Mar 29

Keynesianism

This school of economic thought, which focuses on macroeconomics, is mainly based on interpretations of John Maynard Keynes’ most important book, the “General Theory of Employment, Interest and Money”, 1936.

Keynes’ main thesis was that unemployment during the Great Depressionwas the result of a decreasing demand, and that the solution was to revive the economic system through public investment. A Keynesian policy would be one that promotes, for example, public works such as building dams or highways.

Supporters of Keynesianism, or Keynesian economics, believe that although businesses and private sector entities working on a liberal environment function in an efficient way, sometimes market failures may appear. For this, they support a certain degree of implication by the public sector in order to prevent these failures and restore the economy if they appear, through fiscal and monetary policies. However, they will give more credit to the former, the latter being more supported by Monetarists.

Keynesianism was the main economic doctrine from 1936 until the advent of Monetarism, with which it coexisted until the stagflation of the seventies.

Joan Robinson, Nicholas Kaldor and John R. Hicks, are just some of the great disciples of Keynes, and therefore Keynesian economists, mainly from the Cambridge School in its not neoclassical meaning, to name a few.

Mar 29

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Alvin Harvey Hansen

Alvin Hansen Hansen was an American economist (1887-1975), professor at Harvard University and one of the main precursor of the New Economic Science or Keynesianism, in the U.S. In fact, Hansen is known for popularizing the IS-LM model.

Hansen, heavily influenced by the psychological environment of the Great Depression, also addressed the concept of steady stateand long-term stagnation.

Mar 29

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John Richard Hicks

John R. Hicks

John R. Hicks was a British economist (1904-1989), professor at the London School of Economics, Cambridge University and University of Oxford. He took special interest on issues concerning microeconomics, growth, economic fluctuations and monetary theory. In his most famous work “Value and Capital”, 1939, Hicks referred to aggregation problems, interest rate, etc. It was also in this book where he developed further the comparative statics, the analysis in economics when describing two possible outcomes. His book “The Social Framework: an Introduction to Economics”, 1942, is a veritable treatise on structural analysis by means of social accounting.

However, Hicks is mainly known for the development of a general equilibrium model, based on J. M. Keynes’ “General Theory”, in which he analyzed four markets: goods, labor, credit and money, called the IS-LM model. This model, firstly named IS-LL, appeared in his article “Mr. Keynes and the Classics: a Suggested Interpretation”, published in 1937 in the journal Econometrica.

He was awarded the Nobel Prize in Economics in 1972, along with Kenneth Joseph Arrow, for his contributions to general equilibrium theory and welfare economics.

Mar 29

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John Maynard Keynes

Keynes was a British economist (1883-1946), son of the economist and methodologist John Neville Keynes. J. M. Keynes first gained notoriety with his work during the Versailles Peace Conference, when he cleverly proposed in his book “The Economic Consequences of the Peace”, 1919, not to punish Germany to avoid future retaliation. Later, during the Great Depression, he fought the conservative views advocating for a restoration of the gold standard in the famous pamphlet “The Economic Consequences of Mr. Churchill”. After a series of papers on monetary issues, he published in 1936 the most important of his works, the “General Theory of Employment, Interest and Money”, which was the foundation of the then called New Economic Science, or Keynesianism. Keynes’ main thesis was that unemployment during the Great Depression was the result of the decrease in effective demand. Therefore, to achieve full employment, it was necessary to revive the economic system through public investment. In the last years of his life, J. M. Keynes participated in the negotiations of Bretton Woods, in 1944, leading to the creation of the International Monetary Fund.

At the Bretton Woods conference, where he was part of the British delegation, he raised the idea that the IMF should be constituted as a true worldwide central bank, capable of issuing paper currency for international payments, for which he proposed the name “bancor”. Most of the ideas mentioned in the “Keynes Plan” were not followed through, since they competed with the U.S. proposals specified in the “White Plan”.

Great disciples of Keynes, part of the Cambridge School, were Joan Robinson, Nicholas Kaldor and John R. Hicks, to name a few.

Mar 29

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Chicago school

From the University of Chicago, and opposing Keynesianism, a number of contributions and doctrinal attitudes of authors can be identified, which turn back to neoclassical economics, are in favour of laissez faire and monetarism. Created around the 1940s, its main precursor is Milton Friedman, along with Frank H. Knight and Friedrich A. von Hayek, the latter acting as a liaison with the Austrian School.

The common view of the Chicago School focuses on the idea that governmental interventions should be at its minimum required, being deregulation the most desirable path. Another characteristic theory of the Chicago School is that the reduction or eradication of all types of regulation on business activities is beneficial for the economy as a whole. They support monetary policies when required by the economic environment, as they assume these to be more reliable and effective than fiscal policies.

The Chicago School based their assumptions on the concept of rational expectations. Milton Friedman defended that the price levels in a certain economy are always determined by the amount of money moving in circulation. According to the Chicago School, by acting and allocating resources in a rational way, people drive economic growth, while at the same time controlling price levels.

Mar 29

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Indifference curves

Indifference curves are lines in a coordinate system for which each of its points express a particular combination of a number of goods or bundles of goods that the consumer is indifferent to consume. This is, the consumer will have no preference between two bundles located in the same indifference curve, since they all provide the same degree of utility. The indifference curves, as we move away from the origin of coordinates, imply higher consumption and, therefore, increasing levels of utility.

An indifference map is a combination of indifference curves, which allows understanding how changes in the quantity or the type of goods may change consumption patterns.

Francis Y. Edgeworth, developed the mathematics concerning the drawing of indifference curves in his book “Mathematical Psychics: an Essay on the Application of Mathematics to the Moral Sciences”, 1881, from earlier works by William Stanley Jevons. However, Vilfredo Pareto was the first economist to draw indifference maps as we know them nowadays, in his book “Manual of Political Economy”, published in 1906.

