Question

Regarding the classical, Keynesian, monetarist, and new classical (DSGE) theories, explain the historical context in which each was developed and rose to prominence within economics. Discuss the key assumptions of each theory and explain the resulting policy implications.

Answer 1

Classical economics is a broad term that refers to the dominant school of thought for economics in the 18th and 19th centuries. Most consider Scottish economist Adam Smith the progenitor of classical economic theory. However, Spanish scholastics and French physiocrats made earlier contributions. Other notable contributors to classical economics include David Ricardo, Thomas Malthus, Anne Robert Jacques Turgot, John Stuart Mill, Jean-Baptiste Say, and Eugen Böhm von Bawerk.

• Classical economic theory was developed shortly after the birth of western capitalism. It refers to the dominant school of thought for economics in the 18th and 19th centuries.
• Classical economic theory helped countries to migrate from monarchic rule to capitalistic democracies with self-regulation.
• Adam Smith’s 1776 release of the Wealth of Nations highlights some of the most prominent developments in classical economics.
• Theories to explain value, price, supply, demand, and distribution, was the focus of classical economics.
• Classical economics was eventually replaced with more updated ideas, such as Keynesian economics, which called for more government intervention.

Keynesian Economics

The terminology of demand-side economics is synonymous with Keynesian economics. Keynesian economists believe the economy is best controlled by manipulating the demand for goods and services. However, these economists do not completely disregard the role the money supply has in the economy and on affecting the gross domestic product, or GDP. Yet, they do believe it takes a great amount of time for the economic market to adjust to any monetary influence.

Keynesian economists believe in consumption, government expenditures and net exports to change the state of the economy. Fans of this theory may also enjoy the New Keynesian economic theory, which expands upon this classical approach. The New Keynesian theory arrived in the 1980s and focuses on government intervention and the behavior of prices. Both theories are a reaction to depression economics.

• Keynesian Economics focuses on using active government policy to manage aggregate demand in order to address or prevent economic recessions.
• Keynes developed his theories in response to the Great Depression, and was highly critical of classical economic arguments that natural economic forces and incentives would be sufficient to help the economy recover.
• Activist fiscal and monetary policy are the primary tools recommended by Keynesian economists to manage the economy and fight unemployment.

Monetarist Economics

Monetary theory is based on the idea that a change in money supply is the main driver of economic activity. It argues that central banks, which control the levers of monetary policy, can exert much power over economic growth rates by tinkering with the amount of currency and other liquid instruments circulating in a country's economy.

• Monetary theory posits that a change in money supply is the main driver of economic activity.
• A simple formula governs monetary theory, MV = PQ.
• The Federal Reserve (Fed) has three main levers to control the money supply: The reserve ratio, discount rate, and open market operations.
• Money creation has become a hot topic of late under the “Modern Monetary Theory (MMT)" banner.

Neoclassical economics is a broad theory that focuses on supply and demand as the driving forces behind the production, pricing, and consumption of goods and services. It emerged in around 1900 to compete with the earlier theories of classical economics.

• Classical economists assume that the most important factor in a product's price is its cost of production.
• Neoclassical economists argue that the consumer's perception of a product's value is the driving factor in its price.
• They call the difference between actual production costs and retail price the economic surplus.