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HISTORY OF ECONOMIC
THOUGHT

Table of Contents
INTRODUCTION
...
6
MERCANTILISM (1500-1760, English and French merchant businessmen)
...
15
CLASSICAL ECONOMIC THOUGHT AND ITS CRITICS (1776-1867)
...
34
KEYNESIANISM: (1930s – 1970s)
...
42

HISTORY OF ECONOMIC THOUGHT
Historically, four mechanisms have been used to deal with the problem of scarcity
...
Next came
tradition, which emphasized past ways of allocating resources
...
The fourth resource-allocating social institution is the market, which
developed over time
...


INTRODUCTION

Relativist and Absolutist Approaches
1
...

- They hold that history plays a part in the development of every economic theory
...
Absolutist – writers stress internal forces, such as the increasing professionalism in economics,
to account for the development of economic theory
...

- According to this view, it is possible to rank theories absolutely according to their worth; the
most recent theory is likely to contain less error and be closer to the truth than earlier theories
...
Modern Orthodox theorists – largely focused on the four problems of allocation, distribution,
stability and growth
...

4
...
They have focused on the forces leading to the development of economic and other
institutions
...
Thus, the difference between heterodox
and orthodox economists are often differences in focus, not diametrically opposed theories
...
If the mainstream sees little
or no value in a group’s views, we define that group as heterodox
...

- Economics does little to encourage heterodoxy and questions the legitimacy of heterodox views
...

- Heterodox economists are individualistic and are loners, they have little desire to compromise
with their fellow professionals
...
The group that is most successful in
competing becomes the mainstream, and groups that are less successful but do attract some
researchers become nonmainstream
...
An example of the interaction between heterodox thinking and mainstream
developments can be seen in the development of the economics of Alfred Marshall, who was able
to find neoclassical economics by wrestling with the competing claims of historically oriented
economists and abstract theorists
...
Positive economics – concerns the forces that govern economic activity
...

Focuses on facts and cause-and-effect behavioral relationships and includes the development and
testing of economic theories
...

2
...
It is the philosophical
branch of economics that integrates economics with ethics
...
The art of economics concerns questions of policy
...
The methodology of the art of economics is more complex because it concerns policy and must
address interrelationships among politics, social forces, and economic forces
...

The importance of empirical verification
1
...

2
...

3
...
Abductive reasoning
uses both deduction and induction to tell a reasonable story of what happened
...


Why study History of Economic Thought?
1
...
Reading the history of economic thought
strengthens theoretical and logical skills by providing opportunities to relate assumptions
to conclusions
...

2
...


The Evolution of Methodological Thought
1
...
A deductive theory is accepted as
true, only after it has been empirically tested and verified
...
Normative discussions were purged
from economics as unscientific
...
Falsificationism – According to Popper it is never possible to ‘verify’ a theory, since
one cannot perform all possible tests of the theory
...
The progression of science depends upon
the continuing falsification of theories
...
It is only
the minimum trait required of a claim that allows it to be engaged with in a scientific
manner – a dividing line between what is considered science and what isn’t
...
Falsificationism to Paradigm – Thomas Kuhn, moved methodology away from
falsificationism by introducing paradigm into the debate
...
Once a superior
paradigm is developed, a scientific revolution becomes possible
...
This work often leads to the
discovery of anomalies that the paradigm fails to account for, but the existence of such
anomalies is not sufficient to overthrow the reigning paradigm—only an alternative
paradigm that is better able to deal with the anomalies can do so
...

Whereas in Popper’s view “truth” (or the closest we can get to truth) will win out, in Kuhn’s
view a superior theory might exist but not be adopted because of the inertia favoring the
existing paradigm
...

Those who disagreed with mainstream theory quickly adopted Kuhn’s analysis, because it
suggested that the paradigm, they preferred might prove to be superior to, and thus able to
supplant, the mainstream view
...
Research Programs - Only if “sufficient” peripheral implications are falsified will the
hard-core assumptions be reconsidered
...

- Lakatos’s research program was formulated in an attempt to resolve the perceived conflict
between Popper’s falsificationism and the revolutionary structure of science described by
Kuhn
...

- Lakatos’s idea lies in the middle of these 2
...

- All of the scientists working in the same research program form a protective belt around
the core
...


PRECLASSICAL ECONOMICS
-

-

-

800BC – 1500: Early Preclassical period
1500 – 1776: Preclassical period
Scarcity is the source of all economic problems
...

The early preclassical thinkers gave greatest attention to nonmarket-allocating
mechanisms
...
Thus, early preclassical writers were not interested in markets because
of the relative unimportance of markets in the daily activities of people
...
In a premarket setting,
thinkers focused on the use of authority as an allocator of resources
...
Guan Zhong (725-645 BC) – light/heavy theory
...
When it was “locked away,” it became
heavy, and its price would rise
...
Guan Zhong also used this light/ heavy theory to develop a quantity theory of
money, asserting that when money was heavy, its price should rise (prices of goods would
fall), and when money was light, its price would fall (prices of goods would rise)
...
This would not only help stabilize the price level, but also make money for the
government
...

Hesiod and Xenophon – to Hesiod scarcity didn’t arise from limited resources and
unlimited desires; rather, it was one of the evils released when Pandora opened the box
...


-

-

The word economics was used by him as the title of his book Oeconomicus
...

Xenophon, writing some 400 years later Hesiod, applied the concepts of efficient
management at the level of household, the producer, the military, and the public
administrator
...


4
...

Realizing that increasing specialization and division of labor result in economic exchange,
al-Ghazali was able to point to the difficulties of barter and the consequent need for a
currency to facilitate these exchanges
...

Scholastic represents a gradual acceptance of certain aspects of economic activity as
compatible with religious doctrine
...

Feudal economy – consisted of subsistence agriculture in a society bound together
not by a market but by tradition, custom, and authority
...
All land was fundamentally owned by the
Roman Catholic Church or the king
...
Those included supplying services and goods
...

