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Economic thought, a brief history (Reactions to Keynes (Time horizon:…
Economic thought, a brief history
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2) Classical economics
Significant forerunners in France, Britain, and Italy, first by some considered to be William Petty
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Francois Quesnay
Tableau Économique (1756): depiction of production, distribution, and utilization of nation's social wealth with production divided in sectors of agriculture ("productive class" providing a net product) and industry ("sterile class" processing part of net product into other forms), landowning class obtaining the net product as rent which should be the only income taxed since other incomes are used up for the recipients' substinence
Adam Smith
The Wealth of Nations (1776): shaping the new field of political economy thematically and methodologically
On the invisible hand:
- metaphor of the invisible hand often misunderstood as an extreme view that nothing but selfishness, unequivocally resulting in beneficial unintended consequences, is needed for societies to reach optimal outcomes (this view was held by Mandeville, Fable of the Bees (1705), which Smith and Ricardo disagreed with)
- attack on the mercantilist system: "wretched spirit of monopoly" of merchants hungry for money and power at the expense of general public
- need for some institutional preconditions so that "by pursuing his own interest he frequently promotes that of the society more effectually than when he really intends to promote it" -- "not because of some natural coincidence between the self-interest of each and the good of the all but because human institutions are arranged so"
=> legislator's task is to create institutions that make acting for the good of all in the interest of everyone
On the division of labour:
- most important source of growth in labour productibity and per capita income: first within and between firms and regions and finally between countries
-- it 1) yields gains from specialization, 2) saves time lost in changing between tasks, and 3) promotes development of machines, mechanizing production
=> new trades and occupations, including "philosophers or men of speculation", systematically producing new knowledge and improvements
- advantages of free trade had to benefit all countries and parties involved
- capital accumulation sets in motion a "virtuous cycle" as a motor of the wealth-producing machine and the source and effect of continual transformation
- mercantile system of monopolies, import restrictions and export promotion resulted in a misguided allocation of resources, dampened economic dynamism, and unwanted distributional effects, going against the liberal principles of "equality, liberty, and justice" and the "natural cause of things" with agriculture as the primary sector followed only after by industry, cities with domestic trade and finally foreign trade (which entailed higher risks for capital investment and thus it is better to invest at home)
On wages, profits, and rent:
- conflicting interests and unequal negotiating power
- workers' three disadvantages: large numbers hindering organized interests, laws prohibiting collusion and strikes, and inability to hold out labour disputes for long => wages only reached a subsistence level
- only rapid capital accumulation coupled with demand greater than supply would raise wages and improve the lot of the "labouring poor" which, however, would accelerate population growth (anticipating Malthus although not as pessimistic)
- misguided reasoning for a tendency of general rate of profits to fall in the long run, increasing capital "intensifying the competition"
- theory of wage and profit differentials where alongside productivity other factors determine the wages, such as "convenience", inherent risks, and costs of learning a profession
- profit and rents (and interest) only pure property incomes, a "deduction" from the product of labour but nevertheless socially acceptable => reinterpretation of the ethical status of profits: even egoistic, greedy capital owners when judged by their contribution rather than intentions, can promote the general good provided that appropriate institutions and policies are in place
On the role of the state and taxes:
- new distinction between areas of economic activity reserved for the state or left for the private sector: the state should only occupy tasks that private agents are incapable of or cannot do as well or at a higher cost
- after fixing the legitimate tasks, means of financing them must be decided without burdening the private sector with excessive taxation
- should not be interpreted as an argument for "minimal state", taking into account the wide set of regulatory tasks Smith envisages for the legislators, transforming the old authoritarian state to a modern constitutional and achievement-oriented one, reacting appropriately to the changing needs
-- potential negative by-products of division of labour => state-financed elementary education
-- administration of justice, policing, and national defense
-- infrastructure provision to enable movement of goods and people
-- organization of large-scale projects in the general interest
-- regulation of the "unstable" banking sector, "those exertions of the natural liberty of a few individuals, which might endanger the secutiry of the whole sociery"
-- taxes should be proportionally equal, thus obeying the ability-to-pay and equivalence principles (taxation based on income and benefits resulting from government activities)
