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 Economic Theory                                   

 As economies have developed over time, so        
 economic theory has developed as well to try to  
 explain changing circumstances. In the 19th
 century and the beginning of the 20th century
 Classical theory held the balance of power in
 economic circles, but it began to lose it at the
 time of the Great Depression of the 1930s.
 Classical theory had difficulty in explaining
 why the depression kept getting worse, and an
 economist called John Maynard Keynes began to
 develop alternative ideas.

 This marked the birth of Keynesian economics and
 most post-war governments managed the economy
 using Keynesian policies up until the beginning
 of the 1970s. Then Keynesian theory ran into
 trouble as unemployment and inflation began to
 rise together - a phenomenon known as
 stagflation[Look up Stagflation in glossary]. At
 this point another economist stepped in - Milton
 Friedman. He was known as a Monetarist, and
 along with a number of other Monetarist
 economists at Chicago University did a lot of
 work trying to explain what caused inflation.

 However, the Conservative government of the
 1980s gradually became disillusioned with
 Monetarism and then returned to a modern
 variation of classical economic management -
 Neo-Classical economics. Like Classical
 economics, it stresses the role of free markets
 in delivering the best possible level of
 economic growth.




 (Neo-)Classical Theory - Introduction          

 The term 'Classical' refers to work done by a  
 group of economists in the 18th and 19th      
 centuries. Much of this work was developing  
 theories about the way markets and market   
 economies work. Much of this work has      
 subsequently been updated by modern       
 economists and they are generally termed 
 neo-classical economists, the word neo  
 meaning 'new'.                          
                                         
 In this section we look more generally at the
 work of Classical economists. Follow the
 links below or at the foot of the page to
 find out more detail about what they believed
 in and the policies they proposed.




 (Neo-)Classical Theory - Beliefs               

 Classical economists were not renowned for     
 being a happy, optimistic bunch of economists  
 (in terms of their economic thinking!). Some   
 believed that population growth would be too   
 rapid for the resources available (Malthus     
 was a particular exponent of this view). If    
 this wasn't enough to depress the rate of      
 long-term growth (and the rest of the          
 population along with it!) then diminishing    
 returns                                        
 would cause further problems for growth.

 They believed that the government should not
 intervene to try to correct this as it would
 only make things worse and so the only way to
 encourage growth was to allow free trade and
 free markets. This approach is known as a
 'laissez-faire' approach.
 Essentially this approach places total
 reliance on markets, and anything that
 prevent markets clearing properly should be
 done away with.

 Much of Adam Smith's early work was on this
 theme, and he introduced the notion of an
 invisible hand that guided economic activity and led to the
 optimum equilibrium. Many people see him as
 the founding father of modern economics.

 The Victorian period of rapid expansion
 worldwide seemed to cheer the Classical
 economists up a little and they became a bit
 more optimistic, but still maintained their
 total faith in the role of markets. For some
 more detail on their theories, policies and
 Classical aggregate supply and demand
 analysis, follow the links below.



 (Neo-)Classical Theory - Theories                                           

 Classical theories revolved mainly around the role of markets in the               Theory
 economy. If markets worked freely and nothing prevented their rapid                  Neo-Classical
 clearing then the economy would prosper. Any imperfections in the market                 Introduction
 that prevented this process should be dealt with by government. The main                 Beliefs
 roles of government are therefore to ensure the free workings of markets                 Theories
 using 'supply-side policies' and               AS & AD
 to ensure a balanced budget. The main                Policies
                                                                                          VE Policies
 theories used to justify this view were:                                             Keynesian
                                                                                      Monetarist
    * Free market theory
    * Say's Law
    * Quantity Theory of Money

 Free market theory

 The Classical economists assumed that if the economy was left to itself,
 then it would tend to full employment equilibrium
 . This would happen if
 the labour market worked properly. If there was any unemployment, then the
 following would happen:

  unemployment (a                       increased            equilibrium
    surplus of     [-->] fall in [-->]  demand for  [-->] restored at full
      labour)             wages           labour             employment

 This can be shown on a diagram of the labour market. Wages are initially
 too high and there is unemployment of ab. This causes wage rates to fall
 and employment increases as a result from Q1 to Q2. Any unemployment left
 in the economy would be purely voluntary unemployment
  - people who have chosen not to work at the going wage rate.

 The same would also be true in the 'market for loanable funds'
 . If there was any discrepancy between savings and investment
  the equilibrium would change in the
 market. This would again require a free market and flexible prices. In
 this market the price is the rate of interest.
 Say, for example, investment
 increased, then the following process would occur to restore equilibrium:

                                                increased
                                                savings as
                                                borrowers
 increase in      increased      increased         are          equilibrium
 investment [-->]  demand  [-->]  rate of [-->] attracted [-->] is restored
                  for money      interest
                                                by higher
                                                 rates of
                                                 interest

 Say's Law

 Say's Law is imaginatively named after an
 economist called Say. Jean Baptiste Say was an economist of the early
 nineteenth century. His law says (excuse the pun!) that:

      'Supply creates its own demand.'