The serf paid the lord for use of the land with labor, crops, and sometimes money
...

Although there were strong elements in the feudal society that reinforced tradition and were
hostile to change, other factors began to erode feudalism’s foundations
...


ARISTOTLE
He rejected Plato’s call for a communist social order in which material things are held in common
...

Because men would feel that they had not received what was rightly theirs, when work and reward
was not strictly and tightly connected, as it is under a system of private property
...
When individuals believe and feel certain
that they will be permitted to keep the fruits of their own labor they will have an inclination to
apply themselves in various productive ways, which would not be the case with common or
collective ownership
...

While Aristotle defended private ownership of property, he did not place the individual at the
center of social concerns
...
” In his view, there was
no life for man outside the city-state into which he was born, neither a physical nor a moral
existence independent of the community and the State
...
Rather the acquisition and use of wealth is a means to pursuing and
attaining those two “higher” ends
...

Aristotle’s defense of slavery under the presumption that some people may be born “naturally” for
servitude since they lacked the potential for these “higher” callings and pursued ends helped
reinforce an institution that freed up the enlightened few of ancient Greek society to supposedly
devote their lives to the non-material purposes of life, while others under coerced compulsion
provided the goods and services permitting them their lives of leisure
...
It incorporates both the production and
consumption of wealth in attaining those “higher” ends
...
”
-

-

-

Chrematistics was concerned with wealth getting, including moneymaking and exchange
...

Aristotle’s main contributions to economic thinking concerned the exchange of
commodities and the use of money in this exchange
...
Hence the production of commodities to satisfy needs
was right and natural, whereas the production of goods in an attempt to satisfy unlimited
desires was unnatural
...

By “natural,” Aristotle meant wealth-getting activity that is clearly and consciously
pursued as a means to the ends of “truth” and “virtue
...

In the Politics, Aristotle views labor as a commodity that has value but does not give value
...
Aristotle observed that labor skill is not a
determinant of exchange value
...
He maintained that value is not created solely by the expenditure
of labor in the production process
...
He says that, in the end, the basic
requirement of value is utility regarding a person's desires
...
To him private property was superior to public property on five grounds—
progress, peace, practice, pleasure and philanthropy
...
Money served only as a medium of exchange, it cannot be
regarded as productive
...
This is a powerful idea for the
various Utopians and socialists who hope to end societal conflicts by eliminating the
conflicts that are inherent in scarcity
...
The rulers were the
king and warriors and the ruled were artisans and unskilled workers
...
At the age of thirty they will have to pass an examination
...

Plato’s main contribution was in his account of division of labour
...
He based the
origin of the state on division of labour
...

Thus, Plato’s idea of division of labour is different from that of Adam Smith
...

Secondly to Adam Smith the advantages of division of labour go to only the employers,
but to Plato it is beneficial to the entire society
...
The size of population in his state
was assumed on the basis of the best results of division of labour
...
The right number of
populations suggested by Plato for a state was 5040
...
It also helps to reap maximum
productive efficiency
...
But if the number exceeds 5040 new colonies
must be established
...
Plato considered value as an inherent quality of the
commodity
...
Only farmers and artisans were allowed
to get property while the rulers and the administrators were not allowed to enjoy the
property rights
...
Plato advocated communism
to eliminate the evils of caste system
...

Plato’s vision and “ideal” ended up serving as an inspiration and standard for much of the
twentieth century under the name of the Total State in both its communist and fascist forms
...
There would be no free
movement of people from city-state to city-state
...
”
Plato’s assumption is that the social environment – the political and economic institutions
in which men live and work – determines their behavioral characteristics
...

Thus, in Plato’s ideal Republic, the guardians would renounce material ownership
...
Women would be shared in common, and
female guardians would have their children taken away shortly after birth to prevent a selfinterested bonding with the child
...
Thomas Aquinas was a very complex and interesting thinker
...

The significance of St
...

The most important contribution of Thomas Aquinas was Just price (“Justum Pretium”)
...
He recognized time and place utility
...
It was, however,
believed that the exact determination of price was not possible
...

The Medieval School believed that value should be equal to costs including the expenditure
on labour
...
Just price was determined
by law
...
Like the Hebrews the Medieval church of fathers also prohibited the taking of
interest
...
But the lender was entitled
for a compensation if the principal amount was not returned within the stipulated time
...
Aquinas followed Aristotle regarding private property
...
The power of acquiring the
property gives the rights on individual
...

The method of using the property was much more important than the right of ownership
...

Again, following Aristotle, Aquinas approved the regulation of private property by the state
and accepted an unequal distribution of private property
...

He argued, private property was an addition to natural law, not a contradiction (naked,
clothes)
Scholastic usury- any taking of interest
...
The scholastic view gradually
moderated from a fairly strict prohibition of interest early in the period to its acceptance—
at least for business purposes—later
...
And
since the economic activity they observed during those early times was not organized into
a market system as we know it, they concentrated not on the nature and meaning of a price
system but on ethical questions concerning fairness, justice, and equity
...
Aristotle and other Greeks examined the
role of private property and incentives
...

Viewed over time, scholastic doctrine represents a slow retreat to a greater acceptance of
economic pursuits
...


MERCANTILISM (1500-1760, English and French merchant businessmen)
-

-

-

-

It is an economic theory that advocates government regulation of international trade to
generate wealth and strengthen national power
...
It advocates trade policies that protect domestic industries
...
Each
municipality levied its own tariff on any goods that passed through its borders
...
The four factors are entrepreneurship, capital goods, natural resources, and
labor
...
It imposes tariffs on imports
...
It doesn't allow anything that could help foreign companies
...
Its taxes
pay for increase national growth and political power
...
Thus, they concluded that any increase in the wealth and
economic power of one nation occurred at the expense of other nations and saw trade as a
means of increasing the wealth and power of a nation and, in particular, focused on the
balance of trade between nations
...
They
strengthened the need for a self-governing nation to protect business rights
...
An example is The
British East India Company
...
It
then plundered their riches
...


