Neoclassical economics is a term variously used for approaches to

economics focusing on the determination of prices, outputs, and income distributions in markets
through supply and demand, often as mediated through a hypothesized maximization of income-
constrained utility by individuals and of cost-constrained profits of firms employing available
information and factors of production, in accordance with rational choice theory.[1] Neoclassical
economics dominates microeconomics, and together with Keynesian economics forms the
neoclassical synthesis, which dominates mainstream economics today.[2] There have been many
critiques of neoclassical economics, often incorporated into newer versions of neoclassical theory as
human awareness of economic criteria changes.

The term was originally introduced by Thorstein Veblen in 1900, in his Preconceptions of
Economic Science, to distinguish marginalists in the tradition of Alfred Marshall from those in the
Austrian School.[3][4][5]

"No attempt will here be made even to pass a verdict on the relative claims of the recognized two or
three main "schools" of theory, beyond the somewhat obvious finding that, for the purpose in hand,
the so-called Austrian school is scarcely distinguishable from the neo-classical, unless it be in the
different distribution of emphasis. The divergence between the modernized classical views, on the
one hand, and the historical and Marxist schools, on the other hand, is wider, so much so, indeed, as
to bar out a consideration of the postulates of the latter under the same head of inquiry with the
former." - Veblen

It was later used by John Hicks, George Stigler, and others[6] to include the work of Carl Menger,
William Stanley Jevons, John Bates Clark and many others.[4] Today it is usually used to refer to
mainstream economics, although it has also been used as an umbrella term encompassing a number
of other schools of thought,[7] notably excluding institutional economics, various historical schools
of economics, and Marxian economics, in addition to various other heterodox approaches to
economics.

Overview
Neoclassical economics is characterized by several assumptions common to many schools of
economic thought. There is not a complete agreement on what is meant by neoclassical economics,
and the result is a wide range of neoclassical approaches to various problem areas and domains—
ranging from neoclassical theories of labor to neoclassical theories of demographic changes. As
expressed by E. Roy Weintraub, neoclassical economics rests on three assumptions, although
certain branches of neoclassical theory may have different approaches:[8]

1. People have rational preferences among outcomes that can be identified and associated with
a value.
2. Individuals maximize utility and firms maximize profits.
3. People act independently on the basis of full and relevant information.

From these three assumptions, neoclassical economists have built a structure to understand the
allocation of scarce resources among alternative ends—in fact understanding such allocation is
often considered the definition of economics to neoclassical theorists. Here's how William Stanley
Jevons presented "the problem of Economics".

"Given, a certain population, with various needs and powers of production, in possession of certain
lands and other sources of material: required, the mode of employing their labour which will
maximize the utility of their produce."[9]
From the basic assumptions of neoclassical economics comes a wide range of theories about various
areas of economic activity. For example, profit maximization lies behind the neoclassical theory of
the firm, while the derivation of demand curves leads to an understanding of consumer goods, and
the supply curve allows an analysis of the factors of production. Utility maximization is the source
for the neoclassical theory of consumption, the derivation of demand curves for consumer goods,
and the derivation of labor supply curves and reservation demand.[10] Market supply and demand
are aggregated across firms and individuals. Their interactions determine equilibrium output and
price. The market supply and demand for each factor of production is derived analogously to those
for market final output to determine equilibrium income and the income distribution. Factor demand
incorporates the marginal-productivity relationship of that factor in the output market. [11] [12][6][13]

Neoclassical economics emphasizes equilibria, where equilibria are the solutions of agent
maximization problems. Regularities in economies are explained by methodological individualism,
the position that economic phenomena can be explained by aggregating over the behavior of agents.
The emphasis is on microeconomics. Institutions, which might be considered as prior to and
conditioning individual behavior, are de-emphasized. Economic subjectivism accompanies these
emphases. See also general equilibrium.

Origins
Classical economics, developed in the 18th and 19th centuries, included a value theory and
distribution theory. The value of a product was thought to depend on the costs involved in
producing that product. The explanation of costs in Classical economics was simultaneously an
explanation of distribution. A landlord received rent, workers received wages, and a capitalist tenant
farmer received profits on their investment. This classic approach included the work of Adam Smith
and David Ricardo.

However, some economists gradually began emphasizing the perceived value of a good to the
consumer. They proposed a theory that the value of a product was to be explained with differences
in utility (usefulness) to the consumer. (In England, economists tended to conceptualize utility in
keeping with the Utilitarianism of Jeremy Bentham and later of John Stuart Mill.)

The third step from political economy to economics was the introduction of marginalism and the
proposition that economic actors made decisions based on margins. For example, a person decides
to buy a second sandwich based on how full they are after the first one, a firm hires a new employee
based on the expected increase in profits the employee will bring. This differs from the aggregate
decision making of classical political economy in that it explains how vital goods such as water can
be cheap, while luxuries can be expensive.

The Marginal Revolution

Neoclassical economics is frequently dated from William Stanley Jevons's Theory of Political
Economy (1871), Carl Menger's Principles of Economics (1871), and Leon Walras's Elements of
Pure Economics (1874–1877). These three economists have been said to have begun “the Marginal
Revolution”. Historians of economics and economists have debated:

 Whether utility or marginalism was more essential to this revolution (whether the noun or
the adjective in the phrase "marginal utility" is more important)

 Whether there was a revolutionary change of thought or merely a gradual development and
change of emphasis from their predecessors
  Whether grouping these economists together disguises differences more important than their
similarities.[14]

In particular, Jevons saw his economics as an application and development of Jeremy Bentham's
utilitarianism and never had a fully developed general equilibrium theory. Menger did not embrace
this hedonic conception, explained diminishing marginal utility in terms of subjective prioritization
of possible uses, and emphasized disequilibrium and the discrete; further Menger had a
philosophical objection to the use of mathematics in economics, while the other two modeled their
theories after 19th century mechanics.[15] Walras' conception of utility, like that of Menger, was that
of usefulness in general,[16] rather than the hedonic conception of Bentham or of Mill; and Walras
was more interested in the interaction of markets than in explaining the individual psyche.[14]

Alfred Marshall's textbook, Principles of Economics (1890), was the dominant textbook in England
a generation later. Marshall's influence extended elsewhere; Italians would compliment Maffeo
Pantaleoni by calling him the "Marshall of Italy". Marshall thought classical economics attempted
to explain prices by the cost of production. He asserted that earlier marginalists went too far in
correcting this imbalance by overemphasizing utility and demand. Marshall asserted the question of
whether supply or demand was more important was analogous to the pointless question of which
blade of a scissors did the cutting.

Marshall explained price by the intersection of supply and demand curves. The introduction of
different market "periods" was an important innovation of Marshall's:

 Market period. The goods produced for sale on the market are taken as given data, e.g. in a
fish market. Prices quickly adjust to clear markets.
 Short period. Industrial capacity is taken as given. The level of output, the level of
employment, the inputs of raw materials, and prices fluctuate to equate marginal cost and
marginal revenue, where profits are maximized. Economic rents exist in short period
equilibrium for fixed factors, and the rate of profit is not equated across sectors.
 Long period. The stock of capital goods, such as factories and machines, is not taken as
given. Profit-maximizing equilibria determine both industrial capacity and the level at which
it is operated.
 Very long period. Technology, population trends, habits and customs are not taken as given,
but allowed to vary in very long period models.

Marshall took supply and demand as stable functions and extended supply and demand explanations
of prices to all runs. He argued supply was easier to vary in longer runs, and thus became a more
important determinate of price in the very long run.

Further developments
An important change in neoclassical economics occurred around 1933. Joan Robinson and Edward
H. Chamberlin, with the near simultaneous publication of their respective books, The Economics of
Imperfect Competition (1933) and The Theory of Monopolistic Competition (1933), introduced
models of imperfect competition. Theories of market forms and industrial organization grew out of
this work. They also emphasized certain tools, such as the marginal revenue curve.

Joan Robinson's work on imperfect competition, at least, was a response to certain problems of
Marshallian partial equilibrium theory highlighted by Piero Sraffa. Anglo-American economists
also responded to these problems by turning towards general equilibrium theory, developed on the
European continent by Walras and Vilfredo Pareto. J. R. Hicks's Value and Capital (1939) was
influential in introducing his English-speaking colleagues to these traditions. He, in turn, was
influenced by the Austrian School economist Friedrich Hayek's move to the London School of
Economics, where Hicks then studied.

These developments were accompanied by the introduction of new tools, such as indifference
curves and the theory of ordinal utility. The level of mathematical sophistication of neoclassical
economics increased. Paul Samuelson's Foundations of Economic Analysis (1947) contributed to
this increase in formal rigor.

The interwar period in American economics has been argued to have been pluralistic, with
neoclassical economics and institutionalism competing for allegiance. Frank Knight, an early
Chicago school economist attempted to combine both schools. But this increase in mathematics was
accompanied by greater dominance of neoclassical economics in Anglo-American universities after
World War II.

Hicks' book, Value and Capital had two main parts. The second, which was arguably not
immediately influential, presented a model of temporary equilibrium. Hicks was influenced directly
by Hayek's notion of intertemporal coordination and paralleled by earlier work by Lindhal. This
was part of an abandonment of disaggregated long run models. This trend probably reached its
culmination with the Arrow-Debreu model of intertemporal equilibrium. The Arrow-Debreu model
has canonical presentations in Gerard Debreu's Theory of Value (1959) and in Arrow and Hahn's
"General Competitive Analysis" (1971).

Many of these developments were against the backdrop of improvements in both econometrics, that
is the ability to measure prices and changes in goods and services, as well as their aggregate
quantities, and in the creation of macroeconomics, or the study of whole economies. The attempt to
combine neo-classical microeconomics and Keynesian macroeconomics would lead to the
neoclassical synthesis[17] which has been the dominant paradigm of economic reasoning in English-
speaking countries since the 1950s. Hicks and Samuelson were for example instrumental in
mainstreaming Keynesian economics.

Macroeconomics influenced the neoclassical synthesis from the other direction, undermining
foundations of classical economic theory such as Say's Law, and assumptions about political
economy such as the necessity for a hard-money standard. These developments are reflected in
neoclassical theory by the search for the occurrence in markets of the equilibrium conditions of
Pareto optimality and self-sustainability.

Criticisms
Neoclassical economics is sometimes criticized for having a normative bias. In this view, it does not
focus on explaining actual economies, but instead on describing a "utopia" in which Pareto
optimality applies.

The assumption that individuals act rationally may be viewed as ignoring important aspects of
human behavior. Many see the "economic man" as being quite different from real people. Many
economists, even contemporaries, have criticized this model of economic man. Thorstein Veblen
put it most sardonically. Neoclassical economics assumes a person to be,

"a lightning calculator of pleasures and pains, who oscillates like a homogeneous globule of desire
of happiness under the impulse of stimuli that shift about the area, but leave him intact."[18]

Large corporations might perhaps come closer to the neoclassical ideal of profit maximization, but
this is not necessarily viewed as desirable if this comes at the expense of neglect of wider social
issues. The response to this is that neoclassical economics is descriptive and not normative. It
addresses such problems with concepts of private versus social utility.

Problems exist with making the neoclassical general equilibrium theory compatible with an
economy that develops over time and includes capital goods. This was explored in a major debate in
the 1960s—the "Cambridge capital controversy"—about the validity of neoclassical economics,
with an emphasis on the economic growth, capital, aggregate theory, and the marginal productivity
theory of distribution. There were also internal attempts by neoclassical economists to extend the
Arrow-Debreu model to disequilibrium investigations of stability and uniqueness. However a result
known as the Sonnenschein-Mantel-Debreu theorem suggests that the assumptions that must be
made to ensure that the equilibrium is stable and unique are quite restrictive.