David Ricardo
One of the first to investigate economic matters through small models that addressed a specific problem, intended to create a foundation for policy recommendations (Schumpeter talks about "Ricardian vice")
Theory of value and distribution:
- objecting Smith's view that only at an early stage of the society does the direct amount of labour define the relative product prices, Ricardo maintains that labour theory of value at least approximately holds when workers use tools, when the indirect labour embodied in generating those tools is added
- technical progress reduces the "difficulty of production" measured by level of total labour => the higher labour productivity, the less expensive commodities in terms of required total labour, and thus the more wealthy a nation
- Ricardo claims Smith to not have recognized that given a state of technology, real wage rate and profit rate have an inverse relationship
- change in income distribution impacts relative commodity prices because of differing proportions of indirect and direct labour (time profiles and compound interest effect)
Theory of ground rent
- differential rent attributable to differences in production costs (differing quality of land, the best quality is scarce)
- pj = rj / i, price of land of given quality defined by rent of land of given quality and the interest rate
- assuming no technological progress, growing need for wheat (unit cost of wheat rises, as prices and ground rents) and a given real wage rate, profit rate falls for agricultural producers and the economy as a whole
"Say's Law":
- there is always sufficient demand to ensure the full employment of capital, contradicting Malthus's view that a "general glut" of commodities could be possible; even when savings mean a decreased demand for goods, they are used for investment meaning demand for goods
=> economic system can never be demand constrained (here only applied to commodities, not to labour)
Theory of comparative advantage in foreign trade:
- even when one party has an absolute advantage over production of all goods, it is possible to reach mutual gains through trade
John Stuart Mill
"abstinence theory": saving involves an "abstinence from present consumption" and should be considered a sacrifice compensated for by profit or interest, introducing a subjective element in profit
viewed Ricardo's foreign trade analysis incomplete for not explaining amounts of commodities produced, exported, and imported by a country
as a utilitarian, maintained rising income to be accompanied by falling marginal utility => advocated income and inheritance taxation to diminish inequality, which inhibits the principle of equal opportunities of the young
Development of the classical approach: Piero Straffa reformulated the "standpoint of the old classical economists from Adam Smith to Ricardo" in a logically coherent form
- showed that for a given system of production and a given wage rate, relative prices, profit rates, and rents can be consistently determined without any recourse to supply and demand functions
Marx and the socialists
Socialist ideas (especially that of common property) have roots in early Christianity
- Thomas More: Utopia (1516)
- other "early" or "utopian" socialists, some marginalist economists favouring certain socialist ideas (e.g. socialization of land)
Emergence of the "social question" in the wake of the Industrial Revolution in the first hald of the 19th century gave rise to socialist ideas' prominence
Theory of value and surplus value
- "common third" of two commodities exchanged is the shared characteristic as abstract products of human labour
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The rise of marginalism
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"Revolution" in the final third of the 19th century?
- No, since concepts of marginal utility and productivity have been known for a long time
- Yes, since it presented an entirely new explanation of income distribution, seeking to explain all rates of remuneration (wage and profit rates, land rate) in terms of a single principle (marginal productivity w.r.t. each factor), considering all incomes as indexes of relative scarcities of fully employed factors of production
Menger
- Principles of Economics (1871), seminal work of the "Austrian" school, aiming for a general theory of human economic behaviour
- starting with the assumption that all goods (product, labour, and land services) can be hierarchically ordered: first order are goods that directly satisfy needs and wants, second order are one needed in the production of first order goods, and so on
- by the "causal-genetic" perspective, preferences and estimations of the economic subjects directly determined the values of the "goods of first order" from which values of "goods of higher order" could be derived
... attempting to resolve the imputation problem, Mengel proposed "loss principle" (worth of the loss in output when one unit of some input is removed)
- von Wieser pointed out further problems: production as a circular process leads to many products belonging to several orders, over- or underdetermination of the imputation problem when number of first order goods is greater or lesser than that of all other orders => in a circular framework, values of all goods must be determined simultaneously
-- starting from the loss principle, von Wieser elaborated what was later called the concept of "opportunity costs"
- radically subjectivist branch of Austrian school: von Mises
