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Ijaz 1
 Brief History
of
Economic Thought
a. http://www.personal.umd.umich.edu/~delittle/Encyclo
pedia%20entries/philosophy%20of%20economics.pdf
b. https://www.alleywatch.com/2013/08/a-brief-history-
of-economic-thought/
c. http://en.citizendium.org/wiki/History_of_economic_th
ought
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• As the science of decision making, Economic Philosophy operates in our daily
life.
• We live in a world of finite resources; economists must decide how to use these
limited inputs to satisfy our never-ending list of Wants and Needs.
• To do this, economists study and analyze the relationships between Resources —
Materials and Labor — and the Production, Distribution, and Consumption of
the resulting goods and products.
• Economists can study how these decisions are made on a Microeconomic Level
between individuals involved in a business decision or transaction, or on a
Macroeconomic Level that considers the entire city, state, or country as a
singular unit.
• For example, a Microeconomist might consider how supply and demand is
impacting prices at one firm, or the way taxes have changed that firm’s costs
overtime. A macroeconomist, on the other hand, studies the way Gross National
Product (GDP) is affected by changes in national income and unemployment.
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• Although both of these fields operate on different scales, Microeconomics and
Macroeconomics largely share the same methodologies. They also share an
underlying assumption of self-interest upon which all modern economic theory
rests.
• Adam Smith first coined this term to describe the notion that People Will Act
Purposefully to maximize their satisfactions, given their limited time,
information, resources, and budgets.
• As part of those rational decisions, Charles Nelson argues that people must
consider their resources as they relate to the production of their goods and
services.
• Economists typically categorize these resources into categories:
a. Land (Natural Resources),
b. Labor (Time, Effort And Skill)
c. Capital (Including Human-made Tools)
which culminate in entrepreneurship as the coming together of economic
resources to form productivity.
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The Field Of Economics draws from many other disciplines to illustrate
how these concepts function in real-life.
a. Mathematical formulas and models describe how resources are
turned into capital, or the way labor can be cut-down by
advancements in production.
b. Economists base their perception of the economy on the pillars of
philosophy.
c. Social scientists consider economics as they try and understand
the welfare of certain population groups.
d. Policy makers measure economic impacts in order to shape the
way members of the public do business with one another.
Economic thought has been evolving for hundreds of years. The
following timeline of important figures and dates can help illustrate how
the field has developed.
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• 850-1000 A.D. – Marks the Rise Of Feudalism, which arose in England
and entails a society where land is held in exchange for service.
Peasants or a working class are protected by a military class in reward
for obedience. The origination and existence of this inequitable, often
cruel system is debated today.
• 1723-1790 — Adam Smith is largely considered the father of modern
economics. Smith’s Wealth of Nations, considered his opus (work),
includes the ‘Invisible Hand,’ a term that describes the self-regulatory
nature of functioning markets; and the notion that Rational Self-
interest In A Free-market Economy Leads To Economic Well-being.
• 1766-1843 — Thomas Robert Malthus studied populations, and was
one of the first economists to explore the Relationship Between
Population Growth And Inflation. His main contributions include his
work on the relationship between food supply and populations,
and Economic Rent Theory.
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• 1748-1832 — Jeremy Bentham was a British economist who is today
often associated with the Doctrine Of Utilitarianism. Far ahead of his
time, he advocated for Universal Suffrage and is considered a
forefather of Welfare Economics.
• 1772 -1823 — David Ricardo was inspired by Adam Smith’s Wealth of
Nations, and at the age of 37 went on to propose the Labor Theory Of
Value, which argues that labor is the only factor that should
determine the value of a commodity. This is in opposition to Demand,
which is the backbone of capitalism.
• 1806-1873 — John Stuart Mill drew from the ideas of Smith and
Ricardo when he wrote Principles of Political Economy, which became
the leading economic text of its time. Mill is credited with the Idea Of
A Free Market Economy, and was a strong advocate for creating
a democratic economy (as opposed to capitalism).
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• 1818-1883 — Karl Marx is most noted for his advocacy of socialism
and communism over capitalism, which he strongly denounced. He
is arguably one of the most influential economists in history. Marx
believed that communism was inevitable in the process of
evolution that begins with feudalism and passes through capitalism
and socialism.
• 1842-1924 — Alfred Marshall focused on the study of
microeconomics and wrote Principles of Economics, which is one of
the most notable economics textbook of all time. Marshall proposed
the idea that economics was a scientific discipline that required
more mathematics and less philosophy and rhetoric.
• 1857-1929 — Thorstein Veblen is best known for his book The
Theory of the Leisure Class, and his ‘Institutional Economics’
approach explored the effects of social establishments — such as
religion, poverty, and political affiliation — on economic
productivity.
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• 1883-1950 — Joseph Schumpeter contributed the idea of ‘Creative
Destruction,’ which implies that the Economy Is In A Constant, Cyclical
State Of Productivity And Collapse. He is also one of the first to lay out
a clear Concept of Entrepreneurship.
• 1883-1946 — John Maynard Keynes was one of the most revolutionary
economists of the 20th century. He argued against free market
principles and stated that aggregate demand — as opposed to worker
flexibility — played the largest role in employment. He also promoted
fiscal measures as a means of correcting depressions and recessions;
the bailouts issued in response to the recent recession are one such
example.
• 1912-2006 — Milton Friedman was an advocate of Free Markets, and
his philosophies became a major tenet of the Fiscal Conservative
Movement. He was an advisor to President Richard Nixon and was
president of the American Economic Association in 1967.
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• 1908-2006 — John Kenneth Galbraith explored the role of
corporations in the U.S. economy, and was critical of their
influence and replacement of smaller firms in his
book American Capitalism: The Concept of Countervailing
Power.
• 1919- 2005 — Robert Heilbroner is the author of The Worldly
Philosophers, and was a socialist for most of his life. He was
critical of the study of economics and argued for a renewed
look at the field.
• The evolution of economics has continued to the present day,
and this fascinating field will undoubtedly continue to play a
major role in worldwide business, government, and society as a
whole in the years, decades, and centuries to come.
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History of
Economic
Thought
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Modern Economic Thought originated in the late eighteenth century
with the work of David Hume and Adam Smith, the founders of
Classical Economics. The nineteenth and twentieth centuries saw
major developments in the methodology and scope of economic
theory; and the early twenty-first century has seen a rethinking of
some previously accepted tenets.