Neoclassical economics is also often seen as relying too heavily on complex mathematical models,
such as those used in general equilibrium theory, without enough regard to whether these actually
describe the real economy. Many see an attempt to model a system as complex as a modern
economy by a mathematical model as unrealistic and doomed to failure. A famous answer to this
criticism is Milton Friedman's claim that theories should be judged by their ability to predict events
rather than by the realism of their assumptions. Mathematical models also include those in game
theory, linear programming, and econometrics. Critics of neoclassical economics are divided in
those who think that highly mathematical method is inherently wrong and those who think that
mathematical method is potentially good even if contemporary methods have problems.

The assumption of rational expectations which has been introduced in some more modern
neoclassical models (sometimes also called new classical) can also be criticized on the grounds of
realism.

In general, allegedly overly unrealistic assumptions are one of the most common criticisms towards
neoclassical economics. It is fair to say that many (but not all) of these criticisms can only be
directed towards a subset of the neoclassical models (for example, there are many neoclassical
models where unregulated markets fail to achieve Pareto-optimality and there has recently been an
increased interest in modeling non-rational decision making).

Keynesian economics (pronounced /ˈkeɪnziən/, also called

Keynesianism and Keynesian theory) is a macroeconomic theory based on the ideas of 20th
century British economist John Maynard Keynes. Keynesian economics argues that private sector
decisions sometimes lead to inefficient macroeconomic outcomes and therefore advocates active
policy responses by the public sector, including monetary policy actions by the central bank and
fiscal policy actions by the government to stabilize output over the business cycle.[1] The theories
forming the basis of Keynesian economics were first presented in The General Theory of
Employment, Interest and Money, published in 1936; the interpretations of Keynes are contentious,
and several schools of thought claim his legacy.

Keynesian economics advocates a mixed economy—predominantly private sector, but with a large
role of government and public sector—and served as the economic model during the latter part of
the Great Depression, World War II, and the post-war economic expansion (1945–1973), though it
lost some influence following the stagflation of the 1970s. The advent of the global financial crisis
in 2007 has caused a resurgence in Keynesian thought. The former British Prime Minister Gordon
Brown, former President of the United States George W. Bush, President of the United States
Barack Obama, and other world leaders have used Keynesian economics through government
stimulus programs to attempt to assist the economic state of their countries.[2]

Overview
According to Keynesian theory, some microeconomic-level actions—if taken collectively by a large
proportion of individuals and firms—can lead to inefficient aggregate macroeconomic outcomes,
where the economy operates below its potential output and growth rate. Such a situation had
previously been referred to by classical economists as a general glut. There was disagreement
among classical economists (some of whom believed in Say's Law—that "supply creates its own
demand"), on whether a general glut was possible. Keynes contended that a general glut would
occur when aggregate demand for goods was insufficient, leading to an economic downturn with
unnecessarily high unemployment and losses of potential output. In such a situation, government
policies could be used to increase aggregate demand, thus increasing economic activity and
reducing unemployment and deflation. Most Keynesians advocate an activist stabilization policy to
reduce the amplitude of the business cycle, which they rank among the most serious of economic
problems. Now, this does not necessarily mean fine-tuning, but it does mean what might be called
'coarse-tuning.' For example, when the unemployment rate is very high, a government can use a
dose of expansionary monetary policy.

Keynes argued that the solution to the Great Depression was to stimulate the economy
("inducement to invest") through some combination of two approaches: a reduction in interest rates
and government investment in infrastructure. Investment by government injects income, which
results in more spending in the general economy, which in turn stimulates more production and
investment involving still more income and spending and so forth. The initial stimulation starts a
cascade of events, whose total increase in economic activity is a multiple of the original
investment.[3]

A central conclusion of Keynesian economics is that, in some situations, no strong automatic

mechanism moves output and employment towards full employment levels. This conclusion
conflicts with economic approaches that assume a strong general tendency towards equilibrium. In
the 'neoclassical synthesis', which combines Keynesian macro concepts with a micro foundation,
the conditions of general equilibrium allow for price adjustment to eventually achieve this goal.
More broadly, Keynes saw his theory as a general theory, in which utilization of resources could be
high or low, whereas previous economics focused on the particular case of full utilization.

The new classical macroeconomics movement, which began in the late 1960s and early 1970s,
criticized Keynesian theories, while New Keynesian economics has sought to base Keynes' ideas on
more rigorous theoretical foundations.

Some interpretations of Keynes have emphasized his stress on the international coordination of
Keynesian policies, the need for international economic institutions, and the ways in which
economic forces could lead to war or could promote peace.[4]

[edit] Precursors
Keynes's work was part of a long-running debate within economics over the existence and nature of
general gluts. While a number of the policies Keynes advocated (notably government deficit
spending) and the theoretical ideas he proposed (effective demand, the multiplier, the paradox of
thrift) were advanced by various authors in the 19th and early 20th century, Keynes's unique
contribution was to provide a general theory of these, which proved acceptable to the political and
economic establishments.

[edit] Schools
See also: Underconsumption, Birmingham School (economics), and Stockholm school (economics)

An intellectual precursor of Keynesian economics was underconsumption theory in classical

economics, dating from such 19th century economists as Thomas Malthus, the Birmingham School
of Thomas Attwood,[5] and the American economists William Trufant Foster and Waddill
Catchings, who were influential in the 1920s and 1930s. Underconsumptionists were, like Keynes
after them, concerned with failure of aggregate demand to attain potential output, calling this
"underconsumption" (focusing on the demand side), rather than "overproduction" (which would
focus on the supply side), and advocating economic interventionism. Keynes specifically discussed
underconsumption (which he wrote "under-consumption") in the General Theory, in Chapter 22,
Section IV and Chapter 23, Section VII.

Numerous concepts were developed earlier and independently of Keynes by the Stockholm school
during the 1930s; these accomplishments were described in a 1937 article, published in response to
the 1936 General Theory, sharing the Swedish discoveries.[6]

[edit] Concepts

The multiplier dates to work in the 1890s by the Australian economist Alfred De Lissa, the Danish
economist Julius Wulff, and the German American economist Nicholas Johannsen,[7] the latter
being cited in a footnote of Keynes.[8] Nicholas Johannsen also proposed a theory of effective
demand in the 1890s.

The paradox of thrift was stated in 1892 by John M. Robertson in his The Fallacy of Savings, in
earlier forms by mercantilist economists since the 16th century, and similar sentiments date to
antiquity:[9][10]

Today these ideas, regardless of provenance, are referred to in academia under the rubric of
"Keynesian economics", due to Keynes's role in consolidating, elaborating, and popularizing them.

[edit] Keynes and the Classics

Part of the series on

Capitalism

Concepts[show]

Central bank
Commercial law
Companies law
Comparative advantage
Competition law
Consumer protection
Copyright
Corporations
Deregulation
Economic freedom
Economic liberalism
Financial regulation
Fiscal policy
Free market
Free price system
Free trade agreements
Freedom of contract
 Globalization
Inflation
Intellectual property
Invisible hand
Labour law
Limited government
Market
Monetary policy
Monopoly
Oligopoly
Patents
Private property
Privatization
Regulated market
Recession
Spontaneous order
Stagflation
Supply and demand
Wage labour
Economic theories[show]

Austrian school
Chicago school
Classical economics
Keynesian economics
New Keynesian economics
Marxian economics
Monetarism
Neoclassical economics
Supply-side economics
Institutional economics
New institutional economics
Origins[show]

Age of Enlightenment
Feudalism
Industrial Revolution
Physiocrats
Mercantilism
Islamic capitalism
People[show]

Ronald Coase
Milton Friedman
Friedrich Hayek
John Maynard Keynes
Alfred Marshall
Karl Marx
John Stuart Mill
Ludwig von Mises
Ayn Rand
David Ricardo
Joseph Schumpeter
 Adam Smith
Thorstein Veblen
Max Weber
Variants[show]

Anarcho-capitalism
Consumer capitalism
Corporate capitalism
Creative capitalism
Crony capitalism
Democratic capitalism
Eco-capitalism
Finance capitalism
Global capitalism
Humanistic capitalism
Inclusive capitalism
Late capitalism
Laissez-faire capitalism
Liberal capitalism
Merchant capitalism
Mixed economy
Monopoly capitalism
Neo-Capitalism
Philanthrocapitalism
Technocapitalism
Regulatory capitalism
Rentier capitalism
Social capitalism
Social market economy
State capitalism
State monopoly capitalism
Welfare capitalism
Related topics[show]

Anti-capitalism
Advanced capitalism
Criticism
Consumerism
Corporate nationalism
Corporatism
Culture of capitalism
History
History of theory
Perspectives on Capitalism
Periodizations of capitalism
Trickle-down economics
Movements[show]

Liberalism
Libertarianism
Neoconservatism
Neoliberalism
Objectivism
 Objectivist movement
Ordoliberalism
Social democracy

Capitalism Portal
Philosophy Portal
Economics Portal
Politics Portal
v•d•e

Keynes sought to distinguish his theories from and oppose them to "classical economics," by which
he meant the economic theories of David Ricardo and his followers, including John Stuart Mill,
Alfred Marshall, Francis Ysidro Edgeworth, and Arthur Cecil Pigou. A central tenet of the classical
view, known as Say's law, states that "supply creates its own demand". Say's Law can be interpreted
in two ways. First, the claim that the total value of output is equal to the sum of income earned in
production is a result of a national income accounting identity, and is therefore indisputable. A
second and stronger claim, however, that the "costs of output are always covered in the aggregate
by the sale-proceeds resulting from demand" depends on how consumption and saving are linked to
production and investment. In particular, Keynes argued that the second, strong form of Say's Law
only holds if increases in individual savings exactly match an increase in aggregate investment.[11]

Keynes sought to develop a theory that would explain determinants of saving, consumption,
investment and production. In that theory, the interaction of aggregate demand and aggregate
supply determines the level of output and employment in the economy.

Because of what he considered the failure of the “Classical Theory” in the 1930s, Keynes firmly
objects to its main theory—adjustments in prices would automatically make demand tend to the full
employment level.

Neo-classical theory supports that the two main costs that shift demand and supply are labor and
money. Through the distribution of the monetary policy, demand and supply can be adjusted. If
there were more labor than demand for it, wages would fall until hiring began again. If there was
too much saving, and not enough consumption, then interest rates would fall until people either cut
their savings rate or started borrowing.

[edit] Wages and spending

During the Great Depression, the classical theory defined economic collapse as simply a lost
incentive to produce, and the mass unemployment as a result of high and rigid real wages.[citation
needed]

To Keynes, the determination of wages is more complicated. First, he argued that it is not real but
nominal wages that are set in negotiations between employers and workers, as opposed to a barter
relationship. Second, nominal wage cuts would be difficult to put into effect because of laws and
wage contracts. Even classical economists admitted that these exist; unlike Keynes, they advocated
abolishing minimum wages, unions, and long-term contracts, increasing labor-market flexibility.
However, to Keynes, people will resist nominal wage reductions, even without unions, until they
see other wages falling and a general fall of prices.

He also argued that to boost employment, real wages had to go down: nominal wages would have
to fall more than prices. However, doing so would reduce consumer demand, so that the aggregate
demand for goods would drop. This would in turn reduce business sales revenues and expected
profits. Investment in new plants and equipment—perhaps already discouraged by previous
excesses—would then become more risky, less likely. Instead of raising business expectations,
wage cuts could make matters much worse.

