School of thought
Intros
Lessons
- The 3 School of Thoughts
- Classical School of Thought
- Keynesian School of Thought
- Monetarist School of Thought
- Classical School of Thought
- Self-regulated economy
- Goes back to Full Employment
- Money Wage is flexible
- Little to no government intervention
- Keynesian School of Thought
- Needs fiscal or monetary policy
- Future expectations
- Sticky money wage rates
- Stays in Recession if no Aid
- Monetarist School of Thought
- Self-regulated economy
- Goes back to Full Employment
- Quantity of money
- Sticky money wage rates
Topic Notes
Introduction to Schools of Economic Thought
Welcome to our exploration of the three main schools of economic thought! As your friendly math tutor, I'm excited to guide you through this fascinating topic. Let's start with the introduction video, which is crucial for grasping these concepts. Now, let's dive into the three primary schools of thought that macroeconomists often discuss. First, we have the Classical school, which emphasizes free markets and minimal government intervention. Next, there's the Keynesian school, which advocates for active government involvement to stabilize the economy. Lastly, we'll explore the Monetarist school, focusing on the importance of money supply in economic stability. Each of these economic theories offers unique perspectives on how economies function and how to address economic challenges. Understanding these schools of thought is essential for anyone interested in economics, as they form the foundation for many modern economic policies and debates. So, let's embark on this journey together and unravel the complexities of these influential economic theories!
Classical School of Thought
The Classical school of thought in economics, originating in the late 18th and early 19th centuries, laid the foundation for modern economic theory. This influential perspective emerged during the Industrial Revolution, a time of rapid economic change and technological advancement. The Classical school's principles continue to shape economic discourse and policy-making to this day.
Origins and Key Proponents
Adam Smith, often referred to as the father of modern economics, initiated the Classical school with his seminal work "The Wealth of Nations" (1776). Smith introduced the concept of the "invisible hand," arguing that individual self-interest in free markets leads to optimal economic outcomes. Following Smith, David Ricardo further developed Classical ideas, particularly in international trade theory with his concept of comparative advantage. John Stuart Mill, another prominent figure, synthesized and refined Classical principles, contributing significantly to economic methodology.
Main Principles
The Classical school is built on several key principles:
- Self-regulating markets: Classical economists believed that free markets naturally tend towards equilibrium without government intervention.
- Say's Law: Named after Jean-Baptiste Say, this principle states that "supply creates its own demand," suggesting that production is the source of demand.
- Full employment: The Classical view holds that economies naturally tend towards full employment in the long run.
- Wage and price flexibility: Classicists argued that prices and wages are flexible, allowing markets to clear and maintain equilibrium.
Self-Regulating Markets and Full Employment
The concept of self-regulating markets is central to Classical economics. This idea posits that free markets, driven by the pursuit of self-interest, will naturally achieve optimal outcomes without government intervention. For instance, if there's an oversupply of a product, prices will fall, encouraging more consumption and less production until equilibrium is restored.
Classical economists argued that economies naturally tend towards full employment. They believed that any unemployment would be temporary, as wage flexibility would ensure that labor markets clear. For example, if unemployment rises, wages would fall, making it more attractive for businesses to hire, thus restoring full employment.
Aggregate Demand and Supply in Classical Economics
The Classical view of aggregate demand and supply differs significantly from modern macroeconomic perspectives:
Aggregate Supply
Classical economists viewed aggregate supply as the primary driver of economic output. They argued that the economy's productive capacity, determined by factors like labor, capital, and technology, sets the level of output. This view is represented by a vertical aggregate supply curve in the long run, indicating that output is fixed regardless of price level changes.
Aggregate Demand
While recognizing the role of demand, Classical economists believed that supply ultimately determines the level of economic activity. They argued that changes in aggregate demand primarily affect prices rather than output in the long run. This perspective is illustrated by a downward-sloping aggregate demand curve, showing an inverse relationship between price level and quantity demanded.