-

-

-

-

Many members of Parliament owned stock in the company
...

Mercantilism also worked hand-in-hand with the gold standard
...
The nations with the most gold was the richest
...
They also funded wars against other
nations who wanted to exploit them
...

The goal of economic activity was production, they advocated increasing the nation’s
wealth by simultaneously encouraging production, increasing exports, and holding down
domestic consumption
...
The mercantilists advocated
low wages in order to give the domestic economy competitive advantage in international
trade
...
Thus, when the goal of economic activity is defined in terms
of national output and not in terms of national consumption, poverty for the individual
benefits the nation
...

Mature mercantilists realized that it was not possible for all nations to have a favorable
balance of trade and that trade can be mutually beneficial to nations, and that advantages
will accrue to nations that practice specialization and division of labor
...

The mercantilists believed there was a basic conflict between private interests and the
public welfare
...

Classical economists, on the other hand, found a basic harmony in the system and saw
public good as flowing naturally from individual self-interest
...

The classicals maintained that real output depended not on the quantity of money but on
real forces: labor supply, natural resources, capital goods, and the institutional structure
...
Whereas mercantilist writers were generally pamphleteers
scrambling for some particular form of state advantage, the cameralists were either

bureaucrats in one of the 360 tyrannical German states, or else university professors
advising the princes and their bureaucracy how best to maximize their revenue and power
...


Precursors of the Preclassical economics:
Thomas Mun: Director of the East India company
...
English policy was designed to keep the colonies a raw materialexporting economy that was dependent on England for manufactured goods
...
Mun argued for a favorable
balance and an inflow of gold and silver
...

William Petty: was the first to explicitly advocate the use of what we would call statistical
techniques to measure social phenomena
...
In their view,
morality consists of emotions or sentiments as well as human reason
...
Mandeville has no concept of a natural harmony; he found
the world to be wicked but maintained that “private vices by the dexterous management of a skillful
politician might be turned into public benefits”
...
He also advocated
a large population and child labor since to him, production was the goal of society
...
Mandeville also said the role of government is to take imperfect
humankind, and by rules and regulations channel its activities toward the social good
...
Price specie-flow mechanism à he pointed out that it would be
impossible for an economy to maintain a favorable balance of trade continuously
...

This increase in the quantity of money would lead to a rise in the level of prices in the economy
with the favorable balance of trade
...
Exports will decrease and imports will increase for
the economy with the initial favorable trade balance because its prices are relatively higher than
those of other economies
...
This process will ultimately lead to a self-correction of the trade balances
...

Mandeville maintained that prosperity and employment
were furthered by spending, particularly on luxurious
consumption
...
Furthermore,
he also maintained that the growth of economic freedom went hand in hand with the growth of
political freedom
...


PHYSIOCRACY (1750-1780)
-

-

-

-

-

-

Physiocrat, any of a school of economists founded in 18th-century France and
characterized chiefly by a belief that government policy should not interfere with the
operation of natural economic laws and that land is the source of all wealth
...

They also pictured a predominantly agricultural society and therefore attacked
mercantilism not only for its mass of economic regulations but also for its emphasis on
manufactures and foreign trade
...
Again, whereas mercantilists
claimed that coin and bullion were the essence of wealth, the physiocrats asserted that
wealth consisted solely of the products of the soil
...
On the other hand, they claimed that government
should fix the rate of interest
...

In reaction to the mercantilist notion that wealth was created by the process of exchange,
they studied the creation of physical value and concluded that the origin of wealth was in
agriculture, or nature
...
Therefore,
production from land created the surplus that the physiocrats called the net product
...

The ‘tableau economique’ represents a bold, creative conception of the inter- relatedness
of macroeconomic sectors with great simplicity
...
Farmers are placed at the center of the circular flow,
because (according to the physiocrats) land is the only factor producing a net product
...

They believed that the basic motivation for the economic activities of human beings was
the desire to maximize gain
...
à Laissez-faire
The physiocrats maintained that the primary obstacles to economic growth proceeded from
the mercantilist policies regulating domestic and foreign trade
...

The physiocrats, who considered the source of the net product to be agriculture, maintained
that laissez faire would lead to increased agricultural production and ultimately to greater
economic growth
...
Their
main field of interest was jurisprudence and their writings were very much influenced by
Greek thought
...
Agriculture was
their chief occupation
...
Cato had written more on the
technical aspects of agriculture
...
Varro advised crop growing and stock
breeding
...

Formerly, the barter system was prevalent, but later bimetallism, that is, coins of bronze
and silver was adopted
...
Roman jurists recognized the importance of money as
medium of exchange
...
The Romans strongly condemned usury and money lending
...
In the city of Rome, the usual rate of interest was
4 to 8 percent
...
They attached more value
to hired labourers than to slaves and advocated that hired labourers should be used, in place
of slaves to do the work in unhealthy regions and they should be assigned more important
jobs on projects employing slave labour
...
Some
commodities have greater value than their price
...


-

The Romans discarded the communal ownership of property
...
Aristotle had limited the right
of property; while the Roman law of private property showed unrestricted individualism
which later provided the basis for the institution of capitalism
...

The mercantilists achieved the first tentative insights into the role of money in determining
the general level of prices and into the effects of foreign trade balances on domestic
economic activity
...

The mercantilists and the scholastics perceived a fundamental conflict in the economy,
viewing exchange as a process in which one party gains at the expense of another
...

The physiocrats, on the other hand, perceived the working-out of the conflicts inherent in
relative scarcity as basically harmonious
...


CLASSICAL ECONOMIC THOUGHT AND ITS CRITICS (17761867)
- The three major treatises of the classical period were Inquiry into the Nature and Causes of the
Wealth of Nations (1776) by Adam Smith, On the Principles of Political Economy and Taxation
(1817) by David Ricardo, and Principles of Political Economy (1848) by John Stuart Mill
...

