, Nicholson published the first volume of his Principles, intended as a textbook for economics for the
lay public.
 Unimpressed by Neoclassicism, Nicholson sought to restate the old Classical truths in practical, appealing
form.
 Nicholson's attack on utility theory and Marshall's consumer surplus prompted a brief controversy with F.Y.
Edgeworth in the 1894.
 While severely critical of the Neoclassicals, Nicholson was no less repelled by the English Historical School.
 A believer in the virtues of competition, Nicholson was a virulent opponent of both trade unions and corporate
trusts and was highly disturbed by the appeal of simple-minded socialism.
 However, at the same time, Nicholson was a believer in government regulation and a proponent of the under
consumption thesis of economic fluctuations.
 Nicholson was the first president of the Scottish Economic Society.

The Stockholm School

 In the 1930s the Stockholm School of Economics was founded by Eli Heckscher (1879–1952), Bertil Ohlin
(1899–1977), Gunnar Myrdal (1898–1987) et al. based on the works of John Maynard Keynes and Knut
Wicksell (1851–1926), advising the founders of the Swedish Socialist welfare state.
 In 1933 Ohlin and Heckscher proposed the Heckscher-Ohlin Model of International Trade, which claims that
countries will export products that use their abundant and cheap factors of production and import products that
use their scarce factors of production.
 In 1977 Ohlin was awarded a share of the Nobel Economics Prize.
 In 1957 Myrdal published his theory of Circular Cumulative Causation, in which a change in one institution
ripples through others.
 In 1974 he received a share of the Nobel Economics Prize.

Wicksell
 Knut Wicksell, Swedish economist is an important source of inspiration for the Stockholm School.
 The Stockholm School is a school of economic thought. It refers to a loosely organized group of Swedish
economists that worked together, in Stockholm, Sweden primarily in the 1930s.
 The Stockholm School had - like John Maynard Keynes - come to the same conclusions in macroeconomics
and the theories of demand and supply.
 Like Keynes, they were inspired by the works of Knut Wicksell, a Swedish economist active in the early years
of the twentieth century.
 Wicksell developed his theory of value and distribution around the theory of marginal productivity.
 His theory of capital and interest forms the main part of his thought.
 He assumes that the capital saved during the preceding year (previous period or year) helps in the production
during the current years.
 He also assumes that capital saved during the current period helps in the production during the next year.
 Wicksell, a high rate of interest stimulates saving and a low rate discourages it.
 He distinguished between Market Rate of Interest (bank rate of interest) and Natural Rate of Interest as
follows: (there are two types of interest).
 Natural Rate of Interest-is the rate at which the demand for loan capital and the supply of saving exactly agree.
 Thus, the natural rate is one which equalizes saving and investment.
 The Market Rate of Interest- is the price of money determined according to the Walras formula.
 It is the actual rate of interest.
 Sometimes it is also known as bank rate of interest.
 The market rate of interest tends to equalize the natural rate, but it may be below or above it.
 Saving and Investment
 Wicksell does not agree with Walras that with a fall in prices the purchasing power and hence, effective
demand increases.
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 He believes that since the expenditure of one is the income for another, the aggregate purchasing power would
always remain the same.
 He said that when conditions are not normal, saving would not be equal to investment.
 Since the decisions to save and invest are taken by different people, amount of saving may be more than the
investment.
 In such situation income would be reduced, consumption would decline and price would fall.
 If the investments are more than the saving, the price would rise.
 He suggests that these situations would be controlled by manipulating the bank rate, i.e., by keeping the market
rate below or above the natural rate so that investment may experience a boost or a fall, prices may rise or fall,
finally leading to a rise or fall in the market rate.
 This is what is known as “the cumulative process” of Wicksell.
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CHAPTER 2: HETERODOX ECONOMIC THOUGHT

Heterodox Economic Thought

 Heterodox economics refers to schools of economic thought or methodologies that are outside "mainstream
economics", often represented by expositors as contrasting with or going beyond neoclassical economics.
 Heterodox economics is an umbrella term used to cover various approaches, schools, or traditions.
 These include Anarchist, Socialist, Marxian, Institutional, Evolutionary, Georgist, Austrian, Feminist, Social,
Post-Keynesian and Ecological Economics among others.
 Heterodox economics is more "radical" in dealing with the "institutions – history – social structure nexus".
 Heterodox economists as trying to do three things:
1. Identify shared ideas that generate a pattern of heterodox critique across topics and chapters of introductory
macro texts;
2. Give special attention to ideas that link methodological differences to policy differences; and
3. Characterize the common ground in ways that permit distinct paradigms to develop common differences
with textbook economics in different ways.

One study suggests four key factors as important to the study of economics by self-identified heterodox
economists: history, natural systems, uncertainty, and power.

Early Critics of Neoclassical Economics

 A number of heterodox schools of economic thought challenged the dominance of neoclassical economics
after the neoclassical revolution of the 1870s.
 In addition to socialist critics of capitalism, heterodox schools included advocates of various forms of
mercantilism, American School dissenters from neoclassical methodology, historical school and advocates of
unorthodox monetary theories such as Social credit.
 Other heterodox schools active before and during the Great Depression included Technocracy and Georgism.
 Criticism of the neoclassical model of individual behavior: The notion of pleasure seeking is itself a
meaningless assumption because it is either impossible to test or too general to refute. Economic theories that
reject the basic assumption of economic decisions as the outcome of pleasure maximization.
 Criticism of the neoclassical model of market equilibrium: the concept of market equilibrium has been
criticized by Austrians, post-Keynesians and others, who object to applications of microeconomic theory to
real-world markets, when such markets are not usefully approximated by microeconomic models. Heterodox
economists assert that micro-economic models rarely capture reality.

The Old Historical School

 Important writers of the older historical school are Friedrich List (1789-1846), Wilhelm Roscher (1817-94),
Bruno Hildebrand (1812-78), and Karl Knies (1821-98).
 There was a great deal of nationalistic feeling in the economic analysis of these writers.
 They asserted that economics and the social sciences must use a historically based methodology and that
classical theory, particularly in the hands of Ricardo and his followers.
 List argued that state guidance was necessary. List’s protectionist views were so warmly received in the United
States that he was often called the father of American protectionism. List stated that economies in the
temperate zone will go through five stages: nomadic life; pastoral life; agriculture; agriculture and
manufacturing; and manufacturing, agriculture, and commerce.
 Hildebrand posited three economic stages based on barter, money, and credit.