Illustrative Example: The Classical Model
Consider a simplified Classical model of the economy:
- Assume an economy initially at full employment with output Y* and price level P1.
- If aggregate demand increases (AD curve shifts right), the Classical model predicts:
- Short-term: Output may temporarily exceed Y* as prices begin to rise.
- Long-term: Prices will continue to rise (to P2) until output returns to Y*.
- Result: Higher price level, but output remains at full employment level Y*.
This example illustrates the Classical belief in the economy's self-correcting nature and the long-run neutrality of money.
Conclusion
Keynesian School of Thought
The Keynesian school of thought, founded by British economist John Maynard Keynes, revolutionized economic theory in the 20th century. Keynes' seminal work, "The General Theory of Employment, Interest, and Money," published in 1936, laid the foundation for this influential economic perspective. Keynesian economics emerged as a response to the Great Depression, challenging the prevailing Classical economic theories of the time.
At its core, Keynesian economics emphasizes the importance of government intervention in managing economic fluctuations. This stands in stark contrast to Classical economics, which advocated for a hands-off approach and believed in the self-correcting nature of markets. Keynes argued that markets could remain in a state of disequilibrium for extended periods, leading to prolonged economic downturns and high unemployment.
One of the key concepts in Keynesian theory is the idea of "sticky wages." This refers to the tendency of wages to remain rigid or slow to adjust in response to changes in economic conditions. Classical economists assumed that wages would quickly adjust to clear the labor market, but Keynes observed that in reality, wages often resist downward pressure. This stickiness can lead to persistent unemployment during economic downturns.
Keynesian economics places a strong emphasis on aggregate demand as the primary driver of economic activity. Aggregate demand consists of four components: consumption, investment, government spending, and net exports. Keynes argued that during recessions, a fall in aggregate demand could lead to a self-reinforcing cycle of reduced spending, lower production, and increased unemployment. This concept is often illustrated using the Keynesian cross diagram, which shows how changes in aggregate demand affect overall economic output.
In contrast to the Classical view of a vertical aggregate supply curve, Keynesian theory posits that the aggregate supply curve is relatively flat in the short run. This implies that changes in aggregate demand can have significant effects on output and employment without causing substantial changes in the price level. The Keynesian aggregate supply curve becomes steeper in the long run as prices and wages adjust, but the short-run effects on output are considered crucial for economic policy.
Keynesian policy recommendations focus on using fiscal and monetary tools to manage aggregate demand and stabilize the economy. During recessions, Keynesians advocate for expansionary fiscal policies, such as increased government spending and tax cuts, to stimulate economic activity. This approach, often referred to as "pump-priming," aims to boost aggregate demand and pull the economy out of a downturn.
Fiscal policy plays a central role in Keynesian economics. Government spending is seen as a powerful tool to influence aggregate demand directly. Keynesians argue that during economic slumps, increased government expenditure can create a multiplier effect, where the initial spending leads to further rounds of economic activity. This multiplier effect is based on the idea that one person's spending becomes another's income, creating a ripple effect throughout the economy.
Monetary policy is also important in Keynesian theory, although it is generally considered less effective than fiscal policy, especially during severe recessions. Keynesians support the use of expansionary monetary policies, such as lowering interest rates and increasing the money supply, to encourage borrowing and spending. However, they recognize that in some situations, such as a liquidity trap, monetary policy may have limited effectiveness.
The Keynesian approach to economic management has had a profound impact on government policies worldwide. Many countries adopted Keynesian principles in the post-World War II era, leading to the rise of the welfare state and active government involvement in economic affairs. While Keynesian economics has faced criticism and challenges, particularly from monetarist and neoclassical economists, it remains a significant influence on modern macroeconomic policy.
In recent years, there has been a resurgence of interest in Keynesian ideas, particularly in the wake of the 2008 financial crisis and the COVID-19 pandemic. The concept of countercyclical fiscal policy, where governments increase spending during downturns and reduce it during booms, has gained renewed attention. This approach aims to smooth out economic fluctuations and prevent severe recessions.
