Classical economics

Adam Smith is often touted as the world's first free-market capitalist. While that designation is probably a bit overstated, Smith's place in history as the father of modern economics and a major proponent of laissez-faire economic policies is quite secure. Read on to learn about how this Scottish philosopher argued against mercantilism to become the father of modern free trade. Early Life The recorded history of Smith's life begins on June 16, 1723, at his baptism in Scotland. His birthday is undocumented. Smith attended the University of Glasgow at age 14, later transferring to Balliol College in Oxford, England. He spent years teaching and tutoring, publishing some of his lectures in "The Theory of Moral Sentiments" in 1759. The material was well received and laid the foundation for the publication of "An Inquiry Into the Nature and Causes of the Wealth of Nations" (1776), which would cement his place in history. Invisible Hand Theory "An Inquiry Into the Nature and Causes of the Wealth of Nations," also shortened as "The Wealth of Nations," documented industrial development in Europe. While critics note that Smith didn't invent many of the ideas that he wrote about, he was the first person to compile and publish them in a format designed to explain them to the average reader of the day. As a result, he is responsible for popularizing many of the ideas that underpin the school of thought that became known as classical economics. Other economists built on Smith's work to solidify classical economic theory, which would become the dominant school of economic thought through the Great Depression. Laissez-faire philosophies, such as minimizing the role of government intervention and taxation in the free markets, and the idea that an "invisible hand" guides supply and demand are among the key ideas Smith's writing is responsible for promoting. These ideas reflect the concept that each person, by looking out for him or herself, inadvertently helps to create the best outcome for all. "It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest," Smith wrote. By selling products that people want to buy, the butcher, brewer and baker hope to make money. If they are effective in meeting the needs of their customers, they will enjoy the financial rewards. While they are engaging in their enterprises for the purpose of earning money, they are also providing products that people want. Such a system, Smith argued, creates wealth not just for the butcher, brewer and baker, but for the nation as a whole when that nation is populated with citizens working productively to better themselves and address their financial needs. Similarly, Smith noted that a man would invest his wealth in the enterprise most likely to help him earn the highest return for a given risk level.

Published Philosophy "The Wealth of Nations" is a massive work consisting of two volumes divided into five books. The ideas it promoted generated international attention and helped drive the move from landbased wealth to wealth created by assembly-line production methods driven by division of labor. One example Smith cited involved the labor required to make a pin. One man undertaking the 18 steps required to complete the tasks could make but a handful of pins each week, but if the 18 tasks were completed in assembly-line fashion by 10 men, production would jump to thousands of pins per week. He applied a similar logic regarding wealth generation and efficiency to British rule over the American colonies. According to his calculations, the cost of maintaining the colonies was simply not worth the return on investment. Interestingly, while much of the philosophy behind Smith's work is based on self-interest and maximizing return, his first published work, "The Theory of Moral Sentiments," was a treatise about how human communication relies on sympathy. While this may seem to be at odds with his economic views of individuals working to better themselves with no regard for the common good, the idea of an invisible hand that helps everyone through the labor of self-centered individuals offsets this seeming contradiction. Today, the invisible-hand theory is often presented in terms of a natural phenomenon that guides free markets and capitalism in the direction of efficiency, through supply and demand and competition for scarce resources, rather than as something that results in the well-being of individuals. The Bottom Line The ideas that became associated with Smith not only became the foundation of the classical school of economics, but also gained him a place in history as the father of economics. His work served as the basis for other lines of inquiry into the economics field, including ideas that built on his work and those that differed. Smith died on July 19, 1790, but the ideas he promoted live on. In 2007, the Bank of England placed his image on the 20 note.

Keynesian Economics
Why do economic downturns, such as the Great Depression, occur? How does an economy find itself in the perfect storm of high unemployment, a liquidity crisis and rapidly declining consumption? How can the effects of recessions and depressions be mitigated? For years economists struggled with these problems, but a British economist's ideas in the early twentieth century offered a possible solution. Read on to find out how John Maynard Keynes' theories changed the course of modern economics. Keynesian Economics John Maynard Keynes (1883-1946) was a British economist educated in economics at the Universityof Cambridge. He was fascinated by mathematics and history, but eventually took