- The economic ideas of the scholastics, physiocrats, and mercantilists were the basis of a more
or less unified system of the classical economists
...

- The view that markets automatically provide harmonious solutions to the conflicts was first
significantly advanced by the physiocrats who followed that the government should adopt a
general policy of non-interference – laissez-faire
...
(economic
freedom leads to efficiency)
2 broad developments relating to the concept of harmony in the economic system:
1
...

2
...

Karl Marx:
- The foremost critic of classical economics, and the person who coined the term classical
...

- Although the classical found in the economy a basic harmony that led them to advocate a
governmental policy of laissez faire, they also found a number of conflicts
...
Marx pointed to the economic clash between capitalists and
laborers
...
à Marx wanted to show how exploitation was embedded in a system
in which labor did not own the means of production
...

- Marx saw the activities of the capitalists as ultimately harmful to the proletariat and the society
...


ADAM SMITH
- Smith was influenced by his teacher, Francis Hutcheson (1694-1746), and by David Hume (17111776)
...
16701733), whose satirical style had given his presentation of the mercantilist position wide currency
...
Mandeville maintained that the pursuit of individual self-interest
would generate many undesirable social and economic consequences, and therefore he built a case
for government intervention in the economy
...
He didn’t study economics in isolation rather he filled in his economic model
with political, sociological, and historical material
...

Contextual Economic Policy: (The art of economics)
- Smith conceded that markets often fail to produce ideal social results, but current reality
convinced him that the results of government intervention were less acceptable than those flowing
from free markets
...

- His broad knowledge of history and of how people behave in practice, if not in theory, made him
a master of the art of economics
...

Natural Order, Harmony, and Laissez-faire
- Like mercantilists, Smith believed that it was possible to discover the laws of the economy by
means of hard analysis
...

Difference between Smith’s system and that of most mercantilists
1
...

2
...

- Human beings are rational and calculating and driven by self-interest
...
Government should not interfere in this process and should therefore
follow a policy of laissez faire; pointed out how private self-interest will lead to the public
good in a nonregulated market economy
...
The capitalist views the market in
terms of final goods and, in order to increase revenues, produces the commodities that
people desire
...

If profits above a normal rate of return exist in any sector of the economy, other firms will
enter these industries and force down prices to a cost of production at which no excess
profits exist
...
Consumers direct the economy by their dollar votes in
the market; changes in their desires are shown in rising and falling prices—and,
consequently, rising and falling profits
...

- Given a few conditions, the self-interest of resource owners would lead to long-run natural prices
that would equalize the rates of profits, wages, and rents among the various sectors of the economy
...

- He argued that in general any government interference is undesirable, because it infringes upon
the natural rights and liberties of individuals
...

- He believed that many of the mercantilist arguments for government intervention, although
purporting to promote the social good, were in fact self-serving
...

- Although he was generally against the regulation of international trade, he made exceptions for
tariffs that protected infant industries
...

- The government was to provide for the national defense, build and maintain roads and schools,
administer justice, and keep vital records
...

Causes of Wealth of Nations:
1
...
It is an observed fact that
specialization and division of labor increase the productivity of labor
...
The division of labor in turn,
depends upon what Smith called the extent of the market and the accumulation of capital
...
A limited market, on the other hand, permits only limited
division of labor
...

- In a simple economy in which each household produces all of its own consumption needs
and the division of labor is slight, very little capital is required to maintain (feed, clothe,
house) the laborers during the production process
...

- This stock of goods comes from saving and is, in this context, what Smith called capital
...
Thus, the extent
to which production processes requiring division of labor may be used is limited by the
amount of capital accumulation available
...
Productive and Unproductive labor: accumulation of capital also determines the rtaio
between the number of laborers who are productively employed and those who are not so

employed
...

- According to Smith, the
larger the share of the labor
force involved in producing
tangible real goods, the
greater the wealth of the
nation
...

- Furthermore, an unequal distribution of income in favor of the capitalists is of tremendous
social importance
...
”
- Furthermore, because economic growth is inhibited by government spending for
unproductive labor, it is better to have less government and, consequently, lower taxes on
the capitalists so that they may accumulate more capital
...
Individual self-interest coupled with the
accumulation of capital leads to an optimum allocation of capital among the various
industries
...
In a system of free markets operating
without government direction, a given level of investment spending would be allocated so
as to ensure the highest rates of economic growth
...

International Trade: (trade isn’t a zero sum game)
- Smith argued for unregulated foreign trade, reasoning that if England can produce a good
at lower costs than France, and if France can produce another good at lower costs than
England, the it is beneficial to both parties to exchange these goods, with each trading
the good it produces at lower costs for the good it produces at higher costs
...
(Also applies to trade within a country as well)

-

As labor becomes more divided and specialized, he pointed out, its productivity increases
dramatically
...

- Smith maintained that the primary determinant of growth was capital accumulation
...

- Smith, who was very policy-oriented in his analysis of international trade, criticized, in
particular, mercantilist policies that had restricted the quantity of trade, concluding that
those policies erroneously assessed the wealth of a nation as consisting of the bullion the
nation held, rather than correctly defining a nation’s wealth as a flow of goods
...
A policy of laissez faire, he believed, would lead to ever higher levels of wellbeing in all countries
...
Because
a commodity’s marginal utility often decreases as more of it is consumed, it is quite
possible that another unit of water would give less marginal utility than another unit of
diamonds
...
Because
Smith did not recognize this (nor did other economists until the 1870s), he could neither
find a satisfactory solution to the diamond-water paradox nor see the relationship between
use value and exchange value
...

- Even though Smith on occasion discussed prices in ethical terms, he had a more important
reason for being interested in the factors determining relative prices
...

- Short run market prices are determined by supply and demand
...