• Nineteenth- and early twentieth-century economists Applied
Deductive Reasoning to axioms considered to be self-evident and
simplified assumptions which were thought to capture the essential
features of economic activity. That methodology yielded concepts
such as Elasticity and Utility, tools such as marginal analysis, and
theorems such as the Law of Comparative Advantage. An
understanding of the relationships governing transactions between
consumers and producers was considered to provide all that was
necessary to explain the behaviour of the economic system.
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• In 20th century, Economic Statistics enabled economists to
use inductive reasoning to test theoretical findings against observed
economic behaviour, and to develop new theories.
• National Economy emerged as a complex interactive system, and
analysis of that concept provided explanations of
Recessions, Unemployment and Inflation.
• Empirical data and inductive reasoning enabled those theories to be
refined, and led to the Development Of Forecasting Models that could
be used as tools of economic management.
• The Development Of Economic Thought in the early 21st century has
been stimulated by the financial crisis and Great Recession, and the
questions that these events raised concerning the functioning of the
global financial system and the part that it plays in the functioning of
the economic system generally.
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• The biggest difference between Deductive and Inductive
reasoning is that deductive reasoning starts with a statement
or hypothesis and then tests to see if it’s true through
observation, where inductive reasoning starts with
observations and moves backward towards generalizations
and theories.
• Deduction moves from idea to observation, while Induction
moves from observation to idea.
• Deduction moves from more general to more specific, while
induction moves from more specific to more general.
• DeductionAll men are mortal. Harold is a man. Therefore, Harold is
mortal.
• Induction I have a bag of many coins, and I’ve pulled 10 at
random and they’ve all been pennies, therefore this is
probably a bag full of pennies.
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 Overview: Categories of Economic Thought
• Historians categorise economic thought into “Periods” and
“Schools”, and tend to attribute each innovation to one
individual.
• This categorisation is helpful for the purpose of explanation,
but the reality has been a story of interwoven intellectual
threads in which advances attributed to particular
individuals or schools have often prompted the work of
others.
• For example, the Quantity Theory Of Money, which achieved
prominence in the twentieth century and is associated
with Milton Friedman, was first formulated at least three
centuries earlier.
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• Many of those threads, that have permeated the categories referred to as
"Classical economics" and "Neoclassical economics", had earlier origins.
• "Classical", in economics, denotes the adoption in the late eighteenth
century of an approach that was inspired by the enlightenment and the
methodology of the physical sciences, and that had abandoned previous
examinations of economics in terms of ethics, religion and politics.
• Preoccupation with those threads was overshadowed in the twentieth
century by the responses of Keynesianism and monetarism to the
problems of unemployment and inflation.
• Development of Neoclassical Economics (theory that focuses on supply
and demand as the driving forces behind the production, pricing, and
consumption of goods and services) started before that time, and has
continued thereafter.
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 Classical Economics
• David Hume. Scottish philosopher what was later known as
Monetary Economics, and was an opponent of "mercantilism".
• Mercanilist Policy at the time, regulated trade in ways that
subsidised exports so as to promote inflows of gold and silver, and
restricted imports in order to discourage outflows.
• Hume contested the mercantilist thesis, partly on the grounds that
an inflow of money would cause inflation, and partly on the
grounds that nations would benefit from the international
specialisation that would result from the introduction of Free Trade.
• Hume argued that all government intervention in commerce tended
to obstruct economic progress.
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•Adam Smith. A major advance in the development of economics
occurred with the publication in 1776 of Adam Smith's An Inquiry
into the Nature and Causes of The Wealth of Nations.
• Using deductive logic in a manner similar to its use in the physical
sciences. His main purpose was to recommend changes of economic
policy in the interests of economic growth.
• He argued, Division Of Labour was the main cause of economic
growth. His famous maxim was that the extent of the market is
determined by the division of labour.
• To thus Expand Markets, Required That They Should Not Be
Impeded By Governmental Policies. He therefore opposed
government intervention in commerce (as in mercantilist trade
regulation. Mercantilism is associated with policies which restrict
imports, increase stocks of gold and protects domestic industries).
But he did not oppose all governmental intervention into the
economy.
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• He advocated Government Spending on public goods such as
defense, law enforcement, infrastructure, and education.
• He identified economic drawbacks of all forms of taxation
(except the taxation of land values) and of public expenditure.
• He examined the relation of price to value and concluded that
the price of a product tends to equality with its cost of
production, which he termed its "NATURAL PRICE".
• He reasoned that "when the quantity brought to market is just
sufficient to supply the effectual demand and no more, the
market price naturally comes to be either exactly, or as nearly
as can be judged of, the same with the Natural Price" - an
outcome which he took to be the normal result of market
bargaining.
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Jean-Baptiste Say was an influential advocate of Adam Smith's , his
contribution was "Say's Law of Markets."
• Later paraphrased as "Supply Creates Its Own Demand," Say's law stated
that, although there could be an imbalance between the supply and the
demand for particular products, no such imbalance could exist in the
economy as a whole.
• It was based upon the postulate that Money Plays No Part In The
Functioning Of The Economy Beyond Its Role As A Medium Of Exchange.
(The claim that money is nothing but a medium of exchange, is another
way of saying that people use money only for buying things (including
stocks and bonds).
• Say justified. it would be foolish to hold money out of circulation because
that would mean needlessly going without things (or without dividends or
interest).
• Say's Law remained part of mainstream classical economics until John
Maynard Keynes drew attention to the speculative and precautionary
motives
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for holding money. Ijaz 20
Thomas Malthus. In his influential Essay on the Principle of
Population, he postulated that the
a.Population would grow at a geometric rate (2, 4, 8, 16...)
while
b.Food production could only increase arithmetically (1, 2,
3, 4 ....) and concluded that the food supply would
eventually be insufficient to support the population.
• This theory led him to oppose the introduction of the UK's
Poor Law, and to Advocate The Protection Of Agriculture.
• In other respects, he followed Adam Smith in opposing
government intervention in commerce.
• Evidence in support of his postulates was lacking at the
time, and they have since been found to be mistaken, mainly
because they took no account of the benefits of technical
change.
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David Ricardo. With minor reservations, David Ricardo accepted and extended Adam
Smith’s economics.