Further, if wages and prices were falling, people would start to expect them to fall. This could make
the economy spiral downward as those who had money would simply wait as falling prices made it
more valuable—rather than spending. As Irving Fisher argued in 1933, in his Debt-Deflation
Theory of Great Depressions, deflation (falling prices) can make a depression deeper as falling
prices and wages made pre-existing nominal debts more valuable in real terms.

[edit] Excessive saving

To Keynes, excessive saving, i.e. saving beyond planned investment, was a serious problem,
encouraging recession or even depression. Excessive saving results if investment falls, perhaps due
to falling consumer demand, over-investment in earlier years, or pessimistic business expectations,
and if saving does not immediately fall in step, the economy would decline.

The classical economists argued that interest rates would fall due to the excess supply of "loanable
funds". The first diagram, adapted from the only graph in The General Theory, shows this process.
(For simplicity, other sources of the demand for or supply of funds are ignored here.) Assume that
fixed investment in capital goods falls from "old I" to "new I" (step a). Second (step b), the
resulting excess of saving causes interest-rate cuts, abolishing the excess supply: so again we have
saving (S) equal to investment. The interest-rate (i) fall prevents that of production and
employment.

Keynes had a complex argument against this laissez-faire response. The graph below summarizes
his argument, assuming again that fixed investment falls (step A). First, saving does not fall much
as interest rates fall, since the income and substitution effects of falling rates go in conflicting
directions. Second, since planned fixed investment in plant and equipment is mostly based on long-
term expectations of future profitability, that spending does not rise much as interest rates fall. So S
and I are drawn as steep (inelastic) in the graph. Given the inelasticity of both demand and supply, a
large interest-rate fall is needed to close the saving/investment gap. As drawn, this requires a
negative interest rate at equilibrium (where the new I line would intersect the old S line). However,
this negative interest rate is not necessary to Keynes's argument.
Third, Keynes argued that saving and investment are not the main determinants of interest rates,
especially in the short run. Instead, the supply of and the demand for the stock of money determine
interest rates in the short run. (This is not drawn in the graph.) Neither changes quickly in response
to excessive saving to allow fast interest-rate adjustment.

Finally, because of fear of capital losses on assets besides money, Keynes suggested that there may
be a "liquidity trap" setting a floor under which interest rates cannot fall. While in this trap, interest
rates are so low that any increase in money supply will cause bond-holders (fearing rises in interest
rates and hence capital losses on their bonds) to sell their bonds to attain money (liquidity). In the
diagram, the equilibrium suggested by the new I line and the old S line cannot be reached, so that
excess saving persists. Some (such as Paul Krugman) see this latter kind of liquidity trap as
prevailing in Japan in the 1990s. Most economists agree that nominal interest rates cannot fall
below zero. However, some economists (particularly those from the Chicago school) reject the
existence of a liquidity trap.

Even if the liquidity trap does not exist, there is a fourth (perhaps most important) element to
Keynes's critique. Saving involves not spending all of one's income. It thus means insufficient
demand for business output, unless it is balanced by other sources of demand, such as fixed
investment. Thus, excessive saving corresponds to an unwanted accumulation of inventories, or
what classical economists called a general glut.[12] This pile-up of unsold goods and materials
encourages businesses to decrease both production and employment. This in turn lowers people's
incomes—and saving, causing a leftward shift in the S line in the diagram (step B). For Keynes, the
fall in income did most of the job by ending excessive saving and allowing the loanable funds
market to attain equilibrium. Instead of interest-rate adjustment solving the problem, a recession
does so. Thus in the diagram, the interest-rate change is small.

Whereas the classical economists assumed that the level of output and income was constant and
given at any one time (except for short-lived deviations), Keynes saw this as the key variable that
adjusted to equate saving and investment.

Finally, a recession undermines the business incentive to engage in fixed investment. With falling
incomes and demand for products, the desired demand for factories and equipment (not to mention
housing) will fall. This accelerator effect would shift the I line to the left again, a change not shown
in the diagram above. This recreates the problem of excessive saving and encourages the recession
to continue.
In sum, to Keynes there is interaction between excess supplies in different markets, as
unemployment in labor markets encourages excessive saving—and vice-versa. Rather than prices
adjusting to attain equilibrium, the main story is one of quantity adjustment allowing recessions and
possible attainment of underemployment equilibrium.

[edit] Active fiscal policy

This section does not cite any references or sources.
Please help improve this article by adding citations to reliable sources. Unsourced material may be
challenged and removed. (March 2009)

As noted,[clarification needed] the classicals wanted to balance the government budget. To Keynes, this
would exacerbate the underlying problem: following either policy[clarification needed] would raise saving
(broadly defined) and thus lower the demand for both products and labor. For example, Keynesians
see Herbert Hoover's June 1932 tax increase as making the Depression worse.[citation needed][clarification
needed]

Keynes′ ideas influenced Franklin D. Roosevelt's view that insufficient buying-power caused the
Depression. During his presidency, Roosevelt adopted some aspects of Keynesian economics,
especially after 1937, when, in the depths of the Depression, the United States suffered from
recession yet again following fiscal contraction. But to many the true success of Keynesian policy
can be seen at the onset of World War II, which provided a kick to the world economy, removed
uncertainty, and forced the rebuilding of destroyed capital. Keynesian ideas became almost official
in social-democratic Europe after the war and in the U.S. in the 1960s.

Keynes′ theory suggested that active government policy could be effective in managing the
economy. Rather than seeing unbalanced government budgets as wrong, Keynes advocated what
has been called countercyclical fiscal policies, that is policies which acted against the tide of the
business cycle: deficit spending when a nation's economy suffers from recession or when recovery
is long-delayed and unemployment is persistently high—and the suppression of inflation in boom
times by either increasing taxes or cutting back on government outlays. He argued that governments
should solve problems in the short run rather than waiting for market forces to do it in the long run,
because "in the long run, we are all dead."[13]

This contrasted with the classical and neoclassical economic analysis of fiscal policy. Fiscal
stimulus (deficit spending) could actuate production. But to these schools, there was no reason to
believe that this stimulation would outrun the side-effects that "crowd out" private investment: first,
it would increase the demand for labor and raise wages, hurting profitability; Second, a government
deficit increases the stock of government bonds, reducing their market price and encouraging high
interest rates, making it more expensive for business to finance fixed investment. Thus, efforts to
stimulate the economy would be self-defeating.

The Keynesian response is that such fiscal policy is only appropriate when unemployment is
persistently high, above the non-accelerating inflation rate of unemployment (NAIRU). In that case,
crowding out is minimal. Further, private investment can be "crowded in": fiscal stimulus raises the
market for business output, raising cash flow and profitability, spurring business optimism. To
Keynes, this accelerator effect meant that government and business could be complements rather
than substitutes in this situation. Second, as the stimulus occurs, gross domestic product rises,
raising the amount of saving, helping to finance the increase in fixed investment. Finally,
government outlays need not always be wasteful: government investment in public goods that will
not be provided by profit-seekers will encourage the private sector's growth. That is, government
spending on such things as basic research, public health, education, and infrastructure could help
the long-term growth of potential output.
A Keynesian economist might point out that classical and neoclassical theory does not explain why
firms acting as "special interests" to influence government policy are assumed to produce a negative
outcome, while those same firms acting with the same motivations outside of the government are
supposed to produce positive outcomes. Libertarians counter that because both parties consent, free
trade increases net happiness, but government imposes its will by force, decreasing happiness.
Therefore firms that manipulate the government do net harm, while firms that respond to the free
market do net good.

In Keynes' theory, there must be significant slack in the labor market before fiscal expansion is
justified. Both conservative and some neoliberal economists question this assumption, unless labor
unions or the government "meddle" in the free market, creating persistent supply-side or classical
unemployment.[clarification needed] Their solution is to increase labor-market flexibility, e.g., by cutting
wages, busting unions, and deregulating business.

Contrary to some critical characterizations of it, Keynesianism does not consist solely of deficit
spending. Keynesianism recommends counter-cyclical policies to smooth out fluctuations in the
business cycle. An example of a counter-cyclical policy is raising taxes to cool the economy and to
prevent inflation when there is abundant demand-side growth, and engaging in deficit spending on
labor-intensive infrastructure projects to stimulate employment and stabilize wages during
economic downturns. Classical economics, on the other hand, argues that one should cut taxes when
there are budget surpluses, and cut spending—or, less likely, increase taxes—during economic
downturns. Keynesian economists believe that adding to profits and incomes during boom cycles
through tax cuts, and removing income and profits from the economy through cuts in spending
and/or increased taxes during downturns, tends to exacerbate the negative effects of the business
cycle. This effect is especially pronounced when the government controls a large fraction of the
economy, and is therefore one reason fiscal conservatives advocate a much smaller government.

[edit] "Multiplier effect" and interest rates

Main article: Spending multiplier

Two aspects of Keynes' model had implications for policy:

First, there is the "Keynesian multiplier", first developed by Richard F. Kahn in 1931. Exogenous
increases in spending, such as an increase in government outlays, increases total spending by a
multiple of that increase. A government could stimulate a great deal of new production with a
modest outlay if:

1. The people who receive this money then spend most on consumption goods and save the rest.
2. This extra spending allows businesses to hire more people and pay them, which in turn allows a
further increase consumer spending.

This process continues. At each step, the increase in spending is smaller than in the previous step,
so that the multiplier process tapers off and allows the attainment of an equilibrium. This story is
modified and moderated if we move beyond a "closed economy" and bring in the role of taxation:
the rise in imports and tax payments at each step reduces the amount of induced consumer spending
and the size of the multiplier effect.

Second, Keynes re-analyzed the effect of the interest rate on investment. In the classical model, the
supply of funds (saving) determined the amount of fixed business investment. That is, since all
savings was placed in banks, and all business investors in need of borrowed funds went to banks,
the amount of savings determined the amount that was available to invest. To Keynes, the amount
of investment was determined independently by long-term profit expectations and, to a lesser
extent, the interest rate. The latter opens the possibility of regulating the economy through money
supply changes, via monetary policy. Under conditions such as the Great Depression, Keynes
argued that this approach would be relatively ineffective compared to fiscal policy. But during more
"normal" times, monetary expansion can stimulate the economy.[citation needed]

[edit] Postwar Keynesianism

Main articles: Neo-Keynesian economics, New Keynesian economics, and Post-Keynesian economics

Keynes's ideas became widely accepted after WWII, and until the early 1970s, Keynesian
economics provided the main inspiration for economic policy makers in Western industrialized
countries.[14] Governments prepared high quality economic statistics on an ongoing basis and tried
to base their policies on the Keynesian theory that had become the norm. In the early era of new
liberalism and social democracy, most western capitalist countries enjoyed low, stable
unemployment and modest inflation, an era called the Golden Age of Capitalism.