interest in economics at the prompting of one of his professors, famed economist Alfred Marshall (1842-1924). After leaving Cambridge, he took up a variety of government positions, focusing on the application of economics to real world problems. He rose in importance during the World War I, and served as an advisor at conferences leading to the Treaty of Versailles. It was his 1936 book, "General Theory on Unemployment, Interest and Money", however, which would lay the foundations for his legacy:Keynesian economics. The field of economics studied by Keynes at Cambridge focused on classical economics, whose founders included Adam Smith, the author of "An Inquiry into the Nature and Causes of the Wealth of Nations" (1776). Classical economics focused on a laissez-faire approach to market corrections, and in some ways was still a relatively primitive approach to the field. Prior to classical economics, much of the world was still emerging from a feudal economic system, and industrialization had yet to fully take hold. Keynes' book essentially created the field of modern macroeconomics by looking at the roleaggregate demand plays. (Find out how five ground-breaking thinkers laid our financial foundations inHow Influential Economists Changed Our History.) The Keynesian theory attributes the emergence of a depression to several factors:

The circular relationship between spending and earning (aggregate demand) Savings Unemployment

Aggregate Demand Aggregate demand is the total demand for goods and services in an economy, and is often considered to be the gross domestic product (GDP) of an economy at a given point in time. It has four key components:

Consumption (by consumers who buy goods and services) - C Investment (by businesses in order to produce more goods and services) - I Government spending - G Net exports (value of exports minus imports) - NX

Together, these components become C + I + G +NX, the formula for aggregate demand. If one of the components decreases, another one of the components will have to increase in order to keep GDP at the same level. (To learn more, check out our related article Understanding Supply-Side Economics.) Savings Savings is was viewed by Keynes to have an adverse effect on the economy, especially if the savings rate is high or excessive. Because a major factor in the aggregate demand model is

consumption, if individuals put money in the bank rather than buying goods or services, the GDP will fall. In addition, a decline in consumption leads businesses to produce less and require fewer workers, which increases unemployment. Businesses also are less willing to invest in new factories. Unemployment One of the groundbreaking aspects of the Keynesian theory was its treatment of employment. Classical economics focused on the idea that markets settle at full employment. Keynes theorized, however, that wages and prices are flexible, and that full employment is not necessarily attainable or optimal. This means that the economy seeks to find a balance between the wages that workers demand and the wages that businesses can supply. If the unemployment rate falls, fewer workers are available to businesses looking to expand, which means that workers can demand higher wages. A point exists at which the business will no longer hire. Wages can be expressed in both "real" and "nominal" terms. Real wages take into account the effect of inflation, while nominal wages do not. To Keynes, businesses would have a hard time forcing workers to cut their nominal wage rates, and it was only after other wages fell across the economy or the price of goods fell (deflation) that workers would be willing to accept lower wages. In order to increase employment levels the real, inflation-adjusted wage rate would have to fall. This, however, could result in a deepening depression, lower sentiment and a decrease in aggregate demand. Additionally, Keynes theorized that wages and prices responded slowly (were "sticky") to changes in supply and demand. One possible solution was direct government intervention. (Take a deeper look into how employment is measured and perceived by certain markets in Surveying The Employment Report.) The Role of Governments One of the primary players in the economy is the central government. It can influence the direction of the economy through its control of the money supply; both by its ability to alter interest rates or by buying back or selling government-issued bonds. In Keynesian economics the government takes an interventionist approach it does not wait for market forces to improve GDP and employment. This results in the use of deficit spending. As one of the components of aggregate demand function mentioned earlier, government spending can create demand for goods and services if individuals are less willing to consume and businesses less willing to build more factories. Government spending can use up the extra production capacity. Keynes also theorized that the overall effect of government spending would be "multiplied" if the businesses employed hire more people, and if the employees spend money through consumption. It is important to understand that the role of the government in the economy is not solely to dampen the effects of recessions or pull a country out of a depression - it also must keep the economy from heating up too quickly. Keynesian economics suggests that the interaction between the government and the overall economy move in the opposite direction of the

business cycle: more spending in a downturn, less spending in an upturn. If an economic boom creates high rates of inflation, the government could cut back its spending or increase taxes. This is referred to as fiscal policy. (Find out how current financial policies may effect your portfolio's future returns, in How Much Influence Does The Fed Have?) Use of the Keynesian Theory The Great Depression served as the catalyst that shot John Maynard Keynes into the spotlight, though it should be noted that he wrote his book several years after the Great Depression. During the early years of the Depression, many key figures, including then President Franklin D. Roosevelt, felt that the notion of the government "spending the economy to health" seemed too simple a solution. It was by placing the economy in terms of the demand for goods and services that made the theory stick. In his New Deal, Roosevelt employed workers in public projects, both providing jobs and creating demand for goods and services offered by businesses. Government spending also rapidly increased during the World War II, as the government poured billions of dollars into companies manufacturing military equipment. The Keynesian theory was used in the development of the Phillips curve, which examines unemployment, and the ISLM Model.