The Younger Historical School

 The second generation of the German historical school had one outstanding leader, Gustav von Schmoller
(1838-1917).
 The writers of the younger historical school, Gustav von Schmoller (1838-1917) attacked classical economic
theory and were very interested in social reform through state action.
 Because of this, they were called “socialists of the chair”.
 Although the historical school has not had a major impact on recent developments in theory, its lessons remain
valid and have influenced many of the critics of economic theory.
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The Old Institutional School

 The Institutional Approach to Economic Theory, Walton Hamilton gave five propositions that summarized the
various aspects of Old Institutional Economics:
 Institutional Economics is not defined in terms of any policy proposals.
 Institutional Economics draws on many different fields of study such as psychology, sociology, and
anthropology to develop a better analysis of human behavior.
 Institutions are a vital component of any economy and a major task for economics should be to study
institutions and the process of institutional change.
 The economy is an open ended system subject to evolutionary change, embedded with complex elements such
as culture, social class, political power, and other variables.
 The neoclassical idea of the rational utility maximizing agent is inadequate and erroneous.
 Institutional Economics doesn’t take the individual as given.
 Instead, individuals are shaped by institutional and cultural arrangements.
 The “downward causation” of institutions can influence behavior in important ways.
 The old institutionalism holds to the idea of interactive and partially malleable agents, mutually entwined in a
web of partially durable and self-reinforcing institutions.
 The quintessential feature of Old Institutional Economics is that it rejects methodological individualism.
 The relationship between the individual and the economy isn’t a one way street.
 Human preferences and motives aren’t solely determined by individual cognition and socioeconomic activity
isn’t solely determined by individuals.
 Human preferences are shaped by institutions and institutions are the outcomes of individual behavior.

The Development of Modern Heterodox School

 Heterodox groups agree that politics and economics cannot be separated.
 Even though heterodox economists are often ignored by the mainstream, they nonetheless influence it.
 Heterodox economists have a tendency to turn inward and separate themselves from the profession - in which
case their analysis becomes a separate field of study that either totally replaces mainstream economics or
continues its existence independently of the mainstream.
 Al heterodox schools are partisan; and for a group to have a significant impact on theory, it must appear
nonpartisan, associated with neither the left nor the right.
 Heterodox economists would not be complete without some mention of the many other groups that exist, such
as the feminist economists, black economists, and libertarian economists.
 Libertarian economists focus on the moral principles of freedom and the market, black economists on
distribution and equity issues as they affect blacks, and feminist economists on distribution and equity issues
as they affect women.
 Particular versions of heterodox theory have failed to replace orthodox theory, heterodox theory has failed. For
this reason, heterodox theory is often omitted from histories of economic theory.
 An examination of heterodox thinking reveals that although it has not replaced the accepted stream of
economic thought, it often forces orthodox theory into new channels and sometimes offers seminal ideas that
are destined to become part of the accepted theoretical structure.

The New Institutionalist School

 New institutional schools: In 1972 American economists Harold Demsetz (1930–) and Armen Alchian (1914–
2013) published Production, Information Costs and Economic Organization, founding New Institutional
Economics, an updating of the works of Ronald Coase (1910–2013) with mainstream economics.
 Sometimes known as Younger Institutional School.
 A host of writers of the younger generation, namely W.E. Atkins, Tyson, S.H. Slitcher, W.H. Hamilton, A.B.
Wolfe, R.G. Tugwell etc., comprised the Younger School.
 Approach of the new institutional school was positive.
 The younger school was essentially concerned with correcting the maladjustment in the economic system with
the help of social control over man-made institutions.
 Instead of waiting for some evolution, they made evolution.
 Sought to replace old economics with new economics.
 Despite their extreme optimism they could not wholly succeed in their missions.
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 Nevertheless, they carried out important researches in the field of sociology, history and statistics, and
succeeded in arousing a permanent interest in social reform.
 Generally, the institutional approach to economic theory is not in any way new, but as a system of thought it
could be developed only at the hands of American economists during the last century. The foundation of the
new system was laid by Veblen with the publication of his book, ‘Theory of the Leisure Class’.

Quasi- Institutionalists
 Another group of writers who accept many of the insights of the institutionalists and who were strongly
influenced by them, but who are too individualistic and iconoclastic to fit the institutionalist mold.
 These include Joseph Schumpeter, Gunnar Myrdal, and John Kenneth Galbraith.
 One of these groups has organized itself loosely under the banner of “socio economics”.
 Socioeconomists believe that social forces must be more strongly integrated into economic models.
 Socioeconomists argue for a communitarian approach to value. Their theory holds that individuals are guided
by their concern for community as well as by self-interest, and that policy needs to be aimed at building
communities.

Joseph Schumpeter (1883–1950)

 Austrian School economist and political scientist.
 Best known for his works on business cycles and innovation.
 Insisted on the role of the entrepreneurs in an economy.
 Published on Business Cycles: A theoretical, historical and statistical analysis of the Capitalist process (1939).
 Synthesized the theories about business cycles, suggesting that they could explain the economic situations.
 Capitalism necessarily goes through long-term cycles because it is entirely based upon scientific inventions
and innovations.
 A phase of expansion is made possible by innovations, because they bring productivity gains and encourage
entrepreneurs to invest.
 When investors have no more opportunities to invest, the economy goes into recession, several firms collapse,
closures and bankruptcy occur.
 This phase lasts until new innovations bring a creative destruction process, i.e. they destroy old products,
reduce the employment, but they allow the economy to start a new phase of growth, based upon new products
and new factors of production.

Gunnar Myrdal
 The second quasi-institutionalist is Gunnar Myrdal (1898-1987), one of many Swedes who have made
important contributions to economics.
 Myrdal is critical of orthodox economic theory, yet his criticism is not as strident as that of Veblen, Commons,
or Hobson.
 His major criticisms of orthodox economic theory center on the role of value judgments in theory, the scope
and methodology of theory, and the implicit laissez-faire bias of theory.
 Myrdal took an interest in underdeveloped countries and the world economy as well as in the special problems
of affluent economies.
 Myrdal found that orthodox economic theory was not very helpful in underdeveloped nations. It failed in two
major areas: i) orthodox international trade theory gives incorrect answers when applied to the foreign trade
problems of developing nations and ii) orthodox theory seems incapable of formulating internal policies that
will lead to economic growth and development.
 Many of his books have been read in the United States by people other than economists; these books include
An International Economy (1956), Rich Lands and Poor (1957), Beyond the Welfare State (1960), Challenge
to Affluence (1962), Asian Drama (1968), and The Challenge of World Poverty (1970).
 Myrdal argues that in order for anyone to understand economic development, “history and politics, theories
and ideologies, economic structures and levels, social stratification, agriculture and industry, population
developments, health and education, and so on, must be studied not in isolation but in their mutual
relationship.”
 In 1974, Myrdal received a share of the Nobel Economics Prize.
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John Kenneth Galbraith (1908–2006)