In terms of policy, the twin tools of post-war Keynesian economics were fiscal policy and monetary
policy. While these are credited to Keynes, others, such as economic historian David Colander,
argue that they are rather due to the interpretation of Keynes by Abba Lerner in his theory of
Functional Finance, and should instead be called "Lernerian" rather than "Keynesian".[15]

Through the 1950s, moderate degrees of government demand leading industrial development, and
use of fiscal and monetary counter-cyclical policies continued, and reached a peak in the "go go"
1960s, where it seemed to many Keynesians that prosperity was now permanent. In 1971,
Republican US President Richard Nixon even proclaimed "we are all Keynesians now".[16]
However, with the oil shock of 1973, and the economic problems of the 1970s, modern liberal
economics began to fall out of favor. During this time, many economies experienced high and rising
unemployment, coupled with high and rising inflation, contradicting the Phillips curve's prediction.
This stagflation meant that the simultaneous application of expansionary (anti-recession) and
contractionary (anti-inflation) policies appeared to be necessary, a clear impossibility. This dilemma
led to the end of the Keynesian near-consensus of the 1960s, and the rise throughout the 1970s of
ideas based upon more classical analysis, including monetarism, supply-side economics[16] and new
classical economics. At the same time Keynesians began during the period to reorganize their
thinking (some becoming associated with New Keynesian economics); one strategy, utilized also as
a critique of the notably high unemployment and potentially disappointing GNP growth rates
associated with the latter two theories by the mid-1980s, was to emphasize low unemployment and
maximal economic growth at the cost of somewhat higher inflation (its consequences kept in check
by indexing and other methods, and its overall rate kept lower and steadier by such potential
policies as Martin Weitzman's share economy).[17]

Currently, multiple schools of economic thought exist that trace their legacy to Keynes, notably
Neo-Keynesian economics, New Keynesian economics, and Post-Keynesian economics. Keynes'
biographer Robert Skidelsky writes that the post-Keynesian school has remained closest to the spirit
of Keynes' work in following his monetary theory and rejecting the neutrality of money.[18][19]

In the postwar era Keynesian analysis was combined with neoclassical economics to produce what
is generally termed the "neoclassical synthesis", yielding Neo-Keynesian economics, which
dominated mainstream macroeconomic thought. Though it was widely held that there was no strong
automatic tendency to full employment, many believed that if government policy were used to
ensure it, the economy would behave as neoclassical theory predicted. This post-war domination by
Neo-Keynesian economics was broken during the stagflation of the 1970s. There was a lack of
consensus among macroeconomists in the 1980s. However, the advent of New Keynesian
economics in the 1990s, modified and provided microeconomic foundations for the neo-Keynesian
theories. These modified models now dominate mainstream economics.
Post-Keynesian economists on the other hand, reject the neoclassical synthesis, and more generally,
neoclassical economics applied to the macroeconomy. Post-Keynesian economics is a heterodox
school which holds that both Neo-Keynesian economics and New Keynesian economics are
incorrect, and a misinterpretation of Keynes's ideas. The Post-Keynesian school encompasses a
variety of perspectives, but has been far less influential than the other more mainstream Keynesian
schools.

[edit] Main theories

The two key theories of mainstream Keynesian economics are the IS-LM model of John Hicks and
the Phillips curve; both of these are rejected by Post-Keynesians.

It was with John Hicks that Keynesian economics produced a clear model which policy-makers
could use to attempt to understand and control economic activity. This model, the IS-LM model is
nearly as influential as Keynes' original analysis in determining actual policy and economics
education. It relates aggregate demand and employment to three exogenous quantities, i.e., the
amount of money in circulation, the government budget, and the state of business expectations. This
model was very popular with economists after World War II because it could be understood in
terms of general equilibrium theory. This encouraged a much more static vision of macroeconomics
than that described above.[citation needed]

The second main part of a Keynesian policy-maker's theoretical apparatus was the Phillips curve.
This curve, which was more of an empirical observation than a theory, indicated that increased
employment, and decreased unemployment, implied increased inflation. Keynes had only predicted
that falling unemployment would cause a higher price, not a higher inflation rate. Thus, the
economist could use the IS-LM model to predict, for example, that an increase in the money supply
would raise output and employment—and then use the Phillips curve to predict an increase in
inflation.[citation needed]

[edit] Criticism
This article's Criticism or Controversy section(s) may mean the article does not present a neutral
point of view of the subject. It may be better to integrate the material in those sections into the
article as a whole. (November 2010)

[edit] Monetarist criticism

One school began in the late 1940s with Milton Friedman. Instead of rejecting macro-measurements
and macro-models of the economy, the monetarist school embraced the techniques of treating the
entire economy as having a supply and demand equilibrium. However, because of Irving Fisher's
equation of exchange, they regarded inflation as solely being due to the variations in the money
supply, rather than as being a consequence of aggregate demand. They argued that the "crowding
out" effects discussed above would hobble or deprive fiscal policy of its positive effect. Instead, the
focus should be on monetary policy, which was considered ineffective by early Keynesians.

Monetarism had an ideological as well as a practical appeal: monetary policy does not, at least on
the surface, imply as much government intervention in the economy as other measures. The
monetarist critique pushed Keynesians toward a more balanced view of monetary policy, and
inspired a wave of revisions to Keynesian theory.

[edit] New classical macroeconomics criticism

See also: Lucas critique
Another influential school of thought was based on the Lucas critique of Keynesian economics.
This called for greater consistency with microeconomic theory and rationality, and particularly
emphasized the idea of rational expectations. Lucas and others argued that Keynesian economics
required remarkably foolish and short-sighted behavior from people, which totally contradicted the
economic understanding of their behavior at a micro level. New classical economics introduced a
set of macroeconomic theories which were based on optimising microeconomic behavior. These
models have been developed into the Real Business Cycle Theory, which argues that business cycle
fluctuations can to a large extent be accounted for by real (in contrast to nominal) shocks.

[edit] Austrian School criticism

Austrian economist Friedrich Hayek criticized Keynesian economic policies for what he called their
fundamentally collectivist approach, arguing that such theories encourage centralized planning,
which leads to malinvestment of capital, which is the cause of business cycles.[20] Hayek also
argued that Keynes' study of the aggregate relations in an economy is fallacious, as recessions are
caused by micro-economic factors. Hayek claimed that what starts as temporary governmental fixes
usually become permanent and expanding government programs, which stifle the private sector and
civil society.

Other Austrian school economists have also attacked Keynesian economics. Henry Hazlitt
criticized, paragraph by paragraph, Keynes' General Theory.[21] Murray Rothbard accuses
Keynesianism of having "its roots deep in medieval and mercantilist thought."[22]

[edit] Methodological disagreement and different results that emerge

Beginning in the late 1950s neoclassical macroeconomists began to disagree with the methodology
employed by Keynes and his successors. Keynesians emphasized the dependence of consumption
on disposable income and, also, of investment on current profits and current cash flow. In addition
Keynesians posited a Phillips curve that tied nominal wage inflation to unemployment rate. To
buttress these theories Keynesians typically traced the logical foundations of their model (using
introspection) and buttressed their assumptions with statistical evidence.[23] Neoclassical theorists
demanded that macroeconomics be grounded on the same foundations as microeconomic theory,
profit-maximizing firms and utility maximizing consumers.[23]

The result of this shift in methodology produced several important divergences from Keynesian
Macroeconomics:[23]

1. Independence of Consumption and current Income (life-cycle permanent income hypothesis)

2. Irrelevance of Current Profits to Investment (Modigliani-Miller theorem)
3. Long run independence of inflation and unemployment (natural rate of unemployment)
4. The inability of monetary policy to stabilize output (rational expectations)
5. Irrelevance of Taxes and Budget Deficits to Consumption (Ricardian Equivalence)

Keynesian responses to the critics

The heart of the 'new Keynesian' view rests on microeconomic models that indicate that nominal
wages and prices are "sticky," i.e., do not change easily or quickly with changes in supply and
demand, so that quantity adjustment prevails. According to economist Paul Krugman, "while I
regard the evidence for such stickiness as overwhelming, the assumption of at least temporarily
rigid nominal prices is one of those things that works beautifully in practice but very badly in
theory."[24] This integration is further spurred by the work of other economists which questions
rational decision-making in a perfect information environment as a necessity for micro-economic
theory. Imperfect decision making such as that investigated by Joseph Stiglitz underlines the
importance of management of risk in the economy.

Over time, many macroeconomists have returned to the IS-LM model and the Phillips curve as a
first approximation of how an economy works. New versions of the Phillips curve, such as the
"Triangle Model", allow for stagflation, since the curve can shift due to supply shocks or changes in
built-in inflation. In the 1990s, the original ideas of "full employment" had been modified by the
NAIRU doctrine, sometimes called the "natural rate of unemployment." NAIRU advocates suggest
restraint in combating unemployment, in case accelerating inflation should result. However, it is
unclear exactly what the value of the NAIRU should be—or whether it even exists.

The Crash of 2008 led to a revival of interest in and debate about Keynes. Keynes's biographer,
Robert Skidelsky, wrote a book entitled Keynes: The Return of the Master.[25] Other books about
Keynes published immediately following the Crash were generally favorable.[26]

Monetarism is the view within monetary economics that variation in the money
supply has major influences on national output in the short run and the price level over longer
periods and that objectives of monetary policy are best met by targeting the growth rate of the
money supply.[1]

Monetarism today is mainly associated with the work of Milton Friedman, who was among the
generation of economists to accept Keynesian economics and then criticize it on its own terms.
Friedman and Anna Schwartz wrote an influential book, A Monetary History of the United States,
1867-1960, and argued that "inflation is always and everywhere a monetary phenomenon."
Friedman advocated a central bank policy aimed at keeping the supply and demand for money at
equilibrium, as measured by growth in productivity and demand. The monetarist argument that the
demand for money is a stable function gained considerable support during the late 1960s and 1970s
from the work of David Laidler.[citation needed] The former head of the United States Federal Reserve,
Alan Greenspan, is generally regarded as monetarist in his policy orientation. The European Central
Bank officially bases its monetary policy on money supply targets.

Critics of monetarism include both neo-Keynesians who argue that demand for money is intrinsic to
supply, and some conservative economists who argue that demand for money cannot be predicted.
Joseph Stiglitz has argued that the relationship between inflation and money supply growth is weak
when inflation is low.

Description
Monetarism is an economic theory which focuses on the macroeconomic effects of the supply of
money and central banking. Formulated by Milton Friedman, it argues that excessive expansion of
the money supply is inherently inflationary, and that monetary authorities should focus solely on
maintaining price stability.

This theory draws its roots from two almost diametrically opposed ideas: the hard money policies
that dominated monetary thinking in the late 19th century, and the monetary theories of John
Maynard Keynes, who, working in the inter-war period during the failure of the restored gold
standard, proposed a demand-driven model for money which was the foundation of
macroeconomics. While Keynes had focused on the value stability of currency, with the resulting
panics based on an insufficient money supply leading to alternate currency and collapse, then
Friedman focused on price stability, which is the equilibrium between supply and demand for
money.

The result was summarized in a historical analysis of monetary policy, Monetary History of the
United States 1867-1960, which Friedman coauthored with Anna Schwartz. The book attributed
inflation to excess money supply generated by a central bank. It attributed deflationary spirals to the
reverse effect of a failure of a central bank to support the money supply during a liquidity crunch.

Friedman originally proposed a fixed monetary rule, called Friedman's k-percent rule, where the
money supply would be calculated by known macroeconomic and financial factors, targeting a
specific level or range of inflation. Under this rule, there would be no leeway for the central reserve
bank as money supply increases could be determined "by a computer", and business could
anticipate all monetary policy decisions.[2][3]

Rise
Clark Warburton is credited with making the first solid empirical case for the monetarist
interpretation of business fluctuations in a series of papers from 1945.[1]p. 493 Within mainstream
economics, the rise of monetarism accelerated from Milton Friedman's 1956 restatement of the
quantity theory of money. Friedman argued that the demand for money could be described as
depending on a small number of economic variables. Thus, where the money supply expanded,
people would not simply wish to hold the extra money in idle money balances; i.e., if they were in
equilibrium before the increase, they were already holding money balances to suit their
requirements, and thus after the increase they would have money balances surplus to their
requirements. These excess money balances would therefore be spent and hence aggregate demand
would rise. Similarly, if the money supply were reduced people would want to replenish their
holdings of money by reducing their spending. In this, Friedman challenged a simplification
attributed to Keynes suggesting that "money does not matter."[4] Thus the word 'monetarist' was
coined.