In conclusion, the Keynesian school of thought represents a fundamental shift in economic thinking, emphasizing the role of government in managing aggregate demand and stabilizing the economy. Its focus on sticky wages, the importance of fiscal policy, and the short-run
Monetarist School of Thought
The Monetarist school of thought, a prominent economic theory that emerged in the mid-20th century, has significantly influenced modern economic policy and understanding. At its core, Monetarism emphasizes the critical role of money supply in determining economic outcomes, particularly inflation and economic growth. This theory, which combines elements of both Classical and Keynesian economics, was primarily developed and popularized by Nobel laureate Milton Friedman and his colleague Karl Brunner.
Milton Friedman, often regarded as the father of Monetarism, argued that the quantity of money in circulation is the primary determinant of economic activity and price levels. His work, along with that of Karl Brunner, challenged the prevailing Keynesian orthodoxy of the time, which focused more on fiscal policy as a tool for economic management. Monetarists contend that changes in the money supply have a direct and predictable effect on nominal GDP and inflation rates.
The Monetarist theory combines aspects of Classical economics, such as the belief in the long-run neutrality of money, with Keynesian insights about short-term economic fluctuations. However, unlike Keynesians, Monetarists argue that these fluctuations are primarily caused by changes in the money supply rather than by variations in aggregate demand. This synthesis creates a unique perspective on macroeconomic dynamics and policy prescriptions.
Central to Monetarist thought is the concept of the money supply. Monetarists argue that controlling the growth rate of the money supply is crucial for maintaining price stability and fostering sustainable economic growth. They posit that excessive growth in the money supply leads to inflation, while insufficient growth can result in economic stagnation or recession. This focus on monetary aggregates distinguishes Monetarism from other schools of economic thought.
In the Monetarist view, the relationship between money supply and economic activity is explained through the concept of the velocity of money. This theory suggests that there is a stable relationship between the quantity of money, its velocity (the rate at which money circulates in the economy), and nominal GDP. Monetarists use this relationship to argue that controlling the money supply can effectively manage inflation and economic growth.
Regarding aggregate demand and supply, Monetarists offer a distinct perspective. They argue that in the short run, changes in the money supply can affect aggregate demand, leading to fluctuations in output and employment. However, in the long run, they believe that the economy will return to its natural rate of output, with changes in the money supply primarily affecting price levels rather than real economic variables.
To illustrate this, consider a graph with aggregate demand (AD) and aggregate supply (AS) curves. In the Monetarist model, an increase in the money supply shifts the AD curve to the right, initially increasing both output and price level. However, as prices adjust over time, the short-run AS curve shifts leftward, returning output to its natural level but at a higher price level. This graphical representation underscores the Monetarist belief in the long-run neutrality of money and the primacy of monetary factors in determining inflation.
Monetarist policy recommendations flow directly from these theoretical foundations. The primary policy prescription is the adoption of a stable, rules-based monetary policy. Friedman famously advocated for a "k-percent rule," where the central bank would increase the money supply by a fixed percentage each year, regardless of economic conditions. This approach aims to provide a stable monetary environment, reducing uncertainty and promoting long-term economic growth.
Monetarists are generally skeptical of discretionary fiscal and monetary policies, arguing that they can be destabilizing and often lead to unintended consequences. Instead, they favor predictable, transparent monetary policies that focus on controlling inflation through careful management of the money supply. This stance has influenced central banking practices worldwide, with many adopting inflation targeting as a key policy objective.
In terms of inflation control, Monetarists emphasize the importance of maintaining a low and stable rate of money supply growth. They argue that inflation is always and everywhere a monetary phenomenon, directly linking excessive money creation to rising price levels. This view has led to a greater focus on inflation targeting in monetary policy frameworks globally.
