ECONOMICS

What Does It Mean To Me?

THEORIES OF
ECONOMICS
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Economists have
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 The major theorists in each
area are:
1) Neo-classical
Adam SMITH Jean-Baptiste
SAY
David RICARDO Irving
FISHER
2)Keynesian
Thomas MALTHUS
John Maynard KEYNES Sir John
Richard HICKS
Sir Roy Forbes HARROD
3) Monetarist
Milton FRIEDMAN
Friedrich August Von
HAYEK
 NEO-CLASSICAL THEORY

The term ‘classical’ refers to

work done by a group of economists
in the 18th and 19th centuries.
Much of this work was developing
theories about the way markets and
market economies work. Much of
this work has subsequently been
updated by modern economists.
Adam SMITH (1723-
1790)
*Father of Economics
*Developed much of
the theory about
markets that we
regard as standard
theory now.
• Scottish
• Graduated from
Glasgow at the age
of 17
• fellow at Oxford
• lecturer in
 Adam Smith argues
that it was market
forces that ensured
the production of the
right goods and
services. This would
happen because
producers would want
to make profits by
providing them.
Without government
intervention, thus
forming laissez-
faire environment,
public well-being
his was
wouldtheincrease
basis offrom
the free market economy
COMPETITION would mean
that producers would
try to outsell each
other and this would
bring prices down to
their lowest possible
levels (making minimal
profit). If there is
not enough competition,
this would mean that
producers would make
more profit. This
would soon attract more
producers into the
industry, bringing
prices down. All this
would end up benefiting
 Smith also recognized the danger of
monopolies:
“A monopoly granted either to an
individual or to a trading
company has the same effect as a
secret in trade or manufacturers.
The monopolists, by keeping the
market constantly under-stocked,
by never fully supplying the
effectual demand, sell their
commodities much above the
natural price, and raise their
emoluments, whether they consist
These concepts developed by
SMITH are so fundamental
that they are still present
in nearly all economics
courses.

(something to look forward

to!!!!)
 Thomas MALTHUS
(1766-1834)
*Cambridge in
mathematics
*widely considered to
be the founder of
social demography
*greater contribution
in the area of
ecological-
evolutionary theory
*His essay, “The
Principle of
Population,” points
out that our ability
Malthus believed that population growth was
continuously being checked--held down tto
sustainable levels--in all past, present,
and future societies. He described
environmental constraints within which all
societies must exist, and these constraints
were a major obstacle to any real progress.
The constant effort towards population,
which is found to act even in the most
vicious societies, increases the number of
people before the means of subsistence are
increased. The food previously divided
between 7 million must now be divided
between 8 million. The poor consequently
must live much worse, and many of them
reduced to severe distress.
 The number of labourers also being above
the proportion of the work in the market,
reduces the price of labor while the price
of provisions would, at the same time,
tend to rise. The labourer, therefore,
must work harder to earn the same as
before.
During this season of distress, the
discouragements of marriage, and the
difficulty of rearing a family are so
great that population is at a stand.
In the meantime, the cheapness of labor
encourages the cultivators to employ more
labor and expand production until the
means of subsistence is in the same
Along with Malthus,
David RICARDO
(1772-1823), was
concerned about the
impact that rising
populations would
have on the economy.
He developed two
key theories still
important today:
1) Distribution
Theory
2) International
Trade Theory
 Distribution Theory
Ricardo argued that with more
people, more land would have to be
cultivated. However, the return
from the land would not be constant
as the amount of capital available
would not grow at the same rate. In
fact, the land would suffer from
DIMINISHING RETURNS. Extra land
that was brought into cultivation
would become more and more marginal
in terms of profitability, and
eventually returns would not be
enough to attract any further
capital. At this point, the maximum
 International Trade Theory
(COMPARATIVE ADVANTAGE)
Ricardo’s theory focused on
comparative costs and
looked at how a country
could gain from trade when
it had relatively lower
costs (I.e. comparative
advantage)
The original example focused on the trade
in wine and cloth between England and
Portugal. Ricardo showed that if one
country produced a good at a lower
opportunity cost than another country,
then it should specialize in that good.
The other country would therefore
specialize in the other good, and the two
 If all countries
specialized where
they had a
comparative
advantage, then the
level of world
welfare should
increase.
Jean-Baptiste SAY
(1776-1832) was a
French businessman,
which explains why he
was responsible for
introducing the work
of Adam Smith to
Europe. Say can take
credit for the way in
which we tend to
divide the FACTORS
OF PRODUCTION into
Land (all natural
resources, Labor (all
human resources, and
Capital (man-made
Say was also responsible for
introducing the concept of
ENTREPRENEUR into economics.
However, he is best known for his
“LAW OF MARKETS” or Say’s Law,
which states:

