Progress in Economics
As elusive as soap in the bath?
The issue of social science
• Pure science includes subjects such as
Physics and Chemistry
• They have the ability to use laboratory
experiments to test theories and
examine the world
• Social sciences have no laboratory,
there can be no experiments, just
observation.
No lab, so what do you do?
• There are two ways to approach a
problem when you can’t experiment
• 1. Observe the world and see if you can
see a pattern
• 2. Think about the world and form a
theory which you then test against
reality
No lab, so what do you do?
• The first is called Induction or the
inductive method
• The second Deduction or the deductive
method
• The problem is the first is logical
nonsense and the second may never
work!
Induction
• The process of induction
• Observe the data – an empirical study
• Form a theory (hypothesis) from those
observations
• Usually works in the hard sciences.
Repeat experiments, get the same
results time and time again and you are
probably on safe ground
Induction
• Social sciences have a problem
• No matter how many observations are
made there is no inevitability that future
observations will support the same
theory.
Induction
• I observe only white swans
• I induce that all swans are white
• But a black one might be out there
Deduction
• Start with axioms which are taken to be
true
• Apply deductive logic and form a
theory
• Then test against reality (the data)
Deduction
• Axiom: Consumers try to maximise
their satisfaction through rational
decisions
• Logic: Consumers will try to get the
best value for money from their income
when deciding what to buy
• Theory: If the price of a good rises
Consumers will buy less of it
Deduction
• Problems for Economics
• Consumers may not be rational
• More than just price may change at the
same time
• So price may rise and people buy more
of a good – maybe incomes changed,
people judge quality by price, a good
consumed with it got cheaper
Deduction
• So economics must make the
assumption of Ceteris Paribus – All
other things stay the same – for the
theory to make sense
• Also the assumptions may be wrong.
Hypothetico-Deductive Method
• Science requires a theory to produce a
set of predictions which have the
potential to be falsified by the evidence.
• So Economists favour the hypotheticodeductive method of reasoning as
induction and deduction seem
inadequate
Hypothetico-Deductive Method
Hypothesis
Revised
hypothesis
Deduction
Induction
Proposition
Empirical testing
Hypothetico-Deductive Method
Hypothesis
There is a relationship between the
Level of unemployment and wage rises
Revised
hypothesis
Deduction
When unemployment is low
Induction
Unions can ask for higher wages
Proposition
Inflation is caused by
‘wage-push’ factors
Empirical testing
The Phillips Curve
Hypothetico-Deductive Method
Revised hypothesis
Inflation is caused by cost
factors and highest during
low unemployment
Hypothesis
Deduction
Proposition
Induction
There is a trade-off between
Unemployment and inflation
Empirical testing
Phillips curve
It turned out to be wrong!
The Reality
• Economists debate – argue with each
other to make progress
• The problem is that when forming the
hypothesis they will rely on selecting
axioms
• And the economists core belief will
guide that choice
Progress through debate
• Since the start of Economics as a
distinct subject (1776) economists have
argued their point
• One of the oldest debates in economics
is the one about the cause of
recessions.
Progress through debate
• There are two fundamental schools of
thought:
• Those who believe that the economy is
essentially self regulating
• Those who believe that the economy
can fail to employ everyone and growth
is not assured
What causes recessions?
• This debate has been an active one
since the 18th Century
• We will concentrate on its latest
incarnation the Keynesian – Monetarist
debate
How debates proceed
• One side lays out their theory. They
state their assumptions and put
forward their predictions
• They appeal to the data to support their
theory
• The other side put forward their
objections and may state a theory of
their own
Keynesian thinking
• Keynes reignited this old debate in his
‘General Theory’ in 1936. His aim was
to explain the ‘Great Depression’ of
1930 to 33.
• His axiom is that the economy is not
self-regulating
• His hypothesis is that it is possible for
expenditure in the economy to be less
than the total level of output
Keynesian thinking
Hypothesis
It is possible for effective demand to be
less than total output
Revised
hypothesis
Deduction
This will lead to a ‘surplus’ level of
Induction
output and so workers will be
released by firms
Proposition
Without government action
to boost demand the situation
persists
Empirical testing
Keynesian thinking
Hypothesis
Revised
Hypothesis
Governments should
Manage the economy
Deduction
Proposition
Induction
If effective demand rises
the recession will end
Empirical testing
The Great Depression 1930
To 1933
Keynesian thinking
• The Keynesian view was very
persuasive in the wake of the
experience of the 1930s
• Governments after 1945 followed a
policy of managing the level of
economic activity by manipulating the
level of demand.
• They did this by varying their own
spending and taxation levels
Monetarist thinking
• Monetarists represent the type of
thinking that dominated economics
prior to the Great Depression
• There axiom was that the economy is
essentially self-regulating, but cyclical
• Their hypothesis was that prolonged
recessions must be caused by some
sort of intervention in the normal
process
Monetarist thinking
• For the Monetarists, led by Milton
Friedman and the Chicago School the
problem was the quantity of money in
circulation
Monetarist thinking
Hypothesis
Effective demand is determined by the
quantity of money in circulation
Revised
hypothesis
Deduction
A fall in the money supply will leadInduction
to a fall in demand and so output
Proposition
The Central Bank should
maintain a stable money supply
Empirical testing
Monetarist thinking
Hypothesis
Deduction
Proposition
Revised
Hypothesis
Central Banks should
adopt a ‘Money
Supply Rule’
Induction
The Great Depression
was caused by the
Federal Reserve Bank
Empirical testing
During Great Depression the Federal
Reserve allowed the US money supply
to fall by a third
Monetarist thinking
• After the failure of Keynesian policy in
the 1970s the Monetarist view became
the norm
• This developed into the ‘New
Classical’ approach as Monetarism is
essentially a ‘one problem’ theory.
The debate
• In the 1970s Keynesians and
Monetarists debated how the economy
worked with passion
• The debate was often difficult as each
side talked at cross-purposes
• This was because their axioms – which
were based on their core beliefs conflicted
The debate
• But as time wore on progress was
made.
• Keynesians (now called PostKeynesians and New-Keynesians)
accepted that ‘money does matter’
• Milton Friedman discussed the
Monetarist case in the format of the
Keynesian IS/LM model
The debate
• By the 1990s a consensus was
reached.
• Inflation stability was prioritised but not
by manipulating the money supply.
Instead interest rates were used
• Aggregate demand was monitored to
smooth out the business cycle while
not threatening the inflation target
The latest
• The Global Financial Crisis was met by
a massive Keynesian style stimulus to
boost demand in the economy
• No serious objections to this was
raised by market economists
recognising this was a major and
unusual demand side shock
• Monetary policy was changed to
support an economic recovery
The latest
•
•
•
•
Sadly the debate now reignites
There is still disagreement on
1. What caused the GFC
2. How to design policy to recover from
it after the initial shock
The latest
• But that’s why
economics is so
interesting – it’s
always changing