Economics is the science that concerns itself with the production, distribution, and consumption of goods and services. It has influenced the world of finance in many important junctions throughout history and is a vital part of our everyday lives. In this article, we’ll look at the development and evolution of economic theories or ‘schools of thought’ of which were moulded by time to suit the economic conditions endemic to that period. Do take note that economic theories are really just a combination of beliefs derived from the behaviours of individual and groups and thus, there is no consensus about which theory is correct, but the one most used by governments is Keynesianism and you’ll get to see why later on.

Classical Economics 

One of the earliest and perhaps most prominent contributions to the study of macroeconomics was introduced in the 18th century by Adam Smith and subsequently expanded by David Ricardo and Robert Malthus. These ‘classical economists’ believed that competition was self-regulating and that governments should take no part in business be it through tariffs, taxes or any other means, unless it was to protect free-market competition.

The main idea was that markets work best when they are left alone because the price mechanism (the system in which the forces of demand and supply determine the prices of goods) acts as a powerful ‘invisible hand’ (note to illustrator, this bit is important) to allocate resources to where they are best employed. The ‘invisible hand’ refers to the unobservable market force that helps the demand and supply of goods in a free market reach full employment of resources. The most important implications of classical economics are efficiency and full employment—attained without government intervention because all markets, especially resource and labour markets, achieve equilibrium. With equilibrium, a market has neither a surplus nor a shortage. A surplus in any labour market would mean unemployment. With no surplus, there is no unemployment. ‘Value theories’ were also developed to quantify and explain the exchange value (or price) of goods and services and value of a product was thought to depend on the costs involved in producing that product. Such costs could comprise any of the factors of production (including labour, capital, or land) and taxation.

Neoclassical Economics 

Neoclassical economics, as its name implies, developed from the classical economics dominant in the 19th and 20th centuries. Its beginning can be traced to the Marginal Revolution of the 1860s (referring to the change in economic theory from classical to neoclassical economics), which brought the concept of utility (total satisfaction received from consuming a good or service) as the key factor in determining value in contrast to the classical view that the costs involved in production were value’s determinant.

Individuals are viewed to have rational preferences, and they maximise utility. Here, utility maximisation refers to the belief that when individuals purchase a good or a service, they strive to obtain the most amount of value possible, while at the same time spending the least amount of money possible. When combined, the consumer is attempting to derive the greatest amount of value from their available funds.

Keynesian Economics 

During the Great Depression of the 1930s, existing classical and neoclassical economic theories were unable either to explain the causes of the severe worldwide economic collapse or to provide a solution to jump-start production and employment.

John Maynard Keynes sparked a revolution in economic thinking which then overturned the prevailing idea that free markets could automatically provide full employment. Keynes argued that inadequate overall demand could lead to prolonged periods of high unemployment. An economy’s output of goods and services (or aggregate demand AD) is the sum of four components: consumption C, investment I, government spending G, and net exports NX (the difference between what a country sells to and buys from foreign countries). Any increase in demand has to come from one of these four components. But during a recession, strong forces often dampen demand as consumer spending goes down. For example, during economic downturns uncertainty often erodes consumer confidence, causing them to reduce their spending, especially on goods like a house or a car. This reduction in spending by consumers can also result in less investment spending by businesses, as firms respond to weakened demand for their products. This puts the task of increasing output on the shoulders of the government. According to Keynesian economics, government intervention is necessary to moderate the booms and busts in economic activity, otherwise known as the business cycle.

His theories propose that governments are obligated to use monetary policy, (meaning to change interest rates or money supply) and fiscal policy, (meaning government spending) to alter the economy from how it would otherwise behave. He strongly supported government deficit spending (government’s expenditures exceed its revenues) as a way to solve unemployment. Note that his theories were developed during horrific levels of unemployment in the Great Depression. He argued a drop in consumer spending during the recession could be met by a corresponding increase in government deficit spending, maintaining the correct level of aggregate demand to prevent high levels of unemployment.

Ironically, after four decades of dominance, flaws in Keynesian economics were revealed by another macroeconomic phenomenon, stagflation (a period of slow economic growth occurring simultaneously with high rates of inflation). This was due to the fact that the 1970s stagflation was caused by high oil prices, high inflation as well as unemployment, which contradicted the Keynesian economic theories that state that inflation have an inverse relationship with unemployment and a positive relationship with economic growth, causing Keynesian economists to reconsider their beliefs.

Monetarist Economics 

Subsequently, monetary economic theory then appeared in the arena when some of the ideals of classical economic theory were again embraced, as Keynesianism failed in the 1970s. Monetarism, which became influential from the 1970s to the 1980s, is most widely associated with Milton Friedman and is a school of thought in puts emphasis on the role of governments in controlling the amount of money in circulation, as it is believed that variations in the money supply have major influences on national output in the short run and on price levels in the long run. In the years that followed, however, monetarism fell out of favour with economists, and the link between different measures of money supply and inflation proved to be less clear than most monetarist theories had suggested. Many central banks today have stopped setting monetary targets and instead have adopted strict inflation targets.

References

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Merit Advisors, (2016). [online] Available at: http://meritasadvisors.com/wp-content/uploads/2011/03/Schools-of-Economic-Thought.pdf [Accessed 14 Oct. 2016].

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Whistling In The Wind. (2013). Guide To The Economic Schools Of Thought. [online] Available at: https://whistlinginthewind.org/2013/10/06/guide-to-the-economic-schools-of-thought/ [Accessed 14 Oct. 2016].

Newworldencyclopedia.org. (2016). Neoclassical economics – New World Encyclopedia. [online] Available at: http://www.newworldencyclopedia.org/entry/Neoclassical_economics [Accessed 14 Oct. 2016].

Policonomics.com. (2016). Neoclassical Economics: Marginal revolution | Policonomics. [online] Available at: http://www.policonomics.com/lp-neoclassical-economics-marginal-revolution/ [Accessed 14 Oct. 2016].

Imf.org. (2016). What Is Keynesian Economics? – Back to Basics – Finance & Development, September 2014. [online] Available at: http://www.imf.org/external/pubs/ft/fandd/2014/09/basics.htm#author [Accessed 14 Oct. 2016].

Download the Report and Infographic Here:

The Evolution of Macroeconomic Schools of Thought Report

 

The Evolution of Macroeconomic Schools of Thought Infographic

Prepared by Tan Joey.