“Supply creates it’s own

demand.”
 Say’s Law provides justification
for the Classical view that the
economy will tend towards full
employment. This is because,
according to this law, any
increase in output of goods and
services (supply) will lead to an
increase in expenditure to buy
those goods and services (demand).
There will not be any shortage of
demand and there will always be
jobs for all workers (Full
Employment). If there was any
unemployment it would simply be
temporary as the pattern of demand
shifted. However, equilibrium
 Irving FISHER (1867-
1947) graduated from Yale
specializing in
mathematics. One area he
developed was index
numbers. Index numbers
that we use today include
the FTSE index to measure
share values and the RPI
to measure inflation. He
also wrote about and
campaigned for world
peace, healthy eating and
healthy lifestyle. Much
of the Classical and
Monetarist theory of
 Equation of Exchange

The Fisher equation appears in various

guises, but perhaps the most common is:

MV=PT
Where:

M is the amount of money in

circulation
V is the velocity of circulation
of that money
P is the average price level
 MV = PT
This equation is in fact an identity as
it will always be true.
At its simplest level you could imagine
an economy that has a good money supply
of $5m. If this $5m is on average used
20 times a year, it will have generated
$100m of spending. In the Fisher
equation above M would be equal to $5m, V
would be equal to 20, and PT would be
equal to $100m.
This $100m could be made up of, say 100
transactions of $1m each. PT can
therefore be though of as equivalent to
 Classical economists then
tried to show that V and T
would be stable in the long-
term, thus implying that any
increases in the money supply
(M) would cause prices (P)
to rise-- (i.e. inflation)
 KEYNESIAN THEORY
Keynesian economics is a
theory suggested by John
Maynard Keynes in which
government spending and
taxation is used to
stimulate the economy. This
theory is also called fiscal
policies or DEMAND-SIDE
ECONOMICS.
John Maynard KEYNES
(1883-1946) is perhaps
one of the best known
economists. His work
changed the whole face of
post-World War II economic
policy.
*graduate of Cambridge --
studied Classics and Math.
His reputation does not
rest solely on the General
Theory of Employment,
Interest and Money (1936),
which initiated the so-
called Keynesian
Revolution, but also on
his other writings, most
notably A Treatise on
Keynes argued that an economic slump
was not a long-run phenomenon that we
should all get depressed about and
leave the markets to sort out.
(Remember that Smith felt that government
should always stay out of economic policy---
laissez-faire) Keynes felt that a slump
(or trough) was a short-run problem
stemming from a lack of demand.
If the private sector was not prepared
to spend to boost demand, then the
government should do it instead by
running a budget deficit. When times
were good again and the private sector
was spending again, the government
could trim its spending and pay off the
The idea, according
to Keynes, was to
balance your budget
in the medium term,
not in the short-
run.
One of his best
known quotes
summarizes this
focus on the short-
run policies:
“In the long-run
we are all dead.”
 the
So his theory was that
government should actively
intervene in the economy to
manage the level of demand.
These policies are often known as DEMAND
MANAGEMENT POLICIES, aptly named since
the idea of them is to manage the level
of aggregate demand.
If you want to impress your teacher with
your astute knowledge of Keynesian
economics, you could call these policies
COUNTER-CYCLICAL DEMAND MANAGEMENT
POLICIES. They are called this because
the government should be doing the exact
We can see these policies in the
graph below:
P
R
I
C AD4
E AD3
S
AD2