- Because Smith was somewhat confused about the factors determining relative prices, he
developed three separate theories relating to them:
(1) a labor cost theory of value:
- In primitive society: According to Smith’s labor cost theory, the exchange value,
or price, of a good in an economy in which land and capital are nonexistent, or in

which these goods are free, is determined by the quantity of labor required to
produce it
...
It is essential to be able
to measure the differences in the amount of hardship and ingenuity required to
produce the two goods
...

However, this does not provide any solution to the problem, his value theory has
the purpose to explain those forces that determine relative prices but wages
themselves are one of the many prices in an economy that his theory must explain
...
They are no longer free goods, and the final price of a good also must
include returns to the capitalist as profits and to the landlord as rent
...

(2) a labor command theory of value
- According to Smith, under the labor command theory, the value of a good “to those
who possess it, and who want to exchange it for some new productions, is precisely
equal to the quantity of labor which it can enable them to purchase or command”
...

(3) a cost of production theory of value
...
In a cost theory the value of a commodity depends on the
payments to all the factors of production: land, capital and labor
...
Labor is the only factor of production owned by most
households; so a household’s income generally depends upon the wage rate and the number
of hours worked
...

- Because wages, profits, and rents are prices in an economy, their relative values—along
with the quantities of labor, capital, and land that individuals bring to the market—
determine the distribution of income
...
If this means a labor theory of relative prices, the answer is yes and no
...

According to Smith, the general level of prices can best be measured by the price of gold,
silver, or corn
...
We must conclude that for a modern economy Smith did not accept a
labor theory of value to explain relative prices
...

He was policy oriented; was primarily interested in questions of economic policy affecting
economic growth and development, specifically in determining policies that would best
promote the wealth of the nation
...


RICARDO AND MALTHUS
-

Ricardo was a man of financial world (stockbroker turned economist) and Malthus was a
man of the spiritual world
...

The Malthusian Population Doctrine:
3 factors that account for the formation of Robert Malthus’ s theory:
1
...
Perceived increasing poverty of the lower-income class
3
...

The Population Thesis:
- It was founded on two assumptions: (1) that food is necessary for the existence of
humankind, and (2) that passion between the sexes is necessary and will remain unchanged
...
Malthus
contended that human beings, in the absence of checks on population, will tend to increase
their numbers geometrically, but that the food supply can only increase arithmetically
...

- Malthus’s failure to recognize the possibility of technological developments that could
solve the population problem also vitiated much of his theory
...

1
...


Commented [2]: Although the principle of diminishing
returns was first developed by a French economist,
Turgot, in 1765, it had to be rediscovered by West,
Malthus, Torrens, and Ricardo in 1815

2
...
(but concluded that this would only rsult in vice, misery, and degradation
of character because premarital sexual relations would occur)
Flaws:
- Never seriously discussed teh feasibility of controlling population by means of
contraception
...

- Failed to consider the possibility that developments in agricultural technology might permit
sufficient increase in the supply of food to feed an increased population
...
He abstracted from the economy of his time
and built an analysis based on the deductive method
...

- The burning issue of his time was the tariffs on the importation of grain into England and
their effect on the distribution of income, and Ricardo was keenly aware of this question
...

- One key point at which all the issues converged concerned the policy question of free
versus regulated international trade
...

- Ricardo maintained that the principal purpose of economics is to determine the laws that
regulate the distribution of income among landlords, capitalists, and laborers
...

- In general, in his model, Ricardo had three main groups: capitalists, laborers and landlords
...
They perform two essential functions for the economy
...

- Ricardo held to a labor cost theory to explain changes in relative prices over time
...
Real wage =wages fund/labor force
...
The classical
economists were particularly critical of the spending habits of landlords and considered teh
activities of the landowning class to be harmful to the growth and development of the

Commented [3]: Adam Smith had dealt with questions
of political economy in two ways: (1) by using deductive
theory to analyze the economy of his time, and (2) by
presenting a descriptive, informal narrative of
contemporary and historical institutions
...


Commented [4]: Whereas Adam Smith had continued
the mercantilist concern with the forces determining the
wealth of nations

emerging industrial society
...

Corn Laws: were tariffs and other trade restrictions on imported food and grain ("corn") enforced
in the United Kingdom between 1815 and 1846
...
The Corn Laws enhanced the
profits and political power associated with land ownership
...
Economic
historians see the repeal of the Corn Laws as a decisive shift toward free trade in Britain
...

(2) Neutral money - A change in money supply might result in changes in both the absolute
level of prices and relative prices
...

(4) Constant returns in manufacturing and diminishing retuns in agriculture - Supply curves
in manufacturing are horizontal, or perfectly elastic (marginal costs are constant as output
increases); supply curves in agriculture slope upward (marginal costs increase as output
expands)
(5) Full employment - The economy tends to operate automatically at full employment of its
resources in the long run
...

(7) Economic actors - Individuals are rational and calculating in their economic activities
...
The interactions of such a society in perfectly competitive
markets will lead to a uniform rate of profits for investments of comparable risk, to uniform
levels of wages for laborers of the same skills and training, and to common levels of rent
for land of the same fertility
...

(9) Wages fund doctrine - The wage rate equals the wages fund divided by the size of the labor
force
...

- Ricardo then addressed the confusion over value in use and value in exchange that Smith
had illustrated in the diamond-water paradox
...
Ricardo saw that
this was circular reasoning

between use value and exchange value, Ricardo held that use value is essential for the
existence of exchange value, though not its measure
...
The price of
commodities that yield utility derives from two sources: their scarcity and the quantity of
labor required to produce them
...
) have a price that is determined by their
scarcity alone
...
A measure of the quantity of labor: his solution was to measure the quantity of labor by the
amount of time involved in producing a good, that is by clock hours
...
Capital goods: Ricardo solved this problem by identifying capital as merely stored-up labor,
labor that has been applied in a previous period
...