The first example of indifference map showed in the adjacent graph is the most common representation. It shows four convex indifference curves (red), showing each curve what amount of a good or bundle of goods x₁ the consumer has to give up in order to be able to consume more goods, or bundles of goods, x₂. This relation gives us the marginal rate of substitution (MRS) between these goods, which is the slope of the curve in each of its points.

Our second example is an indifference map with four parallel lines (green). This is the case for goods or bundles of goods, y₁ and y₂, which are perfect substitutes, since the lines are parallel and MRS = 1, that is the slope has an angle of 45º with each axis. It can also be the case for goods or bundles of goods that are perfect substitutes but in different proportions. In that case, the slope will be different and the MRS can be defined as a fraction, such as 1/2 ,1/3 , and so on. For perfect substitutes, the MRS will remain constant.

Our third example shows an indifference map with four indifference curves (blue) that represent perfect complementary goods, z₁ and z₂. This is, there will not be an increase on the consumer’s utility unless both goods increase in the required proportion. The best example of complementary goods are shoes, since the consumer’s utility will not increase when he or she gets a new right shoe without getting a new left shoe. Notice that the elbows are collinear, and the line crossing them defines the proportion in which each good needs to increase in order to have an increase in the utility. In this case the horizontal fragment of each indifference curve has a MRS = 0 and the vertical fractions a MRS = ∞.

These explanations of indifference curves can also be applied to production. In that case, the MRS turns into marginal rate of technical substitution and marginal rate of transformation.
Video – Indifference curves:

Mar 29

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Neoclassical school of economics

This school of thought, which appeared around 1870 in what is known as the marginal revolution, can be considered a development of the classical school of economics’ main ideas. Supporting the concept of marginalism, and being more scientific in its work than its predecessors, the neoclassical school left aside classical economics’ matters such as wealth distribution and value theory, to study thoroughly the mechanisms that allow the allocation of scarce resources in different markets. This is, understanding how agents, such as consumers and producers, will try to maximize its objective function, utility and production, considering some given constraints, such as budget and input constraints. Indeed, it was the neoclassical school that initiated the study of optimisation problems including utility maximisation and, its dual problem, cost minimisation.

Although the boundaries of this school are quite diffuse, a number of common characteristics can be found in its adherents’ work. They will work supporting methodological individualism, and extensively using mathematics in order to support their conclusions. There will usually appear analysis studying the relations between both supply and demand, instead of studying them separately. They will use throughout their studies the Latin phrase ceteris paribus, as well as the term homo economicus. Finally, it was in the work of neoclassical economists that a distinction between positive economics and normative economics started to shape.

As the neoclassical school includes many renowned doctrines and schools, a mention to some of these schools is in order. The Austrian school included one of the most important marginalist economist, Carl Menger, as well as other renowned neoclassical economists such as Eugen von Böhm-Bawerk, Ludwig H. E. von Mises and Friedrich A. von Hayek. The Lausanne school included economists such as Léon Walras and Vilfredo Pareto. Finally, the Cambridge school included Alfred Marshall, considered the “father of modern economics”, as well as Arthur C. Pigou and Francis Ysidro Edgeworth.

Mar 27

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Edgeworth box

In 1881, Francis Y. Edgeworth came up with a way of representing, using the same axis, indifference curves and the corresponding contract curve in his book “Mathematical Psychics: an Essay on the Application of Mathematics to the Moral Sciences”. However, the representation given, using as an example the work being done by Friday and wages being paid by Robinson Crusoe, was not the one we commonly know nowadays.

It was Vilfredo Pareto, in his book “Manual of Political Economy”, 1906, who developed Edgeworth’s ideas into a more understandable and simpler diagram, which today we call the Edgeworth box.

This diagram is widely used in welfare economics, game theory or general equilibrium theory, to name a few. It is easy to draw and can be easily explained. In the adjacent image, we can see two examples of an Edgeworth box, and how it is drawn.

The first example is mainly used for welfare economics and distribution matters. As we see, this “box” is formed using two sets of typical indifference maps, which in this case represent the indifference curves of agents A (green) and B (red), who must choose quantities of goods x and y. When the indifference map of agent B is rotated, and put on top of the map of agent A, the box is formed. When indifference curves are tangent to each other, which is the case in this example, a contract curve (blue) can be drawn using these tangency points.

Our second example is mainly used to explain Ricardian trade theory graphically. In this case, we draw the production-possibility frontier for countries 1 (green) and 2 (red). When we rotate the diagram of country 2, we end up with an Edgeworth box, which here will help understand how great the gains of international trade are and therefore helps illustrate how trade is not a sum zero game.

Video – Edgeworth box:

Mar 27

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Malthusian population theory

Thomas Robert Malthus stated this theory, which indicated that the population would increase geometrically, while food production would only increase in arithmetical proportion, thus creating the conditions for a shortage in the long term that would require an adjustment lowering the birth rate.

Nowadays, we call Malthusianism a doctrine, strongly influenced by the theory explained above, which recommends that the world’s population should stop increasing since resources and the available capacity of the biosphere are insufficient to meet future needs. This doctrine promotes birth control, primarily through measures of delayed marriage and of contraceptive character.

Mar 27

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Anne-Robert-Jacques Turgot

Turgot Turgot was a French abbot (1727-1781), Baron de l’Aulne, who after leaving the clergy became an economist and stateman, and author of the book “Reflections on the Formation and Distribution of Wealth” published in 1776. One of the great Physiocrats, and student of François Quesnay, was the first to clearly formulate the law of diminishing returns. Turgot was an early supporter of trade and economic liberalization, this being the main reason of his great influence on Adam Smith.