 After World War II, Canadian-born John Kenneth Galbraith became one of the standard bearers for pro-active
government and liberal-democrat politics.
 Argued that the "conventional wisdom" of the conservative consensus was not enough to solve the problems of
social inequality.
 He argued, in an age of big business, it is unrealistic to think of markets of the classical kind. They set prices
and use advertising to create artificial demand for their own products, distorting people's real preferences.
 Consumer preferences actually come to reflect those of corporations – a "dependence effect" – and the
economy as a whole is geared to irrational goals.
 The New Industrial State: Galbraith argued that economic decisions are planned by a private-bureaucracy, a
techno structure of experts who manipulate marketing and public relations channels.
 This hierarchy is self-serving, profits are no longer the prime motivator, and even managers are not in control.
Because they are the new planners, corporations detest risk; require steady economic and stable markets.
 They recruit governments to serve their interests with fiscal and monetary policy, for instance adhering to
monetarist policies which enrich money-lenders in the City through increases in interest rates.
 While the goals of an affluent society and complicit government serve the irrational techno structure, public
space is simultaneously impoverished.
 In Economics and the Public Purpose (1973) Galbraith advocates a "new socialism" as the solution,
nationalising military production and public services such as health care, introducing disciplined salary and
price controls to reduce inequality.
 In his most recent essays, The Nature of Mass Poverty (1979) and The Anatomy of Power (1983), Galbraith
has moved so far along this road as to reach the point of calling for State intervention systematically directed
to redistributing income in favour of the poorest strata of society.

Post-Keynesians
 In the 1970s, post-Keynesians namely Sidney Weintraub, Paul Davidson, Joan Robinson and John Eatwell
have criticized the mainstream Keynesian model.
 They held an organizational meeting in 1974, at which they founded their publication, the Journal of Post-
Keynesian Economics (JPKE).
 Joan Robinson called it a “method of analysis which takes account of the difference between the future and the
past”.
 J. K. Galbraith said that “an industrial society is in a process of continuous and organic change, that public
policy must accommodate to such change, and that by such public action performance can, in fact, be
improved.”

British Post-Keynesians
 The British post-Keynesians (sometimes called neo-Ricardians) believe that the correct approach is to go back
to the Ricardian theory of production and supplement it with a Kalecki class theory of business cycles.
 They argued that the division of income between wages and profits is indeterminate and independent of total
output.
 Hence, the distribution of income is determined not by marginal productivity but by other forces, which are
macroeconomic in nature.

American Post-Keynesians
 Alfred Eichner has extended the microeconomic analysis of the firm, which he calls the megacorp, arguing that
it determines investment internally from retained profits.
 Paul Davidson (1930-) developing the post-Keynesian role of money, he emphasizes the existence of
irreversible time and true uncertainty, which cannot be reduced to a probability distribution and hence cannot
be changed to risk and then to certainty equivalents.
 Hyman Minsky (1919-1997) argues that the financial system is like a house of cards in imminent danger of
collapse.
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CHAPTER 3: GENERAL EQUILIBRIUM AND WELFARE ECONOMICS

 Households: Representative and heterogeneous cases, fixed endowment of time, preferences on consumption
and leisure, utility maximisers.
 Firms: Profit maximisers, Cobb-Douglas technology
 Government: Collects sales and income taxes, spends on public goods.
 Markets: Competitive equilibrium, Goods market clears through price and quantity adjustment, Labour market
clears through labour-leisure and choice decision, capital market clears all capital used in production, assumes
a closed economy or global economy.

Micro to Macroeconomics: General Equilibrium Analysis

 Price system is the key to allocation of resources in the economy.
 Markets for goods, labour, capital and financial services are inter-linked.
 An economy is inhabited by households and firms, a government which taxes and spends and the international
sector.
 A competitive equilibrium solution is outcome of the utility maximising behaviour of households and profit
maximising activities of firms.
 General equilibrium model brings all of these elements together.

Leon Walras (1834 – 1910)

 Leon Walras was the son of the distinguished Auguste Walras, remembered for his exposition of the early
principle of value related to scarcity.
 Engineering and not economics was his first preference.
 He started with economics on the suggestion of his father.
 It was a turning point in Walras’ career when he got (in 1870) the professorship of political economy in the
faculty of law at Lausanne .
 Walaras contributed to the marginal utility revolution in economics using calculus techniques.
 Walras’ greatest contribution to economic science is a new method of analysis, i.e., the general equilibrium
method.
 The equilibrium was not new & was used by Jevons, Menger and others.
 But they had all taken up the case of sectional equilibrium and had not attempted to look at the economy in its
over-all terms.

Walrasian General Equilibrium

 Walras’ general equilibrium analysis, which considers the interrelationships among the many variables in the
economy, is often compared with Alfred Marshall’s partial equilibrium analysis. The partial equilibrium
analysis is also known as the ceteris paribus method.
 Walras viewed the economic system, as a unified system in which all the markets are interlinked and the price
in different markets are determined simultaneously.
 The demand and supply of a specific good or service is not merely a function of its own price but of all the
prices prevailing in the economy.
 Thus, it is not proper to study a market in isolation from the rest of the system. In the light of the interrelations
between markets, Walras adopted the general equilibrium method to deal with the problem of valuation.
 According to the general equilibrium approach, the economic system as a whole is in equilibrium and the
valuation problem is solved only when all demands in the economy become equal to all supplies in the
economy as a whole.

Approaches to Welfare Economics

 The issue of welfare gained increasing importance especially after focus shifted to income distribution
 Welfare economics studies how to make economies operate more efficiently as well as the trade-offs between
efficiency and equity.

Early Neoclassical Approach to Welfare Economics

 A.C. Pigou is considered to have done a pioneering work in the field of welfare economics.
 Pigou was Marshall’s student and teacher of J.M. Keynes.
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 Credited for establishing a scientific welfare economics.

 Others who preceded him had provided what may be called ‘case-to-case’ studies and the areas where there
was a need for state intervention for improving the welfare of the society
 Pigou was the first to put the whole thing into a system.
 Those who had tried to concern themselves with the overall performance of the economy had primarily
concentrated upon changes in wealth of the society
 Pigou shifted on to the consideration of national welfare.
 He provided a general rule where by the social welfare was to be judged with reference to social marginal cost
and social marginal benefit.

New Trends in Welfare Economics Approach

 Marshall’s analysis of economic welfare runs in terms of partial equilibrium and partial chunks of welfare in
the form of consumer’s surplus and producer’s surplus.
 In Marshall when consumer’s or producer’s surplus in one industry is augmented through fiscal action, the
other industries in the economy are left untouched.
 Marshall’s welfare economics is based upon partial equilibrium approach, Pigou’s is that of total welfare.

