Carl Menger, was an Austrian economist (1840-1921), who is considered to be, along with W. S. Jevons and M.-E.-L. Walras, a co-founder of marginalism and of the theory of utility, and was also founder of the Austrian School, where his main followers Wieser and Böhm-Bawerk were his disciples. In his “Principles of Economics”, 1871, Menger attacked as incorrect the labor theory of value, expressing his view that the factor determining the value of a good is not the amount of work nor other goods needed to produce it, but the importance we place on the basis of the satisfaction we believe that it can offer.
Neoclassical Economics: Carl Menger
Neoclassical Economics: William Stanley Jevons
Jevons was a British economist (1835-1882), who is considered, along with Carl Menger and M.-E.-L. Walras, a co-founder of marginalism and theory of utility. Jevons is the author of the book “The Theory of Political Economy”, 1871, in which he devised the concept of marginal utility, from an additive and separable utility function, although it was not measurable on cardinal terms. These studies were possible thanks to Johann H. von Thünen’s works, who was the first economist to use the word “marginal”, which meaning Jevons adopted in his works using the term “final”. He is also considered as a precursor of Econometrics for his work on business cycle, index numbers and moving averages, topics on which he used his extensive knowledge of mathematics.
Although his works on marginal utility are considered pioneer during the marginal revolution, and important for the development of neoclassical economics, Jevons considered there would be only one possible solution when considering barter exchange. However, there are infinite solutions, as was demonstrated later on by Francis Y. Edgeworth, whose indifference curves are based on Jevons’ earlier work.
Neoclassical Economics: Marginal revolution
Marginalism is a method of analysis used in microeconomics, which seeks to explain economic phenomena through mathematical functions (production, consumption, etc..). The term “marginal” was first used by Johann H. von Thünen in his “The Isolated State”, in 1826. The Marginal revolution, which took place a few decades later, around 1870, brought the prevailing classical view of value theory to an end. Indeed, thanks to the work of three economists: W. S. Jevons, Carl Menger and M.-E.-Léon Walras. Even though these economists worked independently, they shared a few ideas which made their work the beginning of the utility theory:
–utility was measurable in cardinal units, such as monetary units;
-the utility function is additive and separable;
-they all use the Gossen’ laws.
Phillips curve: NCM’s view
New Classical Macroeconomics takes expectations one step further than monetarists did when using adaptive expectations. Rather than supposing that agents will learn to adjust their behaviour based on past experiences, they apply rational expectations, and directly assume that:
- All agents have sufficient working knowledge of the economy and its basic structural relationships to anticipate cause and effect;
- All agents assume that markets naturally reach an equilibrium;
- Information is perfect: market force drivers are ‘common knowledge’.
This all signals a return to the cornerstones of neoclassical economics, and although in practical terms it may be a slight stretch, it means taking the expectations-augmented Phillips curve one step further:
As New Classical Macroeconomics views it, agents are able to anticipate future events without needing to have experienced them previously. This time around, agents will anticipate expansionist monetary policies, and therefore skip point B. Agents have sufficient working knowledge of the economy and monetary policy is transparent enough for agents to directly associate a fall in interest rates with a rise in inflation. Therefore, they waste no time in asking for salary raises (the change on inflation expectations shift the curve directly to point C), and inflation rises before a drop in unemployment is ever reached. Expansionist monetary policy is not even effective in the short term. In the very short term, a small effect might exist, but only as a result of the time needed for expectations to lead to action.
The only way for monetary policy to work under these scenarios is for it to be enough of a surprise and of enough magnitude to pose an economic shock. If agents are not expecting dramatic policy, they have no time to put themselves in order. In this way, economic policy must go beyond expectations, otherwise even an inkling that the government is likely to act will lead to agents immediately counteracting policy, probably before policy is even enacted.
William Sharpe
William Forsyth Sharpe, born in 1934, is an American economist and Professor of Finance at Stanford University. In 1990 he won the Nobel Prize in Economic Sciences along with Harry Markowitz and Merton Miller. He was awarded this prize for his contribution to the theory of price formation for financial assets
Sharpe used Makowitz´s previous work on the portfolio theory as a basis and developed in 1952 the capital asset pricing modelknown as CAPM, which is used for pricing financial assets. An investor can determine its portfolio risk exposure, by choosing a combination of fixed income securities and equity securities. He also developed the so-called Sharpe ratio which measures the return of an asset according to the level of risk taken. His innovating discoveries and theories were included in his “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk”, 1964.
Franco Modigliani
Franco Modigliani, 1918-2003, was an American, Italian born economist, and Professor at the Massachusetts Institute of Technology. He has mainly worked in the fields of savings and financial markets, and his pioneering analyses in these subjects granted him the Nobel Prize in Economic Sciences in 1985.
The life-cycle hypothesis raised by Modigliani in his “The Life Cycle Hypothesis of Savings, the Demand for Wealth and the Supply of Capital”, 1966, tries to explain and rationalize the level of savings in the economy. As Modigliani explained, consumers seek for stable consumption levels throughout their lives; this is why they save during their working years since later, during their retirement, they will only have their savings. This proposition complements Friedman´s permanent income hypothesis, whereby consumers adjust their consumptions patterns when their income varies.
Modigliani also developed important theorems in the corporate finance area. The Modigliani-Miller theorem, formulated along with Merton Miller, demonstrates that under certain conditions, a firm´s value will remain unchanged, independently of weather equity or debt financing is used. Modigliani addresses this topic in his article “The Cost of Capital, Corporation Finance and the Theory of Investment”, 1958.
