Different Schools of Thought in Economics: A Brief Discussion Topic 1 Based upon: Macroeconomics, 12 th edition by Roger A. Arnold and A cheat sheet for understanding the different schools of economics by Cullen Roche
The Major Schools of Thought 1. Classical 2. Keynesian 3. Monetarist 4. New Classical 5. New Keynesian 6. Post Keynesian 7. Market Monetarist 8. Behavioral
1. Classical Economics Overview: The original school of economics based on the understandings of the classics like Adam Smith, David Ricardo and John Stuart Mill that stressed economic growth and freedom emphasizing free markets and self regulating economy. Mission Statement: The invisible hand of the free markets is all we need to achieve equilibrium. General view of the economy: The economy is inherently stable and full employment is the norm. Prices and wages are flexible. If the economy is either in a recessionary or inflationary gap, long run equilibrium will be restored through labor market adjustments. Government intervention is disruptive to the natural order of markets and does more harm that good. How to fix the economy: Let the free markets do their thing. Laissez-faire or non-interference is the right and sensible economic policy
2. Keynesian Economics Overview: A school of thought established by the work of John Maynard Keynes. Based on experience of the Great Depression, Keynes and the Keynesians challenged the classical view of economics. Keynesian economics emphasizes market failure and promotes government intervention. Mission Statement: If left on its own, economy may not be able to self regulate during times of deep recessions. General view of the economy: The economy is inherently unstable. Prices are wages may be inflexible downward, i.e., the economy may not be self regulating when in a recessionary gap. The private sector cannot get the economy out of recession and government has to play an important role to bring the economy back to long run equilibrium. How to fix the economy: Laissez-faire does not work and the government has to undertake expansionary fiscal policy to pull the economy out of a recession.
3. Monetarist Overview: Monetarism, pioneered by Milton Friedman, maintains that the money supply is the chief determinant of output and price level of the economy. Mission Statement: Monetarists believe that business cycle fluctuations are best countered by appropriate monetary policy. General view of the economy: The foundation of monetarism is the Quantity Theory of Money. The theory based on the equation of exchange - an accounting identity - states that the money supply multiplied by velocity equals real GDP multiplied by the price level. Monetarist theory views velocity as generally stable and predictable implying that nominal income is largely a function of the money supply. Variations in nominal income reflect changes in real economic activity and inflation. How to fix the economy: Economic problems can be fixed through prudent monetary policy the objectives of which are best met by targeting the growth rate of the money supply.
4. New Classical Overview: The New Classical school is the modern adaptation of the classical school. It is based on neoclassical framework, which seeks to explain the macroeconomy through microeconomic foundations. It emphasizes rational expectations and arose out of the failures of the Old Keynesian schools during the failure of the Phillips curve and stagflation in the 1970 s. Mission Statement: Proper macroeconomic analysis must be based on neoclassical microfoundations. General view of the economy: Rational agents are always making optimal decisions and firms are always maximizing profits, but the economy is often shocked by real effects like unanticipated policy changes, changes in technology or changes in raw materials. How to fix the economy: New Classical economists are generally associated with a laissez faire approach to policy.
5. New Keynesian Overview: The New Keynesians are the adaptation of the Old Keynesians who responded to the criticism of the New Classicals in the 1970s and 80 s by creating an updated model of the economy to help explain some of the Keynesian failures of the 70 s. Although it adopted the term Keynesian in its name the school actually pitches a fairly broad tent using some neoclassical foundations as well as Monetarist perspectives. Mission Statement: Although economic agents are rational, policymakers can improve economic stability and help attain full employment through various stabilization policies designed to combat a variety of market failures. General view of the economy: Economic agents are rational, but markets are imperfect due to phenomena such as sticky prices. This can result in market failures leading to business cycle fluctuations. How to fix the economy: New Keynesians do not disagree with the use of monetary policy, but will at times also recommend fiscal policy to help stabilize the economy especially during deep recessions since monetary policy may become ineffective due to interest-insensitive investments and liquidity trap.
6. Post Keynesian Overview: A branch of Keynesian economics that seeks to get back to the true Keynesian thoughts about the economy and find ways to improve it. Mission Statement: Keynes had it all right all along. Recessions and involuntary unemployment are the result of aggregate demand shortages resulting primarily from market failures. General view of the economy: Capitalism exists on an inherently unstable foundation and will at times require some forms of government intervention to achieve prosperity. How to fix the economy: Counter-cyclical policies with a focus on fiscal policy.
7. Market Monetarist Overview: Largely seen as a revival of traditional Monetarism utilizing the foundations of Milton Friedman s work with some modifications. Mission Statement: The Central Bank can steer the economy on a smooth path to prosperity through a laissez faire approach if they implement Nominal GDP (NGDP) targeting. General view of the economy: The economy is unlikely to reach equilibrium without a permanent NGDP targeting rule in place. How to fix the economy: Through NGDP targeting.
7. Market Monetarist We can understand the policy prescription in terms of the equation of exchange which states that the money supply times velocity must equal (nominal) GDP: M V GDP. Now suppose a financial crisis occurs, and as a result, people try to hold more money (spend less). This reaction is likely to reduce velocity, and if the Central Bank (CB) doesn t sufficiently offset this decline in velocity, GDP will decline. If velocity declines by, say, 8%, and the money supply rises by 6%, GDP will decline by 2%. If the objective is to raise GDP by 5%, an 8% decline in velocity would obligate the CB to increase the money supply by 13%. Any less of an increase would prompt market monetarists to argue that the monetary policy is too tight.
8. Behavioral Economics Overview: One of the newest and fastest growing schools of economics. Widely perceived as one of the most positive recent developments in economics. Mission Statement: The best way to understand the workings of the economy is by understanding the way the human mind reacts and adapts to markets and the economy. General view of the economy: The economy is complex, dynamic and uncertain and is being navigated by imperfect participants. Because of this it could be appropriate for government to intervene at times. How to fix the economy: Behavioralists don t make specific policy recommendations, but generally believe that we can better understand the economy if we better understand human psychology as it pertains to money, markets and the economy.
8. Behavioral Economics Save More Tomorrow (SMarT) Pension Program Life cycle hypothesis: People will calculate the appropriate savings rate and are assumed to spread their wealth over their entire lifespans, in order to live a stable life. It turns out that many people deviate from this hypothesis, and even those willing and intending to accumulate sufficient pensions, sometimes fail to save enough for their retirement. Probable causes: 1. Loss Aversion Bias 2. Self control issues (leads to procrastination) 3. Hyperbolic Discounting 4. Inertia Paper: Thaler, R. H., & Benartzi, S. (2004). Save more tomorrow : Using behavioral economics to increase employee saving. Journal of political Economy, 112(S1), S164- S187. Summary: https://inudgeyou.com/en/financial-nudge-the-classic-example-of-savemore-tomorrow/
8. Behavioral Economics The SMarT plan: The increase in pension contributions will happen when they get their next payraise. The employees saving rate would increase by 3% per pay raise until it reaches a pre-set maximum. People will stay in the program until they actively decide to opt-out of it. So, the default option is to stick to the program, once it has been chosen. 286 employees met with a financial consultant, who recommended a new saving rate, based on what the employees found economically possible, and what the software recommended. 79 accepted the new saving rate. To the 207 who refused the recommended saving rate, the consultant offered the SMarT plan as an alternative. 162 of the 207 employees joined the SMarT plan
8. Behavioral Economics