While Monetarism has faced challenges and critiques, particularly regarding the stability of money demand and the effectiveness
Comparison of the Three Schools
The Classical, Keynesian, and Monetarist schools of thought represent three influential approaches to understanding and managing economic systems. Each school offers unique perspectives on economic theories, policy recommendations, market efficiency, and the role of government in the economy.
Classical School
The Classical school, pioneered by economists like Adam Smith and David Ricardo, emphasizes the self-regulating nature of markets. They believe in the concept of "invisible hand," where free markets naturally achieve equilibrium without government intervention. Classical economists advocate for minimal government involvement, free trade, and flexible prices and wages.
Keynesian School
The Keynesian school, founded by John Maynard Keynes, argues that markets can fail to achieve full employment and economic stability. Keynesians support active government intervention through fiscal and monetary policies to manage aggregate demand and stabilize the economy. They emphasize the importance of government spending and tax cuts during recessions to stimulate economic growth.
Monetarist School
The Monetarist school, led by Milton Friedman, focuses on the role of money supply in determining economic outcomes. Monetarists believe that controlling the money supply is crucial for managing inflation and maintaining economic stability. They advocate for a steady, predictable growth in the money supply and minimal government intervention in other areas of the economy.
| Aspect | Classical | Keynesian | Monetarist |
|---|---|---|---|
| Market Efficiency | Self-regulating | Can fail | Generally efficient |
| Government Role | Minimal | Active | Limited to monetary policy |
| Policy Focus | Supply-side | Demand-side | Money supply |
| Inflation View | Price mechanism | Cost-push or demand-pull | Monetary phenomenon |
Approaching Economic Problems
When addressing economic issues like inflation or unemployment, each school would propose different solutions:
Inflation:
- Classical: Allow market forces to adjust prices and wages naturally.
- Keynesian: Implement contractionary fiscal policies to reduce aggregate demand.
- Monetarist: Tighten monetary policy to slow money supply growth.
Unemployment:
- Classical: Reduce labor market rigidities and allow wages to adjust.
- Keynesian: Increase government spending to stimulate job creation.
- Monetarist: Maintain stable monetary growth to support long-term employment.
Examples Illustrating Differences
During the Great Depression, Classical economists initially advocated for non-intervention, believing markets would self-correct. In contrast, Keynesians supported large-scale government programs like the New Deal to stimulate economic recovery. The 2008 financial crisis saw a resurgence of Keynesian policies, with governments implementing stimulus packages and bailouts. Monetarists, however, warned about the risks of excessive money creation and potential long-term inflationary pressures.
In the 1970s, when many countries faced stagflation (high inflation and unemployment), Keynesian policies struggled to address the issue effectively. Monetarists gained influence by emphasizing
Real-World Applications and Case Studies
Economic theories have profoundly shaped policy decisions and historical events throughout modern history. By examining real-world examples and case studies, we can better understand the practical applications of different schools of economic thought and their impact on society. This analysis provides valuable insights into the development and evolution of economic theory.
One of the most significant examples of economic policy influenced by Keynesian economics is the New Deal in the United States during the 1930s. In response to the Great Depression, President Franklin D. Roosevelt implemented a series of programs and reforms based on John Maynard Keynes' ideas of government intervention to stimulate economic growth. The New Deal included public works projects, financial reforms, and social welfare programs. While controversial, these policies helped reduce unemployment and stabilize the economy, demonstrating the potential effectiveness of Keynesian approaches in times of crisis.
Conversely, the economic policies of the 1980s in the United States and United Kingdom, often referred to as "Reaganomics" and "Thatcherism" respectively, were heavily influenced by monetarist and supply-side economic theories. These approaches, championed by economists like Milton Friedman, emphasized controlling the money supply, reducing government regulation, and lowering taxes to promote economic growth. The implementation of these policies led to periods of economic expansion but also increased income inequality, showcasing both the potential benefits and drawbacks of these economic schools of thought.