Gossen (1854): early formulation of marginal utility theory, inspired by Rau
- real purpose of life, misunderstood by Christian churches as denunciation of pleasure, was to maximize "sum of life's pleasures": hedonism based on two premises
- Gossen's first law: "magnitude of pleasure decreases continuously if we continue to satisfy one and the same enjoyment without interruption"
- Gossen's second law: "to maximize his total pleasure, an individual free to choose between several pleasures but whose time is not sufficient to enjoy all to satiety must ... satisfy first all pleasures in part in such a manner that the magnitude of each -- when its enjoyment is broken off shall be the same for all pleasures"
=> time and income constraints, former helps explaining the finding of happiness increasing with income only up to a point
- optimistic view of individual egoism's relation to societal welfare: time constraint curbing greed and cravings and division of labour encouraging cooperation and interdependence result in each individual pursuing "his own personal welfare" while also contributing to "welfare of all mankind"
Jevons
- The Coal Question (1865): dismal view of England's development in the face of exhaustible coal resources
- Theory of Political Economy (1871): break with classical economics and a turn to physics and use of mathematics to qualify as a respectable science
- on classical theory of value, Jevons argued that the value of a commodity is not determined by its required amount of labour but by its "final degree of utility", a subjective valuation by each individual consumer (still, Jevons maintained equilibrium relative prives to be equal to relative labour costs) => the novel point is the reverse in causality
Forerunners:
- Thünen (1850): marginal productivity
- Cournot and Rau: Cournot and Rau: concept of a demand curve for a good
- Rau: concept of marginal utility in substance
- Cournot: case of monopoly, confirmation of MR=MC condition for profit maximization
The Methodenstreit: question of the appropriate method for economics, debate between
- "historical-ethical" approach in Germany led by Schmoller: formulation of an economic theory could only result from historical studies and discoveries of behavioural regularities, going even to antitheoretical
- marginal utility school led by Menger: attack on historicism, fundamental insights possible here and now by introspection
- so-called Freiburg school, ordoliberalism, of Eucken partially as a reaction to the Methodenstreit as well as fascism and communism, seeking a "third way" of a "mixed system"
Walras: starting point for the theory of general economic equilibrium
- "pure science of economics" as analysis of ideal types, abstracted from real types, whose interactions are analyzed with mathematical methods: only when the theoretical foundation is completed should the practical problems in "applied economics" be pursued
- pure exchange as the first major problem of a "mathematical theory of social wealth": can welfare be increased through exchange given initial endowments and at what relative prices?
-- Walras's law (utility is maximized when marginal utility divided by price is equal for all goods; value of sales must equal value of purchases, which is extended to the whole economy, and thus equilibrium in n-1 markets implies equilibrium at the n'th market, meaning that only n-1 equations expressing equilibrium are independent of one another)
- price formation for consumer goods as the second major problem: subject to the "law of cost of production or of the cost price"
-- assuming all goods are produced with fixed input quantities of "productive services", four sets of equations describe the system of general equilibrium: equation sets that
1) describe the supplies of different productive services as dependent on the relative price of all goods and services
2) describe consumer demand as dependent on relative prices
3) express the equality of amounts of productive services supplied and demanded
4) express the equality of prices and production costs for consumer goods
-- number of equations equals the number of unknowns, Walras concluded to have found a theoretical solution to the problem "solved in practice by the market by the mechanism of free competition"
- price formation of capital goods as the third major problem: durable capital goods that are subject to depreciation and yield a "net income" for their productive services
-- in equilibrium, net income relative to the price of a brand-new unit of a capital good is uniform across all capital goods (close connection between the price of the capital good and of its productive service)
-- "law of production costs" of the price of a brand-new capital good: fifth set of equations that express the equality of capital goods prices to their production costs (now, number of additional unknowns exceeded that of additional equations, so Walras attempted to close the system by including an equation expressing equilibirum between gross savings and gross investments without new unknowns: by this, he surmised that it should be possible to determine not only competitive profit rate but also the overall rate of capital accumulation and thus the growth of the economy)
- explaining the tendency to equilibrium in markets: concept of "tâtonnement", groping or trial-and-error movement toward equilibrium
-- Walras maintained that the process would always converge towards general equilibrium i.e. to be globally stable, law of supply and demand being comparable to the law of universal gravitation in astronomy; he assumed trading would only take place when equilibrium quote of prices had been found and that there would be no transactions at what late would be called "false prices"