Pareto, Wilfed (1848 – 1923)

 Pareto’s name is associated with general equilibrium, welfare economics and ordinal utility.
 He was a forerunner of the axiomatic approach culminating with the Arrow–Debreu model.
 The impact of Pareto’s work was not immediate and to begin with confined to Italy and France.
 Pareto was preoccupied by the idea of the economy as a complete system and by the interaction between the
various parts of the economy, in line with Walras’ thinking and far from the partial equilibrium analysis of
Marshall.
 One of Pareto's major contributions was to establish that an ordinal notion of utility is sufficient for the
construction of equilibrium theory.
 Despite the name, this graphical representation first appeared in Pareto’s Manuale, where it was used to
motivate the attempted proofs of the welfare theorems in the general case.
 Pareto provided the standard equilibrium conditions for the consumer side of economy, with the marginal rate
of substitution equal to the price ratio.
 Of all Pareto's contributions it is ‘Pareto optimality’ that has made the greatest impact.
 Yet, it was not Pareto who first gave a definition of this concept, as Edgeworth in 1881 had defined a situation
in which the utility of each individual is maximized given the utilities of all others.
 Pareto had the insight that this notion of efficiency was independent of all institutional arrangements and
distributional considerations.
 Pareto went on to establish the first theorem of welfare economics, i.e. a competitive equilibrium is a Pareto
optimum and a tentative version of the second theorem, that any Pareto optimum can be obtained as a
competitive equilibrium from an appropriate distribution of initial resources.

Caldor and Hicks Criterion of Efficiency Condition

 John Hicks (1904–89) of England was a Keynesian who in 1937 proposed the Investment Saving – Liquidity
Preference Money Supply Model, which treats the intersection of the IS and LM curves as the general
equilibrium in both markets.
 Hicks may have been close to being in the last generation of economists who could take up almost any
theoretical problem.
 The most familiar of his many contributions in the field of economics were his statement of consumer demand
theory in microeconomics, and the IS/LM model (1937), which summarised a Keynesian view of
macroeconomics.
 His powerful and original mind first made its mark on what is now called microeconomics and in welfare
economics. Hicks’ best-known work, Value and Capital (1939), goes beyond microeconomics to offer
economic dynamics and discussion of monetary theory which reaches into macroeconomics.
 Value and Capital is a work very rich in ideas and a short account cannot do it justice. It showed that the basic
results of consumer theory could be obtained from ordinal utility; it expounded what became known as the
‘Hicksian substitution effect’, obtained by varying income as relative prices changed so as to maintain an
index of utility constant.
 11

Market Socialism
 The theory of Market Socialism was developed in the late 1920s and 1930s by economists Fred M. Taylor
(1855–1932), Oskar R. Lange (1904–65), Abba Lerner (1903–82) et al., combining marxian economics with
neoclassical economics after dumping the labour theory of value.
 In 1938 Abram Bergson (1914–2003) defined the Social Welfare Function.
 12

CHAPTER 4: THE KEYNESIAN ECONOMICS

John Maynard Keynes (1883-1946)

 British economist
 His ideas fundamentally affected the theory and practice of modern macroeconomics
 Refined earlier work on the causes of business cycles
 One of the founders of modern macroeconomics
 Most influential economist of the 20th century.
 In the 1930s, spearheaded a revolution in economic thinking, overturning the older ideas of neoclassical
economics that held that free markets would, in the short to medium term, automatically provide full
employment, as long as workers were flexible in their wage demands.
 Argued that aggregate demand determined the overall level of economic activity, and that inadequate
aggregate demand could lead to prolonged periods of high unemployment.
 Advocated the use of fiscal and monetary measures to mitigate the adverse effects of economic recessions and
depressions.
 Following the outbreak of the Second World War, Keynes's ideas concerning economic policy were adopted
by leading Western economies.
 During the 1950s and 1960s the success of Keynesian economics resulted in almost all capitalist governments
adopting its policy recommendations.

The General Theory of Employment

 On top of the supply of money, Keynes identified the propensity to consume, inducement to invest, marginal
efficiency of capital, liquidity preference, and multiplier effect as variables which determine the level of the
economy's output, employment, and price levels.
 Much of this esoteric terminology was invented by Keynes especially for his General Theory.

Interest and Money

 In Keynesian terminology the rate of interest is the price paid for parting with cash or liquidity and using it for
investment in assets. Thus, it is determined by the liquidity preference.
 It is the price, which equilibrates the desire to hold wealth in the form of cash with the available quantity of
cash and determined by the demand for and the supply of money.
 Supply of money refers to the total quantity of money in the country of all purposes at any time.
 Though the supply of money is a function of the rate of interest, yet it is considered to be fixed by the
monetary authorities.
 Keynes coined a new term ‘liquidity preference’ for demand for money by which his theories of interest is
commonly known.
 Liquidity preference is the desire to hold cash.
 Thus the higher the liquidity preference, the higher will be rate of interest that will have to be paid for money
holders, and vice versa.
 This preference may be for meeting: The daily needs of life – transaction motive Contingent needs; and
Business needs, chiefly influenced by the strength of the speculation motive.
 Classical approach on demand for money was incomplete because it ignored the possibility of people choosing
to hold money as an asset instead of other financial assets.

The Concept of Multiplier

 The ratio between an increment of investment and the resultant increment of the total income, the propensity to
consume remaining the same, is called by Keyes as multiplier.
 The creation of one gives rise to a number of waves, similarly in Economy, each injection of money gives rise
to a series of new money.
 The multiplier is, thus, a number by which the increase in investment must be multiplied in order to give the
resulting increase in income.

Theory of Employment & Price

 Keynes proposes his alternative which is based on the relationship between saving and investment.
 13

 In his view unemployment arises whenever entrepreneurs’ inducement to invest fails to keep pace with
society’s propensity to save (propensity is one of Keynes’s synonyms for ‘demand’).
 The levels of saving and investment are necessarily equal, and income is therefore held down to a level at
which the desire to save is no greater than the inducement to invest.
 Prices are regid in short run, when prices are rigid, all necessary information are not transmitted to market
participants; hence, market might not work well.

Classical Economics Vs Keynesian economics

Basic Theory:
 Classical economic theory is rooted in the concept of a laissez-faire economic market. This ensures
economic resources are allocated according to the desires of individuals and businesses in the marketplace.

 Keynesian economic theory relies on spending and aggregate demand to define the economic marketplace.
Keynesian economic theory relies heavily on the fact that a nation’s monetary policy can affect a
company’s economy.

Government Spending
 Government spending is not a major force in a classical economic theory. Classical economists believe that
consumer spending and business investment represents the more important parts of a nation’s economic
growth.
 Keynesian economics relies on government spending to jumpstart a nation’s economic growth during
sluggish economic downturns. Keynesians believe the nation’s economy is made up of consumer spending,
business investment and government spending. However, Keynesian theory dictates that government
spending can improve or take the place of economic growth in the absence of consumer spending or
business investment.

Short Vs. Long-term Affects

 Classical economics focuses on creating long-term solutions for economic problems. The effects of
inflation, government regulation and taxes can all play an important part in developing classical economic
theories.
 Keynesian economics often focuses on immediate results in economic theories. Policies focus on the short-
term needs and how economic policies can make instant corrections to a nation’s economy.