The transition of former Soviet bloc countries to market economies in the 1990s provides another compelling case study. The "shock therapy" approach, advocated by economists like Jeffrey Sachs, involved rapid privatization and liberalization of these economies. While this led to initial economic hardships, countries like Poland experienced significant long-term growth. In contrast, Russia's transition was more tumultuous, highlighting the complexities of applying economic theories to diverse socio-economic contexts.
The 2008 global financial crisis and subsequent policy responses offer a more recent example of economic theory in action. The crisis exposed weaknesses in the prevailing neoclassical economic models and led to a resurgence of Keynesian ideas. Governments and central banks implemented large-scale stimulus packages and unconventional monetary policies, such as quantitative easing, to stabilize financial markets and boost economic recovery. The effectiveness and long-term consequences of these interventions continue to be debated, influencing ongoing developments in economic theory.
In the realm of international trade, the adoption of free trade policies by many countries in the late 20th century was heavily influenced by classical and neoclassical economic theories. The formation of trade blocs like the European Union and agreements like NAFTA (now USMCA) were based on the principle of comparative advantage. While these policies have generally led to increased global trade and economic growth, they have also faced criticism for their impact on domestic industries and income distribution, leading to ongoing debates about the optimal approach to international economic relations.
The implementation of carbon pricing mechanisms in various countries represents an application of environmental economics principles. For instance, Sweden's carbon tax, introduced in 1991, has been credited with significantly reducing the country's carbon emissions while maintaining economic growth. This case study demonstrates how economic theories can be applied to address contemporary challenges like climate change.
These real-world examples and case studies illustrate the profound impact of economic theories on policy decisions and historical events. They also highlight the complexities involved in applying theoretical concepts to diverse real-world situations. As economic conditions evolve and new challenges emerge, the outcomes of these applications continue to shape the development of economic theory, driving ongoing debates and refinements in our understanding of how economies function and how best to manage them for societal benefit.
Modern Perspectives and Evolving Theories
The landscape of modern economics has been shaped by the evolution of classical schools of thought, adapting to address contemporary challenges and incorporating new perspectives. As global markets become increasingly interconnected, traditional economic theories have undergone significant transformations to remain relevant in today's complex economic environment.
Keynesian economics, for instance, has evolved into New Keynesian economics, which incorporates microeconomic foundations and rational expectations. This modern approach attempts to explain why prices and wages might be "sticky," leading to involuntary unemployment and monetary policy effectiveness. Similarly, classical economics has given rise to New Classical economics, emphasizing rational expectations and the idea that markets clear quickly.
The Chicago School's monetarist ideas have been refined and integrated into broader macroeconomic models, influencing central bank policies worldwide. Behavioral economics, a relatively new field, has challenged the assumption of rational economic actors, incorporating psychological insights into economic decision-making processes. This has led to a more nuanced understanding of consumer behavior and market dynamics.
Current economic challenges, such as income inequality, climate change, and technological disruption, are driving the development of new economic theories. Environmental economics and ecological economics have gained prominence, focusing on sustainable development and the integration of natural capital into economic models. The digital economy has spurred research into platform economics, network effects, and the economics of information goods.
The 2008 financial crisis and subsequent global economic shocks have led to a reevaluation of financial regulation theories and the role of central banks. This has resulted in the emergence of macroprudential policies and a greater focus on systemic risk in financial systems. The COVID-19 pandemic has further accelerated the evolution of economic thought, highlighting the need for more resilient economic structures and the importance of public health in economic stability.
Future Directions in Economic Theory
Looking ahead, several potential directions for economic theory are emerging. The integration of big data and artificial intelligence into economic modeling promises more accurate predictions and policy recommendations. Complexity economics, which views the economy as a complex adaptive system, is gaining traction, offering new insights into economic phenomena that traditional models struggle to explain.
The growing importance of intangible assets in the knowledge economy is driving research into new measures of economic value and productivity. Additionally, the rise of cryptocurrencies and blockchain technology is challenging traditional notions of money and financial systems, potentially leading to new theories of monetary economics.