The rise of the popularity of monetarism also picked up in political circles when Keynesian
economics seemed unable to explain or cure the seemingly contradictory problems of rising
unemployment and inflation in response to the collapse of the Bretton Woods system in 1972 and
the oil shocks of 1973. On the one hand, higher unemployment seemed to call for Keynesian
reflation, but on the other hand rising inflation seemed to call for Keynesian disinflation. The result
was a significant disillusionment with Keynesian demand management: a Democratic President
Jimmy Carter appointed a monetarist Federal Reserve chief Paul Volcker who made inflation
fighting his primary objective, and restricted the money supply (in accordance with the Friedman
rule) to tame inflation in the economy. The result was the creation of the desired price stability.

Monetarists not only sought to explain present problems; they also interpreted historical ones.
Milton Friedman and Anna Schwartz in their book A Monetary History of the United States, 1867-
1960 argued that the Great Depression of 1930 was caused by a massive contraction of the money
supply and not by the lack of investment Keynes had argued. They also maintained that post-war
inflation was caused by an over-expansion of the money supply. After Henry Hazlitt,[5] they made
famous the assertion of monetarism that 'inflation is always and everywhere a monetary
phenomenon'. At first, to many economists whose perceptions had been set by Keynesian ideas, it
seemed that the Keynesian vs. monetarist debate was merely about whether fiscal or monetary
policy was the more effective tool of demand management. By the mid-1970s, however, the debate
had moved on to more profound matters when monetarists presented a more fundamental challenge
to Keynesian orthodoxy.
Many monetarists sought to resurrect the pre-Keynesian view that market economies are inherently
stable in the absence of major unexpected fluctuations in the money supply. Because of this belief
in the stability of free-market economies they asserted that active demand management (e.g. by the
means of increasing government spending) is unnecessary and indeed likely to be harmful. The
basis of this argument is an equilibrium between "stimulus" fiscal spending and future interest rates.
In effect, Friedman's model argues that current fiscal spending creates as much of a drag on the
economy by increased interest rates as it creates present consumption: that it has no real effect on
total demand, merely that of shifting demand from the investment sector (I) to the consumer sector
(C).

When Margaret Thatcher, leader of the Conservative Party in the United Kingdom, won the 1979
general election defeating the incumbent Labour Party led by James Callaghan, Britain had endured
several years of severe inflation, which was rarely below 10% and by the time of the election in
May 1979 stood at 27%.[6] Thatcher implemented monetarism as the weapon in her battle against
inflation, and succeeded at reducing it to 4% by 1983 - although this was achieved largely by the
mass closure of inefficient factories, which resulted in a recession and in unemployment doubling
from around 1,500,000 people to more than 3,000,000. This policy was controversial with the
public and even some of her own Members of Parliament (MPs), but she still won the 1983 general
election by a landslide. This came at a time of a global recession, and Mrs Thatcher's monetarist
policies earned her the respect of political leaders worldwide as Britain was a world leader in the
fight against the recession and one of the first nations to re-establish economic growth.[2]

Practice
A realistic theory should be able to explain both the deflationary waves of the late 19th Century, the
Great Depression, and the stagflation period beginning with the uncoupling of exchange rates in
1972.

Monetarists argue that there was no inflationary investment boom in the 1920s, in contrast to both
Keynesians and to economists of the Austrian School, who argue that there was significant asset
inflation and unsustainable GNP growth during the 1920s. Instead, monetarist thinking centers on
the contraction of the M1 during the 1931-1933 period, and argues from there that the Federal
Reserve could have avoided the Great Depression by moves to provide sufficient liquidity. In
essence, they argue that there was an insufficient supply of money. This argument is supported by
macroeconomic data, such as price stability in the 1920s and the slow rise of the money
supply.[citation needed]

The counterargument is that microeconomic data support the conclusion of a poorly distributed
pooling of liquidity in the 1920s, caused by excessive easing of credit.[citation needed] This viewpoint is
argued by followers of Ludwig von Mises, who stated at the time that the expansion was
unsustainable.

From their conclusion that incorrect central bank policy is at the root of large swings in inflation
and price instability, monetarists argued that the primary motivation for excessive easing of central
bank policy is to finance fiscal deficits by the central government. Hence, restraint of government
spending is the most important single target to restrain excessive monetary growth.

With the failure of demand-driven fiscal policies to restrain inflation and produce growth in the
1970s, the way was paved for a new policy of fighting inflation through the central bank, which
would be the bank's cardinal responsibility. In typical economic theory, this would be accompanied
by austerity shock treatment, as is generally recommended by the International Monetary Fund:
such a course was taken in the United Kingdom, where government spending was slashed in the late
70s and early 80s under the political ascendance of Margaret Thatcher. In the United States, the
opposite approach was taken and real government spending increased much faster during Reagan's
first four years (4.22%/year) than it did under Carter (2.55%/year) [ref: 2006 Economic Report of
the President, Table B-78 and B-60].

In the ensuing short term, unemployment in both countries remained stubbornly high while central
banks raised interest rates to restrain credit. These policies dramatically reduced inflation rates in
both countries (the United States' inflation rate fell from almost 14% in 1980 to around 3% in
1983[citation needed]), allowing liberalization of credit and the reduction of interest rates, which lead
ultimately to the inflationary economic booms of the 1980s. Arguments have been raised, however,
that the fall of the inflation rate may be less from control of the money supply and more to do with
the unemployment level's effect on demand; some also claim the use of credit to fuel economic
expansion is itself an anti-monetarist tool, as it can be argued that an increase in money supply
alone constitutes inflation.[citation needed]

Monetarism re-asserted itself in central bank policy in western governments at the end of the 1980s
and beginning of the 1990s, with a contraction both in spending and in the money supply, ending
the booms experienced in the US and UK.

With the crash of 1987, questioning of the prevailing monetarist policy began. Monetarists argued
that the 1987 stock market decline was simply a correction between conflicting monetary policies in
the United States and Europe. Critics of this viewpoint became louder as Japan slid into a sustained
deflationary spiral and the collapse of the savings-and-loan banking system in the United States
pointed to larger structural changes in the economy.

In the late 1980s, Paul Volcker was succeeded by Alan Greenspan, a leading monetarist. His
handling of monetary policy in the run-up to the 1991 recession was criticized from the right as
being excessively tight, and costing George H. W. Bush re-election. The incoming Democratic
president Bill Clinton reappointed Alan Greenspan, and kept him as a core member of his economic
team. Greenspan, while still fundamentally monetarist in orientation, argued that doctrinaire
application of theory was insufficiently flexible for central banks to meet emerging situations.

The crucial test of this flexible response by the Federal Reserve was the Asian financial crisis of
1997-1998, which the Federal Reserve met by flooding the world with dollars, and organizing a
bailout of Long-Term Capital Management. Some have argued that 1997-1998 represented a
monetary policy bind, just as the early 1970s had represented a fiscal policy bind, and that while
asset inflation had crept into the United States (which demanded that the Fed tighten the money
supply), the Federal Reserve needed to ease liquidity in response to the capital flight from Asia.
Greenspan himself noted this when he stated that the American stock market showed signs of
irrationally high valuations.[7]

In 2000, Alan Greenspan raised interest rates several times. These actions were believed by many to
have caused the bursting of the dot-com bubble. In autumn of 2001, as a decisive reaction to the
September 11 attacks and the various corporate scandals which undermined the economy, the
Greenspan-led Federal Reserve initiated a series of interest cuts that brought the Federal Funds rate
down to 1% in 2004. His critics, notably Steve Forbes, attributed the rapid rise in commodity prices
and gold to Greenspan's loose monetary policy[citation needed], and by late 2004 the price of gold was
higher than its 12 year moving average; these same forces were also blamed for excessive asset
inflation and the weakening of the dollar[citation needed]. These policies of Alan Greenspan are blamed
by the followers of the Austrian School for creating excessive liquidity, causing lending standards
to deteriorate, and resulting in the housing bubble of 2004-2006.

Currently, the American Federal Reserve follows a modified form of monetarism, where broader
ranges of intervention are possible in light of temporary instabilities in market dynamics. This form
does not yet have a generally accepted name.[citation needed]
In Europe, the European Central Bank follows a more orthodox form of monetarism, with tighter
controls over inflation and spending targets as mandated by the Economic and Monetary Union of
the European Union under the Maastricht Treaty to support the euro.[8] This more orthodox
monetary policy followed credit easing in the late 1980s through 1990s to fund German
reunification, which was blamed for the weakening of European currencies in the late 1990s.[citation
needed]

Current state

Critics point to policies that add "restraint on compensation increases" as a consequence of Monetarism.[9]

However, total compensation, (including eg. health insurance), has in fact increased.

Since 1990, the classical form of monetarism has been questioned because of events which many
economists have interpreted as being inexplicable in monetarist terms, namely the unhinging of the
money supply growth from inflation in the 1990s and the failure of pure monetary policy to
stimulate the economy in the 2001-2003 period. Alan Greenspan, former chairman of the Federal
Reserve, argued that the 1990s decoupling was explained by a virtuous cycle of productivity and
investment on one hand, and a certain degree of "irrational exuberance" in the investment sector.
Economist Robert Solow of MIT suggested that the 2001-2003 failure of the expected economic
recovery should be attributed not to monetary policy failure but to the breakdown in productivity
growth in crucial sectors of the economy, most particularly retail trade. He noted that five sectors
produced all of the productivity gains of the 1990s, and that while the growth of retail and
wholesale trade produced the smallest growth, they were by far the largest sectors of the economy
experiencing net increase of productivity. "2% may be peanuts, but being the single largest sector of
the economy, that's an awful lot of peanuts."
There are also arguments which link monetarism and macroeconomics, and treat monetarism as a
special case of Keynesian theory. The central test case over the validity of these theories would be
the possibility of a liquidity trap, like that experienced by Japan. Ben Bernanke, Princeton professor
and current chairman of the US Federal Reserve, has argued that monetary policy could respond to
zero interest rate conditions by direct expansion of the money supply. In his words, "We have the
keys to the printing press, and we are not afraid to use them." Another popular economist, Paul
Krugman, has advanced the counterargument that this would have a corresponding devaluationary
effect, like the sustained low interest rates of 2001-2004 produced against world currencies.[citation
needed]

Historian David Hackett Fischer, in his study The Great Wave, questioned the implicit basis of
monetarism by examining long periods of secular inflation that stretched over decades. In doing so,
he produced data which suggest that prior to a wave of monetary inflation, there is a wave of
commodity inflation, which governments respond to, rather than lead. Whether this formulation
undermines the monetary data which underpin the fundamental work of monetarism is still a matter
of contention.[citation needed]

Monetarists of the Milton Friedman school of thought believed in the 1970s and 1980s that the
growth of the money supply should be based on certain formulations related to economic growth.
As such, they can be regarded as advocates of a monetary policy based on a "quantity of money"
target. This can be contrasted with the monetary policy advocated by supply side economics and the
Austrian School which are based on a "value of money" target (albeit from different ends of the
formula).[citation needed] Austrian economists criticise monetarism for not recognizing the citizens'
subjective value of money and trying to create an objective value through supply and demand.

These disagreements, along with the role of monetary policy in trade liberalization, international
investment, and central bank policy, remain lively topics of investigation and argument.

Gold standard
While most monetarists believe that government action is at the root of inflation, very few advocate
a return to the gold standard. Friedman, for example, viewed a pure gold standard as highly
impractical.[10] For example, whereas one of the benefits of the gold standard is that the intrinsic
limitations to the growth of the money supply by the use of gold or silver would prevent inflation, if
the growth of population or increase in trade outpaces the money supply, there would be no way to
counter-act deflation and reduced liquidity (and any attendant recession) except for the mining of
more gold or silver under a gold or silver standard.

