Two extremes of economists, one group includes Keynesian economists who think the economy should be managed by intervention, and the other includes such as monetarists who believe the economy could self-adjust to equilibrium itself and do not need interventions.
Keynesian
The interventionists include Karl Marx and John Maynard Keynes. In 1936, Keynes published a book The General Theory of Employment, Interest, and Money. He challenged the classical economists that insisted that the economy would self-correct over time. Instead, Keynes considered that government should intervene in the economy by government spending in the short run. Instead of waiting until the economy is back on the right track, the government should actively stimulate by such as government spending (multiplier effects would result in more output. Marginal Propensity to Consume MPC less than 1 could result in the multiplier effects in IS model).
For example, if consumers spend less (consumption decreases), then the government could increase government spending and increase the money supply to boost the economy in recession. Consider
Critics: Some opposite ideas are there. Government spending may not efficiently increase the economy. For example, as in the Broken Window Fallacy, if a window is broken, then a series of jobs and works are created. The householder spends money to pay the worker who fixes the window. The worker then gets money to spend it…etc. However, those created jobs and works are actually wastes, because the window does not have to be broken to make the series of works happen. The householder can spend money on other things he wants.
Are Government spendings similar to the broken window? Maybe it is not. If government spend for indeed useful things such as public university, national defense, then government spendings do create jobs. However, if gov spends on useless things such as deliberately breaking a window and fixing it, then the economy would be inefficient, through current jobs are created. In the meantime, if the government spends on useful things in the beginning but the sub-things are useless in the following chain, then Broke Window Fallacy comes again.
In addition, if the government needs to borrow money to finance the spending, then crowding out effects also exist that private investment and consumption are crowded out or reduced. Because government borrowings bring fewer loanable funds and higher interest rates. The higher the interest rate, the higher the cost of investment.
In summary, Keynesian thinks the government should react to stimulate the economy in recession, decrease the unemployment rate and increase the growth of the economy by government spending (Expansionary Fiscal Policy). It is generally agreed that the Keynesian idea that an increase in government spending does help to make the economy leave recession in the short run. However, the trade-off is the long-run development, and it cannot be captured in current economic theory. Further studies are needed.
P.S. Gov always prefers Keynesianism in facing depression.
New Keynesian
Similar to the new classical, new Keynesian also assume households and firms maximise their own expected utility with rational expectation. The difference is that the new Keynesian assumes also a market failure because markets are not perfectly competitive in price and wage. Thus, prices and wages become “sticky” that fails to adjust with the economic conditions.
The sticky price is one of the reasons that the economy cannot achieve full employment. Therefore, fiscal policy and monetary policy could stabilise the macroeconomy and achieve an efficient macroeconomic outcome.
Coordination Failure is another important new Keynesian concept to explain the recession and unemployment. The invisible hand fails to coordinate the usual, optimal, flow of production and consumption. See further studies.
Labour market failure: Efficiency wages also explain the unemployment condition. That theory aims to explain the long-term effect of previous unemployment on permanent unemployment in the long run. (See E200 notes). Shapiro and Stiglitz (1984) developed the shirking model, and their works contribute to the explanation of the employment rate.
See notes of E200.
Taylor rule describes the relationship between the nominal interest rate (, which is set by CB), and other economic factors. Those factors are inflation, output, economic condition (Taylor, 1993).
$$ i_t=\pi_t+r_t^* + a_{\pi}(\pi_t -pi_t^*)+a_y (y_t-y_t^*) $$
In short, the nominal interest rate is affected by inflation, and how the economy deviates from the target.
Some central figures of the new Keynesian areGregory Mankiw, Stanley Fischer, and Jordi Gali.
Monetarism
Fewer interventionists are groups of economists who believe the government and central bank should not interact with the economy operating. Those economists include such as monetarism and the Austrian School of economics. Monetarism is the economic theory focusing on the money supply and central banking system.
Milton Friedman, a Nobel Prize holder and professor at the University of Chicago, is one of the most famous proponents of monetarism (classicalism). He holds different opinions from Keynes and those Cambridge economists who consider money demand determines the amount of money in the market. Instead, Friedman emphasizes the importance of the money supply from the central bank. (Look at the blog post about the Quantity Theory of Money, QTM.)
