Economic Thoughts

Various Schools of Economic Thoughts

Different School of Economic thoughts

• Classical
• Neo Classical
• Keynesian
• Monetarism
• New Classical

What is Classical Economics?

The Classical school, which is regarded as the first school of economic thought, is associated with the 18th Century Scottish economist Adam Smith, and those British economists that followed, such as Robert Malthus and David Ricardo.

The term classical economics was first used by Karl Marx (1818 – 1883) to describe early economists like Adam Smith (1723 – 1790), David Ricardo (1772 – 1823), John Stuart Mill (1806 – 1873) and Thomas Robert Malthus (1766 – 1834). Most important is Smith’s work An Inquiry into the Nature and Causes of the Wealth of Nations (1776) because it marks the starting point of economics as a science.

• The main idea of the Classical school was that markets work best when they are left alone, and that there is nothing but the smallest role for government. 

• The approach is firmly one of laissez-faire and a strong belief in the efficiency of free markets to generate economic development.

• Markets should be left to work because the price mechanism acts as a powerful ‘invisible hand’ to allocate resources to where they are best employed.

• In terms of explaining value, the focus of classical thinking was that it was determined mainly by scarcity and costs of production.

In terms of the macro-economy, the Classical economists assumed that the economy would always return to the full-employment level of real output through an automatic self-adjustment mechanism.

It is widely recognized that the Classical period lasted until 1870.

Neo-classical

The neo-classical school of economic thought is a wide ranging school of ideas from which modern economic theory evolved. The method is clearly scientific, with assumptions, and hypothesis and attempts to derive general rules or principles about the behavior of firms and consumers.

For example, neo-classical economics assumes that economic agents are rational in their behavior, and that consumers look to maximize utility and firms look to maximize profits. 

The contrasting objectives of maximizing utility and profits forms the basis of demand and supply theory. Another important contribution of neo-classical economics was a focus on marginal values, such as marginal cost and marginal utility.

Neo-classical economics is associated with the work of William Jevons, Carl Menger and Leon Walras.

Keynesian economics

Keynesian economists broadly follow the main macro-economic ideas of British economist John Maynard Keynes.

• The central tenet of this school of thought is that government intervention can stabilize the economy.

Relating to the ideas of John Maynard Keynes, who believed that, in a recession, the economy can be made to grow and unemployment reduced by increasing government spending and making reductions in interest rates. 

• Theory based on the ideas of economist John Maynard Keynes that optimum economic performance could be achieved by influencing aggregate demand through government fiscal (public spending and taxation) policy, not through the free market philosophy characterized by the classical and neo-classical schools.

• In essence, Keynesian economists are skeptical that, if left alone, free markets will inevitably move towards a full employment equilibrium.

The Keynesian approach is interventionist, coming from a belief that the self interest which governs micro-economic behavior does not always lead to long run macro-economic development or short run macro-economic stability.

• Keynesian economics is essentially a theory of aggregate demand, and how best to manipulate it through macro-economic policy.

• Keynes is widely regarded as the most important economist of the 20th Century, despite falling out of favor during the 1970s and 1980s following the rise of new classical economics.

• Keynesian economics dominated economic theory and policy after World War II until the 1970s, when many advanced economies suffered both inflation and slow growth, a condition dubbed “stagflation.”

Background About John Maynard Keynes (1883–1946)

Keynesian economics gets its name, theories, and principles from British economist John Maynard Keynes (1883–1946), who is regarded as the founder of modern macroeconomics. His most famous work, The General Theory of Employment, Interest and Money, was published in 1936. But its 1930 precursor, A Treatise on Money, is often regarded as more important to economic thought. Until then economics analyzed only static conditions—essentially doing detailed examination of a snapshot of a rapidly moving process. Keynes, in Treatise, created a dynamic approach that converted economics into a study of the flow of incomes and expenditures. He opened up new vistas for economic analysis.

In The Economic Consequences of the Peace in 1919, Keynes predicted that the crushing conditions the Versailles peace treaty placed on Germany to end World War I would lead to another European war.

He remembered the lessons from Versailles and from the Great Depression, when he led the British delegation at the 1944 Bretton Woods conference—which set down rules to ensure the stability of the international financial system and facilitated the rebuilding of nations devastated by World War II. Along with U.S. Treasury official Harry Dexter White, Keynes is considered the intellectual founding father of the International Monetary Fund and the World Bank, which were created at Bretton Woods.

Monetarism Economics

Monetarism is mainly associated with Nobel Prize–winning economist Milton Friedman. In his seminal work A Monetary History of the United States, 1867–1960, which he wrote with fellow economist Anna Schwartz in 1963, Friedman argued that poor monetary policy by the U.S. central bank, the Federal Reserve, was the primary cause of the Great Depression in the United States in the 1930s.