3
...
Price is determined at the margin, and at the margin there is
no rent
...
The differing rents
received by lands of differing fertilities will not, therefore, influence changes in relative prices
over time
...
In contrast to Adam Smith, Ricardo held that use value was necessary for the existence of
exchange value
...
His labor theory of value was developed only for freely reproducible goods produced under
market conditions of pure competition
...
His main concern was to explain the economic forces causing changes in relative prices
over time
...
Although changes in market, or short-run, prices may result from a number of demand and
supply factors, changes in natural, or long-run equilibrium, prices are explained by changes
in the quantity of labor required to produce commodities
...
Although certain factors modify these principles, particularly the element of profits, they
do not confute the essential conclusion that changes in relative prices are for the most part
explained by the quantity of labor required to produce goods
...

By his comparative advantage doctrine, Ricardo proved that the determining element for
gains from international trade is not absolute advantage but comparative advantage
...
He argued
that the value of skill and hardship were settled by the
“higgling and bargaining” in the market, and that the
wage rates paid to different laborers would reflect their
skills and the hardship of their jobs
...


if a country has an absolute advantage in the production of both goods, it will benefit by
trading
...

- What Ricardo proved with his theory of comparative advantage is that voluntary trade or
exchanges between parties can benefit both, because the increased efficiencies that
result from specializing in the product in which one has a comparative advantage lead to
larger total output
...

Say’s Law:
- A law stating that supply creates its own demand
...
Apart from minor
fluctuations in total output, a capitalist economy tends to operate at a level of full
employment
...
Rather than adhering to mercantilist policies, Say’s law makes a
strong case for laissez-faire
...
← Ricardo defended Say’s law and the
quantity theory of money
- Say's Law implies that production is the key to economic growth and prosperity and the
government policy should encourage (but not control) production rather than promoting
consumption
...
Thus, the source of demand is production, not money itself
...
His clear, analytical mind was able to
sort the important from the trivial and build a theoretical framework that dominated
economic thinking for one hundred years
...

Ricardo’s concern with the distribution of income led him to give much greater attention
than previous economists had to the microeconomic issue of formulating a theory of value,
or relative prices; thus, although Ricardo’s major policy interest was in macroeconomic
issues, he moved the focus of economics toward microeconomic questions
...

He strengthened the Smithian case for laissez faire with his argument showing the gains in
welfare from free and open international trade
...


J
...
MILLS:
-

-

-

-

J
...
Mill made lasting and important contributions to economic theory
...

He extended the Ricardian theory of international trade to explain the terms of trade in a
comparative advantage model and came close to explicitly developing the concept of price
elasticity of demand
...
Toward the end of his career, he withdrew his support from the wages fund doctrine,
removing an important economic argument from the arsenal of those who believed that the
mass of society were unable to raise their wages through collective bargaining or political
processes
...

Laws of production are determined by natural forces, but laws of distribution can be
changed by social intervention
...
Beginning in the 1990s, however, many of the societies began to abandon
Marxian ideology and to experiment with a transition to “capitalism
...

Marx was ethnically Jewish
...
In his Economic and Philosophical
Manuscripts, Marx made clear his philosophical objection to capitalism and how he
believed it alienates human beings from themselves
...
Thus, the very existence of markets—especially labor markets—
undermines people’s ability to achieve true happiness
...
But highly specialized labour makes it impossible
...
With the fall of capitalism, a

new set of relations of production will emerge, which Marx called socialism; socialism, in
turn, will finally give way to communism
...
People would
no longer be motivated to work by monetary or material incentives, and the social classes
that existed under capitalism, and to a lesser extent under socialism, would disappear
...
Under socialism,
each person contributes to the economic process according to his or her ability and receives
an income according to his or her contribution; under communism, each contributes
according to his or her ability but consumes according to his or her needs
...
According to this view, ethnic and
nationalistic feelings are a product of capitalism that will disappear under socialism
...
Under capitalism, labor no longer owns its
workshops, its tools, or the raw materials of the production process
...

- According to Marx, in precapitalistic economies human goods were produced primarily for
their use value; that is, commodities were produced for consumption by the producer
...
An understanding of capitalism,
therefore, requires an understanding of the exchange relationships that develop between
owners of commodities, the most important being the relationship between the capitalist
and the proletariat
Marx’s Labor Theory of Value:
- He then turned to labor as the common element and concluded that it is the amount of labor
time necessary to produce commodities that governs their relative prices
...

Marx on Capitalism:
- The chief actor in the Marxian model, as in the Ricardian model, is the capitalist
...
But whereas capitalists in the Marxian system
rationally and calculatingly pursue their economic advantage and sow the seeds of their
own destruction, in the Ricardian system these same rational and calculating capitalists, in
following their own self-interest, promote the social good
...

- Although Marx did not fully develop his theories of business crises, he clearly argued that
periodic fluctuations in economic activity were a fundamental part of a capitalist economy
and one more manifestation of the basic contradictions in capitalism that would lead to its
ultimate destruction
...
Modern work is alienated
...
And
one should be able to see themselves in the work they’ve produced
...
Specialized jobs make the modern economy very efficient, but it makes it hard for any
worker to derive a sense of genuine contribution they might be making to the real needs of
humanity
...
Modern work is insecure; jobs are not very secure
...

3
...
He believed the capitalists shrunk the wages
of laborer as much as possible in order to skim off profit
...

4
...
Capitalism included many crises
...

Capitalist crises are crises of abundance rather than – as in the past – crises of shortages
...
Capitalism is bad for capitalists: bourgeois marriage is an extension of business
...
It makes us value things that have no objective value
...