Monetarists also oppose fixed fiat currencies advocating the flexible fiat currency which has
become standard in most countries.

Austrian School is a heterodox school of economic thought that emphasizes

the spontaneous organizing power of the price mechanism. Its name derives from the identity of its
founders and early supporters, who were citizens of the old Austrian Habsburg Empire, including
Carl Menger, Eugen von Böhm-Bawerk, Ludwig von Mises, and Nobel laureate Friedrich Hayek.[1]
Currently, adherents of the Austrian School can come from any part of the world, but they are often
referred to simply as Austrian economists and their work as Austrian economics.

The Austrian School was influential in the late 19th and early 20th century. Austrian contributions
to mainstream economic thought include involvement in the development of the neoclassical theory
of value and the subjective theory of value on which it is based, as well as contributions to the
"economic calculation debate" which concerns the allocative properties of a centrally planned
economy versus a decentralized free market economy.[2] From the middle of the 20th century
onwards, it has been considered outside the mainstream,[3][4] with notable criticisms related to the
School leveled by economists such as Bryan Caplan, Jeffrey Sachs, and Nobel laureates Paul
Samuelson,[5] Milton Friedman,[6] and Paul Krugman.[7] Followers of the Austrian School are now
most frequently associated with libertarian political perspectives that emanate from such bodies as
the Ludwig von Mises Institute and George Mason University in the US.[8]

Austrian School principles advocate strict adherence to methodological individualism – analyzing

human action exclusively from the perspective of an individual agent.[9] Austrian economists also
argue that mathematical models and statistics are an unreliable means of analyzing and testing
economic theory, and advocate deriving economic theory logically from basic principles of human
action and have given this method the name, praxeology. Additionally, whereas experimental
research and natural experiments are often used in mainstream economics, Austrian economists
contend that testability in economics is virtually impossible since it relies on human actors who
cannot be placed in a lab setting without altering their would-be actions. Mainstream economists are
generally critical of methodologies used by modern Austrian economists;[10] in particular, a primary
Austrian School method of deriving theories has been criticized by mainstream economists as a
priori "non-empirical" analysis[5] and differing from the practices of scientific theorizing, as widely
conducted in economics.[11][12][10]

Austrian School economists generally hold that the complexity of human behavior makes
mathematical modeling of an evolving market extremely difficult (or undecidable) and advocate a
laissez faire approach to the economy. They advocate the strict enforcement of voluntary
contractual agreements between economic agents, and hold that commercial transactions should be
subject to the smallest possible imposition of coercive forces. In particular, they argue for an
extremely limited role for government and the smallest possible amount of government intervention
in the economy.

History and mainstream opinion

Classical economics focused on the labour theory of value, which holds that the value of a
commodity is equal to the amount of labour required to produce it. In the late 19th century,
however, attention was focused on the concepts of “marginal” cost and value. The Austrian School
was one of three founding currents of the marginalist revolution of the 1870s, with its major
contribution being the introduction of the subjectivist approach in economics.[13] Carl Menger's
1871 book, Principles of Economics was the catalyst for this development; while marginalism was
generally influential, there was also a more specific school that grew up around Menger, which
came to be known as the “Psychological School,” “Vienna School,” or “Austrian School.”[14]
Thorstein Veblen introduced the term neoclassical economics in his Preconceptions of Economic
Science (1900) to distinguish marginalists in the objective cost tradition of Alfred Marshall from
those in the subjective valuation tradition of the Austrian School.[15][16]

Austrian economics is closely associated with the advocacy of laissez-faire views. The Austrian
School, especially through the works of Friedrich Hayek, was influential in the revival of laissez-
faire thought in the 20th century.[17]

Origins and etymology

The school originated in Vienna, in the Austrian Empire. However, later adherents of the school
such as Murray Rothbard have derived the roots of the thought of the Austrian School from the
Spanish Scholastics teaching at the University of Salamanca of the 15th century and the French
Physiocrats of the 18th century.[18] The School owes its name to members of the German Historical
School of economics, who argued against the Austrians during the Methodenstreit ("methodology
struggle"), in which the Austrians defended the reliance that classical economists placed upon
deductive logic. Their Prussian opponents derisively named them the "Austrian School" to
emphasize a departure from mainstream German thought and to suggest a provincial, Aristotelian
approach.

Specifically, in 1883 Menger published Investigations into the Method of the Social Sciences with
Special Reference to Economics (Untersuchungen über die Methode der Socialwissenschaften und
der politischen Oekonomie insbesondere), which attacked the methods of the Historical school.
Gustav von Schmoller, a leader of the Historical school, responded with an unfavorable review,
coining the term "Austrian school".[19]

The name "Psychological School" derived from the effort to found marginalism upon prior
considerations, largely psychological – compare behavioral economics. The school was no longer
centered in Austria after Hitler came to power, and is now based almost entirely in the United
States.

First wave

Carl Menger was closely followed by Eugen von Böhm-Bawerk and Friedrich von Wieser, in what
is known as the "first wave" of the School. Austrian economists developed a sense of themselves as
a school distinct from neoclassical economics during the economic calculation debate with socialist
economists. Ludwig von Mises and his student Friedrich A. Hayek represented the Austrian
position in contending that without monetary prices and private property, meaningful economic
calculation is impossible.[20]

The Austrian economist Böhm-Bawerk wrote extensive critiques of Marx in the 1880s and 1890s,
as was part of the Austrian economists' participation in the late 19th Century Methodenstreit, during
which they attacked the Hegelian doctrines of the Historical School.

Inter-war period

Austrian economics after 1920 can be broken into two general trends. One, exemplified by
Friedrich A. Hayek, while distrusting many neoclassical concepts (like most of the corpus of
Keynesian macroeconomics), generally accepts a large part of the neoclassical methodology; the
other, exemplified by Ludwig von Mises, seeks a different formalism for economics, considering
the neoclassical methodology to be irredeemably flawed.[21] According to Austrian school
economists, the main area of contention between the mainstream and the Austrian school is on their
view of the market system as a process, not only to be studied using equilibrium models, but to be
viewed as an incessant process that only tends toward a constantly changing equilibrium. This
difference is the root of the Austrian business cycle theory, the economic calculation debate, and
their different views of monopoly and competition.

A second area of contention between neoclassical theory and the Austrian school is over the
possibility of consumers being indifferent between choices – neoclassical theory says it is possible,
whereas Mises rejected it as being “impossible to observe in practice.” Additionally, Mises and his
students argued, building on Czech economist František Čuhel (1862–1914),[22] that utility
functions are ordinal, and not cardinal; that is, the Austrians contend that one can only rank
preferences and cannot measure their intensity. The Austrian School rejects any neoclassical results
that are based on cardinal utility and criticizes mainstream economics for supposedly accepting
cardinality,[23] despite the fact that neoclassical economists have shown that their work holds for
ordinal preferences.[24][25][26]
Finally there are a host of questions about uncertainty and the utility of "conventional" financial
models raised by Mises and other Austrians, who argue for a fundamentally different means of risk
assessment in economics compared to that used by the mainstream. Mises and others argued that
numerically accurate "probabilities" could never be assigned to "singular" cases. The utility and
accuracy of financial modeling is an on-going source of debate, even within the Austrian School.[27]
These questions are directly linked to the dynamic market process approach to economic theory,
where it is argued by Mises and others that the unique confluence of events in each moment of time
in real markets makes the assignment of "objective" probabilities unrealistic, as these events are
intrinsically unique and not capable of numerical probabilistic modeling. Mises and others argued
that the application of probabilistic uncertainty would require the ability to exactly replicate
objectively similar events to obtain an accurate understanding of the range of probabilistic
outcomes of any event, and this is not possible in real markets, where past market events intimately
affect the present and the future.

Later reputation

Austrian economics was ill-thought of by most economists after World War II because it rejected
mathematical and statistical methods in the area of economics.[28] Its reputation rose somewhat in
the late 20th century with the work of Israel Kirzner and Ludwig Lachmann, as well as a renewed
interest in Hayek after he won the Bank of Sweden Prize in Economic Sciences in Memory of
Alfred Nobel (a.k.a. the Nobel Prize in Economics).[29] Following Hayek, one of Ludwig von
Mises's students, Murray Rothbard, became prominent in both Austrian applied theory and
Libertarian philosophical thought.[30] However, it remains a distinctly minority position, even in
such areas as capital value.

Currently, universities with a significant Austrian presence are George Mason University, Loyola
University New Orleans, and Auburn University in the United States and Universidad Francisco
Marroquín in Guatemala. The library of Universidad Francisco Marroquín is named after Ludwig
von Mises, and the university also provides seminars and lectures through a program named for
Austrian School proponent Henry Hazlitt. Austrian economic ideas are also promoted heavily by
bodies such as the Mises Institute and the Foundation for Economic Education. In May 2010, Antal
E. Fekete declared his intention to establish a New School of Austrian Economics in Budapest,
based on the Real bills doctrine, but the status of this "New Austrian School" remains uncertain.[31]

Influence
According to Austrian school economist Peter J. Boettke, during its history the position of the
Austrian School within the economics profession has changed several times from the center to the
fringe of the mainstream. By the mid-1930s, the mainstream had more or less absorbed what were
seen as the important contributions of the Austrians, and it is currently a distinctly minority
position.[3]

The former U.S. Federal Reserve Chairman, Alan Greenspan, speaking of the originators of the
School, said in 2000, "the Austrian school have reached far into the future from when most of them
practiced and have had a profound and, in my judgment, probably an irreversible effect on how
most mainstream economists think in this country."[32]

Nobel Laureate James M. Buchanan is sometimes considered to be a member of the Austrian

School[33][34] and he stated that, "I certainly have a great deal of affinity with Austrian economics
and I have no objections to being called an Austrian. Hayek and Mises might consider me an
Austrian but, surely some of the others would not."[35] Republican U.S. congressman Ron Paul is a
firm believer in Austrian school economics and has authored six books on the subject.[36][37] Paul's
former economic adviser, Peter Schiff,[38] is an adherent of the Austrian school.[39] Jim Rogers,
investor and financial commentator, also considers himself of the Austrian School of economics.[40]
Prominent Chinese economist Zhang Weiyin, who is known in China for his advocacy of free
market reforms, supports some Austrian theories such as the Austrian theory of the business
cycle.[41]

Methodology
Austrian economists reject empirical statistical methods, natural experiments and constructed
experiments as tools applicable to economics, saying that while it is appropriate in the natural
sciences where factors can be isolated in laboratory conditions, the actions of human beings are too
complex for this "numerical" treatment as passive non-adaptive subjects. Instead one should isolate
the logical processes of human action. Von Mises called this discipline "praxeology" – a term he
adapted from Alfred Espinas (but which had been in use by others).[42]

The Austrian praxeological method is based on the heavy use of logical deduction from what they
assert to be undeniable, self-evident axioms or irrefutable facts about human existence. The primary
axiom from which Austrian economists deduce further certain conclusions is the action axiom,
which holds that humans take conscious action toward chosen goals.[43] Austrian economists focus
on goal-directed action and say that it is undeniable because in order to deny action, one would have
to employ action in the act of denial.

