Session 3
The History of Economic Thought [II]. Principles of neo-
classical economic thought; price theory and allocation of
resources. Post 1945 economic thought: the rise and fall
of keynesianism and monetarism.
Outline the main differences between the neo-classical,
keynesian and monetarist schools of thought as related to
inflation, unemployment, economic growth and state
involvement in the economy.
CONCEPTS FOR REVIEW:
Price determination, allocation of resources,
supply and demand, Say's law, aggregate demand
and aggregate supply, the quantity theory of
money, the public sector borrowing requirement.
NEO-CLASSICAL ECONOMICS
While classical economics (Smith, Ricardo, Marx) was concerned with
long-run developments of economies as a whole, and in particular the
relationship between the distribution of the economic surplus and the
pattern of development, NEO-CLASSICAL value theory became essentially
a theory of the allocation of scarce resources in a static economy.
Neo-classical utilised Ricardo's economic model to extend it and create
the MARGINALIST MODEL (the concepts of 'marginal utility' and
'marginal productivity') to analyse the pricing of goods, services and
factors of production in competitive markets. The founders of the
neo-classical system were J. M. Clark, F. Y. Edgeworth, I. Fisher,
A. Marshall, V. Pareto, L. Walras and K. Wicksell
They emphasized that the market prices of goods and factors were related
to their scarcity. The neo-classical scheme is based on the idea of
a PERFECTLY COMPETITIVE ECONOMY IN EQUILIBRIUM.
Prices of commodities, derived from individual rational maximizing
behaviour in the markets, distinguish NEO-CLASSICAL approach from both
CLASSICAL ECONOMICS and KEYNESIAN ECONOMICS.
In common with many classical theorists the 19th century neo-classical
economists accepted that there exist market forces which tend to
maintain full employment. This contrast sharply with the Keynesian view
that involuntary unemployment may exist even in spite of market forces.
THE MAIN TENETS OF NEO-CLASSICAL ECONOMICS
Three assumptions are made by neo-classical economists:
a) supply creates its own demand, because it is assumed that prices
behave in such a way that the value of all commodities produced
is just equal to the value of expenditure on commodities as a whole.
This notion is known as the Say's law (from a French economist,
1767-1832)
b) market always clear. That is, they are always in equilibrium. Supply
equals demand.
c) both capital and labour create value. Therefore both capital and
labour are "rightly" rewarded in the process of production. The
relative mix of capital and labour will allow to treat economics
as a set of mathematical equations forming 'the production
function'.
-from a), the conclusion is that there are no business cycles. Therefore,
the economy is always in equilibrium and at full employment. Or, even
better, any level of unemployment in the economy is "voluntary".
People unemployed are those who do not want to work or do not accept a
given level of wages.
-from b), it follows that there is always a right price for everything,
including factors of production (capital and labour)
-from c) two conclusions:
1.- political: There is no contradiction between owners
of capital and labourers, because both are fairly
rewarded in the process of production.
2.- economic: wages and gross profits are the outcome of a
mathematical equation which will fix the right values
for them. There is no room, then, for having labour
organizing trade unions to fight for higher wages. This
is "unscientific".
Moreover, the 'prices' of capital and labour are an outcome of two
separate markets:
the money market and the labour market
The money market will clear the right supply of money consistent with
the right demand for money. Thus, the price of money, which will be
'the interest rate', will become the PRICE OF CAPITAL.
The labour market will clear the right supply of labour consistent with
the right demand for labour. Thus, the price of labour will be equal
to the right level of wages for any economy.
Owners of capital will invest as long as the rate of profits is
higher than the interest rate. Thus, if a central bank keeps the
interest rate low, more investment will occur, and economic growth
will follow.
This model assumes NO INFLATION (because the money market will clear
all the time).
Assumes full employment, because if wages are too high less demand for
labour will follow as a "punishment by the market" against those who
interfere with it, creating "voluntary unemployment".
Because neo-classical school assumes perfect competition, it denies
any role by the government (state) in the economy, except fiddling with
interest rate to protect rate of profits.
Because wages and employment are determined by supply and demand, the
government does not have any role related to these economic variables.