Policy Implications of Keynesians

 Keynesian economics subsumed policy argumentation and developed a model that had built into it the need for
activist government policies.
 In this model, aggregate demand controlled the level of income in the economy, and the government had to
control aggregate demand through monetary and fiscal policies.
 During the 1950s and 1960s, Keynesian policy came to mean fine-tuning through monetary and fiscal policy.
 Abba Lerner (1903-1982) was an influential force in directing Keynesian analysis toward such fine-tuning. In
his Economics of Control (1944), Lerner advocated that government not follow a policy of sound, finance
(always balance the budget); it should instead follow a policy of functional finance, which considered only the
results of policies, not the policies themselves.
 The monetary and fiscal policy suggested by the Keynesians were finally embraced by U.S. economists,
because they required little direct government intervention in the economy.

Keynesian Economics and Underdeveloped Countries

 The Keynesian theory is not applicable to every socio-economic set-up.
 It only applies to advanced democratic capitalist economies.
 As Schumpeter wrote, “Practical Keynesianism is a seedling which cannot be transplanted into foreign soil; it
dies there and becomes poisonous before it dies.
 But left in English soil this seedling is a healthy thing and promises both fruit and shade.
 All this applies to every bit of advice that Keynes ever offered.”
 14

 Prof. Das Gupta, “Whatever the generality of the General Theory may be in the sense in which the term
‘general’ was used by Keynes, the applicability of the propositions of the General Theory to conditions of an
underdeveloped economy is at best limited.”
 For underdeveloped countries “the old fashioned prescription of work harder and save more still seems to hold
as the medicine for economic progress” than the Keynesian hypothesis that consumption and investment
should be increased simultaneously.
 15

CHAPTER 5: THE POST KEYNESIAN DEVELOPMENT IN ECONOMIC THOUGHT

 Post-Keynesian economics is a school of economic thought with its origins in The General Theory of John
Maynard Keynes, with subsequent development influenced to a large degree by Michał Kalecki, Joan
Robinson, Nicholas Kaldor, Sidney Weintraub, Paul Davidson, Pier Sraffa and Jan Kregel.
 Historian Robert Skidelsky argues that the post-Keynesian school has remained closest to the spirit of Keynes'
original work.
 The term post-Keynesian was first used to refer to a distinct school of economic thought by Eichner and Kregel
(1975) and by the establishment of the Journal of Post Keynesian Economics in 1978.
 Post-Keynesian economics can be seen as an attempt to rebuild economic theory in the light of Keynes' ideas
and insights.
 Some post-Keynesians took a more progressive view than Keynes himself, with greater emphases on worker-
friendly policies and redistribution.
 Joan Robinson regarded Michał Kalecki’s theory of effective demand to be superior to Keynes’ theories.
 Kalecki's theory is based on a class division between workers and capitalists and imperfect competition.

Emergence of Macro Economics

 New Keynesians: Policy Can Work
 Incorporate rational expectations
 Prices and wages are “sticky” in short run.
 Price-wage stickiness: impediments to adjustment exist (contracts, adjustment costs, etc.)
 Activist policies can work
 Stabilize the economy/make things better
 The private sector is an important source of shifts in aggregate demand.
 Monetary and fiscal policies should be used to offset drops in private sector spending.

The Emergence of Econometrics as the Sister Discipline of Economics

 In the 1930s Norwegian economist Ragnar Frisch (1895–1973) and Dutch economist Jan Tinbergen (1903–94)
pioneered Econometrics, receiving the first-ever Nobel Prize in Economics in 1969.
 In 1936 Russian-American economist Wassily Leontief (1905–99) proposed the Input-Output Model of
economics, which uses linear algebra and is ideally suited to computers, receiving the 1973 Nobel Economics
Prize.
 After World War II, Lawrence Klein (1920–) pioneered the use of computers in econometric modeling,
receiving the 1980 Nobel Economics Prize.
 In 1963–64 as John Tukey of Princeton University was developing the revolutionary Fast Fourier Transform,
which greatly speeded up the calculation of Fourier Transforms, his British assistant Sir Clive Granger (1934–
2009) pioneered the use of Fourier Transforms in economics, receiving the 2003 Nobel Economics Prize.
 Ragnar Frisch's assistant Trygve Haavelmo (1911–99) received the 1989 Nobel Economics Prize for clarifying
the probability foundations of econometrics and for analysis of simultaneous economic structures.

Monetarists
Inspired by: Friedman (1912), Brunner (1916), Meltzer (1928).
 The 1960s saw the emergence of an exactly opposite school of thought, viz., the monetarist school, which
holds that changes in money supply are the primary cause of fluctuations in real GDP and the ultimate cause of
inflation.
 Milton Friedman, the leader of the school, restated the Quantity Theory of Money and held the view that
“Inflation is always and everywhere a purely monetary phenomenon”.
 The monetarists challenged the Keynesian approach to macroeconomics and emphasized the importance of
monetary policy in macroeconomic stabilizations.
 The monetarist approach postulates that the growth of money supply determines nominal GDP in the short run
and prices in the long run.
 This analysis pins faith on the Quantity
 Theory of Money and argues that the velocity of money is stable in which case movements in money supply
will affect nominal GDP proportionately.
 16

The Importance of Money

 The only times that major economic contractions occurred were when the absolute value of the money stock
fell.
 From evidences, changes in money cause changes in money income.
 Monetarists believe that money is a substitute for a wide range of real and financial assets, but not single asset
could be a close substitute for money.
 So, interest rate affects money demand.

Implications of Monetarist
 Monetary policy is more effective than fiscal policy.
 No long-run trade-off between inflation and unemployment.
 The market system was not perfect, the government would only make things worse.
 Fiscal policy could only influence the distribution of income and the allocation of resources.
 The only way to increase output permanently is to make market work better.
 Adaptive expectation.

Can Capitalism survive? The Radical view

 Capitalism and socialism: the two structures that have divided the world on the future of society.
 These systems present two very different futures for our world, and both have strong supporters and
opponents.
 Capitalism is a free market (governed by supply and demand) and private property, including the ownership of
the means of production.
 The most prominent problem is wealth gap and its consequential injustice.
 This needs to be addressed through a better wealth distribution system, to allow all individuals the potential,
regardless of circumstances they were born into, to earn the best society can offer.
 This involves taxes, including income tax, sales tax (though exempting necessities like food and rent), and
especially estate tax.
 Taxation of any sort is unfair; however, taxation is necessary to prevent the wealthy and corporations from
monopolizing and owning the democratic process, which would quickly make society unjust and unproductive.
 The money from taxes would go to a tight safety net preventing downward spirals and enabling upward
mobility, preventing the wealth gap from growing too large while still providing benefits for those who work
and contribute versus those who don't.
 The role of the government should be to work without bias for the happiness of all the people, and that will not
happen if a section of the population has greater influence.
 The representatives in representative democracy are not infallible or necessarily virtuous, and money can
corrupt the process and consequently the society.
 The government being transparent would help the problem.
 17

CHAPTER 6: THE DEVELOPMENT OF MODERN MICROECONOMIC THEORY

 Modern microeconomics has evolved significantly from its neoclassical roots and is much better defined by its
eclectic formalistic modeling approach than by its beliefs.
 Its roots are to be found in Cournot and Edgeworth rather than in Marshall.
 The movement away from Marshallian economics started in the late 1930s with the publication of John
Hicks’s Value and Capital and Paul Samuelson’s Foundations of Economic Analysis.
 Their work was a culmination of many years of frustration on the part of some economists with Marshall’s
avoidance of formalizing economic theory.
 Samuelson’s and Hicks’s work was followed by even greater formalization of neoclassical thinking in the
work of Arrow and Debreu.
 After that work was complete, modern microeconomics turned to eclectic applied policy work, in which
assumptions could differ from core general equilibrium assumptions.