Criticisms of Keynesian Theory One of the more outspoken critics of Keynes and his approach was economist Milton Friedman. Friedman helped develop the monetarist school of thought (monetarism), which shifted its focus toward the role money supply has on inflation rather than the role of aggregate demand. Government spending can push out spending by private businesses because less money is available in the market for private borrowing, and monetarists suggested this be alleviated through monetary policy: the government can increase interest rates (making borrowing money more expensive) or sell Treasury securities (decreasing the amount of available funds for lending) to beat inflation. (For more on this, read Monetarism: Printing Money To Curb Inflation.) Another criticism of the theory is that it leans toward a centrally planned economy. If the government is expected to spend funds to thwart depressions, it is implied that the government knows what is best for the economy as a whole. This eliminates the effects of market forces on decision-making. This critique was popularized by economist Friedrich Hayek in his 1944 work, "The Road to Serfdom". In the forward to a German edition of Keynes' book, it is indicated that his approach might work best in a "totalitarian state". Conclusion While the Keynesian theory in its original form is rarely used today, its radical approach to business cycles and solutions to depressions had a profound impact on the field of economics. Today, many governments use portions of this theory to smooth out the boom-and-bust cycles of their economies, and economists combine Keynesian principles with macroeconomics and monetary policy to determine what course of action to take.

Monetarists economics
Picture yourself as the host of an economists' dinner party where no one is having any fun (perhaps not a hard thing to imagine). There are two competing schools of thought on what should be done to fix the party. The Keynesian economists in the room would tell you to break out the party games and snacks, and then force people into a rousing game of Twister. Meanwhile, Milton Friedman and his monetarist pals have a different solution. Control the booze, and let the party take care of itself. Of course, the economy is slightly more complicated than a dinner party gone bad. But the fundamental question is the same: Is it better to intervene when things go wrong, or attempt to prevent problems before they start? This article will explore the rise of the laid-back monetarist approach to controlling inflation, touching upon its proponents, successes and failures. The Basics of Monetarism Monetarism is a macroeconomic theory borne of criticism of Keynesian economics. It was named for its focus on money's role in the economy. This differs significantly from Keynesian economics, which emphasizes the role that the government plays in the economy through expenditures, rather than the role of monetary policy. To monetarists, the best thing for the economy is to keep an eye on the money supply and let the market take care of itself. In the end, the theory goes, markets are more efficient at dealing with inflation and unemployment. Milton Friedman, a Nobel Prize-winning economist who once backed the Keynesian approach, was one of the first to break away from commonly accepted principles of Keynesian economics. In his work "A Monetary History of the United States, 1867-1960" (1971), a collaborative effort with fellow economist Anna Schwartz, Friedman argued that the poor monetary policy of the Federal Reservewas the primary cause of the Great Depression in the United States, not problems within the savings and banking system. He argued that markets naturally move toward a stable center, and an incorrectly set money supply caused the market to behave erratically. With the Bretton Woodssystem's collapse in the early 1970s and the subsequent increase in both unemployment and inflation, governments turned to monetarism to explain their predicaments. It was then that this economic school of thought gained more prominence. Monetarism has several key tenets:

Control of the money supply is the key to setting business expectations and fighting inflation's effects. Market expectations about inflation influence forward interest rates. Inflation always lags behind the effect of changes in production.

Fiscal policy adjustments do not have an immediate effect on the economy. Market forces are more efficient in making determinations. A natural unemployment rate exists; trying to lower the unemployment rate below that rate causes inflation.

