Macroeconomic Schools of
Thought
ECON 101: PRINCIPLES OF ECONOMICS
SUMMER SESSION I
APPENDIX CH 24 + OTHER SOURCES
Philosophical Debates in Economics
 Consider a riddle:
“A man and his son are driving to a championship
football game. It is late December and the roads are
covered with snow. They hit a patch of ice and crash into
a telephone pole. An ambulance rushes the son to a
nearby hospital and operating room. The doctor walks in
and says, “I can’t operate, that’s my son.” How could this
be true?”
Whatever your answer is, assume it is incorrect
and come up with a second answer.
Why Economists Disagree
 A paradigm is a conceptual framework, a context for
organizing thought.
 It is like a pair of theoretical spectacles used to observe
and think about the world.
 There are competing paradigms for understanding the
economy, competing frameworks for organizing
economic theory.
 So why do these frameworks exist?
Two Competing Theories of Knowledge
 Blank Slate Theory of Knowledge
 The mind confronts the world directly
 Individuals have experiences from which they generate ideas
 You put your hand in a fire and generate the idea “hot”
 You look at a rose and generate the idea “beautiful”
 Your mind reflects the world as if it were a mirror
 The world writes on you as if you were a blank slate
Two Competing Theories of Knowledge
 Paradigmatic Theory of Knowledge
 The mind never perceives the world directly or experiences
sensations innocently, that is, untranslated, or unmediated by
a person’s prior conceptual framework.
 Everyone is wearing theoretical spectacles and thinking within
some paradigm
 What one sees is a product of what is “out there” and the lens
used to study it.
Paradigmatic Theory of Knowledge
 From a paradigmatic perspective, observation and
thinking are active rather than passive processes.
 Instead of reflecting what is “out there”, the observer
partially constructs what she or he sees.
 In particular, paradigms influence thought in the
way we attend to how we think about things (or in
our case, the economy).
The starting point
 The term macroeconomics originated in the 1930s.
 The decade witnessed substantial progress in the
study of aggregative economic questions.
 One theory and set of policy conclusions swept the
field and became a new orthodoxy in macroeconomic
policy questions.
 The book containing this theory was The General
Theory of Employment, Interest and Money by
John Maynard Keynes.
The starting point.
 This book started the Keynesian Revolution.
 But revolution against what?
 Keynesians called the old orthodoxy “classical
economics”
 To study this emergence of Keynesian Theory, we
need to study what was it that Keynes was against.
 To do this, we must study classical economics.
 But classical economics emerged as a revolution
against a body of economic doctrines known as
mercantilism.
Mercantilism I
 Mercantilist thought was associated with the rise
of the nation-state in Europe during the sixteenth
and seventeenth century.
 Two tenets of mercantilism were:
 1. Bullionism – A belief that the wealth and power of a nation
were determined by its stock of precious metals.
 2. The belief in the need for state action to direct the
development of the capitalist system.
Mercantilism II
 Adherence to bullionism led countries attempt to secure
an excess of exports over imports to earn gold and silver
through foreign trade.
 Methods use to achieve this: export subsidies, import
duties, development of colonies to provide export
markets.
 State action was believed to be necessary to cause the
developing capitalist system to further the interests of
the state (example: regulate trade, ban bullion exports)
Classical Economics I
 “Classical”—written on macroeconomic issues before
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1936.
More conventional terminology distinguishes
between two periods in the development of economic
theory before 1930.
Classical – Adam Smith (Wealth of Nations, 1776),
David Ricardo (1817), John Stuart Mill (1848)
Neoclassical –Alfred Marshall (1920), A. C. Pigou
(1933)
Keynes lumped these two periods together as
“classical”
Classical Economics II
 Unlike the mercantilists, emphasized the importance
of real factors in determining the wealth of nations.
 Stressed the optimizing tendencies of the free market
in the absence of state control.
 Classical analysis was primarily real analysis: the
growth of an economy was the result of increase
stocks of the factors of production and advances in
techniques of production.
Classical Economics III
 Money only played a role in facilitating transactions
as a means of exchange (money had no intrinsic
value)
 Most questions in economics could be answered
without the role of money.
 Classical economists mistrusted the government and
stressed the harmony of individual and national
interests when the market was left unfettered by
government regulations, except those necessary to
ensure that the market remained competitive.