Monetarism gained prominence in the 1970s. In 1979, with U.S. inflation peaking at 20 percent, the Fed switched its operating strategy to reflect monetarist theory. 

The foundation of monetarism is the Quantity Theory of Money. It says that the money supply multiplied by velocity (the rate at which money changes hands) equals nominal expenditures in the economy (the number of goods and services sold multiplied by the average price paid for them).

Difference Between Keynesian and Monetarism (Theory Widely used in 20th Century)

Keynesianism held sway for the first quarter century after World War II. But the monetarist challenge to the traditional Keynesian theory strengthened during the 1970s, a decade characterized by high and rising inflation and slow economic growth. Keynesian theory had no appropriate policy responses, while Friedman and other monetarists argued convincingly that the high rates of inflation were due to rapid increases in the money supply, making control of the money supply the key to good policy.­

In 1979, Paul A. Volcker became chairman of the Fed and made fighting inflation its primary objective. The Fed restricted the money supply (in accordance with the Friedman rule) to tame inflation and succeeded. Inflation subsided dramatically, although at the cost of a big recession.­

Monetarism had another triumph in Britain. When Margaret Thatcher was elected prime minister in 1979, Britain had endured several years of severe inflation. Thatcher implemented monetarism as the weapon against rising prices, and succeeded in halving inflation, to less than 5 percent by 1983.­

But monetarism’s ascendance was brief. The money supply is useful as a policy target only if the relationship between money and nominal GDP, and therefore inflation, is stable and predictable. That is, if the supply of money rises, so does nominal GDP, and vice versa. To achieve that direct effect, though, the velocity of money must be predictable.­

Although most economists today reject the slavish attention to money growth that is at the heart of monetarist analysis, some important tenets of monetarism have found their way into modern nonmonetary analysis, muddying the distinction between monetarism and Keynesianism.

Probably the most important is that inflation cannot continue indefinitely without increases in the money supply, and controlling it should be a primary, if not the only, responsibility of the central bank.

New classical

The New Classical school is the modern adaptation of the classical school, arose out of the failures of the Old Keynesian schools during the failure of the Phillips Curve and stagflation in the 1970’s.

It is an attempt to explain macro-economic problems and issues using micro-economic concepts like rational behavior, and rational expectations.

New classical economics is associated with the work of Chicago economist, Robert Lucas.

Both Keynesians and monetarists came under scrutiny with the rise of the new classical school during the mid-1970s.

New Generation Keynesian

A new generation of Keynesians that arose in the 1970s and 1980s argued that even though individuals can anticipate correctly, aggregate markets may not clear instantaneously; therefore, fiscal policy can still be effective in the short run.

The global financial crisis of 2007–08 caused a resurgence in Keynesian thought. It was the theoretical underpinnings of economic policies in response to the crisis by many governments, including in the United States and the United Kingdom.

But the 2007–08 crisis also showed that Keynesian theory had to better include the role of the financial system. Keynesian economists are rectifying that omission by integrating the real and financial sectors of the economy.

Supply Side Economics and Demand Side Economics 

What drives economic growth: supply or demand? It’s one of the most fundamental and fiercely argued debates in economics. How economists and administrations come down on this question drives everything from debates about marginal tax rates for the wealthy to how governments should respond during a recession.

Supply Side Economics or Trickle Down Economics 

Supply-side economics is the theory that says increased production drives economic growth. The factors of production are capital, labor, entrepreneurship, and land.

Supply-side fiscal policy focuses on creating a better climate for businesses. Its tools are tax cuts and deregulation. 

• According to the theory, companies that benefit from these policies are able to hire more workers. The resultant job growth creates more demand which further boosts the economy

Supply-side works by giving incentives to businesses to expand. Deregulation removes restrictions on their growth. It lowers the costs associated with complying. Companies are then free to explore new areas of commerce.

• The theory is called supply-side economics because it focuses on what the government can do to increase the overall supply of goods and services that are created in the economy.

A corporate tax cut gives businesses more money to hire workers, invest in capital equipment, and produce more goods and services.

• An income tax cut increases the dollars per hour worked. It boosts workers' incentive to remain employed and creates more labor. That is one of the four factors of production that drive supply. Adding to supply will allow the economy to grow.

Critics of supply-side economic policy has given it the pejorative nickname “trickle-down economics.” This is because supply-side economists believe that their policies will benefit wealthier people first, then eventually filter down to everybody else.

• Trickle-down economics says what's good for the wealthy will trickle down to everyone in the society. Proponents believe that investors, savers, and company owners are the real drivers of growth.

• Advocates of trickle-down economics promise that businesses will use the extra cash from tax cuts to expand. Investors will use their tax cut windfall to buy more companies or stocks. Owners will invest in their operations and hire workers.

