Economics - Classical School of Thought, Keynesian School of Thought, Supply Side School of Thought, Monetarist School of Thought
Schools of Thought
Introduction
The word economics is derived from “oikonomikos” which means skilled household management. Modern economic thought emerged in the 17th and 18th centuries as the western world began its transformation from an agrarian to industrial society. Four major schools of thought have emerged over the years of economic development.
- Classical School of Thought
- Keynesian School of Thought
- Supply Side School of Thought
- Monetarist School of Thought
Classical Theory:
The Classical Theory is based on the automatic “Self Equilibration” tendency of the economic forces. The classical view is the aggregate supply curve is vertical and is the sole determinant of the level of real output the down sloping aggregate demand curve is stable and is the sole determinant of the price level.
According to the classical economist the economy will operate at its full employment level of output because (1) Say’s law (2) responsive flexible prices and wages, they believed that supply does not change in response to the change in price level.
As we know that lower prices would make production less profitable and would cause producer to offer less output and employ fewer workers, the classical response to this view is that the input costs would fall along with products price and level real profits and out put unchanged. With perfectly flexible wages there would be no change in real reward & therefore in the production decisions of businesses a change in the price level will not cause the economy to stray from full employment.
History Of Classical Theory:
The classical school between 1770----1870 mainly include such leading economist as Adam Smith, David Ricardo, J.B Say, John Stuart Mill & Karl Marx. The later Neo-Classical economist list Alfred Marshall (1870—1930) had hardly any thing to add to the classical theory.
Adam Smith published his “Wealth of Nation” (1776) he wrote this during the Enlightenment the main message of this book “laissez-faire”, the virtue or specialization, free trade & competition it seemed an appropriate tune for that period.
David Ricardo is the most successful and influential, with his 1817 treatise he took economics’ to a higher degree of theoretical sophistication Ricardo’s theory is very clear as compared to the others, that’s why they became the “Classical System”
Jean Baptist Say (1803) wanted to take it back towards demand- and – supply tradition. By the 1860’s the Classical School was in a state of Siege
Beliefs:
Classical economist believed that the government should not intervene to try to correct this as it would only make things worse and so the only way to encourage growth was to allow free trade & free market. The approach is known as “laissez-faire” it means that the economic system where the government intervenes as little as possible &leaves the private sector to organize most economic activities through markets. Classical economists were great advocates of laissez-faire system with minimal govt. interference, they believed free market were the best organizers of economic activity this kind of approach put total reliance on markets.
Adam Smith’s early work was on this theme, he introduce the nation of “Invisible Hand” he argued that the invisible hand would organize market & ensure that they arrived at the optimum out come. This would happen by individuals & firms pursuing their self interest yet despite that apparent selfishness the invisible hand of market still ensure the best out come for all concerned Adam Smith is consider the foundation father of modern economics.
Theories:
Classical theories mainly revolves around the role of marker in the economy, according to the theory if the market worked freely the economy would prosper. Any imperfections in the market that prevent the process should be the responsibility of the government to deal with it and take care of it, so the main role of government are therefore to ensure free workings of markets using “supply side policies ” and to have a balanced budget. The main theories used to justify this view were:
- Free Market Theory
- Say’s Law
- Quantity Theory of Money
Free Market Theory:
The Classical economist assumed that if the economy was left to it self then it would tend to full employment equilibrium, this would happen if the labor market worked properly. If there is any unemployment then the following will happen:
Unemployment (a surplus of lab our) ----- fall in wages---increased demand for lab our--- equilibrium restored at full employment.
This can be shown on a diagram (1.1) of labor market. Wages are initially too high and there is unemployment of ab. This cause wages rates to fall and unemployment increase as a result from Q1 to Q2 any unemployment left in the economy is purely voluntary unemployment people who chose not to work at the going wage rate.
The same would also be true in the market for loan able funds if there was any discrepancy between saving and investment the equilibrium would change in the market. This would again require a free market and flexible prices. In this market the price is the rate of interest say for example investment increased, then the following process would occur to restore equilibrium:
Increase in investment--- increase demand for money---- increase rate of interest---increased saving as borrowed are attracted by higher rates of interest--- equilibrium restored.
Say’s Law:
Say’s law is named after an economist called Say Jean Baptiste Say an economist of early 19th. Century according to his law “Supply create its own demand”. This once again provide a justification for Classical View that the economy will tend to full employment, according to this law an 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. It there was any unemployment it was simply be temporary as the pattern of demand shifted. How ever the same process as shown above would restore equilibrium.
Quantity Theory of Money:
The classical economist view of inflation revolved around the Quantity Theory of Money, and this theory was in turn derived from the Fisher Equation of Exchange this equation says 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 and
T is the number of transactions taking place
Classical economist suggests that V would be relatively stable and T would always tend to full employment. Therefore they come to the conclusion that:
M------P
In other words increase in the money supply would lead to inflation. The message was simple control the money supply to control inflation.
(Neo) Classical Theory ---AD & AS
Classical economist had a complete faith in markets they believe that the economy would always settle automatically at full employment equilibrium in the long run, but there might be a little different reaction in the short run as the economy adjusted to its new long- run equilibrium, we can illustrated these changes as AS & AD analysis:
Classical View the Aggregate Supply & Aggregate demand has different effect for the long and short run. According to the short run any increase in AD in short run will lead to an increase in output (Q1 to Q2) but will also lead to price increase, this will happen as firms suffer from diminishing return and are forced to increase the price of their products to cover the higher costs. Increase in AD may come about for a variety of reasons for instance:
- Increase in the money supply
- Lower levels of taxation
- Increased government expenditure
(For short run please refer to fig 1.2)
On the other hand for the long run the situation will be different the economy will be tended towards full employment on its own, and so any further increase in demand will simply be inflationary. The shape of the long run aggregate supply curve will be therefore vertical please refer to fig 1.3. the long run aggregate supply curve is vertical at the full employment level of output (Qfe) and any increase in AD leads to prices increase but no increase in out put.
According to Classical Economists:
“Don’t just do something, sit there!”
Real World Application
Broadly speaking, the entire US economy is an example of real world application of classical economic policies. With the free market policy backdrop, the US equities markets such as NYSE and NASDAQ present the most eloquent application of free market forces at their best. In the long run these market always reach the most efficient equilibrium without the intervention on government for the most part. The only role played by the government via the SEC is the keep the markets fair and free of deceptions, that is to remove the hindrances from efficient market operations.
Everyday billions of shares from thousands of public corporations change hands at the most optimum prices level without the intervention of any governmental body. No one fixes the number of shares that are bought and sold, no one externally sets the pricing and no one controls who is going to buy or sell when. Trillions of dollars worth of transactions are conducted daily and free market forces and open flow of information control it all.
