Intro To Schools of Economic Thought

(A prelude to aggregate models and policy decisions)

Classical School
Also called 

• neo-classical, supply-side

Major Thinkers

• Adam Smith (Wealth of Nations)
• David Ricardo
• Thomas Malthus
• Alfred Marshall
• Jean-Baptiste Say

Basic Paradigm: competition is good

• forces firms to improve.
• Causes them to lower prices to earn market share
• Invisible hand - pushes the market forward 
• For the consumer: better product at lower prices over time
• Forces bad firms to improve or get out
• New companies must be more efficient to compete

Say's law: Supply creates its own demand in the long run.

• economy will not only improve but balance itself.
• If suppliers overproduce, they create a surplus, they cut production and lower prices. You will recover once you flush out the surplus. Real wealth is in balance. 
• Shortage? Increase production. Raise prices. Hire more people. Raise wages. Real wealth stays the same.

Governments role = limited

• Ensure competition occurs. - forms cartels, trusts. Businesses can cheat.
• Monopolies stop completion 
• Unions - anti competitive. Stops firms from being able to adjust to wage changes. They can break down the fundamental Competitive process. Firms need to be flexible with wages at times.

Modern Policy Examples:

• Trickle Down tax policies.  Lower taxes on the rich.   They control industry and when they profit more, they will build more industries.  More workers will be hired.  Everyone will benefit.
• Lower taxes on businesses and individuals.  This will help production and consumption and make industry more efficient.
• Reduce power of groups like inefficient unions that block wage adjustments and
  
  flexibility.  Create more “Right to Work” laws.
• Support more free trade like the EU, NAFTA, CAFTA, and the WTO
• Get rid of socialistic, anti-competition parts of the economy.
• Lower tax revenues that the government can collect in order to minimize the way government can afford to interfere in the economic markets.

Sum: in the long run, the economy will balance.

Riccardo adds international trade to this. 

• Free trade. 
• The more you trade the more competitive the world market becomes
• the more interlinked it will become, the more efficient it becomes.

Then what happened? 
Great Depression

Keynesian economics

• Demand-side
• John Maynard Keynes
• Neo-Keynesian, 
• Fiscal Policy
• Modern guy is Krugman.

Basic Paradigm: Competition is good but flawed. 

• It's never going to balance itself.
• Gov. Has to balance it. 
• The invisible hand is inefficient.

Says says law is a myth. There is no natural balance.

• Businesses can't really lower prices at will. - sticky prices.
• Paradox of thrift. - people will always save some of their income. Says its a leak. 
• Prices can increase but not decrease. - the ratchet effect 
• Inefficiencies will bring you down eventually. 
• Recessions will be the norm and government must step in.

Government Role

• must now step in and correct the missing Aggregate demand
• Congress will represent the interests of the people and will use the tools of taxes and spending. 

Fiscal Policy

• When recessions occur, governments spend. (also a ratchet effect)  
• Increase taxes and cut spending. - affect Aggregate demand 
• Automatic stabilizers - progressive tax, social security, unemployment insurance.
• In the long run we're all dead.

Modern Policy Examples

• Countercyclical Fiscal Policies like tax cuts during recessions. 
• Social Security programs to help form a safety net for the elderly. 
• Unemployment insurance benefits to help soften the blow of unemployment.

Then what happened? 
Stagflation of the 1970s

Monetary policy 
also refereed to as

• Federal reserve policy
• Central bank policy

Basic Paradigm: Completion is good will be encouraged but needs constant tuning

• The more you do that the less problems you have.

Each recession has lasted about 14 months or less

• Your stimulus hits about a year after the recession started, The recession is over, you create inflation
• Even if you have good intentions you can't time it.  
• Congress jumps into raising taxes and lower spending. - politicians won't do it. 
• The best way to do this is through a central bank. 

Central Bank Can

• focus on inflation. 
• set realistic growth targets. 
• do this with interest rates and the money supply.

Lower interest rates in a recession
Raise them when dealing with inflation.
Modern Policy Examples

• Bond sales and purchases as policy tools (The Open Market Committee)
• The Fed Fund Interest Rate targets.
• The bank Discount Rate
• The bank Reserve Requirements