• In The Principles of Political Economy and Taxation, he accepted the concept of a
value-determined “Natural Price”, although he considered value to be determined by
labour value added, rather than cost.
• He also developed the Wage Fund Concept that the amount available for the payment
of wages is fixed at any particular level of capital investment, so that an increase in
the supply of labour would lead to a reduction in wage rates.
• He pioneered a Definition Of Rent as the difference between the produce of a unit of
labour on the land in question, and its produce on the least productive land in use.
• He explored the Incidence Of Taxation On Wages, Profits, Houses, And Rent,
identifying in each case (but with the exception of rent) its harm to the economy.
• "Law Of Comparative Advantage" that challenged the belief that the Trading Of A
Product Is Possible Only With Those With A Lesser Ability To Produce It. Produced a
logical demonstration that there can be Mutually Beneficial Trade Between Two
Countries, One Of Which Is Better Able Than The Other To Produce All Of The
Commodities
9/19/2019 That Are Traded. Ijaz 22
• Karl Marx. He adapted Ricardo's concept of labour value and put it to an entirely
different use. In his analysis, as in Ricardo's, labour consumption determines value. This,
Marx Termed Exchange Value. But Marx regarded Each Labourer As A Product, whose
exchange value is determined by the labour inputs required to feed, clothe, and train
him. He reasoned that what the employer receives is the labourer's use value, which is
determined by the Utility Of His Products.
• Labourer's Use Value normally exceeds his exchange value, and he termed the
difference surplus value, which was the employer's profit.
• He saw technical progress as a major contributor.
• Marx was probably the first economist to make a systematic attempt to explain the
fluctuations in economic activity known as the Business Cycle.
• If technical progress were to slow down, the only way to maintain growth would be
to invest more and more in machinery and buildings, as a result of which the rate of
profit on new investment would fall, leading to a further reduction in growth.
• Any departure from the conditions necessary for steady growth would lead to the
accumulation of unwanted stocks of goods, producing a downturn in economic
activity - until price-cutting, in order to get rid of surpluses, put the process into
reverse.
• Concludes that Economic Conditions Shape History, And Forecasts A Breakdown Of
The Capitalist System And Its Replacement by socialism.
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 Other Contributors
• John Stuart Mill. His Principles of Political Economy, offered some fresh insights
into increasing returns to scale and their consequences for the development of
Monopolies, and NEOCLASSICAL concepts of elasticity and the determination of
price by the interaction of supply and demand.
• Theory of the Firm by the French economist Antoine Augustin Cournot. used
differential calculus (a branch of mathematics concerned with the
determination, properties, and application of derivatives and differentials) to
demonstrate the Profit-maximising Requirement Of Equality Between Marginal
Cost And Marginal Revenue (Economic Measures Used To Determine The
Amount Of Output And The Price Per Unit Of A Product That Will Maximize
Profits. ), thus anticipating some of the more important developments of
neoclassical economics.

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 Neoclassical Economics
The Neoclassical Approach. The term "neoclassical" is commonly applied to all of
the continuing developments in economic thinking that followed the replacement
of value-based concepts by the concept of markets that are governed by the
interaction of supply and demand.
• In that sense, the term denotes a period rather than a consistent approach -
although it is a period that overlaps the competing approaches of Keynesianism
and monetarism (Monetarism is a school of thought in monetary economics that
emphasizes the role of governments in controlling the amount of money in
circulation. Monetarist theory asserts that variations in the money supply have
major influences on national output in the short run and on price levels over
longer periods.).
• It is nevertheless a period in which most economists have deduced their findings
from the same hypothetical postulates - including the assumption of competitive
markets in which consumers maximise utility and producers maximise profits.
• Within that framework of postulates, neoclassical economists have explored a
variety of aspects of economic activity in
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a variety of different ways. 25
Marginal Analysis. The neoclassical period is also marked by an expansion in the
number of people applying their minds to the problems of economics.
• Innovative concepts of marginal analysis, that are attributable to the
contributions of William Stanley Jevons , Carl Menger and Léon Walras. Their
contributions have been brought together by Alfred Marshall in his Principles of
Economics, which provides the account of those and other contributions.
• The Concept Of Utility, a Rational Consumer Would Continue To Buy Additional
Units Of A Product Until Its Marginal Utility (the increase in utility obtainable
from one additional unit of the product) became level with to its price; and that
a Rational Supplier would continue to offer additional units of a product until
its Marginal Cost became level with the Marginal Revenue that he would get
from selling it.
• The American economist, John Bates Clark, subsequently applied the concept to
a market in which A Rational Employer Would Continue To Hire Labour Until Its
Marginal Product Became Level With The Prevailing Wage Rate.
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Equilibrium and the Price Mechanism. The concept of "Market Equilibrium" is
central to the neoclassical model.
• Léon Walras thought of it as the achievement of an imaginary auctioneer who
adjusts a notional opening price in response to a succession of bids by buyers
and sellers, and permits transactions to take place only when a price is reached
at which buyers are willing to buy all that is offered for sale.
• That is the process of price determination by supply and demand which marks
the abandonment of the concept of value-determined price, and which is
examined in detail in Alfred Marshall's Economics and in Milton Friedman's Price
Theory.
• Walras, and Vilfredo Pareto, developed the Concept Of A General Equilibrium in
which Supply Is Equal To Demand in every market in a closed economy. The
normal assumption of neoclassical economics is that of a stable equilibrium to
which the economy will automatically return after a disturbance.
• In such an economy, Unemployment Does Not Persist because any excess in the
supply of labour, relative to its demand,
9/19/2019 Ijaz is corrected by a reduction in wages.
27
Welfare and Efficiency
• The contributions of the Neoclassical Economists was probably their
development of the Concept Of Welfare.
• In representative government, they assumed success of an economic system to
be the welfare of the individual, and they introduced the concept of economic
efficiency as a measure of that success.
• Vilfredo Pareto defining efficiency as a state In Which No-one Could Be Made
Better Off Without Making Someone Worse Off.
• The Three Types Of Efficiency were identified as
a. Productive Efficiency (the production of good at minimum cost),
b. Allocative Efficiency (the provision of the mix of goods that consumers
want)
c. Distributive Efficiency (the distribution of the goods in such a way as to
maximise individual welfare).
• That work laid the foundations for the subsequent development of the theory of
welfare economics by Sir John Hicks andIjazothers.