As global challenges like climate change and demographic shifts intensify, economic theories are likely to become more interdisciplinary, incorporating insights from natural sciences, sociology, and political science. The future of economic thought may also see a greater emphasis on well-being and quality of life measures, moving beyond GDP as the primary indicator of economic success.
Conclusion
Understanding the three major schools of economic thoughtClassical, Keynesian, and Monetaristis crucial for comprehensive economic analysis. Each perspective offers unique insights into how economies function and how policy should be implemented. The Classical school emphasizes free markets and minimal government intervention, while Keynesian economics advocates for active government involvement during economic downturns. Monetarists, on the other hand, focus on the importance of money supply in economic stability. Recognizing these diverse perspectives enables a more nuanced approach to addressing complex economic issues. The introduction video serves as an excellent foundation for grasping these concepts, but continued learning is essential. As economic theories evolve and new challenges emerge, it's vital to stay informed and explore further. By embracing these varied viewpoints, we can develop a more robust understanding of economic phenomena and make more informed decisions in both personal finance and policy-making.
School of Thought
The 3 School of Thoughts
- Classical School of Thought
- Keynesian School of Thought
- Monetarist School of Thought
Step 1: Introduction to School of Thought
In the realm of macroeconomics, the term "school of thought" refers to a particular idea or way of thinking that a group of economists strongly believes in and incorporates into their practices. This concept is crucial because it highlights the diversity of opinions and approaches within the field of macroeconomics. Different macroeconomists have varying views on how the market operates, leading to the formation of distinct schools of thought. These schools of thought represent the collective beliefs and practices of groups of economists who share similar perspectives on economic issues.
Step 2: Understanding the Classical School of Thought
The Classical School of Thought is one of the earliest and most influential schools in the history of economic thought. It is based on the idea that free markets can regulate themselves if left alone, a concept known as "laissez-faire" economics. Classical economists believe that the economy is always capable of achieving the natural level of real GDP or output, which is determined by the economy's productive capacity. They argue that any deviations from this natural level are temporary and will be corrected by the market forces of supply and demand. This school of thought emphasizes the importance of long-term economic growth and the role of capital accumulation, technological progress, and labor productivity in driving economic development.
Step 3: Exploring the Keynesian School of Thought
The Keynesian School of Thought emerged as a response to the Great Depression of the 1930s, challenging the principles of classical economics. Named after the British economist John Maynard Keynes, this school of thought argues that aggregate demandthe total demand for goods and services within an economyis the primary driver of economic activity and employment. Keynesians believe that during periods of economic downturns, private sector demand often falls short, leading to unemployment and underutilized resources. To address this, they advocate for active government intervention through fiscal and monetary policies to stimulate demand and stabilize the economy. Keynesian economics emphasizes the importance of short-term economic fluctuations and the role of government in managing economic cycles.
Step 4: Analyzing the Monetarist School of Thought
The Monetarist School of Thought, led by economist Milton Friedman, focuses on the role of money supply in influencing economic activity. Monetarists argue that variations in the money supply have significant effects on national output in the short run and the price level over longer periods. They believe that controlling the growth rate of the money supply is crucial for managing inflation and ensuring economic stability. Monetarists are critical of Keynesian policies, particularly the emphasis on fiscal policy, and instead advocate for a rules-based approach to monetary policy. They argue that central banks should follow a fixed rule for increasing the money supply at a steady rate, rather than engaging in discretionary monetary interventions.
Step 5: Conclusion
In summary, the field of macroeconomics is enriched by the diversity of schools of thought, each offering unique perspectives on how the economy operates and how economic policies should be formulated. The Classical School of Thought emphasizes the self-regulating nature of free markets and long-term economic growth. The Keynesian School of Thought highlights the importance of aggregate demand and government intervention in managing economic cycles. The Monetarist School of Thought focuses on the role of money supply and advocates for a rules-based approach to monetary policy. Understanding these different schools of thought provides valuable insights into the complexities of economic theory and policy-making.
