Jim’s Notes

Review and Summary of the Three Big Theories

Classical-based Theories

Review: Classical Theory

Origins and Ideological Biases:

  • counter to Mercantilist theory
  • explain emergence of business cycles and inflations in 19th century
  • justification for free markets, no regulation, industrial revolution,
  • government is inherently inefficient and destructive

Assumptions:

  • Competitive markets
  • Quick adjustment to equilibrium
  • Say’s Law

Rx:

  • Small govt, balanced budget
  • Laissez faire
  • Supply-side focus

Predictions:

  • Self-regulating economy – stable full employment is the natural state
  • Short recessions / inflations
  • Inflation OR recession

Problems:

  • Big business and big govt
  • Public goods/externalities
  • Expectations and AD
  • Fiat money
  • Poor track record at predicting or explaining economic events and trends

Review: Monetarist Theory (Derived from Classical but with Quantity Theory of Money added

Origins and Ideological base:

  • Classical theory updated to counter Keynesian theory
  • Tends to share much with micro-oriented market theories

Assumptions:

  • Competitive markets and all other Classical assumptions
  • Can measure money and inflation
  • Velocity is stable

Rx:

  • Constant money growth
  • ‘Wise’ central bank

Predictions:

  • Central bank manages recessions / inflations
  • Excess money growth = inflation
  • Low interest rates = growth

Problems:

  • Liquidity trap
  • Bubbles
  • Open economy
  • Unstable velocity
  • Bias toward inflation
  • Limited ‘real’ impact

 

Keynesian-related Theories

Review: Keynesian Theory (Original)

Origins and Ideological Base:

  • Explain Great Depression and cycles that Classical couldn’t
  • Industrial and financial capitalism tends to be a powerful growth machine but is sometimes unstable
  • Government policy (fiscal, monetary, and some regulatory) is needed to stabilize macroeconomic conditions
  • Government is not necessarily worse than private enterprise, but private enterprise is preferred IF possible

Assumptions:

  • Monopolistic markets
  • Sticky prices/wages
  • ‘Animal Spirits’ and Expectations
  • Financial and asset markets especially prone to crises and boom-bust cycles without ‘real’ economic reasons

Rx:

  • Counter-cyclical fiscal policy
  • Automatic stabilizers
  • Monetary policy to lower interest rates in recession or raise rates in inflation
  • monetary policy ineffective in liquidity trap or at zero lower bound interest rates
Demand-side focus
  • Predictions:

  • Industrial financial capitalist economy is inherently unstable unless stabilized by fiscal/monetary policies
  • Mild recessions / inflations if recommendations followed
  • Deep, long depressions if recommendations NOT followed
  • Inflation OR recession likely
  • Govt manages macro economic conditions

Problems:

  • Impracticality of responding to economic conditions govt budgets and deficits
  • Lags
  • Appropriate sized responses
  • Financing deficits
  • not a problem with fiat currency and cooperative central bank
  • must balance budgets or limit defiicts over the business cycle if using a fixed-exchange rate currency

Heterodox Theories (Post-Keynesian, MMT)

Origins and Ideological Base:

  • Extension of Keynesian Theory to counter Neoclassical and Monetarist critiques
  • Industrial and financial capitalism tends to be a powerful growth machine but is inherently unstable
  • Financial and banking crises, resulting in high unemployment in the real economy, are an inherent feature of complex financial capitalism
  • Government fiscal policy and strict financial regulation is needed to stabilize economy and achieve full employment
  • Explanation of fiat money systems as actually practiced instead of extending older commodity-based money theories

Rx:

  • Aggressive fiscal policy management to achieve and maintain a guarantee of full employment
  • Increase deficits until full employment achieved
  • Reduce deficits when full employment reached so as to avoid inflation
  • some deficit may be necessary if there is a trade deficit and/or the private sector wants to save
  • Monetary policy should accommodate and support fiscal policy
  • Strict financial and banking regulation to avoid financial crises and smooth cycle