(M\cdot V=P\cdoc Y \)
In the long run, if the central bank creates too much money into the economy, then there are too much money and too little supply of goods. Price would increase and so inflation would increase. That would result in inefficient resource allocation because consumers do not know whether the increase in price is from inflation or from goods and services becoming more valuable. Monetarists do not agree to create too high inflation even though it can increase outputs in the short run, because consumers would recognise the increase in the price level in the long run, and then the price level goes high.
monetarists agree 2% to 3% level increase in money supply or inflation is healthy. As central banks always prefer Keynesianism to stimulate economic growth, monetarists use rules to constrain the power of the central bank.
Classical Theory
The classical theory is firstly formed by Adam Smith. The classical idea states that consumers and firms make decisions in the free market to maximise their own benefits, which are utility and profits. The invisible hands would fix the market itself without any interventions.
The base stone of classical theory is “flexible wages” that wages would increase with inflation and decrease with deflation. However, Keynesian economists believe the price is sticky in the short run.
Ideas:
- Two (or several) countries’ comparisons to find the long-run effects of Keynesian policy. —- DiD or other causality testing method.
- U.S. Gov reacts to the Covid-19 by fiscal policy (government spending and helicopter drop) and monetary policy (lower the federal fund rate) and those policies both boost aggregate demand. However, without any increase in factor inputs and significant technology progress, the aggregate supply is frustrated due to unemployment (probably due to increasing in resource price but I have not investigated). Policies did not really result in hyper-inflation largely because consumers are less confident and unwilling to spend money (MPC is too low), though there is a government spending increase and low-interest rate to boost investment. Economy is current not bad (or maybe its bad). However, it is terrible in the long run. Uncertainty about the future price level and may lose credibility of U.S. dollar. Idea: why no hypter inflation? (my idea is credibility and dollar-oil system).
- China case is different. Sustainable supply (I might think it partially due to the system of organisation of country. Of course, there are complex reasons) and frustrated demand that people do not have enough willingness to spend money on normal goods (however some luxury goods have increasing demand even with price tag rising). Ideas: 1. China consumption structure. Different demand elasticity toward differnt goods. Also, elasticities vary over time. Considering an elasticity index? 2. Potential problem, the broken window fallacy.
- People worried about the stagflation. Theoritically, it should happen in the U.S., but the stagflation seems is delaied or alliviated, probably because the effect is absorbed by other countries such as Canada —- Due to U.S. dollar’s credibility. For China, I personally might not think stagflation would happen in China. As supply is still not bad.
Austrian School of Economics
Carl Menger is considered to be the founder of the Austrian School. The Austrian school focuses mainly on people, their incentives and limited knowledge (including legal, social, cultural, political, and economic institutions). How individuals make decisions constitutes Austrian economic thought. Thus, they emphasise the ever-changing and adaptive nature of the economy.
F.A. Hayek was a leading member of the Austrian School of Economics, and he believed that the prosperity of society was driven by creativity, entrepreneurship, and innovation, which were only possible in a society with free markets. The Nobel prize was awarded to him and Gunnar Myrdal in 1974 for their pioneering work in the theory of money and economic fluctuations and for their penetrating analysis of the interdependence of economic, social and institutional phenomena.
Austrian school emphasises supply and productivity in the recession, while Keynesianism emphasise demand.
Joseph Schumpeter
Schumpeter became known for his original ideas regarding entrepreneurship and “Creative Destruction”.
The Library of Economics and Liberty immortalizes him thus: “Schumpeter pointed out that entrepreneurs innovate not just by figuring out how to use inventions, but also by introducing new means of production, new products, and new forms of organization. These innovations, he argued, take just as much skill and daring as does the process of invention.”
His work venerated entrepreneurship and innovation, arguing that entrepreneurs improve our lives by developing new, unheard-of industries or improving existing goods and services. This foundation is important to remember, as his work does postulate that capitalism is bound to decay into socialism over time.
Schumpeter’s The Theory of Economic Development describes an evenly rotating economy of a stationary state. Within this imaginary state, there is no room for innovations and innovative activities, because these activities would disturb it, causing it to no longer be a stationary state. Innovation is the solution to this state.
Policy Responses to COVID 19 by Country
https://www.imf.org/en/Topics/imf-and-covid19/Policy-Responses-to-COVID-19
Reference
Joseph Schumpeter: the most important economist you might not know of
Friedrich August Hayek
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