Quantity Theory of Money The approach of classical economists toward money states that the amount of money available in the economy is determined by the equation of exchange:

MV=PT Where: M = the amount of money currently in circulation over a set time period V = the "velocity" of money (how often money is spent or turned over during the time period) P = the average price level T = the value of expenditures or the number of transactions Economists tested the formula and found that the velocity of money, V, often stayed relatively constant over time. Because of this, an increase in M resulted in an increase in P. Thus, as the money supply grows, so too will inflation. Inflation hurts the economy by making goods more expensive, which limits consumer and business spending. According to Friedman, "inflation is always and everywhere a monetary phenomenon." While economists following the Keynesian approach did not completely discount the role that money supply has on gross domestic product (GDP), they did feel that the market would take more time to react to adjustments. Monetarists felt that markets would readily adapt to more capital being available. Money Supply, Inflation and the K-Percent Rule To Friedman and other monetarists, the role of a central bank should be to limit or expand the money supply in the economy. "Money supply" refers to the amount of hard cash available in the market, but in Friedman's definition, "money" was expanded to also include savings accounts and other on-demand accounts. If the money supply expands quickly, then the rate of inflation increases. This makes goods more expensive for businesses and consumers and puts downward pressure on the economy, resulting in a recession or depression. When the economy reaches these low points, the central bank can exacerbate the situation by not providing enough money. If businesses - such as banks and other financial institutions - are unwilling to provide credit to others, it can result in a credit crunch. This means there is simply not enough money to go around for new investment and new jobs. According to monetarism, by plugging more money into the economy, the central bank could incentivize new investment and boost confidence within the investor community.

Friedman originally proposed that the central bank set targets for the inflation rate. To ensure that the central bank met this goal, the bank would increase the money supply by a certain percentage each year, regardless of the economy's point in the business cycle. This is referred to as the k-percent rule. This had two primary effects: It removed the central bank's ability to alter the rate at which money was added to the overall supply, and it allowed businesses to anticipate what the central bank would do. This effectively limited changes to the velocity of money. The annual increase in money supply was to correspond to the natural growth rate of GDP. Expectations Governments had their own set of expectations. Economists had frequently used the Phillips curve to explain the relationship between unemployment and inflation, and expected that inflation increased (in the form of higher wages) as the unemployment rate fell. The curve indicated that the government could control the unemployment rate, which resulted in the use of Keynesian economics in increasing the inflation rate to lower unemployment. During the early 1970s, this concept ran into trouble as both high unemployment and high inflation were present. Friedman and other monetarists examined the role that expectations played in inflation rates; specifically, that individuals would expect higher wages if inflation increased. If the government tried to lower the unemployment rate by increasing demand (through government expenditures), it would lead to higher inflation and eventually to firms firing workers hired to meet that demand bump. This would occur any time the government tried to reduce unemployment below a certain point, commonly known as the natural unemployment rate. This realization had an important effect: monetarists knew that in the short run, changes to the money supply could change demand. But in the long run, this change would diminish as people expected inflation to increase. If the market expects future inflation to be higher, it will keep open market interest rates high. Monetarism in Practice Monetarism rose to prominence in the 1970s, especially in the United States. During this time, both inflation and unemployment were increasing, and the economy was not growing. Paul Volcker was appointed as chairman of the Federal Reserve Board in 1979, and he faced the daunting task of curbing the rampant inflation brought on by high oil prices and the Bretton Woods system's collapse. He limited the money supply's growth (lowering the "M" in the equation of exchange) after abandoning the previous policy of using interest rate targets. While the change did help the inflation rate drop from double digits, it had the added effect of

sending the economy into a recession as interest rates increased. Since monetarism's rise in the late 20th century, one key aspect of the classical approach to monetarism has not evolved: The strict regulation of banking reserve requirements. Friedman and other monetarists envisioned strict controls on the reserves held by banks, but this has mostly gone by the wayside as deregulation of the financial markets took hold and company balance sheetsbecame ever more complex. As the relationship between inflation and the money supply became looser, central banks stopped focusing on strict monetary targets and more on inflation targets. This practice was overseen by Alan Greenspan, who was a monetarist in his views during most of his near-20-year run as Fed chairman from 1987 to 2006. Criticisms of Monetarism Economists following the Keynesian approach were some of the most critical opponents to monetarism, especially after the anti-inflationary policies of the early 1980s led to a recession. Opponents pointed out that the Federal Reserve failed to meet the demand for money, which resulted in a decrease in available capital. Economic policies, and the theories behind why they should or shouldn't work, are constantly in flux. One school of thought may explain a certain time period very well, then fail on future comparisons. Monetarism has a strong track record, but it is still a relatively new school of thought, and one that will likely be refined further over time .