FAQs
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What are the main differences between Classical, Keynesian, and Monetarist schools of thought?
The Classical school emphasizes free markets and minimal government intervention, believing in self-regulating markets. The Keynesian school advocates for active government involvement to stabilize the economy, especially during downturns. The Monetarist school focuses on the importance of money supply in economic stability, arguing for controlled monetary growth to manage inflation and promote economic stability.
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How do these schools of thought approach unemployment?
Classical economists believe unemployment is temporary and will resolve through wage adjustments. Keynesians view unemployment as a serious issue requiring government intervention through fiscal policies. Monetarists focus on maintaining stable monetary growth to support long-term employment, believing that short-term interventions can be counterproductive.
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What role does government play in each school of thought?
In Classical economics, government should have minimal involvement. Keynesian economics advocates for active government intervention through fiscal and monetary policies. Monetarists prefer limited government involvement, primarily focused on controlling the money supply through central bank policies.
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How do these schools view inflation?
Classical economists see inflation as a result of changes in the money supply relative to output. Keynesians view inflation as potentially caused by excessive demand or cost pressures. Monetarists consider inflation primarily a monetary phenomenon, directly linked to excessive growth in the money supply.
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Which school of thought is most relevant in modern economics?
Modern economics incorporates elements from all three schools. New Keynesian and New Classical models have evolved, integrating insights from each perspective. The relevance of each school depends on the specific economic situation and challenges. Current economic policy often blends aspects of all three, adapting to complex global economic conditions.
Prerequisite Topics
Understanding the foundations of economic thought is crucial when delving into the concept of "School of thought" in economics. One of the key prerequisite topics that plays a significant role in this understanding is the theory of comparative advantage. This fundamental principle, developed by David Ricardo in the early 19th century, forms the bedrock of many economic schools of thought and continues to influence modern economic theories and policies.
The concept of comparative advantage is essential to grasp before exploring various schools of economic thought because it provides insights into how nations, firms, and individuals can benefit from specialization and trade. This theory explains why countries engage in international trade even when one country can produce all goods more efficiently than another. By understanding comparative advantage theory, students can better comprehend the arguments and perspectives of different economic schools of thought regarding trade policies, economic growth, and resource allocation.
Many schools of economic thought, from classical and neoclassical economics to more modern approaches, incorporate or respond to the principles of comparative advantage in their frameworks. For instance, the Austrian School of economics builds upon this concept to advocate for free markets and minimal government intervention. In contrast, other schools might use comparative advantage as a starting point to argue for strategic trade policies or to analyze the complexities of global economic relationships.
Furthermore, the theory of comparative advantage serves as a foundation for understanding more advanced economic concepts that are central to various schools of thought. These include opportunity cost, production possibilities frontiers, and the gains from trade. By mastering this prerequisite topic, students will be better equipped to critically analyze and compare different economic ideologies and their policy implications.
As students explore different schools of economic thought, they will encounter debates and discussions that often circle back to the principles of comparative advantage. Whether examining the merits of free trade agreements, analyzing the effects of globalization, or considering the role of government in the economy, a solid understanding of this theory is invaluable. It provides a common language and framework for evaluating the strengths and weaknesses of various economic perspectives.
In conclusion, the theory of comparative advantage is a crucial prerequisite for studying schools of economic thought. It not only lays the groundwork for understanding complex economic relationships but also helps students appreciate the nuances and debates within the field of economics. By mastering this fundamental concept, students will be better prepared to engage with and critically evaluate the diverse range of economic theories and their real-world applications.
The 3 School of Thoughts
Macroeconomists have different views about how the market operates.
School of Thought: a particular idea or way of thinking that a group strongly believes in, and takes it into their practices.
We are going to investigate three different macroeconomic school of thoughts and see how each macroeconomist views them.
The three school of thoughts are:
- Classical School of Thought
- Keynesian School of Thought
- Monetarist School of Thought
Classical School of Thought
The word “classical” comes from a group of economists who produced this theory, whose names were Adam Smith, John Stuart Mill, and David Ricardo.