AD1

Q1 Q2 Q3 Q4
OUTPUT

If aggregate demand is low (AD1), then

government should pursue Reflationary
policies, such as cutting taxes or
boosting government spending to push AD
higher and boost employment and output.
 We can see these policies in the
graph below:
P
R
I
C AD4
E AD3
S
AD2

AD1

Q1 Q2 Q3 Q4
OUTPUT

However, if aggregate demand is high

(AD4), causing demand-pull inflation, then
government should pursue Deflationary
policies, such as increasing taxes or
cutting government spending to reduce
demand.
 Sir Roy HARROD
(1900-1978)
*graduate of Oxford
University
*greatest
contributions were
trying to look at
growth not as simple
static equilibrium,
but as a changing
dynamic situation
* also brought
together in a
mathematical framework
the Multiplier and the
 Harrod brought together
theory about the
multiplier and
accelerator to show
mathematically how they
may interact to change
the pattern of growth,
and exaggerate the trade
cycle.
 MULTIPLIER/ACCELERATOR
INTERACTION
The ACCELERATOR THEORY suggests that a
net investment depends on the rate of
change of output. This means that if
there is an increase in government
expenditure this will boost through
the multiplier. This will, in turn,
boost investment through the
accelerator. Then, because of the
increase in investment, the multiplier
takes over again. As growth reaches
its peak, the accelerator kicks in
reverse and investment then falls.
This has a multiplied effect and the
same process begins but heading
 HARROD-DOMAR MODEL
This model is a model of long-term
growth which tends to show that
there will be no natural tendency
for the economy to have a balanced
rate of growth. Growth is split
into different types and analyzed
accordingly.
The overall conclusion of the model
is that the economy does NOT
naturally find a full-
employment equilibrium.
The policy implication of the
conclusion is that the government
Sir John Richard
HICKS (1904-1989)
*Nobel prize winner
in Economics
*graduate of Balloil
College Oxford
*lectured at the
London School of
Economics.

Much of his work was

done in
microeconomics and
the analytical tool
of indifference
Hicks looked at the role Rate of
of the accelerator Interes LM
curve
theory in affecting t
growth and income and
came to conclusions
similar to those of
Harrod…..that the
accelerator may induce
various fluctuations in IS
curve
the level of output.
Output
He also developed the
IS-LM model. This is a Hicks used this model to
way of modeling explore the assumptions
equilibrium in the concerned with
economy by looking at investment, savings, and
equilibrium in the goods the supply and demand for
and service markets (IS money.
curve) and equilibrium
in the money markets It has become a widely
(LM curve). Where accepted alternative
framework to standard
 MONETARIST THEORY
This school of
thought, suggested
by Milton
Friedman,
stressing the
importance of
stable monetary
growth to control
inflation and
stimulate long-
term growth. The
FEDERAL RESERVE
Federal Reserve: SYSTEM conducts
 MONETARIEST
THEORY
Monetarists are a
group of
economists so
named because of
their
Federal Reserve:
preoccupation with Minneapolis
money and its
Their view that the main cause of changes in
effects.
aggregate output and the price level are
fluctuations in the money supply. The
FEDERAL RESERVE is responsible for monetary
policy in the United States.
Milton FRIEDMAN
(1912- ) is the
best known
monetarist. He is
one of the select
elite in our
Virtual economy who
has won a Nobel
Prize in economics
(1976). He was
born in New York Friedman is a great believer
in the power of the free
and has worked for market and much of his work
the government, has been based on this.
Columbia It was his work that
University, and persuaded Mrs. Thatcher to
University of adopt Monetarist policies in
Chicago. His best- 1979 in Great Britain.
 Friedman has made two particularly
fundamental contributions to the
economic policy debate:
1) Quantity Theory of Money
2) Expectations-augmented Phillips
Curve