THE KEYNESIAN CRITIQUE
In the 1930s, when the market system collapsed into dramatic rates of
unemployment (20-30 percent in the U.S. and Western Europe) and negative
economic growth, a British economist, J. M. Keynes, criticised the
neo-classical school as follows:
a) Say's law was an error, because production and consumption are
the outcome of economic actions by different individuals. Keynes
said that Say's law is only true in a society of one individual
where supply and consumption will be about goods for USE and not
goods for THE MARKET.
b) in a national economy, aggregate demand is not homogeneous, because
is made of:
private consumption
government consumption
investment by business persons
and international trade (exports minus imports)
c) markets do not always clear, and there exist instances of
overproduction and underproduction because supply is disorganized
driven by individual efforts to maximize profits producing
commodities for the market;
d) the economy can reach equilibrium at any level of employment,
therefore there can be periods of high unemployment with businesses
not interested in investing more. Keynes developed an equilibrium
condition defined as follows:
If the sum of savings plus taxation plus imports EQUALS
the sum of investment plus government expenditure plus
exports, THEN, the national economy is in equilibrium
and will tend to keep the corresponding level of national
output (and level of employment)
e) from the above it follows that in times of high unemployment, the
government must manage aggregate demand utilizing two main tools:
monetary policy and fiscal policy
the government can manage aggregate demand as follows:
1.- Private consumption. Through reducing taxation more income will
be in the hands of individuals, etc
2.- Government expenditure. Government investments in schools,
hospitals, low-price dwellings, public transport and public
utilities will increase private investment and push the economy
to higher levels of employment.
3.- Investments and international trade. Through monetary policies
such us 'managing' exchange rate and interest rates, and fiscal
policies such as taxation and subsidies, the government could
entice private businesses to invest more, and then, to export
more.
Therefore, Keynesian economics was about managing aggregate demand
to boost employment and economic growth.
All industrial countries adopted some form of Keynesian economic
policies since 1940s until the 1970s. In the 1970s, suddenly, the
price of oil went up several times raising costs of production.
The immediate effect was high levels of unemployment parallel to
very high rates of inflation.
THE MONETARIST APPROACH
Keynesian economics came under heavy criticism by some economists
(M. Friedman, F. Von Hayek and others) who create a new school of
thought called "monetarism".
The main tenet of this theory is that INFLATION IS A MONETARY
PHENOMENON created by excess of money supply (money defined loosely
as banknotes and coins in circulation plus credit). This is known
as the QUANTITY THEORY OF MONEY.
Too much inflation, monetarists will say, stop businesses from
investing, and, therefore, economic growth will slow down.
The only role of the government, they say, was keeping inflation
down through controlling money supply, and, particularly, through
reducing government/state expenditures.
Because of the above, government spending in welfare state, in
education, in health, housing and public utilities should be
reduced to nil. In order to do that, all those services should be
privatized. Thus the public sector borrowing requirement will be
reduced to nil, another correct measure to put inflation down.
Monetarist economics accepts all the neo-classical tenets about
the market, and, therefore, assumes that markets always clear.
Because of the above, they see unemployment as VOLUNTARY. Moreover,
they create the concept of NATURAL RATE OF UNEMPLOYMENT, which is
the rate of unemployment that occurs when the labour market
clears. This is rather comfortable, because technically, any rate
of unemployment will appear as a 'natural rate'.
In the last twenty years, a period of monetarist approach, with the
market taking over all sectors in the economy, one major indicator
of social welfare, unemployment, have been rising constantly, at
a faster pace than employment, which worries industrialized societies.
The following tables, built from "Employment in Europe", European
Commission, 1996, and "Employment Outlook 1996", OECD, 1997,
illustrates long-term tendencies:
TABLE 1. EMPLOYMENT IN THOUSANDS
Country 1975 1995 Total growth (%)
United States 85062 124900 46.8
Canada 8761 13505 54.1
Japan 52570 64556 22.8
Belgium 3565 3793 6.4
Denmark 2365 2639 11.6
Germany 26020 34864 33.9
Greece 3262 3821 17.1
Spain 12383 12042 -2.8
France 21409 22326 4.3
Ireland 1073 1262 17.6
Italy 19300 19939 3.3
Luxembourg 158 213 34.8
Netherlands 5250 6713 27.9
Austria 3087 3759 21.8
Portugal 3889 4407 13.3
Finland 2224 2059 -7.4
Sweden 4062 3985 -18.9
United Kingdom 24589 26172 6.4
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TOTAL 278966 350955 25.8
of which:
EU (15) 132573 147994 11.6
_______________________________________________________________________
_______________________________________________________________________
TABLE 2. UNEMPLOYMENT IN THOUSANDS
Country 1975 1995 Total growth (%)
United States 4365 7404 70.0
Canada 515 1422 176.1
Japan 1303 2877 120.8
Belgium 137 416 203.6
Denmark 93 198 112.9
Germany 915 3209 250.7
Greece 50 380 660.0
Spain 580 3574 516.2
France 863 2850 230.2
Ireland 83 178 114.5
Italy 979 2683 174.1
Luxembourg 0.5 4.8 860.0
Netherlands 206 535 159.7
Austria 52 147 182.7
Portugal 179 347 93.9
Finland 61 430 604.9
Sweden 74 404 445.9
United Kingdom 817 2501 206.1
---------------------------------------------------
TOTAL 11271 29559 162.3
of which:
EU(15) 5088 17856 250.9
________________________________________________________________________
_____________________________________________
Marginal utility: is the extra utility obtained from an extra unit
of any GOOD.