Methodology is the one area where Austrian economists differ most significantly from other
schools of economic thought. Mainstream schools such as the neoclassical economists, the Chicago
school of economics, the Keynesians and New Keynesians, adopt "empirical" mathematical and
statistical methods, and focus on induction to construct and test theories—while Austrian
economists reject this approach in favor of deduction and logically deduced inferences. According
to Austrian economists, deduction is preferred, since if performed correctly, it leads to certain
conclusions and inferences that must be true if the underlying assumptions are accurate. However
Austrian economist Robert Murphy has stated that those using Austrian theories can still err in their
interpretations of history, even if based on a theory formulated by deduction.[44] Caplan makes a
similar point about quantitative significance, explaining that a theory, such as one which logically
relates minimum wage and unemployment, tells nothing of the approximate quantity of change in
unemployment one can expect upon minimum wage increases.

Austrian economists hold that induction does not assure certainty like deduction, as real world
economic data are inherently ambiguous and subject to a multitude of influences which cannot be
separated or quantified, one cause or correlation from another. Austrians therefore claim that
mainstream economics has no way of verifying cause and effect in real work economic events,
since economic data which can be correlated to multiple potential chains of causation.[45]
Mainstream economists counter that conclusions that can be reached by pure logical deduction are
limited and weak.[46]

Critics of the Austrian school contend that by rejecting mathematics and econometrics, it has failed
to contribute significantly to modern economics. Additionally, they contend that its methods
currently consist of post-hoc analysis and do not generate testable implications; therefore, they fail
the test of falsifiability as prescribed by the scientific method.[10][47] Austrian economists counter
that testability in economics is virtually impossible since it relies on human actors who cannot be
placed in a lab setting without altering their would-be actions.

Criticism of mainstream practices

Austrians hold their methodology to be superior to the fundamental scientific principles, such as
empiricism, which mainstream economists strive to uphold. On the Austrian critiques of
mainstream economics, economist Bryan Caplan has asserted that, "Mises and Rothbard reject the
foundations of modern neoclassical economics too quickly, and their substitutes are inadequate."[10]
In their rejection of mainstream practices, Austrians have argued that mainstream economics has an
unsatisfactory record of prediction, citing the Global Financial Crisis as an example.[48][49] However,
there were warnings from the mainstream about an economic bubble in the housing market
discussed in The Economist magazine[50] and by prominent economists;[51][52][53] economists
associated with mainstream economic schools, such as Robert Shiller[54][55] and Nobel laureate,
Joseph Stiglitz,[56] have received international recognition for warning of the impending crisis.
Another mainstream economist who has become popular due to warnings is Nouriel Roubini.[57][58]
Heterodox economists not of the Austrian school who warned of an impending crisis include Dean
Baker, Wynne Godley,[59] Michael Hudson and Steve Keen.[60]

Also of note in relation to contested "accurate predictions" between Austrians and the mainstream
are the false predictions from Austrian School adherents which failed in their timing or description
of the financial crises, as with Ludwig von Mises's failed prediction regarding a collapse of the
British pound[61] or with Peter Schiff who predicted that an economic crisis would cause the U.S.
dollar to weaken significantly, whereas the opposite occurred causing significant client losses
according to reports from 2009;[62] Schiff stated the US Dollar should "completely collapse" after
the dollar's 2008 rally.[63] Some Austrian adherents have been labeled as "permabears" or "Chicken
Littles" for continually making predictions of "catastrophic" financial crises, whilst making little
allowance for spans of stable economic growth.[64][65] For example in 2002, months before a multi-
year advance in the US stock market, Austrian advocate Peter Schiff claimed that the US was at the
early stage of an economic crisis and has frequently predicted an imminent U.S. dollar "crash"
(which has yet to materialize).[66] These claims have prompted Schiff to be labeled a "permabear"
and to draw comparisons of his pronouncements with "stopped clocks" (which are right twice a day
but useless nevertheless).[67]

Academic and political background

Austrian school theorists, like Ludwig von Mises, insist that praxeology must be value-free—that
the method does not answer the question "should this policy be implemented?", but rather "if this
policy is implemented, will it have the effects you intend"? However, Austrian economists often
make policy recommendations that call for the elimination of government regulations and their
policy prescriptions often overlap with libertarian or anarcho-capitalist solutions. These
recommendations are similar to, but further reaching than the minarchist ideas of Chicago School
economists, and frequently address issues that other schools ignore, such as monetary reform.[68]
Both schools advocate strict protection of private property, and support for individualism in
general,[69] and are often cited by libertarian, classical or laissez-faire liberal, fiscal conservative,
and Objectivist groups for support.

Austrian economists view entrepreneurship as the driving force in economic development, see
private property as essential to the efficient use of resources, and usually (if not always) see
government interference in market processes as counterproductive. In this, their views do not differ
far from those of the Chicago school.

As with neoclassical economists, Austrian economists reject classical cost of production theories,
most famously the labor theory of value. Instead they explain value by reference to the subjective
preferences of individuals. This psychological aspect to Menger's economics has been attributed to
the school's birth in turn of the century Vienna. Supply and demand are explained by aggregating
over the decisions of individuals, following the precepts of methodological individualism, which
asserts that only individuals and not collectives make decisions, and marginalist arguments, which
compare the costs and benefits for incremental changes.
Contemporary neo-Austrian economists claim to adopt economic subjectivism more consistently
than any other school of economics and reject many neoclassical formalisms. For example, while
neoclassical economics formalizes the economy as an equilibrium system with supply and demand
in balance, Austrian economists emphasize its dynamic, perpetually dis-equilibrated nature.

The opportunity cost doctrine was first explicitly formulated by the Austrian economist Friedrich
von Wieser in the late 19th century.[70] In its original and purist sense, opportunity cost doctrine
argues that the only cost relevant to the price of a product is the cost involved in choosing it over
other competing, and mutually exclusive, options, and its technical coefficients of production. In the
1930s Gottfried Haberler applied the doctrine to the problems of foreign trade, confident that much
of the work done in classical economics to incorporate the much broader array of costs in price
analysis could be abandoned.[71]

This focus on opportunity cost alone means that their interpretation of the time value of a good has
a strict relationship: since goods will be as restricted by scarcity at a later point in time as they are
now, the strict relationship between investment and time must also hold. A factory making goods
next year is worth much less than the goods it is making next year are worth. This means that the
business cycle is driven by mis-coordination between sectors of the same economy, caused by
money not carrying incentive information correct about present choices, rather than within a single
economy where money causes people to make bad decisions about how to spend their time.

Contributions
Some general contributions of Austrian economists:

 A theory of distribution in which factor prices result from the imputation of prices of consumer
goods to goods of "higher order", that is goods used in the production of consumer goods (goods of
the first order).
 A fundamental rejection of mathematical methods in economics, seeing the function of economics
as investigating the essences rather than the specific quantities of economic phenomena. This was
seen as an evolutionary, or "genetic-causal", approach against the alleged "unreality" and internal
stresses inherent in the "static" approach of equilibrium and perfect competition, which are the
foundations of mainstream Neoclassical economics (see also praxeology). This methodology is also
driven by the belief that econometrics is inherently misleading in that it creates a fallacious
"precision" in economics where there is none.
 Eugen von Böhm-Bawerk's critique of Marx, which centered on the untenability of the labor theory
of value in the light of the transformation problem. There was also the connected argument that
capitalists do not exploit workers; they accommodate workers by providing them with income well
in advance of the revenue from the output they helped to produce.
 Eugen von Böhm-Bawerk's capital theory, which equates capital intensity with the degree of
roundaboutness of production processes.
 Eugen von Böhm-Bawerk's demonstration that the law of marginal utility, as formulated by Menger
necessarily implies the classical law of costs and hence the vast majority of the conclusions of the
British classical economists. This discovery was later fully developed and its implications traced by a
student of von Mises, George Reisman, in his book, Capitalism.
 An emphasis on opportunity cost and reservation demand in defining value, and a refusal to
consider supply as an otherwise independent cause of value.[72] (The British economist Philip
Wicksteed adopted this perspective.)
 The Mises-Hayek business cycle theory, which is asserted as explaining depression as a reaction to
an intertemporal production structure fostered by monetary policy setting interest rates
inconsistent with individual time preferences.
 Hayek's concept of intertemporal equilibrium. (John Hicks took over this theory in his discussion of
temporary equilibrium in Value and Capital, a book very influential on the development of
neoclassical economics after World War II.)
  Mises[citation needed] and Hayek's view of prices as permitting agents to make use of dispersed tacit
knowledge.
 The time preference theory of interest, which explains interest rates through intertemporal choice -
the different time preferences of the borrower or lender - rather than as a price paid for a factor of
production.
 The economic calculation debate between Austrian and Marxist economists, with the Austrians
claiming that Marxism is flawed because prices could not be set to recognize opportunity costs of
factors of production, and so socialism could not make rational decisions.
 Friedrich Hayek was one of the few economists who gave warning of a major economic crisis before
the great crash of 1929.[73][74] In February 1929, Hayek warned that a coming financial crisis was an
unavoidable consequence of reckless monetary expansion.[75]

Notable theories
Economic calculation problem
Main article: Economic calculation problem

The economic calculation problem is a criticism of socialist economics. It was first proposed by
Ludwig von Mises in 1920 and later expounded by Friedrich Hayek.[9][76] The problem referred to is
that of how to distribute resources rationally in an economy. The capitalist solution is the price
mechanism; Mises and Hayek argued that this is the only viable solution, as the price mechanism
co-ordinates supply and investment decisions most efficiently. Without the information efficiently
and effectively provided by market prices, socialism lacks a method to efficiently allocate resources
over an extended period of time in any market where the price mechanism is effective (an example
where the price mechanism may not work is in the relatively confined area of public and common
goods). Those who agree with this criticism argue it is a refutation of socialism and that it shows
that a socialist planned economy could never work in the long term for the vast bulk of the economy
and has very limited potential application. The debate raged in the 1920s and 1930s, and that
specific period of the debate has come to be known by historians of economic thought as The
Socialist Calculation Debate.[77] Ludwig von Mises argued in a famous 1920 article "Economic
Calculation in the Socialist Commonwealth" that the pricing systems in socialist economies were
necessarily deficient because if government owned the means of production, then no prices could be
obtained for capital goods as they were merely internal transfers of goods in a socialist system and
not "objects of exchange," unlike final goods. Therefore, they were unpriced and hence the system
would be necessarily inefficient since the central planners would not know how to allocate the
available resources efficiently.[77] This led him to declare "…that rational economic activity is
impossible in a socialist commonwealth."[9] Mises's declaration has been criticized as overstating
the strength of his case, in describing socialism as impossible, rather than having to contend with a
source of inefficiency.[78][10] A recent paper on this question has criticized the Austrian view from
the viewpoint of computational complexity, arguing that if finding a true economic equilibrium is
not just hard but impossible for a central planner, then the impossibility applies equally well to a
market system, since a system of dispersed calculators (i.e. a market) has no advantage over one
large central calculator in overcoming complexity.[79]

Inflation

The Austrian School has consistently argued that a "traditionalist" approach to inflation yields the
most accurate understanding of the causes (and the cure) for inflation. Austrian economists maintain
that inflation is by definition always and everywhere simply an increase in the money supply (i.e.
units of currency or means of exchange), which in turn leads to a higher nominal price level for
assets (such as housing) and other goods and services in demand, as the real value of each monetary
unit is eroded, loses purchasing power and thus buys fewer goods and services.
Given that all major economies currently have a central bank supporting the private banking
system, money can be supplied into these economies by way of bank-created credit (or debt).[80]
Austrian economists believe that this bank-created credit growth (which forms the bulk of the
money supply) sets off and creates volatile business cycles (see Austrian Business Cycle Theory)
and maintain that this "wave-like" or "boomerang" effect on economic activity is one of the most
damaging effects of monetary inflation.