- reception of Walras's work
-- Schumpeter: "Magna Carta of economics"
-- von Böhm-Bawerk, advocate of the "causal-genetic method": method of simultaneous equations "a mortal sin against all scientific logic"
- some questions on the viability of Walras's construct: does it have a solution (even with a closed system, equations may contradict one another) and if so, is it economically meaningful? is there reason to assume that all resources are fully employed or that their prices could fall to zero in case of excess supply? (then descriptions relevant conditions of equilibrium would be weak inequalities rather than equations)
-- assumption of given initial endowment at best compatile with a short-period equilibrium characterized by differential rates of profit
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-- sum of total savings=sum of total investment not enough to determine rates of profits and capital accumulation: macroeconomic equality is not enough but rather one must also know that composition of investment demand (and respective capital goods' production) => overall output quantities cannot be ascertained and nor can be prices for goods and productive services
Developments in the vein of Walras's theory
- Pareto (1906), Cassel (1918) seeking to determine a long-period equilibrium characterized by a uniform rate of profits: necessitated giving up the assumption of a capital endowment in terms of arbitrarily given amounts of heterogeneous capital goods in the economy (only the case of single type of capital good could retain the long-period method), otherwise capital endowment had to be given as sum of value and its physical composition determined as part of the solution of the system
- some sought ways to avoid the "impasse" and replaced the concept of long-period equilibrium with short-term equilibria
-- temporary equilibrium (Lindahl, Hicks)
-- intertemporal equilibrium (Lindahl, Hayek; later Arrow, Debreu)
Utilitarianism, welfare theory, and systems debate
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Reactions to Keynes
Time horizon: Keynes deliberately restricted the analysis to the short run, focusing the attention on a single (effective demand) effect of investment demand
- at least two further relevant effects that Keynes did not investigate further: 1) effect on the net capital stock i.e. productive capacity or potential output, 2) new knowledge embodied in gross investment and human capital, i.e. productivity-enhancing effect
- how to match the developments of effective demand and potential output (income and capacity effects) so that an increase in productive capacity is met with a respective increase in effective demand?
- Harrod (and Domar): Harrod's "instability theorem": the economy transmits signals that may be misunderstood and thus trigger reactions that worsen the situation
Economic growth and public debt: how large may the latter get?
- Domar (1946): the absolute level of debt is not important per se, but the ratio of government debt to the GDP and whether that is increasing or decreasing over time
- unsustainable when the interest rate on debt exceeds the growth rate of real GDP (and taxes)
Relationship between economic cycles and the long-term trend
- Kalecki: long-term development is nothing but the result of sequence of short-term constellations through which it passes
- booms run up against the "full-employment barrier" where wages, prices, and interest are driven up and profitability of capital formation diminishes, imports may increase and exports decrease, eventually triggering a downturn; in a slump, wages, prices and interest rates fall and have an adverse effect on profitability and international competitiveness
Paul Samuelson's (1939) "multiplier-accelerator" model on cycles and trend
- investment function in which present net investment is assumed to depend on or be induced by a change in effective demand (difference between actual demand of output in present period and realized output in previous period)
- depending on an "accelerator coefficient" and the propensity to save, system may behave very differently over time (typology of possible cases includes steady growth, cycles with constant amplitudes, as well as contracting or exploding cycles), and a change in one of the parameters may cause not only a quantitative but a qualitative change in the system, going against the usual continuity assumption (no room for regime changes)
John Hicks (1950)
- while the "ceiling" a boom may hit can be easily explained, understanding what determines the "bottom" of the slump under which economic activity cannot fall (even in absence of intervention) is not that clear
=> investment is partly "autonomous" and does not depend on demand in given markets but is based on expectations on demand in emerging markets
- also, automatic stabilizers and improving international competitiveness
Major representatives of the mainstream of the time would attempt to understand Keynes's ideas within their usual analytic framework
- in many cases, looking through the neoclassical theory, unemployment was traced back to rigidities in the system that prevent its smooth and efficient functioning (especially in wage rates, goods prices, and interest rate); without the rigidities, the economic system would tend toward full employment and utilization of capital stock, albeit perhaps slowly