Natural rate of unemployment
The term natural rate of unemployment was introduced by Milton Friedman in 1968, in his article “The Role of Monetary Policy”, following his presidential address delivered at the annual meeting of the American Economic Association, in 1967. It is based in Knut Wicksell’ concept of “natural” rate, which defines how there will be no permanent changes in the considered variable below or above its natural level.
The natural rate of unemployment defines the level at which unemployment will remain, no matter how great the effects of monetary policy. The only way to permanently keep unemployment under its natural rate is to resort to higher and higher inflation rates, which in turn would be highly hazardous for the economy. This can be easily understood using an expectations-augmented Phillips curve.
Even though the natural rate of unemployment is usually merged in the economic literature with the term NAIRU, there are a few differences between both terms. These differences are summarized in the following grid:
| Natural rate of unemployment (NRU) | NAIRU | |
| Theoretical starting point | ||
| Origins of deviation |
|
|
| Inflationist mechanism |
|
|
| Type of unemployment |
|
|
| Uniqueness of equilibrium |
|
|
NAIRU
The term NAIRU (non-accelerating inflation rate of unemployment) is a term first used by James Tobin in 1980, in his article “Stabilization Policy Ten Years After”. It refers to the level of unemployment at which the economy settles if monetary policy is held stable. In these terms, it can be associated to Friedman’s natural rate of unemployment.
The NAIRU is based on empirical evidence regarding inflation and unemployment. Indeed, in most countries, inflation rises when unemployment is low because of the higher demand this implies; correspondingly, inflation falls when unemployment is high. This relation explains how unemployment may be above or below the NAIRU level not only because of the effects of monetary policy, but also because other factors such as production costs or trade unions negotiation processes. The Layard-Nickell NAIRU model explains it quite simply.
Even though the term NAIRU is usually merged in the economic literature with the term natural rate of unemployment, there are a few differences between the two. These differences are summarized in the following grid:
| Natural rate of unemployment (NRU) | NAIRU | |
| Theoretical starting point | ||
| Origins of deviation |
|
|
| Inflationist mechanism |
|
|
| Type of unemployment |
|
|
| Uniqueness of equilibrium |
|
|
Expectations-augmented Phillips curve
The expectations-augmented Phillips curve introduces adaptive expectations into the Phillips curve. These adaptive expectations, which date from Irving Fisher’s book “The Purchasing Power of Money”, 1911, were introduced into the Phillips curve by monetarists, specially Milton Friedman. Therefore, we could say that the expectations-augmented Phillips curve was first used to explain the monetarists’ view of the Phillips curve.
Adaptive expectations models led to an important shift in the perception of a government’s ability to act. Under Keynes’ money illusion, changes in nominal variables (prices, wages, etc…) were accepted by agents as real despite overall purchasing power remaining stable.
However, monetarism embraced the adaptive expectations theory to mean that people would stumble once or twice on the same stone, but not a third. In this way, if the government decided on an expansionist monetary policy, inflation would rise and unemployment would fall, based on the Phillips curve. However, a second or third time around, agents would be quick to associate higher inflation with rising salaries in a vicious circle, and adjust their behaviour accordingly based on past experiences. They would anticipate that inflation would drain their purchasing power accordingly, and monetary policy would have little effect. If we see this graphically:
Initially, unemployment and inflation are at point A. The government decides to embark on an expansionist monetary policy, which floods the markets with inexpensive credit, incentivising consumption. Expectations shift to point B along the Phillips curve: unemployment is reduced through economic stimulus with a trade off in the form of inflation. However, after a short period, agents will begin to associate expansionist policies with inflation, which means a drain on their resources, and they will push for higher wages. This will stop the consumption stimulus and also deincentivise hiring. Eventually, agents will shift their expectations curves to point C. A second time around, D will be achieved, leading more or less rapidly to point E. This is why, in the long term, inflation has little effect on unemployment and vice versa. Expansionist monetary policy will lead directly to inflation, with no permanent effect on unemployment.
In summary, monetarists sustained that the Phillips curve will hold up in the short term, but not in the long term. In the long term, the Phillips curve is completely vertical and determines the natural rate of unemployment, as Friedman puts it in his article “The role of Monetary Policy”, 1968.
New Keynesian Economics
The second half of the 20th century was an exciting time for Economics, with developments rapidly succeeding each other as a reaction to the very different economic scenarios the world faced. This development did nothing if not speed up towards the end of the century, when different theories not only succeeded each other, but often coexisted, feeding off the breakthroughs that were being made by the different schools. In this way, the end of the century was curiously reminiscent of the first half, with a return to the two main schools and a whole new focus on mathematics.
Fitting into this retro revival period, Keynesians were also kept busy countering the neo-classicists and monetarists who were intruding onto their sacred ground: macroeconomics and the Phillips curve. This current in economic thought is often overshadowed because of the keen political interest that New Classical Macroeconomics was able to garner, but warrants a much closer look than it is sometimes afforded. Were they able to preserve the monetary illusion? Perhaps not, but they were consistent in their approach: exploring market failure one breakdown at a time.
Main definitions and economists:
–New Keynesian Economics, as a counterattack to New Classical Economics’ theories;
–George Akerlof, the mind behind asymmetric information;
–Gregory Mankiw, whose works marked the beginning of menu costs analysis;
Employment and inflation:
–Menu costs as a way of explaining price stickiness;
–Mankiw’s menu cost model demonstrated how price stickiness originated in menu costs reduces social welfare;
–Layard-Nickell NAIRU model, helps understand how the labour market works from the NKE’s point of view.
–NAIRU, a concept related to the natural rate of unemployment, although with a few subtle differences.