Supply Side Policies

Definition of Supply Side Economics
Supply Side economics is the branch of economics that considers how to improve the productive capacity of the economy. It tends to be associated with Monetarist, free market economics. These economists tend to emphasise the benefits of making markets, such as labour markets more flexible. However, some supply side policies can involve government intervention to overcome market failure Supply Side Policies are government attempts to increase productivity and shift Aggregate Supply (AS) to the right.

Benefits of Supply Side Policies

1. Lower Inflation.

Shifting AS to the right will cause a lower price level. By making the economy more efficient supply side policies will help reduce cost push inflation. 2. Lower Unemployment Supply side policies can help reduce structural, frictional and real wage unemployment and therefore help reduce the natural rate of unemployment. See: Supply side policies for reducing unemployment 3. Improved economic growth Supply side policies will increase the sustainable rate of economic growth by increasing AS. 4. Improved trade and Balance of Payments. By making firms more productive and competitive they will be able to export more. This is important in light of the increased competition from S.E. Asia. see also: Economic Importance of Supply Side Policies

Diagram Showing effect of Supply Side Policies

Classical view of LRAS shifting to the right.

Keynesian view of LRAS shifting to the righ.

Supply Side Policies

Most supply side policies aim to enable the free market to work more efficiently by reducing govt interference. 1. Privatisation. This involves selling state owned assets to the private sector. It is argued that the private sector is more efficient in running business because they have a profit motive to reduce costs and develop better services. See more on Privatisation 2. Deregulation

This involves reducing barriers to entry in order to make the market more competitive. For example BT used to be a Monopoly but now telecommunications is quite competitive. Competition tends to lead to lower prices and better quality of goods / service. 3. Reducing Income Taxes. It is argued that lower taxes (income and corporation) increase the incentives for people to work harder, leading to more output. However this is not necessarily true, lower taxes do not always increase work incentives (e.g. if income effect outweighs substitution effect) 4. Increased education and training Better education can improve labour productivity and increase AS. Often there is under-provision of education in a free market, leading to market failure. Therefore the govt may need to subsidise suitable education and training schemes. However govt intervention will cost money, requiring higher taxes, It will take time to have effect and govt may subsidise the wrong types of training 5. Reducing the power of Trades Unions This should a) increase efficiency of firms e.g. less time lost to strikes b) reduce unemployment ( if labour markets are competitive) 6. Reducing State Welfare Benefits This may encourage unemployed to take jobs. 7. Providing better information about jobs This may also help reduce frictional unemployment 8. Deregulate financial markets to allow more competition and lower borrowing costs for consumers and firms. 9. Lower Tariff barriers this will increase trade 10. Removing unnecessary red tape and bureaucracy which add to a firms costs 11. Improving Transport and infrastructure. Due to market failure this is likely to need govt intervention to improve transport and reduce congestion. This will help reduce firms costs. 12 Deregulate Labour Markets

This is said to be an important objective for the EU to increase competitiveness. E.g. Make it easier to hire and fire workers.

Define Fiscal and Monetary Policy

Monetary Policy

Monetary policy involves influencing the supply and demand for money through interest rates and other monetary tools. Monetary policy is usually conducted by the Central Bank, e.g. UK Bank of England, US Federal Reserve. The target of Monetary policy is to achieve low inflation (and usually promote economic growth) The main tool of monetary policy is changing interest rates. For example, if the Central Bank feel the economy is growing too quickly and inflation is increasing, then they will increase interest rates to reduce demand in the economy. In some circumstances, Central Banks may use other tools than just interest rates. For example, in the great recession 2008-12, Central Banks in UK and US pursued quantitative easing. This involved increasing the money supply to increase demand.

Fiscal Policy

Fiscal policy relates to the impact of government spending and tax on aggregate demand and the economy. Expansionary fiscal policy is an attempt to increase aggregate demand and will involve higher government spending and lower taxes. This expansionary fiscal policy will lead to a larger budget deficit. Deflationary fiscal policy is an attempt to reduce aggregate demand and will involve lower spending and higher taxes. This deflationary fiscal policy will help reduce a budget deficit.

Main Difference Between Fiscal and Monetary Policy

The main difference is that Monetary policy uses interest rates set by the Central Bank. Fiscal policy involves changing government spending and taxes to influence the level of aggregate demand.

Similarities between Fiscal and Monetary Policy

Both aim at creating a more stable economy characterised by low inflation and positive economic growth. Both fiscal and monetary policy are an attempt to reduce economic fluctuations and smooth out the economic cycle.