 This once again provides a justification for the Classical view that the
 economy will tend to full employment. This is because, according to this
 law, any increase in output of goods and services (supply) will lead to an
 increase in expenditure to buy those goods and services (demand). There
 will not be any shortage of demand and there will always be jobs for all
 workers - full employment. If there was any unemployment it would simply
 be temporary as the pattern of demand shifted. However, equilibrium would
 soon be restored by the same process as shown above.

 Quantity Theory of Money

 The classical economists view of inflation revolved around the Quantity
 Theory of Money, and this theory was in turn derived from the Fisher
 Equation of Exchange.
 This equation says that:

                                  MV = PT

 where:
    M is the amount of money in circulation
    V is the velocity of circulation of that money
    P is the average price level and
    T is the number of transactions taking place

 Classical economists suggested that V would be relatively stable and T
 would (as we have seen above) always tend to full employment. Therefore
 they came to the conclusion that:





 (Neo-)Classical Theory - AS & AD                      

 We have seen that Classical economists had complete    
 faith in markets. They believed that the economy       
 would always settle - automatically - at the full      
 employment equilibrium in the            
 long-run. However, they did acknowledge that there      
 might be a slightly different reaction in the short     
 run as the economy adjusted to its new long-run         
 equilibrium. We can illustrate these changes with AS    
 & AD analysis:                                          

 Short-run

 Any increase in aggregate demand in the
 short-run will lead to an increase in output (Q1 to
 Q2), but will also lead to prices increasing. This
 will happen as firms suffer from diminishing returns and are
 forced to increase the prices of their product to
 cover the higher level of costs. Increases in
 aggregate demand may come about for a variety of
 reasons including:

    * Increases in the money supply
    * Lower levels of taxation
    * Increased government expenditure

 Long-run

 In the long-run, however, the situation will be
 different. The economy will have tended towards full
 employment on its own, and so any further increases
 in demand will simply be inflationary. The shape of
 the long-run aggregate supply curve
 will therefore be vertical:

 The long-run aggregate supply curve is vertical at
 the full employment level of output (Qfe), and any
 increase in aggregate demand leads to prices
 increasing, but no increase in output.



 (Neo-)Classical Theory - Policies                 

 So, Classical economists are of the view that the    
 economy is self-adjusting. We can therefore sum     
 up their policy recommendations in a variation on  
 a well-known phrase (you may well have heard it   
 from your teacher or lecturer in its original    
 form!):                                         
                                                
      'Don't just do something, sit there!'    
                                              
 Of course, taking this too literally would be
 unfair on Classical economists, but it would be
 true to say that because the economy tends to
 full-employment, there is no need to actively
 intervene in the economy. In fact intervention
 may simply be destabilising and inflationary. The
 key to long-term stable growth is therefore:

    * Ensure free markets with no imperfections
      (through supply-side policies)
    * Control the growth of the money supply to
      ensure low inflation

 Supply-side policies

 Supply-side policies can be used to reduce market
 imperfections. This should have the effect of
 increasing the capacity of the economy to produce
 (in other words the long-run aggregate supply).
 If the level of aggregate supply increases then
 Say's Law (the
 work of Jean Baptiste Say) predicts that demand
 will also increase. This will be the only
 non-inflationary way to get increases in output.

 Using supply-side policies has increased the
 level of output from Qfe1 to Qfe2, but the price
 level has remained stable. Supply-side policies
 as we have said are ones that reduce market
 imperfections. They may include:

    * Improving education & training to make the
      work-force more occupationally mobile
    * Reducing the level of benefits to increase
      the incentive for people to work
    * Reducing taxation to encourage enterprise
      and encourage hard work
    * Policies to make people more geographically
      mobile (scrapping rent controls, simplifying
      house buying to speed it up, ......)
    * Reducing the power of trade unions to allow
      wages to be more flexible
    * Getting rid of any capital controls
    * Removing unnecessary regulations

 Money supply policies

 The other area that Classical economists felt was
 important was to control monetary growth. In this
 way (as predicted by the Quantity Theory of Money)
 they would be able to maintain low inflation.
 Policies might include:

    * Open-market operations
      [Look up Open-market Operations in glossary]
    * Funding[Look up Funding in glossary]
    * Monetary-base control
      [Look up Monetary-base Control in glossary]
    * Interest rate control