In his Communist Manifesto, he describes a world: - No private property or inherited wealth Steeply graduated income tax - Centralized control of the banking, communication, and transport
industries - Free public education The grand questions that engaged Marx’s attention are the
following: Can one develop a theory that explains the different ways in which societies have been
organized over time, and can this theory be used to predict the possible future organization of
society? Are the societal structures we call feudalism and capitalism part of an evolutionary
development capable of being analyzed, or are they merely a result of random historical
occurrences? Capitalism, however, like feudalism, contains the seeds of its own destruction, as
conflicts inevitably develop with changes in the forces of production
...

• Marxian theory maintains that people under socialism will set aside their ethnic and nationalistic
allegiances and regard all persons as comrades: a common bond exists across ethnic and national

boundaries that binds all together
...

• Communism is a classless society in which the state has withered away
...

• He used the labor theory of value to show that under capitalism the proletariat was being
exploited, as well as to explain the forces determining relative prices
...
Marx’s avowed purpose was to explain the laws
of motion of capitalism, and to this end he applied his theory of history, dialectical
materialism
...

He used the labor theory of value to show that under capitalism the proletariat was being
exploited, as well as to explain the forces determining relative prices
...

Keynesian economics is considered a "demand-side" theory that focuses on changes in the
economy over the short run
...
Keynesians believe consumer
demand is the primary driving force in an economy
...
Its main tools are government spending on infrastructure,
unemployment benefits, and education
...

Most famous work “The General Theory of Employment, Interest, and Money”
...

First it argued that government spending was a critical factor driving aggregate demand
...

Keynes rejected the idea that the economy would return to a natural state of equilibrium
...
In response to this, Keynes advocated a countercyclical fiscal policy in
which, during periods of economic woe, the government should undertake deficit
spending to make up for the decline in investment and boost consumer spending in order
to stabilize aggregate demand
...
It says the free market allows the
laws of supply and demand to self-regulate the business cycle
...
It will enable private entities to own the factors of

Commented [OA7]: Along with U
...
Treasure official
Harry Dexter White, Keynes is considered the
intellectual founding father of the IMF and the World
Bank, which were created at Bretton Woods
...
During he 1973 oil crisis,
Keynesian policy responses did not reduce
unemployment instead leading to a period of high
inflation and stagflation
...
In this theory,
business owners use the most efficient practices to maximize profit
...
Too much government
spending is dangerous because it crowds out private investment
...

3 psychological factors that determine the effective demand:
1
...
People’s
consumption increases with the increase of people’s income, but not as much as
income
...
Expectation of future return on capital assets: which determines the marginal efficiency
of capital
...
Liquidity preference: the strength of people’s desire to maintain their income and
wealth in the form of money
...

Keynes asserted that free markets have no self-balancing mechanisms that lead to full
employment
...
Lowering interest rates is
one-way governments can meaningfully intervene in economic systems, because of the
slow change in prices money supply can be used as a tool and change interest rates to
encourage borrowing and lending
...
The new economic activity then
feeds continued growth and employment
...

Keeping interest rates low is an attempt to stimulate the economic cycle by encouraging
businesses and individuals to borrow more money
...
This new spending stimulates the
economy
...
This is known as a liquidity trap
...
Voluntary unemployment happens when workers make the choice not to work, maybe
because the wage is too low
...
Frictional unemployment; temporary and inevitable
...
Wages are too high for the employers
...


Commented [OA9]: 1
...


Commented [OA10]: when monetary policy becomes
ineffective due to very low interest rates combined with
consumers who prefer to save rather than invest in
higher-yielding bonds or other investments
...
He believed that unemployment was caused
by a lack of demand
...

The government’s job is to create demand (investing in big public works that would employ
many people) even if that meant creating a deficit in the budget
...
The country should reduce their spending in
case of a recession or economic crises, just like a household
...

In terms of interest theory, the traditional view was that the interest rate depends on
investment and savings
...

In terms of monetary policy, Keynes believed that it wasn’t the money supply but the
effective demand that had a direct effect on prices
...
Aggregate demand is influenced by a host of economic decisions
...

2
...
→ Phillips curve (inflation rises when unemployment falls)
...
Monetary policy can produce real effects on output and
employment only if some prices are rigid
...
Keynesians believe that, because prices are
somewhat rigid, fluctuations in any component of spending – consumption, investment or
government spending – cause output to fluctuate
...

3
...
(therefore,
inflation can be useful in the short run)
...
Keynesians do not think that the typical level of unemployment is ideal – partly because
unemployment is subject to the caprice of aggregate demand, and partly because they
believe that prices adjust only gradually
...
They also feel certain that periods of recession
or depression are economic maladies, not, as in real business cycle theory, efficient market
responses to unattractive opportunities
...
Many but not all Keynesians advocate activist stabilization policy to reduce the amplitude
of the business cycle, which they rank among the most important of all economic problems
...

Commented [OA12]: Create jobs → reduced spending
on unemployment benefits→ more people have higher
wages → higher taxes → higher savings

6
...
They have concluded that the costs of low inflation are small
...
This is based on the belief that macroeconomic fluctuations significantly
reduce economic well-being ad the government is knowledgeable and capable enough to
improve in the free market
...
They agree the government has a role to play, but fiscal policy should
target companies
...

- Trickle-down economics say that all fiscal policy should benefit the wealthy since the
wealthy are business owners, benefits to them will trickle down to everyone
...
Monetarists
like Milton Friedman blame the Depression on high interest rates
...
Keynesian theory’s
popularity waned during the 1970s as many advanced economies suffered stagflation, and
it had no appropriate policy response for stagflation
...

- Socialists criticize Keynesianism because it doesn’t go far enough
...
→ Owning
some factors of production
...
The government completely
controls the economy
...
New classical believed that anticipated
changes in the money supply do not affect real output; that markets, even labour market, adjust
quickly to eliminate shortages and surpluses; and that business cycles may be efficient
...
The new classical economists
of the mid-1970s attributed economic downturns to people’s misperceptions about what was
happening to relative prices
...
This revised
theory differs from classical Keynesian thinking in terms of how quickly prices and wages
adjust
...
New classical economists build their
macroeconomic theories on the assumption that wages and prices are flexible
...
New

Commented [OA13]:

-

-

Keynesian economists, however, believe that market-clearing models cannot explain shortrun economic fluctuations, and so they advocate models with “sticky” wages and prices
...