- theoretical focus on causes and effects of rigidities, economic policy focus on overcoming them
- critics: forcing Keynes's thoughts into the "equilibrium logic" underrates the role of uncertainty, fluctuating expectations and the inherent instability of the system
- Hicks (1937) interpreted General Theory in Walrasian equilibrium terms and elaborated the IS-LM model of two relationships: equilibria in the goods market and in the money market
- IS curve reflects the combinations of national income and interest rate where (planned) savings equal investment, and
- LM curve combinations where demand for liquidity equals central bank money supply
- intersection of the curves implies the level of national income and interest rate where both markets are in equilibrium; employment level is determined by effective demand (consumption and investment)
- Modigliani (1944) integrated the labour market into the model, completing the "neoclassical synthesis" as called by Samuelson
=> neoclassical case of full employment and Keynesian one of unemployment result from different constellations of parameters that define the underlying behavioural relationships on investment, saving, and liquidity preference (elasticities with respect to the interest rate)
- neoclassical: highly elastic investment demand, inelastic money demand (no speculative motive)
- Keynesian: investment demand less elastic, highly elastic money demand
- Keynesian "liquidity trap"; system may end up in an "unemployment equilibrium"; expansive monetary policies not enough to lower the interest rate so the remedy lies in expansionary fiscal policy shifting the IS curve
- recent evidence: no downward rigidity of interest rate even though beyond the zero lower bound monetary policies have limited effect, justifying the use of fiscal policies
Post-Keynesian theory
- maintains that neoclassical interpretations of Keynes are misleading, agrees much less on the essence of Keynes's message and how it should be applied
- rejects following neoclassical tenets
- Say's law and assertion of tendency toward full employment
- idea of money as draped like a "veil" over the real economy without exerting any influence
- thesis that savings determine investment, not the other way round
- marginal productivity theory of income distribution
- among others Joan Robinson and Nicholas Kaldor who presented post-Keynesian theories of capital accumulation and income distribution in the mid-1950s
- starting on the assumption of full employment given Keynesian effective demand management
- Kaldor: based essentially on the application of the multiplier in the long run, investment lead to savings of the same magnitudes although through a different mechanism with adjustments in prices, real wages, and distribution of income given quantities (assumed constant in a fully employed economy in the short run)
- increased share of investment I/Y, leading to increased effective demand, higher price level, and falling real wage (given constant money wages), is met with an increase in savings when share of profits increase for which the propensity to save is typically larger
- income distribution not determined by marginal productivities but rather by the factors that affect the speed of capital accumulation
- Kaldor: no equilibrium or rest point in the economy; it is constantly in motion and its development "path dependent" and almost impossible to predict
- Davidson: money is not neutral; many economic decisions face fundamental uncertainty about future events which cannot be captured by probability theory and risk analysis
- Minsky: inherent instability of the financial sector
Neoclassical-Keynesian synthesis
- theoretical developments based on the neoclassical synthesis in response to newly available economic facts
- developments of 1970s and "stagflation" gave rise to critique of Keynes
- Phillips (1958): for Great Britain, there existed a long-term inverse relationship between growth of money wages and the unemployment rate, "Phillips curve I": low unemployment gives employees greater negotiating power
- Samuelson and Solow (1960): interpretation as a long-term stable trade-off between the inflation rate and unemployment, "Phillips curve II": constant level of prices goes with a certain degree of unemployment, lowering of which only achieved with higher inflation rates; in the long run, money is not neutral, but affects unemployment through the inflation rate
- Patinkin: "real cash balance effect" fails when prices are rigid and agents are "rationed" on one market or another; prices and wages no longer perform their role of balancing supply and demand
- Leijonhufvud: "dual-decision hypothesis"
Monetarism redefines quantity theory of money
- Milton Friedman (1956): not a theory about the effect of money supply on the price level but rather a theory about the demand for money, "real cash balances"
- if demand for money is stable, then price level is determined by money supply
- 1968: trade-off between inflation and unemployment only in the short run, and in the long run, "natural rate of unemployment" independent of economic policy measures or rate of inflation holds, expressing not disequilibrium but workers' preferences and anticipations
New classical macroeconomics
- Lucas and Sargent (1979) present a stripped-down version of a general equilibrium model with strict premises
- theory of real business cycles
New Keynesian macroeconomics
- Akerlof and Stiglitz:
- efficiency wages
- credit rationing
New neoclassical synthesis
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