He has also been a darling of right-wing

governments throughout the world helping them
to justify their particular brand of ‘laissez-
faire’ economics. In his view, any attempt to
manage the level of demand (as in Keynesian
economics) would simply be de-stabilizing and
make things worse. The role of
government is simply to use its
monetary policy to control inflation
 QUANTITY THEORY OF MONEY
This theory is based of the Fisher
Equation of Exchange, which states
that:
MV = PT
Where:
M is the amount of money in
circulation
V is the velocity of circulation of
that money
P is the average price level
T is the number of transactions
taking place
 Classical economists suggested that V
would be relatively stable and T
would always tend to full employment.
Friedman developed this and tested it
further, coming to the conclusion
that V and T were both independently
determined in the long-run. The
conclusion from this was that:

M
If the money supply P
grew faster than the
underlying growth rate of output there would be
inflation. Inflation would be bad for the
economy because of the uncertainty it created.
This uncertainty could limit spending and also
limit the level of investment. Higher inflation
may also damage our international
competitiveness. Who will want to buy UK goods
when our prices are going up faster than theirs?
Expectations-augmented Phillips Curve

The Phillips Curve showed a trade-off

between unemployment and inflation.
However, the problem that emerged with it in
the 1970s was its total inability to explain
unemployment and inflation going up together
- stagflation. According to the Phillips
Curve they weren't supposed to do that, but
throughout the 1970s they did. Friedman then
put his mind to whether the Phillips Curve
could be adapted to show why stagflation was
occurring, and the explanation he came up
with was to include the role of expectations
in the Phillips Curve - hence the name
'expectations-augmented' Phillips Curve.
 Friedman argued that there were a series of
different Phillips Curves for each level of
expected inflation. If people expected inflation
to occur then they would anticipate and expect a
correspondingly higher wage rise. Friedman was
therefore assuming no 'money illusion' - people
would anticipate inflation and account for it.
We therefore got the situation
LRPC
shown below:
Inflati
on

X Y
8%

V W
5%
U
Pe=8%
Pe=5%
Pe=0%
Unemployment
 Say the economy starts at point
LRPC U, and the government decides
Inflati that it wants to lower the level of
on unemployment because it is too
high. It therefore decide to
boost demand by 5%. The
X Y increase in demand for goods
8%
and services will fairly soon
V W
begin to lead to inflation, and so
5% any increase in employment will
U quickly be wiped out as people
Pe=8%
Pe=0% Pe=5% realize that there hasn't been a
Unemployment real increase in demand.

So having moved along the Phillips Curve from U to V, the firms now begin to
lay people off once again and unemployment moves back to W. Next time
around the firms and consumers are ready for this, and anticipate the inflation. If
the government insist on trying again the economy will do the same thing (W to
X to Y), but this time at a higher level of inflation.

Any attempt to reduce inflation below the level at U will simply be inflationary.
For this reason the rate U is often known as the natural rate of unemployment.
 Friedrich August
von HAYEK (1899-
1992)
*born in Vienna, was a
great believer in free
markets
*Nobel Prize in
Economics.
*passionate opponent
to Socialism and along
with another economist
called Ludwig von
Mises formed the Mont
Pelerin Society. This
society was pledged to
give individual the
freedom to make their
own economic choices
 Hayek did a considerable amount of
work on the trade-cycle theories that
were developed
by his friend von Mises and combined
them with theories on capital. He
looked at how real
wages will usually fall in a
recession causing firms to switch to
more labour-intensive
methods of production. This in turn
will lead investment to fall. In a
boom time the opposite
will occur.

Hayek also argued like Friedman that

the growth of the money supply should
Timeline
of Famous
Economist
s
 THE END

Compiled from internet sources by Virginia

Meachum, Economics Teacher, Coral Springs
High School