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Competition
• The theorems of welfare economics establish a presumption that
Allocative Efficiency - that is to say that resources will be optimally
allocated as between the production of alternative products - will
be achieved under the hypothetical conditions of Perfect
Competition. (Those conditions include the requirement that for
each product there is no supplier large enough to influence prices,
that all producers supply identical products, and that all consumers
are well informed and behave rationally.)
• Despite the unreasonableness of those requirements, most
economists advocate a presumption that restrictions upon
competition will result in a reduction in efficiency .
• Those theoretical developments were the foundation for antitrust
and other forms of competition policy, the economics and politics
of which have been developed by George Stigler .
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The theory of the Firm
• The tools of welfare economics were also used to develop the theory
of the firm by Nicholas Kaldor and Ronald Coase in his "The Nature of
the Firm.
Economic Growth
• Attempts to create models of economic growth that identify the
contributions of such factors as Investment, Productivity, Innovation
And Institutional Environment; and that explain the differences in
growth experienced by different regions of the world.
• In the simple model proposed by Malthus in 1850, Growth Could Not
Exceed Population Growth, but it was not long before it became
evident that it was doing so.
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• The Harrod-domar Model, assume that there would be sufficient economic growth to
enable some to go into growth-enhancing investments.
• The 1956 Solow Model introduced the influence of the substitution of capital for
labour that results from investment in improved capital equipment.
• Solow also pioneered the Technique Of Growth Accounting , which he used to estimate
relative contributions to historical growth in the United States; and he identified an
unexplained residual which he termed Total Factor Productivity, the growth of which
he attributed to Technological Change.
• Technological change was exogenous (having an external cause or origin) to the Solow
Model, in that it was not the consequence of factors that were represented in the
model.
• Paul Romer and Robert Lucas, some of the factors believed to influence technological
change, such as Expenditure On R&D And Training, have since been embodied in the
growth models, which are termed Endogenous Growth (Endogenous growth theory
holds that investment in human capital, innovation, and knowledge are significant
contributors to economic growth) models.
• The most recent work - contributions to economic growth of institutional factors such
as Quality Of Governance, Trust, And Ethic Diversity; and To Explore Its Links With
Geographical
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 Keynesian macroeconomics-The contribution of John Maynard Keynes
• Maynard Keynes was his examination of the factors determining the levels of national income
and employment, and the causes of economic fluctuations.
• His major the General Theory of Employment, Interest and Money, contains a criticism of
classical economics that their postulates were unrealistic.
• His first target was Say's Law Of Markets with its denial of the possibility of a general deficiency
of demand. He challenged its implicit assumption that money is no more than a medium of
exchange by drawing attention to the speculative motive for holding money.
• He opposed Classical Economists' contention that it was the interest rate that reconciled
savings plans with investment plans, claiming that the level of savings was largely
determined by the level of national income.
• Thirdly, he rejected the Classical Economists' assumption that any tendency for unemployment
to rise would be corrected by a reduction in the general level of wages, substituting the
contention that "wages are sticky downward". His thesis that a deficiency of demand could
occur if there was an excess of planned savings over planned investment, because such an
excess could be removed only by a reduction in national income.
• The implication of that thesis was that the economy could settle down into a condition of high
unemployment, lacking the self-righting mechanism envisaged by the classical economists.
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Neo-Keynesianism
• John Hicks published an article entitled "Mr Keynes and the Classics" in which he
produced a synthesis between the Keynesian and neoclassical models.
• Its main feature is the IS/LM diagram with its intersecting curves, one of which
(Investment/Savings) relates the demand for savings to the interest rate, and the other
(Liquidity/Money Supply) relates the demand for money to the interest rate - and in
which the point of intersection of the two curves represents an equilibrium level of
demand.
• (The IS/LM diagram subsequently came to be known as the Hicks-Hansen diagram. The
important feature of the synthesised model is that it can be made to depict behaviour
in accordance with either the Keynesian model or the neoclassical model, depending
upon what is assumed concerning the slopes of the two curves.
• In doing so it introduced a fundamental departure in the methodology of economics -
a change from an exclusive reliance upon logical deduction from a priori postulates,
to the increasing use of the inductive process of testing hypotheses against empirical
evidence.
• The work of a large body of economists was subsequently devoted to testing such
hypotheses, using the mathematical technique known as "Econometrics". That work
does not appear to have resolved the controversy concerning the usefulness of the two
models (except that some economists now acknowledge that one or the other seems to
have9/19/2019
worked better from time to time and Ijazin some countries' economies) 33
Policy Implications
• Keynesian Stabilisation Policy required governments to counter downturns in demand
by cutting taxes or increasing public expenditure. Since it takes some years for such
actions to take effect, their timing had to be based upon forecasts using computerised
economic forecasting models, but forecasting errors and misguided attempts to
stimulate growth often had destabilising consequences. Measures that unwittingly
stimulated demand at a time when an economy was operating at its full capacity,
frequently gave rise to rising inflation - for which the only remedy appeared to be
wage restraint - and the situation was sometimes exacerbated by the operation of
foreign exchange policies.
• Monetarism and the Chicago School
• The term Chicago School is usually taken to refer to the outlook and methodology of
its economists during the period that started in the 1960s - including Milton Friedman,
George Stigler, Ronald Coase, Robert Lucas, Cary Becker, Harry Johnson and Merton
Miller, and to some like-minded economists in other universities. It is best known for its
advocacy of monetarism but its economists have also made contributions on a wide
range of other topics, including international trade, rational expectations and
institutional economics.
• Their methodology embodies an approach, which philosophers term instrumentalist,
that gives the predictive value of a theory priority over the representativeness of its
assumptions.
9/19/2019 Ijaz 34
Monetarism
• The Quantity Theory Of Money, Irving Fisher, equated the volume of money in circulation
multiplied by a notional "Velocity Of Circulation". to the volume of physical output
multiplied by its unit price (usually written as MV = PT).
• If the velocity of circulation were roughly constant, that would imply an association between
inflation and growth in the money supply.
• Milton Friedman found that periods of monetary expansion had been followed by periods of
inflation, although with long and variable time-lags. That led him to argue that Keynesian
demand management would be ineffective in the long run because it would be accompanied
by a damaging rise in the money supply; and that stability of demand and prices could better
be achieved by control of the money supply.
