Read the following text about classical economic theory, Keynesianism, and various forms of neo-classicism. Then study the exercises which follow:
The 18th and 19th century classical economists, most notably Adam Smith in The Wealth of Nations (1776), argued in favour of "laissez-faire" and insisted that natural forces such as individual self-interest and competition naturally determine prices and incomes. Theoretically, under perfect competition -i.e. in the absence of monopolies, oligopolies, externalities, and so on - wages and prices would be perfectly flexible. It was argued that a perfectly competitive economy would produce a general equilibrium. This in turn would lead to "allocative efficiency", the point at which all the resources of an economy are being fully and efficiently employed, so that no particular output can be increased unless another is reduced, and no-one can become better off without making someone else worse off.
Yet the great depression of the 1930s demonstrated that, at least in the short term, the market system does not automatically lead to full employment. If people are pessimistic about the future, they will save more money and consume less, leading to a fall in production and employment. John Maynard Keynes recommended governmental intervention in the economy, to counter the business cycle: an increase in government spending or a decrease in taxation during a recession, to stimulate the economy and increase output, investment, consumption and employment; and a decrease in government spending or an increase in taxation in a period of inflation. To the classical argument that in the long run economies tend to settle at a full employment equilibrium, Keynes replied that "in the long run, we are all dead."
If the post-war period was the era of Keynesianism, events after the 1973 oil crisis demonstrated that Keynes did not have all the answers, and the late 1970s and the 1980s saw the rise of various forms of neo-classicism, all of which agree that medium or long-term economic growth is damaged by short-term Keynesian or "stop-go" government policies to stabilize the economy.
The ultimate aim of Keynesian governmental intervention or "demand management" is full employment - when no involuntary unemployment exists. However, this is now widely considered to be impossible, and even undesirable, as it causes inflation to rise. Many economists now talk about "the natural rate of unemployment" which corresponds to optimal output, when upward and downward forces on prices and wages are in balance, so that inflation is stable. In the 1960s, it was believed that there was a "trade-off" or exchange between low unemployment and high but stable inflation. Yet the development, in the 1970s and 1980s, of "stagflation" - high unemployment or stagnation and persistent and rising inflation, seems to disprove this. It also became clear that in the long run, low unemployment, achieved by fiscal policies, results in rising inflation, because inertial inflation always rises after inevitable shocks. Since it is argued that attempts to force unemployment below its natural rate lead to accelerating inflation, the natural rate is also known as the non-accelerating-inflation rate of unemployment (or NAIRU).
In his General Theory of Employment, Interest and Money (1936), Keynes argued that people's economic expectations about the future were generally erratic and random, and could consequently be systematically wrong. In the 1970s, the Rational Expectations School, led by Robert Lucas and Thomas Sargent, began to argue that, on the contrary, people (or "economic agents") generally make rational choices according to the information available to them. For example, if people anticipate that the government will cut taxes or allow the money supply to grow or interest rates to fall, so as to boost employment and stimulate demand, they will plan and behave accordingly. Even before the government announces such measures, companies will plan price rises, and trade unions will demand
higher pay. This means that predictable and systematic policies to stabilize the business cycle (e.g. monetary expansion and tax cuts) will instantly be compensated for and thus become ineffective. Ir other words, fiscal or monetary policy will only affect output and unemployment if it is unpredictable and comes as a surprise, in much the same way as only random news shocks stock market prices.
Monetarists such as Milton Friedman argue that the average levels of prices, wages and economic activity are determined by the quantity of money in circulation and its velocity of circulation, and that inflation is caused by excessive monetary growth. Other economists have used the same data to argue that it is increased business activity that causes the money supply to rise, and that the money supply follows prices, and not vice versa. Monetarists claim that Keynesian attempts to stabilize the business cycle only lead to rising prices and the crowding out of private investment, and that the business cycle, inflation and unemployment are the unintended results of misconceived government interventions and of exogenous variables. They insist that free markets and competition are efficient and should be allowed to operate with a minimum of governmental intervention. If money supply, rather than fiscal policy, is the major determinant of nominal GNP growth, the role of the government should be to ensure a fixed growth rate for the money supply.
"Supply-side" theorists agree with Keynesians that there is a role for economic policy, but they argue that it should focus on aggregate supply or potential output rather than on aggregate demand. They recommend boosting supply in a stagnant economy by lowering taxes on capital and business profits, which will lead to an increase in the supply of inputs, namely capital and labour.
Label the following statements with the names of the economists whose ideas they describe:
Adam Smith John Maynard Keynes Milton Friedman Robert Lucas
1. The government should intervene in the economy to counter the business cycle.
2. The cause of inflation is unnecessary monetary growth.
3. Planned governmental intervention is not effective as the market will anticipate it.
4. Prices and incomes will find their natural level in an economy which is powered by free enterprise and individualism.
Match the following
word partnerships, all of which
occurred in the text:
Here is a summary of the text. Use the following to fill in the spaces:
The (1) ......................... economists argued that individual self-interest and competition naturally
determine prices and incomes. In a perfectly competitive market, wages and prices would be perfectly
(2)....................... , leading to a general equilibrium. Yet the Depression of the 1930's demonstrated
that the (3)........................... system does not automatically lead to full employment, because if people
are worried about the future, they save more and (4) ........................................... less, which leads to falls in
production and employment. Keynes recommended governmental intervention in the economy, to
(5)....................... the business cycle - increase or decreases in (6).............................................. and/or government
spending as necessary.
Yet the 'stagflation' of the 1970's demonstrated the limits of Keynesianism. Recent neo-classicists argue
that short-term policies to (7)................................. the economy damage medium or long-term economic
growth, and that full employment is necessarily (8).................................... Furthermore, Rational Expectations
theorists argue that economic agents are able to (9)................................... and counteract fiscal and monetary
policies. Monetarists argue that inflation is caused by excessive monetary growth, so that the role of government is to ensure a fixed growth rate for the money supply. Supply-side theorists believe that
economic policy should focus on (10)........................... supply, eg, boosting a stagnant economy by lowering