The movement away from Marshallian Economics

 The development of modern microeconomic theory started in the 1930s with the fall of Marshallian
economics.
 Marshall’s supply-and-demand analysis was partial equilibrium analysis applied to problems of relative prices.
But many of the questions economists were trying to answer, such as what determines the distribution of
income or what effect certain laws and taxes would have either introduced problems beyond the applicability
of partial equilibrium analysis. Nonetheless, economists continued to apply partial equilibrium arguments to
such issues, assuming that the aggregate market must constitute some as yet unknown combination of all the
partial equilibrium markets.
 Marshallian economists were interested in the art of economics, not in positive or normative economics.
 These formalists agreed with the institutionalists that Marshallian economic theory was inadequate, but their
answer was not to eliminate the theory: they wanted to provide a better, more rigorous general equilibrium
foundation that could adequately answer more complicated questions.

Milton Friedman and the Chicago Approach to Microeconomics

 Freidman, Milton (1912 – 2006).
 He theorized there existed a "natural" rate of unemployment, and argued that governments could increase
employment above this rate (e.g., by increasing aggregate demand) only at the risk of causing inflation to
accelerate.
 He argued that the Phillips curve was not stable and predicted what would come to be known as stagflation.
 Milton Friedman's works include many monographs, books, scholarly articles, papers, magazine columns,
television programs, videos, and lectures, and cover a broad range of topics of microeconomics,
macroeconomics, economic history, and public policy issues.
 Milton Friedman stands as one of the most influential economists of the late twentieth century.
 He argued that the Great Depression had been caused by the Federal Reserve's policies through the 1920s, and
worsened in the 1930s.
 According to Friedman, laissez-faire government policy is more desirable than government intervention in the
economy.
 Governments should aim for a neutral monetary policy oriented toward long-run economic growth, by gradual
expansion of the money supply.
 He advocated the quantity theory of money, that general prices are determined by money.
 Therefore active monetary (easy credit) or fiscal (tax and spend) policy can have unintended negative effects.
 In Capitalism and Freedom (1962) Friedman wrote, there is likely to be a lag between the need for action and
government recognition of the need; a further lag between recognition of the need for action and the taking of
action; and a still further lag between the action and its effects.
 Economists of the Chicago school are known for applying economic analyses to a broad spectrum of issues,
many of which have normally fallen within the purview of other disciplines as far ranging as history, law,
politics, and sociology.
 Examples of such extensions conceived by Chicago economists are search theory (George Stigler), human
capital theory (Gary Becker and Theodore Schultz) and property rights/transaction cost theory (Ronald H.
Coase).
 18

Topics in Modern Microeconomics

 19

CHAPTER 7: THE DEVELOPMENT OF MODERN MACROECONOMIC THOUGHT

 Macroeconomic theories change over time because major economic events - such as the Great Depression of
the 1930s the Great Inflation of the 1970s.
 Different schools of macroeconomic thought have emerged since the publication of Keynes’ General Theory in
1936.
 The reason is that there is wide disagreement among economists.
 The development of new theories and the abandonment of old theories often occur in response to major
macroeconomic development.
 In the 1930s, the Great Depression spurred the Keynesian revolution.
 Keynesian thought dominated macroeconomics until significant inflation emerged in the late 1960s and
brought about the monetarist “counterrevolution.”
 In 1967, Milton Friedman developed a model of the economy where all markets clear continuously, but there
is imperfect information.
 Firms always know the current value of the price level, but workers only learn the actual price level with a
time lag.

Modern Macroeconomics
 Economic "globalization" is a historical process, the result of human innovation and technological progress.
 It refers to the increasing integration of economies around the world, particularly through the movement of
goods, services, and capital across borders.
 The term sometimes also refers to the movement of people (labor) and knowledge (technology) across
international borders.
 There are also broader cultural, political, and environmental dimensions of globalization.
 Its focus is not only on methods of promoting economic growth and structural change but also on improving
the potential for the mass of the population, for example, through health, education, and workplace conditions.
 Amartya Sen (1933-) became well known for his contributions to welfare economics and his work on famine,
the underlying mechanisms of poverty, and gender inequality.
 The world has moved from ancient times when philosophers and religious leaders were the authority on all
things, economic issues included, through the division of disciplines into more specific fields, into an era of
globalization and the emergence of a global economy.
 As economic thought has developed through these times, the direction appears to be one in which, after
separating into a distinct discipline, it now returns to a closer connection with the other disciplines.
 In this way, the future of economic thought may finally be able to uncover and understand the complex
processes and mechanisms which guide economic transactions in human society

Contributions of New Classical Macro Economics

 The assumption of rational expectations requires that people do not repeat mistakes.
 It also provides microeconomic foundations to macroeconomic theory.
 Many of the ideas developed by new classical economists have been applied successfully to financial markets
where continuous market clearing is a reasonable assumption.
 Greater understanding of economic policy.
 New techniques of analysis developed have had a pervasive effect on economic research.