Classical Economics IV
 In summary, two features of the classical analysis
arose as part of the attack on mercantilism:

1. Classical economics stressed the role of real as opposed to
monetary factors in determining output and employment.
Money had a role in the economy only as a medium of
exchange.

2. Classical economics stressed the self-adjusting tendencies of
the economy. Government policies to ensure an adequate
demand for output were considered unnecessary and generally
harmful.
Keynesian I
 Keynesian Economics developed against the
background of the Great Depression of the 1930s.
 Unemployment in 1929 (3.2%), 1933 (25%)
 Keynes, a British economist, was heavily influenced
by events in his own countries than those in the US.
High unemployment in the US caused a debate, led
by Keynes.
Keynesian II
 Keynes thought that high unemployment in
industrialized countries was the result of a deficiency
in aggregate demand.
 Keynes’s theory provided the basis of economic
policies to combat unemployment by stimulating
aggregate demand.
 Before, classical economists recognized the human
cost of unemployment but never had anything to say
about the causes of unemployment.
Keynesian III
 Keynes warned that pessimistic expectations could
precipitate downward spirals in the economy
 Sticky prices!
Monetarist I
 Monetarist Model developed in 1940s by Milton
Friedman, Nobel Prize in Economics 1976, University of
Chicago.
 Argued that the Keynesian approach overstates the
amount of macroeconomic instability in the economy.
 Argued that most fluctuations in real output were caused
by fluctuations in the money supply, rather than by
fluctuations in consumption or investment spending.
Monetarist II
 Friedman argued that the severity of the Great
Depression was caused by the Fed’s allowing the
quantity of money in the economy to fall by more
than 25%.
 Friedman argued that the Fed should adopt a
monetary growth rule, which is a plan for increasing
the quantity of money at a fixed rate. This will reduce
fluctuations in real GDP, employment and inflation.
Monetarist III
 Friedman’s monetarist ideas attracted significant
support during the 1970s and early 1980s, when the
economy experience high rates of unemployment
and inflation.
 Support declined during late 1980s and 1990s when
the unemployment and inflation rate were relatively
low.
New Classical I
 Mid 1970s: Robert Lucas, Thomas Sargent, Robert
Barro.
 Similar thinking to the classical economists from
before the Keynesian Revolution.
 One additional argument: rational expectations.
New Classical II
 Rational expectations –households (workers) and firms form
expectations of the future values of economic variables
(inflation rate) by making use of all available information.
 If actual inflation rate is lower than expected inflation rate,
the actual real wage will be higher than expected real wage.
Higher real wages will lead to a recession because firms will
hire fewer workers and cut back on production.
 As workers adjust their expectations to the lower inflation
rate, real wage will decline, employment and production will
expand, bringing the economy out of recession.
New Classical III
 Agree with monetarists: Fed should adopt a
monetary growth rule. They argue that a monetary
growth rule will make it easier for workers and firms
to accurately forecast the price level, thereby
reducing fluctuations in real GDP.
Real Business Cycle I
 1980s: Finn Kydland, Edward Prescott
 Agree with New Classicals: workers and firms form
their expectations rationally but were wrong about
fluctuations in real GDP
 Fluctuations in real GDP are caused by temporary
shocks to productivity.
Real Business Cycle II
 These shocks can be negative (decline in the
availability of oil or other raw materials) or positive
(technological change that makes it possible to
produce more output with same inputs)
 Model focuses on “real” factors (productivity shocks)
rather than changes in the quantity of money.
Back to the riddle….
 Generally there are two sets of answers.
 Most people give answers like
 1) The doctor is very confused; 2) The boy was messed up
beyond recognition
 1) The doctor gave his sperm to a sperm bank and the boy was
fathered from the bank; 2) The doctor was God
 1) Boy’s dead father was adoptive father; 2) Father in car was
Catholic priest
Back to the riddle…
 The second set of answers includes the possibility
that the doctor is the boy’s mother.
 There is no reason to assume that this is the case, but
the interesting thing about the riddle is the degree to
which traditional gender stereotypes prevent some
people from even considering the possibility.
 Such is the power of paradigms: they assert
themselves before you think and before you “see”
 To some extent, they even think and see for you.