For the classical school of thought, the idea is that the economy will always goes back to full employment (real GDP = potential GDP) because of an automatic self-regulated mechanism.
In other words, we always have
But if real GDP = potential GDP, then why does real GDP fluctuate around potential GDP, creating this business cycle, rather than being equal to it all the time?
It is due to disturbances from an uneven pace in technological advances.
In fact, technological changes play a big role in the aggregate demand and aggregate supply.
Aggregate Demand: The following types of technological changes can shift aggregate demand.
- Productivity of capital: when productivity increases, firms increase their expenditures on equipment and tools, so increases aggregate demand.
- Lengthening lifespan of capital: when equipment or tools last longer, there is a low demand for new capital. Therefore, this decreases aggregate demand.
Short-run Aggregate Supply: The short-run aggregate supply is very flexible. Whether the money wage rate is too low or too high, it will eventually adjust back to equilibrium so that real GDP = potential GDP.
Long-Run Aggregate Supply: This supply curve can change depending on what happens to potential GDP, which is also influenced by technological change.
Technological change can grow at a rapid or slow pace.
- Rapid Pace: a rapid pace of technological change increases potential GDP quickly, causing real GDP to also increase.
- Slow Pace: a slow pace of technological change slows the growth rate of potential GDP, causing real GDP to increase slowly as well.
Policy: The policy for the classical school of thought says that the market works mostly efficiently when it is left alone with little to no government intervention. Therefore, we need to minimize the effects of taxes, employment, investments, and make sure that technological changes are at an efficient level.
This lets the economy to grow at a rapid pace.
Keynesian School of Thought
The word “Keynesian” comes from a macroeconomist named John Maynard Keynes.
He believes that if the economy were to be left alone, then the economy would rarely be at full employment. There needs to be active fiscal and monetary policy keep it at full employment.
In this school of thought, future expectations impact aggregate demand.
Aggregate Demand: depending on future expectations, it can increase or decrease aggregate demand
- When there are future expectations of high profit, people/firms tend to spend more today, causing an increase in aggregate demand
- When there are future expectations of low profit, people/firms tend to spend less today, causing a decrease in aggregate demand and causes a recession.
Short-Run Aggregate Supply: Money wage rate is very sticky in the short-run, causing aggregate supply curve to be really flat or even horizontal.
Due to it being horizontal, the money wage rate does not fall.
Normally in a recession, the economy would shift the upward sloping supply curve to the right so that there is no recessionary gap.
However, we cannot shift the supply curve right with a horizontal line. So, the recessionary gap remains, and we stay in recession until the government intervenes to change the aggregate demand.
Policy: the policy for Keynesian school of thought says that the government needs to use monetary or fiscal policies to actively offset changes in the aggregate demand that causes recession.
Monetarist School of Thought
The word “monetarist” comes from economists named Karl Brunner and Milton Friedman.
From the monetarist school of thought, they believe that the economy goes back to full employment (real GDP = potential GDP) from an automatic self-regulated system. However, this is only applicable if the monetary policy is consistent, and the growth of money is steady.
The quantity of money plays a big role in aggregate supply.
Aggregate Demand: Depending on the quantity of money, aggregate demand can shift.
- If the quantity of money grows at a rapid pace, then the aggregate demand increases.
- If the quantity of money grows at a steady pace, then aggregate demand fluctuations are minimized.
- If the quantity of money is decreased or grows at a slow pace, the aggregate demand decreases, and the economy goes to recession.
Short-run Aggregate Supply: the idea for the short-run aggregate supply works the same as the Keynesian school of thought.
Money wage rate is very sticky, so if a recession happens, then it will take a long time to reach full employment without the help of the government.
Policy: the policy is the same as the classical school of thought. As long as the quantity of money is steady, and there is little to no government intervention (taxes, etc.), then the economy will grow at a steady pace.