The New Keynesian Economics

 The policy ineffectiveness proposition requires prices to be completely flexible.
 A second school of thought - which emerged out of the rational expectations revolution - is called the new
Keynesian school, which, like the new classical school began in the 1970s.
 A notable feature of this school is that prices are assumed to be sticky, or slowly adjusting, rather than
perfectly flexible.
 This school of thought assumes prices are sticky and expectations are rational and explain the effect of
monetary and fiscal policy on the basis of this assumption.
 20

Historical Forerunners of Modern Macroeconomics

 Modern macroeconomics consists primarily of monetary theory, growth theory, and business-cycle theory.
Emphasis on these has fluctuated over the years, in part as the experience of the economy has changed and in
part as techniques have allowed economists to deal with issues that they previously found unmanageable.
 Analysis of economic growth was the primary concern of Adam Smith, who emphasized the relationships
between free markets, private investment spending, laissez faire, and economic growth.
 Ricardo refocused economics, turning it away from economic growth and toward the issue of the forces
determining the distribution of income.
 Joseph Schumpeter distinguishes two types of economists by their thinking about growth viz., optimists and
pessimists.
 The pessimist economists, Malthus, Ricardo, and James Mill strongly emphasized decreasing returns, ever-
increasing rent, and the stationary state toward which the economy was progressing.
 The optimist economists are the Heterodox economists such as Henry Carey and Friedrich List.
 Marx focused on the unequal distribution of income that accompanied that growth and its implications for the
political and social structure.
 Walras, Menger, and others developed a supply-and-demand analysis to explain the value of money, but the
most famous of these theories is probably the one developed by Marshall, which has become known as the
Cambridge cash-balance version of the quantity theory of money.
 The sources of the Keynesian analysis of income determination, with its emphasis on the inherent instability of
capitalism and the role of investment, run from Marx through Tugan- Baranowsky, Juglar, Spiethoff,
Schumpeter, Cassel, Robertson, Wicksell, and Fisher on the orthodox side; and from Marx, Veblen, Hobson,
Mitchell, and others on the heterodox side.

Quantity Theory of Money

 The supply of money was assumed to be determined by the monetary authorities, so some orthodox
economists contended that the basic issues to be analyzed were on the side of demand. The household and firm
are assumed to be rational and to have a demand for money to be used for various purposes. Walras, Menger,
and others developed a supply-and-demand analysis to explain the value of money, but the most famous of
 21

these theories is probably the one developed by Marshall, which has become known as the Cambridge cash-
balance version of the quantity theory of money.
 Marshall’s version of the quantity theory was an attempt to give microeconomic underpinnings to the
macroeconomic theory that prices and the quantity of money varied directly. Marshall reasoned that
households and firms would desire to hold in cash balances a fraction of their money income.
 The first clear statement of the quantity theory of money was made by David Hume in 1752 and held that the
general level of prices depended upon the quantity of money in circulation.
 Knut Wicksell (1851- 1926) tried to develop a so-called income approach to explain the general level of
prices; that is, to develop a theory of money that explains fluctuations in income as well as fluctuations in price
levels.

Business Cycle Theory

 Although fluctuations in business activity and in the level of income and employment had been occurring since
the beginning of merchant capitalism and were acknowledged by orthodox theorists, economists made no
systematic attempts to analyze either depression or the business cycle until the 1890s.
 Heterodox theorist, Marx had pursued these issues with greater vigour. But Marx’s works were largely ignored
by orthodox theory.
 Prior to 1890, orthodox “work on depressions and cycles had been peripheral and tangential.”
 Clement Juglar (1819-1905) cycle was a result not of forces outside the economic system but of forces within
it. He saw the cycle as containing three phases that repeated themselves in continuous order: prosperity, crisis,
liquidation.
 Tugan-Baranowsky’s (1865-1919) main contribution to business cycle was on two principles: (1) the
economic fluctuations are inherent in the capitalist system because they are a result of forces within the
system, and (2) the major causes of the business cycle are to be found in the forces determining investment
spending.
 The sources of the Keynesian analysis of income determination, with its emphasis on the inherent instability of
capitalism and the role of investment, run from Marx through Tugan- Baranowsky, Juglar, Spiethoff,
Schumpeter, Cassel, Robertson, Wicksell, and Fisher on the orthodox side; and from Marx, Veblen, Hobson,
Mitchell, and others on the heterodox side.

Neoclassical Macroeconomics
 One type of macroeconomic analysis with rational expectations assumes that prices are completely flexible.
 If this assumption is valid, then changes in monetary policy, if anticipated in advance, have no short-run effect
on real GDP or on the economy.
 This result is known as the policy ineffectiveness proposition and has been stressed by a school of economists
called the new classical school.
 Robert Barro, for example, has argued that only unanticipated changes in monetary policy cause changes in
real GDP.
 In short, the new classical school of macroeconomics holds that prices are perfectly flexible, expectations are
rational, and therefore anticipated monetary policy will have no effect on the economy.

Keynesian System: The Keynesian Revolution

 The publication of J. M. Keynes’ General Theory saw the birth of macroeconomics as a separate discipline.
 Keynes virtually revolutionized economic thinking.
 Keynesian revolution refers to a change in macroeconomic thinking, shaped by the Great Depression and the
work of Keynes leading to greater considerations of demand-side policies.
 From Keynes’ ideas emerged the Keynesian school, a school of macroeconomic thought concerned with
pursuing demand-side macroeconomic policies - primarily fiscal policies working through the multiplier - to
reduce unemployment and encourage economic growth.

Monetarists
 The 1960s saw the emergence of an exactly opposite school of thought, viz., the monetarist school, which
holds that changes in money supply are the primary cause of fluctuations in real GDP and the ultimate cause of
inflation.
 22

 Milton Friedman, the leader of the school, restated the Quantity Theory of Money and held the view that
“Inflation is always and everywhere a purely monetary phenomenon”.
 The monetarists challenged the Keynesian approach to macroeconomics and emphasized the importance of
monetary policy in macroeconomic stabilizations.
 The monetarist approach postulates that the growth of money supply determines nominal GDP in the short run
and prices in the long run.
 This analysis pins faith on the Quantity
 Theory of Money and argues that the velocity of money is stable in which case movements in money supply
will affect nominal GDP proportionately.

The Essence of Monetarism

 Three central propositions of monetarism are:
 The main determinant of nominal GDP growth is the growth of money supply.
 Wages and prices are relatively flexible. (Recall that one of the postulates of Keynesian economics is that
wages and prices are ‘sticky’.)
 Private sector is stable. So most fluctuations in nominal GDP result from government action such as change in
the central bank’s monetary policy.
 The monetarist school argued that monetary policy was a powerful force - indeed, more powerful than fiscal
policy.
 Milton Friedman and Anna Schwartz showed that decline in money supply growth were responsible for the
prolonged duration of the Great Depression.
 The debate was resolved by means of the IS-LM Keynesian-neoclassical synthesis, in which the monetarists
assumed a highly inelastic LM curve and Keynesians assumed a highly elastic LM curve.

Problems with IS-LM Analysis

 IS-LM analysis remains part of most macroeconomists’ toolbox. It provides the framework most
economists initially use in tackling macroeconomic analysis. By the 1960s, however, it had been well
explored in the literature and found wanting in several ways.
 First, it forced the analysis into a comparative static equilibrium framework.
 Second, in IS-LM analysis the interrelationship between the real and nominal sectors had to occur through
the interest rate and could not occur through other channels.
 Third, the demand for money analysis used to derive the LM curve was not based on a general equilibrium
model; instead, it was assumed in a rather ad hoc fashion.
 Nonetheless, the IS-LM model was adopted. It was neat, it served its pedagogical function well, it was a
rough and ready tool, it provided generally correct insight into the economy, and it was the best model
available.
 In a sense, many macroeconomic researchers in the 1970s and 1980s argued that we should skip the
Keynesian IS-LM interval and return to the macroeconomic debate, as it existed in the 1930s, when issues
were framed in microeconomic terms.
 While IS-LM analysis remained the key undergraduate model in the 1970s and 1980s, graduate research
started to focus on quite different issues. By the early 1990s the change in focus was filtering down to
undergraduate courses. Modern theoretical debates in macroeconomics have little to do with the shapes of
the IS-LM curves.