According to the Austrian Business Cycle Theory, the central bank's policy of attempting to control
the market economy is ineffective and creates volatile credit cycles or business cycles, and, as a
necessary by-product, inflation (especially in asset markets).[81] By the central bank artificially
"stimulating" the economy with artificially low interest rates (thereby permitting excessive
increases in the money supply), the government-sponsored central bank itself allows debasement of
the means of exchange (inflation), often focused in asset or capital markets, resulting in "false
signals" going out to the market place, in turn resulting in clusters of malinvestments, and the
artificial lowering of the returns on savings, which eventually causes the malinvestments to be
liquidated as they inevitably show their underlying unprofitability and unsustainability.[82]

Austrian School economists therefore regard the state-sponsored central bank as the main cause of
inflation, because they regard the bank as the institution charged with the creation of new money.[83]
When newly created currency reserves are injected into the fractional-reserve banking system,
private financial institutions generally choose to further expand the level of bank credit, which
multiplies the inflationary effect many times over.[84]

The Austrian School also views the "contemporary" definition of inflation as inherently misleading
in that it draws attention only to the effect of inflation (rising prices) and does not address the "true"
phenomenon of inflation, which they believe simply involves an increase in the money supply (or
the debasement of the means of exchange). They argue that this semantic difference is important in
defining inflation and finding a cure for inflation. Austrian School economists maintain the most
effective cure is the strict maintenance of a stable money supply.[85] Ludwig von Mises, the seminal
scholar of the Austrian School, asserts that:

Figure 1. Components of the US money supply as measured in modern economics. Included are the printed
dollar bills, as well as other bank notes in circulation and the quantity of bank deposits subject to check.
The currency printed by the Federal government (through the Federal Reserve) and the checkable deposits
are colored in green and white at the bottom of the graphs. The M2 money measure, colored in the lighter
shade of gray, is generally dominated by funds held in private institutions, far exceeding the value of the
currency printed by the Federal government.

Inflation, as this term was always used everywhere and especially in this country, means increasing
the quantity of money and bank notes in circulation and the quantity of bank deposits subject to
check. But people today use the term `inflation' to refer to the phenomenon that is an inevitable
consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of this
deplorable confusion is that there is no term left to signify the cause of this rise in prices and wages.
There is no longer any word available to signify the phenomenon that has been, up to now, called
inflation. . . . As you cannot talk about something that has no name, you cannot fight it. Those who
pretend to fight inflation are in fact only fighting what is the inevitable consequence of inflation,
rising prices. Their ventures are doomed to failure because they do not attack the root of the evil.
They try to keep prices low while firmly committed to a policy of increasing the quantity of money
that must necessarily make them soar. As long as this terminological confusion is not entirely wiped
out, there cannot be any question of stopping inflation.[86]

Following their definition, Austrian economists measure the inflation by calculating the growth of
what they call 'the true money supply', i.e. how many new units of money that are available for
immediate use in exchange, that have been created over time.[87][88][89]

This interpretation of inflation implies that, within a centralized banking system, inflation is always
a distinct action taken by the central government or its central bank,[90] which permits or allows an
increase in the money supply.[91] Mises includes bank credit as a significant contributor to inflation;
the value of bank credit generated by private financial institutions and held within checking
accounts greatly exceeds the value of physical paper bills and metallic coins issued by the Federal
government (see Figure 1). In addition to state-induced monetary expansion via printing of paper
money, the Austrian School also maintains that the effects of increasing the money supply are
exacerbated by the credit expansion performed by private financial institutions practising fractional-
reserve banking system, legally permitted in most economic and financial systems in the world.[92]

Austrian School economists claim that the state uses monetary inflation as one of the three means
by which it can fund its activities, the other two being taxing and borrowing.[93] Therefore,
Austrians often seek to identify reasons why the state resorts to allowing the creation new money
(whether fiat paper or electronic money) and what the new money is used for. Various forms of
military spending are often cited as reasons for resorting to inflation and borrowing, as this can be a
short term way of acquiring marketable resources and is often favored by desperate, indebted
governments.[94] In other cases, the central bank may try avoid or defer the widespread bankruptcies
and insolvencies which cause economic recessions or depressions by artificially trying to
"stimulate" the economy through money supply growth and further borrowing via artificially low
interest rates.[95]

Accordingly, many Austrian School economists support the abolition of the central banks and the
fractional-reserve banking system, and advocate instead a return to money based on the gold
standard, or less frequently, free banking.[96][97] Money could only be created by finding and putting
into circulation more gold under a gold standard.

At the beginning of his career Alan Greenspan, former chairman of the Federal Reserve, was also a
strong advocate of the Gold Standard as a protector of economic liberty:

In the absence of the gold standard, there is no way to protect savings from confiscation through
inflation. There is no safe store of value. If there were, the government would have to make its
holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his
bank deposits to silver or copper or any other good, and thereafter declined to accept checks as
payment for goods, bank deposits would lose their purchasing power and government-created bank
credit would be worthless as a claim on goods. The financial policy of the welfare state requires that
there be no way for the owners of wealth to protect themselves. This is the shabby secret of the
welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of
wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If
one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold
standard. [98]

Advocates argued that the Gold Standard would constrain unsustainable and volatile fractional-
reserve banking practices, ensuring that money supply growth ("inflation") would never spiral out
of control.[99][100] Ludwig von Mises asserted that civil liberties would be better protected:

It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was
devised as an instrument for the protection of civil liberties against despotic inroads on the part of
governments. Ideologically it belongs in the same class with political constitutions and bills of
rights. The demand for constitutional guarantees and for bills of rights was a reaction against
arbitrary rule and the nonobservance of old customs by kings.[101]

Business cycles
Main article: Austrian Business Cycle Theory

According to Austrian School economist Joseph Salerno, what most distinctly sets the Austrian
school apart from neoclassical economics is the Austrian Business Cycle Theory:[102]

The Austrian theory embodies all the distinctive Austrian traits: the theory of heterogeneous capital, the
structure of production, the passage of time, sequential analysis of monetary interventionism, the market
origins and function of the interest rate, and more. And it tells a compelling story about an area of history
neoclassicals think of as their turf. The model of applying this theory remains Rothbard's America's Great
Depression.

The Austrian theory of the business cycle varies significantly from mainstream theories.
Economists such as Gordon Tullock,[103] Bryan Caplan,[10] and Nobel laureates Milton
Friedman[6][104] and Paul Krugman[7] have said that they regard the theory as incorrect.

In contrast to most mainstream theories on business cycles, Austrian School economists focus on
the credit cycle as the primary cause of most business cycles. Austrian economists assert that
inherently damaging and ineffective central bank policies are the predominant cause of most
business cycles, as they tend to set "artificial" interest rates too low for too long, resulting in
excessive credit creation, speculative "bubbles" and "artificially" low savings.[105]

According to the Austrian School business cycle theory, the business cycle unfolds in the following
way. Low interest rates tend to stimulate borrowing from the banking system. This expansion of
credit causes an expansion of the supply of money, through the money creation process in a
fractional reserve banking system. This in turn leads to an unsustainable "credit-fuelled boom"
during which the "artificially stimulated" borrowing seeks out diminishing investment
opportunities. This boom results in widespread malinvestments, causing capital resources to be
misallocated into areas which would not attract investment if the money supply remained stable.

Economist Steve H. Hanke identifies the financial crisis of 2007–2010 as the direct outcome of the
Federal Reserve Bank's interest rate policies as is predicted by Austrian school economic theory.[106]
Some analysts such as Jerry Tempelman have also argued that the predictive and explanatory power
of ABCT in relation to the recent Global Financial Crisis has reaffirmed its status and, perhaps, cast
into question the utility of mainstream theories and critiques.[107]

Austrian School economists argue that a correction or "credit crunch" – commonly called a
"recession" or "bust" – occurs when credit creation cannot be sustained. They claim that the money
supply suddenly and sharply contracts when markets finally "clear", causing resources to be
reallocated back toward more efficient uses.

Criticism of the Austrian School

Critics have concluded that modern Austrian economics generally lacks scientific rigor,[10][12] which
forms the basis of the most prominent criticism of the school. Austrian theories are not formulated
in formal mathematical form,[108] but by using mainly verbal logic and what proponents claim are
self-evident axioms. Mainstream economists believe that this makes Austrian theories too
imprecisely defined to be clearly used to explain or predict real world events. Economist Bryan
Caplan noted that, "what prevents Austrian economists from getting more publications in
mainstream journals is that their papers rarely use mathematics or econometrics."

A related criticism[5][109] is applied to Austrian School leaders; these leaders have advocated a
rejection of methods which involve directly using empirical data in the development of (falsifiable)
theories; application of empirical data is fundamental to the scientific method.[110] In particular,
Austrian School leader, Ludwig von Mises, has been described as the mid-20th century's
"archetypal 'unscientific' economist."[47] Mises wrote of his economic methodology that "its
statements and propositions are not derived from experience... They are not subject to verification
or falsification on the ground of experience and facts."[111] Murray Rothbard was also an adherent of
Mises's methodology, and though Rothbard assigned a quasi-empirical description to it, he
comments that "it should be obvious that this type of 'empiricism' is so out of step with modern
empiricism that I may just as well continue to call it a priori for present purposes".[112] Additionally,
the prominent Austrian economist, F. A. Hayek, stated his belief that social science theories can
"never be verified or falsified by reference to facts."[113] Such rejections of empirical evidence in
economics by Austrian School leaders have led to the school being dismissed within the
mainstream.[5]

Another general criticism of the School is that although it claims to highlight shortcomings in
traditional methodology, it fails to provide viable alternatives for making positive contributions to
economic theory.[114] In his critique of Austrian economics, Caplan stated that Austrian economists
have often misunderstood modern economics, causing them to overstate their differences with it. He
argued that several of the most important Austrian claims are false or overstated. For example,
Austrian economists object to the use of cardinal utility in microeconomic theory; however,
microeconomic theorists go to great pains to show that their results hold for all monotonic
transformations of utility, and so are true for purely ordinal preferences.[25][26] Caplan has also
criticized the school for rejecting on principle the use of mathematics or econometrics.

There are also criticisms of specific Austrian theories. For example, Nobel laureate Milton
Friedman, after examining the history of business cycles in the US, concluded that "The Hayek-
Mises explanation of the business cycle is contradicted by the evidence. It is, I believe,
false."[6][104][115] In addition to Milton Friedman's criticism, Nobel laureate and neo-Keynesian
economist Paul Krugman argued that Austrian business cycle theory implies that consumption
would increase during downturns, and cannot explain the empirical observation that spending in all
sectors of the economy fall during a recession.[7]

Economist Jeffrey Sachs has pointed out that when comparing developed free-market economies,
those that have high rates of taxation and high social welfare spending perform better on most
measures of economic performance compared to countries with low rates of taxation and low social
outlays. He asserts that poverty rates are lower, median income is higher, the budget has larger
surpluses, and the trade balance is stronger (although unemployment tends to be higher). He
concludes that Friedrich Hayek was wrong when he said that high taxation would be a threat to
freedom; but rather, a generous social-welfare state leads to fairness, economic equality,
international competitiveness, and strong vibrant democracies.[116] In response to Sachs' article,
William Easterly states that Hayek, writing in 1944, correctly recognized the dangers of large-scale
state economic planning. He also questions the validity of comparing poverty levels in the Nordic
countries and the United States, when the former have been moving away from social planning
toward a more market-based economy, and the latter has historically taken in impoverished
immigrants. Easterly also argues that laissez-faire countries were the leaders of "the ongoing global
industrial revolution" which is responsible for abolishing much of the world's poverty.[117]