Marginal productivity theory: the hypothesis states that an employer
who seeks to maximize his profits will be
guided by the LAW OF DIMINISHING MARGINAL
PRODUCTIVITY whereby successive units of
LABOUR hired yield successively
diminishing returns to OUTPUT. At a given
level of wages, the employer will continue
to hire labour until the contribution of
the last unit employed is equal to the
wage paid.
________________________________________________________________________
Price determination: as an outome of the 'price mechanism'. The latter
notion is used with reference to the free market
system and the way in which prices "act as
automatic signals which coordinate the actions of
individual decision-making units". Capitalist
economic theory assumes that
"by means of the role of the free market, the
price system provides a mechanism whereby
changes in demand and supply conditions can affect
the allocative efficiency of resources".
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allocation of resources: the allocation of particular amounts of capital
and labour to produce a particular commodity
in such a way that there is no waste of
resources. From the latter, the notion of
allocative efficiency, which is the
production of the best or optimal combination
of outputs by means of the most efficient
combination of inputs.
Optimal output might be determined in various
ways, but in welfare economics it is generally
held to be that output combination which would
be chosen by individual consumers responding
in perfect markets to prices which reflect
true costs of production.
------------------------------------------------------------------------
supply: refers to the supply of a commodity and its relation with
its price. It is assumed that there is a positive relationship
between both, that is, larger supply will occur at higher price
per unit supplied.
demand: refers to the demand for a commodity and its relation with its
price. It is assumed that there is a negative relationship
between both, that is, more demand for a commodity will occur
if the price per unit decreases.
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Say's law: J-B. Say, in his "Trait d'economie politique" (1803) developed
his theory of the markets which is based on the simple
concept that exchange between two parties involves both a
purchase and a sale. Say extended this interdependency of
supply and demand from the barter economy, where every sale
involves a demand of equal value, no excess demand or supply
can exist and no commodity will be produced without a
corresponding level of demand for its consumption, to a
general theory of markets. Say denied that there could ever
be a general glut of commodities. Thus, Say was a forerunner
of the neo-classical school and their equilibrium analysis,
which assumes perfect competition.
------------------------------------------------------------------------
aggregate demand: (also known as aggregate expenditure), is the sum
total of nominal expenditures on goods and services
in the economy. That is
consumption (C), investment (I), and government
expenditure (G) together with exports (X) and
imports (M).
In the short-run the volume of aggregate demand
determines the volume of output and employment.
In textbooks is expressed as follows:
Y = C + I + G + (X-M)
------------------------------------------------------------------------
aggregate supply: the total amount of good and services produced by
a particular economy during one year. In general,
is conceptualized as the quantity of net national
product
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the quantity theory of money: a theory of demand for money which formed
the most important component of macroeconomic analysis before Keynes'
"General Theory of Employment, Interest and Money", 1936. This same
theory is now enjoying a revival in more sophisticated forms.
By and large, the quantity theory of money relates the quantity of
money, the velocity of circulation of each unit of money , to price
level and volume of transactions. All different versions of this theory,
including M. Friedman's statement that inflation is always a monetary
phenomenon, assume the following:
the economy will always tend to full employment,
national income and the stability of the
velocity of circulation of each unit of money arises
from the technological and institutional framework;
monetarists introduced the notion of
'natural rate of unemployment' to justifiy the
assumption that the economy will always tend to
full employment.
------------------------------------------------------------------------
the public sector borrowing requirement: the amount by which the
revenue of public sector organizations falls short of
expenditure.
For purposes of the definition of public sector borrowing
requirement, coverage includes central government, local
authorities and nationalized industries.
The relevant revenues include taxes on both current and
capital accounts, trading surpluses and rent, interest and
dividends.
Expenditure includes grants, spending on goods and gross
capital formation and debt interest.
The deficit is financed by sales of securities to the non-bank
private sector, increases in currency, borrowing from overseas
and bank lending to the public sector.
The effects of borrowing are more likely to be inflationary
if the financing takes the form of new currency coming into
circulation than if genuine borrowing from the non-bank private
sector takes place, as the money supply is obviously increased
by the first process but not by the second.
Public sector borrowing raises interest rates through the
increased sales of bonds and so makes borrowing by companies
more expensive with possible adverse effects on investments.
This is known as financial crowding out.
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