Chapter 2 : School
of Thoughts
Kornkarun Kungpanidchakul, Ph.D.
Macroeconomics
MS Finance
Chulalongkorn University, Spring 2008
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School of thoughts
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Classical Economics
Keynesian Economics
Monetarist
New Classical Economics
Real Business Cycle
New Keynesian Economics
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Classical Economics
• Inspired by
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David Hume
Adam Smith
Thomas Malthus
David Ricardo
Etc.
• The main idea is “invisible hand”. The most
effective market system is the market without
government intervention. The outcome will be
efficient.
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Classical Economics
• Aggregate supply
– Prices and wages can adjust quickly and fully.
– Households and firms learn reasonably and
quickly about economic environment.
– The economy is always fully-employed.
– The position of AS changes because of
capital stock, technology, or skill of labor.
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Classical Economics
• Aggregate demand
– The classical theory centers on the quantity
theory of money
MV = PT
(1)
With M = the quantity of Money in the circulation
V = the transaction velocity of money
P = price level
T = volume of transaction
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Classical Economics
• Aggregate demand
- Assume that T = Q (real output), with Q is
fixed at the fully employed level. Also, the short
run V is fixed.
- Therefore, (1) becomes:
M V  PQ
A change in money supply only affects the
price level.
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Classical Economics
• Implications of Classical Economics
– Money supply changes has not effect on current
output, only affect price.
– Changes in government expenditure has no effect on
current output.
– Changes in the overall level of taxation do not affect
current output.
– Changes in marginal tax rates can cause current
output to change.
– Policy tools will not affect output and employment but
add instability.
– Let market work properly is the best thing the
government can do.
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Neoclassical Economics
• The main decision problem is resource
allocation, not economic growth.
• Price is determined by preference of
consumers, not purely on production cost
(which is claimed by traditional classical
economists).
• “Marginalism”, use marginal value to
analyze economic problems.
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Keynesian Economics
• Motivated by the great depression
• Keynes published “The General theory of
Employment, Income, and Money” in
1936.
• The classical economics cannot explain
the great depression since it considers
only LR equilibrium and expects a
temporary disequilibrium to be adjust
quickly.
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Keynesian Economics
• Keynesians believed that the cause of the great
depression was due to a combination of events
that led to great uncertainty, huge decreases in
investment, and economies being stuck in an
unemployment trap.
• “In the long run, we are all dead”
• Government intervention is needed to help an
economy to go back to the steady state.
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Keynesian Economics
• Aggregate supply
– Wages and quantities do not adjust
immediately (wage/price rigidities in the short
run).
– Involuntary unemployment could occur.
– When prices are rigid, all necessary
information are not transmitted to market
participants; hence, market might not work
well.
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Keynesian Economics
• Aggregate demand
– The main tool used by Keynesian economists
is IS-LM model.
– LM is flat and IS is steep; therefore,
• Liquidity trap, the change in money stock would
have little effect or no effect at all on the interest
rate.
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Keynesian Economics
• Implications of the Keynesian model
– The economy is unstable.
– The economy takes a long time to adjust to
shocks and go back to the steady state.
– AD is the main determinant of output and
employment.
– Fiscal policy is preferred to monetary policy.
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Monetarist
• Inspired by
– Friedman (1912)
– Brunner (1916)
– Meltzer (1928)
• Friedman did not believe the Keynesian
view that money had little or no impact.
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Monetarist
• The important of money
– The only times that major economic
contractions occurred were when the absolute
value of the money stock fell.
– From evidences, changes in money cause
changes in money income.
– Monetarists believe that money is a substitute
for a wide range of real and financial assets, but
not single asset could be a close substitute for
money. So interest rate affect money demand.
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Monetarist
• Monetarists thought that LM is flatter and
IS is steeper than in Keynesians.
• Fiscal policy would lead to a large amount
of “crowding out” of investment and have
little impact on total output.
• There is no liquidity trap.
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Monetarist
• Philips curve
– The second wave of monetarism deal with
Philip curve.
– Philip curve is published in 1958 using UK data.
It shows the inverse relationship between
money wage and the rate of unemployment.
– The Keynesians draw the conclusion of this
finding to support their idea of a permanent
trade-off between inflation and unemployment.
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Monetarist
• Philips curve (cont’)
– To justify Keynesian policy, the workers must
have “money illusion”.
– Friedman argued that money illusion occurs in
the short run only. In the long run, there is no
trade-off between unemployment and inflation
and the evidences seem to confirm this point
of view.
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Monetarist
• Implications of monetarist
– Monetary policy is more effective than fiscal policy.
– No long-run trade-off between inflation and
unemployment.
– The market system was not perfect, the government
would only make things worse.
– Fiscal policy could only influence the distribution of
income and the allocation of resources (crowding out
effect).
– The only way to increase output permanently is to
make market work better.
– Adaptive expectation.
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New Classical Economics
• Initiated by
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Lucas
Wallace
Sargent
Barro
• Initiated because of:
– Theoretical : introduce microeconomic foundation in
macroeconomics instead of AD-AS model.
– Empirical: inconsistencies between Keynesian and
Monetarist and what actually happened in 1970s from
oil price shocks, “Stagflation”.
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New Classical Economics
• Rational Expectation
– Stagflation is inconsistent with adaptive expectation
(backward-looking).
– John Muth developed “rational expectation”, which is
forward looking expectation.
– It features: - people would look to the future.
- people use information wisely.
- people would not make
systematic errors.
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New Classical Economics
• Incorporating rational expectations in the
AS-AD model
1. Imperfect information : Household may not
know the price level at the time they make
decision.
2. Parameterization of AS, Ls and Ld curve:
The curves are parameterized by expectations
of the values of the exogenous variable.
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New Classical Economics
• Implications of new classical economics
– Expectations are formed normally. They may form
wrong expectations, but once they have learnt their
mistake, they will no longer make mistakes.
– Only unanticipated policies have an effect on the
output and employment.
– SR AS is upward sloping from imperfect information.
– LR AS is vertical.
– Self-correcting economy.
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Real Business cycle
• New classical fails to explain the important
empirical fact, deviations from capacity
output tended to be prolonged and
correlated.
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Real Business cycle
• Important summary
1. Random walks : shocks to US output is
random walk so it did not revert back to its
trend.
2. Intertemporal substition : Instead of AS-AD
model, RBC tried to use intertemporal
substitution to explain how shocks are
transmitted into the economy.
3. RBC still uses rational expectation.
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Real Business cycle
• Important summary (cont’)
4. Market are always clearing.
5. Money is neutral.
6. Economic fluctuations are due to supply
side such as technological changes, natural
disaster, tax, input prices, etc.
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New Keynesian Economics
• There are 3 main problems with new
classical
1. Unhappy / involuntary workers.
2. 1982 US recession.
3. Intertemporal substitution of labor does not
seem to be as large as RBC suggested.
4. Hysteresis of unemployment.
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New Keynesian Economics
• New Keynesian uses the new classical
model but introduces:
– Union models
– Contracts and staggering of price and wage
changes
– Menu cost and imperfect competition
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New Keynesian Economics
• Implications of New Keynesian Economics
– Market may not adjust quickly even with
rational expectation.
– Strong recession warrants government
intervention.
– Government should ensure that market works
smoothly as possible via microeconomic
policies.
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