A long tradition in macroeconomics (including both Keynesian and monetarist
perspectives) emphasizes that monetary policy affects employment and production in the
short run because prices respond sluggishly to changes in the MONEY SUPPLY
...
Because prices and wages are inflexible and do not fall immediately, the decreased
spending causes a drop-in production and layoffs of workers
...
Much new Keynesian research attempts to remedy this omission
...
Thus, new Keynesian economics provides a rationale for government intervention
in the economy, such as countercyclical monetary or FISCAL POLICY
...


-

Wage and price stickiness, and the other market failures present in New Keynesian models,
imply that the economy may fail to attain full employment
...


MONETARISM:
-

-

-

Monetarism, school of thought that maintains that the money supply is the chief
determinant on the demand side of short-run economic activity
...

Monetarist theory asserts that variations in the money supply have major influences on
national output in the short-run and on price levels over longer periods
...
As the
availability of money in the system increases, aggregate demand for goods and services go
up
...

Underlying the monetarist theory is the equation of exchange, MV=PQ
...
An increase in Q means that P will remain relatively constant,
while an increase in P will occur if there is no corresponding increase in the quantity of

-

-

-

-

-

-

-

goods and services produced
...

Milton Friedman (1912-2006) was the leading advocate of Monetarism, and one of the
leaders of the Chicago school of economics (a neoclassical school of economic thought
associated with the work of the faculty at the University of Chicago that rejected
Keynesianism in favour of monetarism)
...

The Keynesians believed that the Phillips relationship was stable and up until 1960s they
ignored the possibility of stagflation; as historical evidence suggested that high
unemployment was typically associated with low inflation and vice versa
...

In particular, they suggested that if inflation lasted for several years, workers and firms
would start to take it into account during wage negotiations, causing workers' wages and
firms' costs to rise more quickly, thus further increasing inflation
...
In the 1970s, inflation was
increasing rapidly, as this happened Keynesian policies and theory lost favour
...
Monetary policy became
the only game in town, but the Keynesian models did not include the potential inflationary
effects of monetary policy and so were not well suited to dealing with discussions of
monetary policy
...

The monetarist approach became influential during the 1970s and early 80s
...

He maintained that there is a close and stable association between inflation and the money
supply, mainly that inflation could be avoided with proper regulation of the monetary
bases’ growth rate
...
S
...
Friedman contended that the government should seek to promote economic
stability by controlling the rate of growth of the money supply; specifically, by increasing
the money supply at a constant annual rate tied to the potential growth of GDP
...

Monetarism thus posited that the steady, moderate growth of the money supply could in
many cases ensure a steady rate of economic growth with low inflation
...


Commented [OA15]: Recession-inflation is a situation
in which the inflation rate is high, the economic growth
rate slows, and unemployment remains steadily high
...
An
unfavourable situation like that tends to raise prices at
the same time as it slows economic growth
...

Furthermore, Freidman’s empirical research and some theory supported the conclusion that
the short-run effect of a change of the money supply was primarily on output but that the
longer-run effect was primarily on price level
...
The shortage caused by a greater demand than
supply will force prices to go up, leading to inflation
...

Friedman’s k-percent rule: money supply should be increased by the central bank by a
constant percentage rate every year, irrespective of business cycles
...

Friedman rule – Friedman advocated setting the nominal interest rate at zero
...

Most monetarists oppose the gold standard, as in the case of the growth of population or
increase in trade outpaces the gold supply, there would be no way to counteract deflation
and reduced liquidity except for mining more gold
...

Freidman also warned against increasing the money supply too fast, which would be
counter-productive by creating inflation
...


Monetarism vs Keynesianism:
-

-

While monetarists assume V is constant, Keynesians believe that velocity should not be
constant since the economy is volatile and subject to periodic instability
...

This runs contrary to monetarist theory, which asserts that such actions will result in
inflation
...
Excessive government intervention (stimulus spending) interferes with the
workings of a free market economy and could lead to large deficits, increased sovereign
debt and higher interest rates which would eventually force the economy into a state of
destabilization
...


Commented [OA16]: Policy based on the ad hoc,
case-to-case judgment of policymakers as opposed to
policy set by predetermined rules
...
The result
was a major rise in interest rates
...


Keynes
Friedman
Monetary policy is ineffective in the traps Fiscal policy is ineffective due to the crowding
(liquidity trap)
out effect
Fiscal policy is always effective
Monetary policy is effective in the short run,
but it should not be used due to lags
-

Monetary policy cannot fix the real interest rate in the long run or have an impact on
unemployment in the long run
...


New Classical School (1970s)
-

-

-

-

-

Originated in the early 1970s; emphasizes the ability of a market economy to cure
recessions by downward adjustments in wages and prices
...

Robert Lucas developed the rational expectations (individuals form expectations about the
future based on the information available to them, and that they act on those expectations)
...

They started with a focus on individuals and their decisions
...

Like classical economics, NCM focuses on the determination of long-run aggregate supply
and the economy’s ability to reach this level of output quickly
...

Regarding policy making, the NCM believes that no government intervention concerning
demand is beneficial for the economy, not even in the short run
...

Rational expectations hypothesis also states that people respond strategically to fiscal and
monetary policy changes; not passively as previous models such as the adaptive
expectations assumed
...


-

-

In Panel b, consumers and firms observe that the money supply is being reduced and
anticipate the eventual reduction in the price level to P3
...
Workers agree to lower nominal wages, and the SRAS1 moves to SRAS2
...
The solution moves form (1) to (2) with no loss in GDP
...
It
also argues that fiscal policy does not shift the AD, at all
...
So, these
people will reduce their consumption as a result
...




---