• The controversy that followed was mainly concerned with the nature of the transmission
mechanism (the question whether an excess of money would bid up the prices of goods, or
whether it would be invested in interest-bearing bonds without affecting the prices of goods).
• Harry Johnson. The conventional view had been that the exchange rate is determined by the
balance between the supply and demand of exports and imports, but Harry Johnson treated
it as the relative price of the moneys in circulation in the two countries.
• One of the implications of his theory is that if the exchange rate is fixed, the money supply
cannot be controlled - which was a consideration that influenced the Chicago School's
campaign to put an end to the system of fixed exchange rates then in operation.
• Another is that if the money supply is held constant, the balance of payments is self-
correcting.
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Expectations
• Milton Friedman Phillips curve (which had reflected the observation that inflation tended to
fall when there was a rise in unemployment) on the grounds that It Failed To Take Account Of
Expectations.
• He proposed its replacement by the Expectations-augmented Phillips Curve, and used that
construction to counter fears that a reduction in growth of the money supply would lead to a
sustained increase in unemployment.
• To do so, he introduced the concept of the Non-accelerating-inflation Rate Of Unemployment
(NAIRU), which is usually referred to as its natural rate, and which is the unemployment rate at
which the expected inflation rate is the same as its actual rate.
• Reduction in money supply growth caused unemployment to rise above its natural rate, the
expected inflation rate would fall, that would cause unemployment to revert to its natural
rate. Conversely, a reduction in unemployment accompanying an increase in the money
supply would cause an increase in expected inflation, prompting wage demands which would
lead to an increase in actual inflation - a process which could continue indefinitely.
• Lucas Critiqu. He argued that Policy Actions Tend To Change People's Expectations So That
The Same Policy Action Could Have Future Consequences That Differ From The Consequences
That It Had In The Past. That possibility has fundamental implications for the construction of
forecasting models, and the Lucas critique also raises the possibility that public reactions could
frustrate the achievement of policy objectives.
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Policy Implications And Outcomes
• The Chicago School's prescription for stabilisation problem was confined to the
control the money supply, and its prescription for the reduction of
unemployment was to take measures to improve wage - and price flexibility.
• Concern For Rising Inflation, and the failure of attempts to control it by wage
restraint, led to the widespread adoption of the first of those prescriptions in the
late 1970s. In USA, the Congress passed The Full Employment and Balanced
Growth Act (known as the Humphrey-Hawkins Act) which required the Federal
Reserve Bank to set one-year target ranges for money supply growth twice a
year and to report the targets to Congress.
• In the United Kingdom, the Callaghan administration adopted a specific money
supply objective.
• In both countries, attempts to keep the growth of the money supply within pre-
set limits were generally unsuccessful (and in the United Kingdom, money
supply growth actually increased [35]) and were eventually abandoned.
• None consider control of the money supply to be a practicable instrument of
stabilisation policy.
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Institutional Economics, He Institutionalist School
• The term Institutionalist refers to economists who argue that economic activity
cannot properly be understood except in the context of the public and social
structure in which it takes place.
• Thorstein Veblen - the man who coined the term Conspicuous Consumption - and
whose lasting contributions were the collection of economic statistics and the study of
business cycles.
Modern Institutional Economics
• Ronald Coase, Coase Theorem - Economic Efficiency Will Be Achieved Provided That
Property Rights Are Fully Allocated And Can Freely Be Traded; a proposition which he
developed further in his 1960 paper The Problem of Social Cost.
• Freakonomics Steven Levitt and Stephen Dubner, and which applies economic thinking
to such questions as cheating, drug dealing and the connection between crime and
abortion.
Mechanism Design Theory
• A recent extension to institutional economics is concerned with how well different
institutions and allocation mechanisms achieve goals such as welfare and private
profit.
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International economics
The gains from trade endowed
• David Ricardo's LAW OF COMPARATIVE ADVANTAGE - and its implication that trade
restrictions are damaging to the interests of the country that imposes them - was the
starting-point of the historical development of Trade Theory.
• "Classical" Trade Theory have mainly been attempts to create mathematical models of
inter-country trade. The best-known of those was the Heckscher-Ohlin Theory, that a
country will export those commodities that are intensive in the factor of production
in which it is most well-capable.
• Paul Samuelson, in the absence of productivity differences, trading between two
countries would tend to equalise wages and capital costs in those countries. However,
doubt was cast as United States, which is the world's most capital-intensive country,
had been exporting labour-intensive commodities and importing capital-intensive
commodities.
• The general conclusion has been that international trade is mainly driven by factors
other than labour-intensity and capital-intensity.
• "Modern" trade theory depends mainly upon the econometric analysis of international
trade statistics, and has produced a range of findings concerning the influence of
factors such as innovation and training.
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Public Choice Theory
• Buchanan and Tullock are best known for their analysis of the Behaviour Of
Politicians, civil servants and voters on the assumption that they are mainly
motivated by personal gain, rather than a desire to serve the public interest.
Infant Industries
• Friedrich List argued that free trade should not be permitted until the government
had taken the measures necessary to establish the country's "productive powers".
• That was the argument for Infant-industry Protection and which led to the
introduction of the Smoot-Hartley system of industrial tariffs in the United States.
• Ha-Joon Chang's book Kicking Away The Ladder which suggests that industrial
successes in Britain, United States and South Korea were attributable to the fact
that they were protected from overseas competition until they were large enough
to benefit from economies of scale.
• The mainstream reaction among economists concedes that the case for Free Trade
Does Not Take Account Of The Benefits Of Scale Economies, and that welfare gains
from temporary trade restrictions might in principle be possible if a government
were sufficiently successful in "picking winners" but that Tax Incentives And
Subsidies
9/19/2019 Are More Effective Than Tariffs.
Ijaz 40
 Globalisation
• Globalisation is seen by most economists as contributing to economic welfare by
promoting competition and the division of labour.
• But there are exceptions. Professor Joseph Stiglitz advanced the infant industry
case for protection in developing countries and criticised the conditions imposed
for help by the International Monetary Fund. Professor Dani Rodrik -the benefits
of globalisation are unevenly spread, leading to Income Inequalities that, in his
view, lead to damaging losses of social capital, and to the migration of labour
causing social stresses in receiving countries
Financial Economics
Overview
• Efficient Markets Hypothesis. That hypothesis was the basis of risk analysis
using the assumption that price variations on the markets for financial assets
could be treated as random variations, which could be represented by
established probability distributions.