The Micro Foundations of Macroeconomics

 In the 1970s, economists began to lay the microfoundations of macroeconomics by attempting to fit the
Keynesian models into the neoclassical general equilibrium model.
 They did this for two reasons: first, for theoretical completeness and second, to be able to expand the
model to include inflation in the analysis.
 In the microeconomic foundations approach to macroeconomics, unemployment was a microeconomic, not
a macroeconomic issue.
 Whereas Keynesian analysis pictured unemployment as an equilibrium phenomenon in which individuals
could not find jobs, the micro- foundations literature pictured unemployment as a temporary phenomenon.
 23

 Microfoundations economists argued that to understand unemployment and inflation economists must look
at individuals and firms’ microeconomic decisions and relate those decisions to macroeconomic
phenomena.
 The initial microfoundations models had been partial equilibrium models but the obvious choice was to use
general equilibrium models and it become the central model of microeconomics.
 Microfoundations literature was cemented into the profession’s consciousness in the early 1970s by its
accurate prediction about inflation and argued that the Phillips curve - a curve showing a trade-off between
inflation and unemployment was only a short-term phenomenon.
 The policy implications of the new microfoundations approach were relatively strong.
 Its’ analyses removed the potential for government to affect the natural rate of long-run unemployment
through expansionary monetary and fiscal policy.

The Rise of New Classical Economics

 New classical macroeconomics, sometimes simply called new classical economics, is a school of thought
in macroeconomics that builds its analysis entirely on a neoclassical framework.
 The New Classical School emerged in the 1970s as a response to the failure of Keynesian economics to
explain stagflation and became the dominant school in Macroeconomics.
 New Classical and monetarist criticisms led by Robert Lucas, Jr. and Milton Friedman respectively forced the
rethinking of Keynesian economics.
 This strengthened the case for macro models to be based on microeconomics.
 The rational expectations hypothesis was a by-product of the microeconomic analysis of Charles C. Holt
(1921- ), Franco Modigliani (1918- ), John Muth (1930- ), and Herbert Simon (1916- ).
 The new classical perspective takes root in three diagnostic sources of fluctuations in growth: the productivity
wedge, the capital wedge, and the labor wedge.
 New classical economics is based on Walrasian assumptions. All agents are assumed to maximize utility on
the basis of rational expectations.
 The concept of rational expectations was originally used by John Muth, and was popularized by Lucas.
 One of the most famous new classical models is the real business cycle model, developed by Edward C.
Prescott and Finn E. Kydland.
 The new classical macroeconomics contributed the rational expectations hypothesis and the idea
of intertemporal optimisation to new Keynesian economics and the new neoclassical synthesis.
 Real business cycle theorist Bernd Lucke calls the new classical macroeconomics model the ″caricature of an
economy" because its underlying assumptions exclude any non-rational behaviour or the possibility of market
failure, prices are always fully flexible, and the market is always in economic equilibrium.
 The current mission of the new classical macroeconomics is to find out to which extent this caricature of an
economy already has enough predictive power to explain business cycles.

Keynesian Responses to the New Classicals

 The classical economics cannot explain the great depression since it considers only LR equilibrium and
expects a temporary disequilibrium to be adjust quickly.
 Empirical: inconsistencies between Keynesian and Monetarist and what actually happened in 1970s from oil
price shocks, “Stagflation”.
 Implications of new classical economics are expectations are formed normally, they may form wrong
expectations, but once they have learnt their mistake, they will no longer make mistakes and only
unanticipated policies have an effect on the output and employment.
 New classical fails to explain the important empirical fact, deviations from capacity output tended to be
prolonged and correlated.
 Economic fluctuations are due to supply side such as technological changes, natural disaster, tax, input prices,
etc.
 24

CHAPTER 8: THE DEVELOPMENT OF ECONOMETRICS AND EMPIRICAL METHODS IN

ECONOMICS

 Debate about empirical methods in economics has had both a micro-economic and a macroeconomic front.
 Microeconomic front has been concerned with empirically estimating production functions and supply-and-
demand curves.
 Macroeconomic front has generally been concerned with the empirical estimation of macroeconomic
relationships and their connections to individual behavior.
 Almost all economists believe that economics must ultimately be an empirical discipline, that their theories of
how the economy works must be related to real-world events and data.
 We will distinguish four different approaches to relating theories to the real world: common-sense empiricism,
statistical analysis, classical econometric analysis, and Bayesian econometric analysis.

Common-Sense Empiricism
 Common-sense empiricism is an approach that relates theory to reality through direct observation of real world
events with a minimum of statistical aids.
 Supporters of common-sense empiricism would object to that characterization because the approach can
involve careful observation, extensive field work, case studies, and direct contact with the economic events
and institutions being studied.

Statistical Analysis Approach

 The statistical analysis approach also requires one to look at reality but emphasizes aspects of events that can
be quantified and thereby be subject to statistical measure and analysis.
 A focus is often given to statistically classifying, measuring, and describing economic phenomena.
 The statistical analysis approach is very similar to common-sense empiricism but unlike that approach, the
statistical approach uses whatever statistical tools and techniques are available to squeeze every last bit of
understanding from a data set.
 As the computer has increased researchers' capabilities of statistically analyzing data, the approaches of
common-sense empiricism and statistical analysis have diverged.

Classical Econometric Approach

 The classical econometric approach is a method of empirical analysis that directly relates theory and data.
 This approach makes use of classical statistical methods to formally test the validity of a theory.
 The econometric approach, which developed in the 1930s, is now the approach most typically taught in
modern economics departments.

Bayesian Approach
 The Bayesian approach directly relates theory and data, but in the interpretation of any statistical test, it takes
the position that the test is not definitive.
 It is based on the Bayesian approach to statistics that seeks probability laws not as objective laws but as
subjective degrees of belief.
 In Bayesian analysis, statistical analysis cannot be used to determine objective truth; it can be used only as an
aid in coming to a subjective judgment.
 Thus, researchers must simply use the statistical tests to modify their subjective opinions.
 Bayesian econometrics is a technical extension of common-sense empiricism.

 In it, data and data analysis do not answer questions; they are simply tools to assist the researcher's common
sense.
 Computer certainly has changed economists’ empirical work, and it will do so much more in the future.
 A final change has been the development of a “natural experiment” approach to empirical work.
 This approach uses intuitive economic theory rather than structural models and uses natural experiments as the
data points.