• Supply-siders claim that this greater growth will always make up for the lost tax revenue.

Opponents of supply-side economics argue that rather than increasing revenue for the government, lowering taxes will instead increase the deficit. As a result, the government will have to cut programs or raise other taxes to make up for this shortfall, unless it wishes to run a permanent deficit.

Supply-Side Economics in 4 Steps - Here’s the thinking behind supply-side economics and how it works in four steps:

• Corporations and businesses that produce goods and services are responsible for growing the economy.

• Instead of taking their money through taxes, governments let these producers reinvest their capital in their companies. In practical terms, this means lower tax rates and decreased regulation.

• These actions enable entrepreneurs and companies to produce more goods, stimulating the economy and leading to more growth.

• In turn, this economic growth will offset the costs of lowering taxes, ultimately leading to increased tax revenues for governments.

What Is Demand-Side Economics

Demand-side economics is frequently referred to as “Keynesian economics” after John Maynard Keynes, a British economist who outlined many of the theory’s most important attributes in his General Theory of Employment, Interest, and Money.

According to Keynes’ theories, economic growth is driven by the demand for (rather than the supply of) goods and services. Simply put, producers won’t create more supply unless they believe there’s demand for it.

In contrast to supply-siders, Keynesians place less emphasis on overall levels of taxation, and believe much more in the importance of government spending, especially during periods of weak demand.

It states that demand is the primary driving force of economic growth. Supporters use fiscal policy to better the lives of consumers regardless of whether they work or not

According to the theory, putting more money into consumers' pockets directly drives the demand that increases growth.

What Are the Different Demand-Side Policies - Broadly speaking, there are two-prongs to demand-side economic policies: an expansionary monetary policy and a liberal fiscal policy.

In terms of monetary policy, demand-side economics holds that the interest rate largely determines the liquidity preference, i.e., how incentivized people are to spend or save money. During times of economic slowness, demand-side theory favors expanding the money supply, which drives down interest rates. This is thought to encourage borrowing and investment, the idea being that lower rates make it more appealing for consumers and businesses to buy goods or invest in their businesses—valuable activities that increase demand or create jobs.

When it comes to fiscal policy, demand-side economics favors liberal fiscal policies, especially during economic downturns. These might take the form of tax cuts for consumers, like the Earned Income Tax Credit, or EITC, which was an important part of the Obama administration’s efforts to fight the Great Recession.

Another typical demand-side fiscal policy is to promote government spending on public works or infrastructure projects. The key idea here is that during a recession it’s more important for the government to stimulate economic growth than it is for the government to take in revenue. Infrastructure projects are popular options because they tend to pay for themselves in the long term.

A Brief History of Demand-Side Economics

Before Keynes, the field of economics was dominated by classical economics, based on the works of Adam Smith. Classical economics emphasizes free markets and discourages government intervention, believing that the “invisible hand” of the market is the best way to efficiently allocate goods and resources in a society.

The dominance of classical economic theory was severely challenged during the Great Depression when a collapse in demand failed to result in increased savings or lower interest rates that might stimulate investment spending and stabilize demand.

Writing in his General Theory of 1936, Keynes argued persuasively that, contrary to classical economics, markets have no self-stabilizing mechanism. According to his account, producers make investment decisions based on expected future demand. If demand appears weak (as it does during a recession), businesses are less likely to produce more goods and services, which in turn results in fewer people with jobs or income that might stimulate economic activity. In cases like this, Keynes argued, governments could stimulate demand by increasing spending.

What Is the Differences Between Supply-Side Economics and Demand-Side Economics?

Producers vs. consumers: Demand-side economists argue that instead of enabling businesses to produce more goods, as supply-side economists want to, governments should instead focus on helping the people who buy goods and services, who are far more numerous. Governments can do this by spending money to create jobs, which will in turn give people more money to put toward products and services.

Government intervention: While supply-side economists argue for minimal government oversight of production and the economy, demand-side economists like Keynes generally argue for increased regulation. For instance, When demand for goods weakens—as it does during a recession—the government has to step in to stimulate growth. This will create deficits in the short-term, Keynesians acknowledge, but as the economy grows and tax revenues increase, the deficits will shrink and government spending can be reduced accordingly.

Terms Used in Article :-

Laissez-faire - The view, backed by supporters of the free market, that economic performance is optimized when there is no government interference. One of the basic tenets of classical economics.

Invisible Hand - Economic theory, posited by Scottish economist Adam Smith, that participants in a free market act out of self-interest and that their interaction with other participants will automatically produce the most favorable outcome for all concerned (i.e. the most productive and efficient exchange of goods and services).

Liberal Economics - Another term for the classical theories of economics emphasizing the concept of the free market and laissez-faire policies, with the government's role limited to providing support services.