• The international financial industry made use of the models to select investments
that 9/19/2019
were predicted to give the best return
Ijaz for a stipulated level of risk 41
The Finance Market
• Louis Bachelier, according to which price fluctuations in a speculative market are
analogous to the Brownian Movement of physics (the random walk of statistics
theory), such that there is no combination of prices that offer the prospect of a
certain gain.
• Can Stock Market Forecasters Forecast?. According to Cowles' efficient market
hypothesis, All Of The Available Information That Was Relevant To An Asset's
Prospects Would Already Be Embodied In Its Price (so that the answer to his
question was "no").
• The hypothesis depended upon the assumptions that most traders behave
rationally, and that the activities of the others are mutually cancelling.
• Those assumptions were widely accepted, and on their basis, financial markets
were taken to be essentially stable.
• Hyman Minsky's 1986 Financial Instability Hypothesis, which suggested that
financial markets are apt to become unstable after a period of sustained
economic growth, received little attention at the time.
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Portfolio And Asset Price Theory
• A sequence of Nobel Prize-winning advances concerning the problem of
getting the best return from an investment without exceeding a chosen
level of risk, occurred during the period from the 1950s to the 1970s.
• In his "Separation Theorem", Tobin proposed A Two-stage Process In
Which The Required Risk Ceiling Could Be Maintained By Mixing Risky And
Riskless Assets, and Markowitz demonstrated the benefits of a diversified
portfolio in which the prices of it assets would not rise and fall together,
using the statistical concept of covariance.
• William Sharpe tendency of the price of an asset to rise and fall in concert
with the all-share index, assigning the title "Beta" to its mathematical
definition, and used it to derive a pricing method know as the Capital Asset
Pricing Model
• Fischer Black and Myron Scholes [56] developed the Black-scholes Model -
the expected volatility of an asset is reflected in its price in the options
markets.
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Corporate Finance. Franco Modigliani and Merton Miller, shareholders
should be indifferent to the level of a corporation's debts provided that it
was possible to repay them costlessly with money available at a riskless
rate of interest. Other economists augmented the theory with allowances for
taxation and information.

Recent Developments
The Greenspan Era
• The use of Keynesian fiscal policy to regulate output was considered
ineffective and inflationary, and monetarist attempts to control the money
supply were seen to have been unsuccessful.
• The new rôle of fiscal policy was the maintenance of fiscal stability,
responsibility for the management of the economy had become the
exclusive function of monetary policy, and monetary policy was confidently
expected to prevent serious interruption to economic growth.
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 Post-Great Recession thinking
• The financial crisis of 2008 and the resulting Great Recession
prompted much re-thinking of economic theory.
• Professor Shin of Princeton University reported that the "race is on"
to add a new perspective to macroeconomics by the incorporation
into it of a new theory of financial economics, and there was new
thinking about the use of financial regulation to reduce the risk of
fresh financial shocks.
• Britain's Gordon Brown for a coordinated fiscal stimulus to counter
the expected recessionary effects of the financial crisis. The idea was
dismissed as ineffective by some economists, and as inflationary by
others
• Although fiscal stimulus packages were implemented during the
recession of 2009, they were not sustained and programmes of fiscal
contraction were widely introduced in 2011
9/19/2019 Ijaz 45
• The main reason that was given for that reversal of fiscal policy was the fear that
operators in the bond market would lose confidence in governments' ability to
service the levels of Public Debt (how much a country owes to lenders outside
of itself. These can include individuals, businesses, and other governments).
• The European Union's Fiscal Compact (which places mandatory restrictions upon
the use of fiscal policy by its signatories) remain a matter of controversy.
• United States government has not introduced a major programme of fiscal
contraction, and the Congress has not been able to agree on a plan for the
reduction of the government's budget deficit.
• A controversy also remains unresolved concerning the merit of techniques known
as Quantitative Easing by which central banks seek to increase the money
supply in order to relieve credit crunches and stimulate economic activity.
• The history of economic thought has taken an unexpected turn, and a new
consensus on economic management has not yet emerged.

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 PHILOSOPHY
OF
ECONOMICS
9/19/2019 Ijaz 47
 Philosophy of Economics
• The philosophy of economics concerns itself with conceptual, methodological, and
ethical issues that arise within the scientific discipline of economics.
• The primary focus is on issues of Methodology and Epistemology (the theory of
knowledge, especially with regard to its methods, validity, and scope, and the
distinction between justified belief and opinion.)—the methods, concepts, and
theories through which economists attempt to arrive at knowledge about economic
processes.
• Philosophy of economics is also concerned with the ways in which ethical values are
involved in economic reasoning—the values of human welfare, social justice, and the
tradeoffs among priorities that economic choices require.
• Economic Reasoning has implications for justice and human welfare; economic
reasoning often makes inexplicit but significant ethical assumptions that philosophers
of economics have found it worthwhile .
• Philosophy Of Economics is concerned with the Concrete Social Assumptions that are
made by economists.
• Philosophers have given attention to the Institutions And Structures through which
economic
9/19/2019
activity and change take place. Ijaz 48
• What Is A “Market”?
• Are there alternative institutions through which modern economic activity can proceed?
• What are some of the institutional variants that exist within the general framework of a
market economy?
• What are some of the roles that the state can play within economic development so as to
promote efficiency, equity, human well-being, productivity, or growth?
• The dimension of the philosophy of economics that falls within the philosophy of science has to
do with the status of economic analysis as a body of empirical knowledge.
Primary questions include:
• What is economic knowledge about? What kind of knowledge is provided by the discipline of
economics? How does it relate to other social sciences and the bodies of knowledge
contained in those disciplines? How is economic knowledge justified or evaluated? Does
economic theory purport to offer abstract theories of real social processes—their
mechanisms, dynamics, and institutions? What is the nature of economic explanation? What
is the relationship between abstract mathematical models and theorems, on the one hand,
and the empirical reality of economic behavior and institutions, on the other? What is the
nature of the concepts and theories in terms of which economic beliefs are formulated? Are
there lawlike regularities among economic phenomena? What is the status of predictions in
economics?
9/19/2019 Ijaz 49
The Intellectual Role Of The Philosophy Of Economics
• So what constructive role does philosophy have to play in economics?
• There are several.
• First, philosophers are well prepared to examine the logical and rational
features of an empirical discipline. How do theoretical claims in the discipline
relate to empirical evidence? How do pragmatic features of theories such as
simplicity, ease of computation, and the like, play a role in the rational
appraisal of a theory? How do presuppositions and traditions of research serve
to structure the forward development of the theories and hypotheses of the
discipline?
• Second, philosophers are well equipped to consider topics having to do with the
concepts and theories that economists employ—for example, economic
rationality, Nash Equilibrium(the theory of knowledge, especially with regard to
its methods, validity, and scope, and the distinction between justified belief and
opinion.), perfect competition, transaction costs, or asymmetric information.
Philosophers can offer useful analysis of the strengths and weaknesses of such
oncepts and theories—thereby helping practicing economists to further refine
the theoretical
9/19/2019 foundations of their discipline.
Ijaz 50
• The Philosopher serves as a conceptual clarifier for the discipline, working
in partnership with the practitioners to bring about more successful
economic theories and explanations.
• So far we have described the position of the philosopher as the
“underlaborer” of the economist. But in fact, the line between criticism and
theory formation is not a sharp one.
• Daniel Hausman, there is a very constructive crossing of the frontier that is
possible between Philosophy and Economics; and that philosophical
expertise can result in significant substantive progress with regard to
important theoretical or empirical problems within the discipline of
economics.
• In order to accomplish these goals, the Philosopher Of Economics has a
responsibility parallel to that of or Philosopher Of Physics: he or she must
attain a professional and rigor the philosopher of biology ous understanding
of the discipline as it currently exists.
• The most valuable work in the philosophy of any science proceeds from the
basis of significant expertise on the part of the philosopher about the “best
practice,” contemporary debates, and future challenges of the discipline.
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Important Questions In The Philosophy Of Economics
• These questions serve to give the reader of the types of questions
that philosophers have posed to the discipline of economics.
• Are there laws in economics? The concept of a “law of nature” has
been central to our understanding of the natural sciences. The
intellectual power of classical physics derived from the fact that it was
capable of advancing statements of physical laws that were simple and
universal—laws of gravitation and planetary motion, optics,
electricity and magnetism, etc.
• Is this an essential feature of a successful empirical science? And does
economics possess such laws? Several authors are affirmative on both
points (Kincaid 1996), (Rosenberg 1976). However, several points have
emerged in recent discussions of the social sciences that lead to doubt
about the centrality of laws in the social sciences—including
economics.
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• First, there are significant differences between natural and social
phenomena.
• Second, it is clear that there are regularities within the discipline of
empirical economics—consumption usually rises when prices fall,
trade increases when transport costs fall, and infant mortality usually
falls when states devote more resources to public health.
• The foundational assumptions of economic theory plainly do not fall
in the category of “laws of nature.”
• The assumption of economic rationality does not constitute a
universal generalization about individual behavior.
• IT is more justifiable to seek out causal mechanisms rather than social
laws. Are the assumptions of economics “realistic”?

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• On Friedman’s view, The Value Of A Theory Is Entirely Expressed In Its
Ability To Predict Observable Phenomena; the Theory Is An
Instrument Of Prediction.
• The best explanation of a theory’s having generally reliable
predictions about a range of phenomena is that the mechanisms that
it postulates are in fact true.
• So it is a deficiency in a theory that the mechanisms it postulates are
implausible or false.
• Daniel Hausman puts forward a realist approach to economic theory
(Hausman 1992). Within this approach, the goal for the economist is
to arrive at assumptions that are approximately true.
• Methodological Principle suggests that economists ought to pay
greater attention to economic institutions, comparative economic
analysis, and economic history.
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Are Economic Theories Testable Or Falsifiable?
• This requires us to ask the question, What is the theory intended to describe,
predict, or explain?
• A Theory Has Empirical Content if it makes assertions about causal processes
underlying a domain of phenomena and those assertions have consequences
for observable states of the world.
• Under these circumstances it is possible for us to perform experiments (arrange
the world in a certain way, observe the outcome, and compare with the
theory’s predicted outcome), controlled observations (collect “before-after”
cases and compare the outcomes with the theory’s predictions), piecemeal
observations (examine elements of process in order to assess whether the
postulated causal processes did in fact occur), and so on.
• Through These Efforts We Can Bring Empirical Evidence To Bear On The Task Of
Assessing The Truth Of The Hypothesis.

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• So the question before us is this: does economic theory contain
substantive assumptions about the causal workings of the economic
world that are intended to have implications for future observable
states of the economic world?
• And are we able to perform observations of states of the world that
confirm or falsify the theory (Hands 1992)?
• In principle, it is clear that the answer to this question is affirmative.
• Consider a range of theories of specific economic processes—economic
growth, trade, unemployment, wages, or discrimination.
• Such theories have predictive consequences, and it is not especially
difficult to describe the observations that would need to be secured
to test these theories.

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• The Epistemic (branch of philosophy concerned with the theory of knowledge)
difficulty comes later: most theories of complex phenomena are in fact
falsified—without necessarily being far from the mark in their description of
the underlying processes.
• So how are we to distinguish among “Falsified” Theories to single out the more
likely from the less likely (Lakatos 1974)?
• Are economic theories simply formal mathematical systems, without empirical
relevance?
• Alexander Rosenberg makes a case for the formalist view of economic theory,
having concluded that Economists Have Not Succeeded In Producing Empirical
Theories Or Explanations Of Real Empirical Phenomena.

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• The “Theory” is a set of abstract and non-empirical axioms, and the exercise of
“doing economics” is one of deriving theorems from these axioms (sayings).
• Is this a satisfactory way of understanding the intellectual program of economics,
however? It is not.
• The intellectual charge for the discipline of economics—not always or
successfully achieved—is to provide a social-scientific basis for understanding,
explaining, and, perhaps, predicting economic phenomena.
• Why do interest rates affect investment levels? Why are inflation and
unemployment related? Why is economic growth more rapid in the context of
one set of institutions than another? What are the causal links that secure
connections among economic variables?
• Mathematization of economics ought to be construed as a means to an end
rather than the end itself. The formal or mathematical machinery of economics
is intellectually valuable only insofar as it contributes to a better understanding of
real, empirically given economic processes, causes, and systems.
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• What is the status of the concept of economic rationality?
• The concept of economic rationality is foundational within economic
theory, and especially so within neoclassical economics.
• So a special concern for philosophers of economics has been to provide
critical examination of the theory of economic rationality.
• First, philosophers have devoted a great deal of attention to the gap
between a theory of utility and a theory of individual preference.
• Second, they have taken issue with the assumption of egoism or
rational self-interest that is presupposed in the pure theory.

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• Third, philosophers and others have pointed out that real psychological
actors reason in ways that are at odds with the pure theory of
economic rationality (Simon 1983), (Kahneman, et al. 1982).
• Fourth, philosophers and others have devoted significant attention to
the assumptions underlying game theory (Game theory explores the
possible outcomes of a situation in which two or more competing
parties look for the course of action that best benefits them. No
variables are left to chance, so each possible outcome is derived from
the combinations of simultaneous actions by each party.).
• Finally, “Economic Rationality” in real human persons through
experiment. For example, Robert Axelrod has used experimental
settings to examine how real human reasoners deal with prisoners’
dilemmas; he finds that experimental subjects are frequently able to
achieve cooperation rather than defection, contrary to the prediction
of two person game theory.
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• What is the role of ethical values in economics? Economists
often portray their science as Value-free”—as a technical
analysis of the demands of rationality in the allocation of
resources rather than a specific set of value or policy
commitments.
• It is for citizens and policy makers to make the judgments
about the public good that are needed in order to decide
whether a given road or bridge is socially desirable; it is for
the technical specialist to provide design and estimate of
costs.
• Economic Theory contains a family of substantive
presuppositions about the nature of the good—individual and
social—that directly influence the policy recommendations to
which economic theory gives rise.
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• So the premises and assumptions of economics are
substantially intertwined with normative assumptions about
the good human life and the good society.
• In general, it seems fair to say that the ethical assumptions
that Neoclassical Economics (Neoclassical economics is an
approach to economics focusing on the determination of
goods, outputs, and income distributions in markets through
supply and demand) presupposes fall together into a family of
normative ideals (In philosophy, normative statements make
claims about how things should or ought to be, how to value
them, which things are good or bad, and which actions are
right or wrong) that privilege individualism, inequality, and
the minimal exercise of public policy.
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Is Distributive Justice A Topic For Economists?
• A market economy implies some degree of inequality, of
various kinds:
a. Inequalities Of Outcomes (Wealth And Income),
b. Inequalities Of Opportunity,
c. Inequalities Of Power And Influence,
d. Inequalities Of Levels Of Well-being (Health, Longevity,
Education).
• What sorts of inequalities are morally acceptable in a just
society?
• How extensive can inequalities be before they create
differences among citizens that interfere with their human
dignity and the preconditions of democracy?
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What sort of social world does economic theory presuppose?
• In considering this type of question, philosophers begin to
move into substantive debates about the nature of the
empirica l phenomena under study.
• The discussion falls under the rubric (title) of “criticism,” in
that it focuses on blind spots that can be discerned within the
visual field of economic theorizing.
• Economists make assumptions about the institutions that
constitute the framework of economic transactions, and these
assumptions are sometimes inflexible and unrealistic.
• It is therefore worthwhile for philosophers to devote attention
to the shortcomings of the social institutional assumptions
that economists often make.
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Are There Alternative Economic Institutions That Can Work In A
Modern Economy?
• Economic activity within a modern society requires institutions that define
the use, management, and enjoyment of resources; the deployment and
management of labor; and the management of enterprises.
• Neoclassical Economics(focusing on the determination of goods, outputs,
and income distributions in markets through supply and demand)
presupposes private ownership of capital; “free” workers who do not own
property; and states that have minimal economic influence.
• Are there other institutions through which economic activity might be
conducted within a modern and productive society (Elster and Moene
1989)?
• For example, what is the economic logic of workers’ cooperatives? How
could worker-controlled pension funds be used to enhance democratic
equality? Is there more to be learned from the experience of market
socialism, state ownership, or workers’ control of industrial processes? Are
alternative institutions feasible? Are they efficient? Are they equitable?
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What Can We Learn From Comparative Economic Analysis?
• Economic development has proceeded in very different ways in different nations
and regions since the emergence of modern technologies and economic
institutions. Market institutions developed very differently in Britain, France, and
the United States during the 19th and 20th centuries.
• Collectivized Economies followed different institutional trajectories in Yugoslavia,
the USSR, and China.
• What can we learn about economic processes and dynamics by studying and
comparing national economies in significant detail? For example, what do the
parallel yet different experiences of China and India since 1945 teach us about
alternative pathways of economic development (Drèze and Sen 1989)?
• Does this sort of comparative economic research provide a “post cold war” basis
for analyzing the political economy of development?
• As Economists Come To Confront The Intellectual Challenge Of Providing
Realistic Causal Accounts Of Economic Systems, They Will Be Able To Arrive At
Significant New Insights Through Comparative Economic Analysis.
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What Is The Intellectual Relevance Of The History Of Western Industrial
Capitalism For Economic Theory?
• Re-examination of the history of European capitalism suggests that there
were feasible alternative paths of economic development besides mass
manufacture and specialized production (Sabel and Zeitlin 1997).
• Mass manufacture and mass unskilled labor represented one important
alternative, but there were other historically feasible alternatives.
• As Sabel and Zeitlin demonstrate, another feasible system of industrial
production involves highly skilled workers, flexible production, and
flexible tools and production processes (Sabel 1985).
• Once again, the moral for the discipline of economics is an important
one : It is possible to arrive at more empirically satisfactory economic
theories when we consider the range of institutions through which
economic activity and growth has taken place.
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 Conclusions
• The philosophy of economics serves as a source of sympathetic yet rigorous
critique of the science of economics, broadly construed.
• It raises familiar questions about the Epistemology of this branch of the social
sciences—questions about theory structure, theory confirmation, explanatory
adequacy, and the like.
• It questions the implicit normative assumptions that economics contains. It
raises some of the ethical questions that economics is almost forced to
confront—but rarely does.
• And it suggests the value of a broader and more eclectic approach to economic
theorizing—making more extensive use of alternative theoretical approaches,
incorporating more study of economic institutions, paying more attention to
comparative economic trajectories, and giving more rigorous attention to
economic history.
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