Tuesday, April 01, 2014
Growth, Evolution and Contemporary Perspectives of the Science of Economics
Joshy K. J, PhD Scholar, Reg. No. 1341801, Christ University
Economics is a social science that deals with the economic activities of mankind. In other words, it is a social science of human wants and their satisfaction. It is social as it deals with society and human behaviour. It is a science as it qualifies the important features of any scientific disciplines- it contains a systematic body of knowledge; it has numerous laws, models and theories with universal applicability; these laws can be experimented according to real life situations. The origin of the term economics is from a Greek word 'oikonomia', meaning 'household management'. Thus the science of economics is as old as humanity. However the subject matter and coverage has been evolved tremendously through different schools of economic thought. Great economists and thinkers contributed immensely to the growth of the subject into its present form. A school of thought can be understood as a group of people who share common beliefs or opinions or outlook about a particular discipline or philosophy. This essay is an attempt to describe prominent schools of thought in economics that contributed to the development and evolution of economics discipline over a period of several hundred years. Also this essay tries to familiarize the most significant figures pertaining to different schools of thought along with their contributions.
It is true to say that the feudal economy rose from the remains of the slave economy of the Roman empire. There were some forerunners of classical political economy. The name of William Petty is very relevant in this context, who has made an important innovation concerning the explanation of value. On the one hand, he completely abandoned the subjective theory of value and on the other he introduced the concept of natural value. It means the prices would tend to adjust to the natural value through small oscillations, though the mechanism of this convergence was not clarified. Another scholar John Locke was influenced by Petty who attempted to justify private property by making use of the labour theory of value. Locke's basic idea was that individual liberty implied the right to control one's own labour. The 18th century saw important pre conditions for the industrial revolution in the form of the spread of capitalism in the country side, increase in agricultural productivity, technical innovations etc. Classicals believed that money plays only a neutral role in influencing the variables. Changes in money supply affects only the price level, so that only the nominal variables are changed; that is the real variables remain unchanged.
Classical school is the oldest school of economic thinking. Economists like Adam Smith, David Ricardo, J.S.Mill, J.B.Say, Malthus etc have played important roles in this connection. Classical economics focuses on the tendency of markets to move towards equilibrium position. They believed in the full employment equilibrium. It also focuses on objective theories of value. Adam Smith who is widely considered as the father of modern economics published his famous book, 'An Inquiry into the Nature and Causes of Wealth of Nations' in1776. According to him, it is the division of labour that triggers growth process and capital accumulation that drives it. He was successful in convincing the invisible hand theorem. That is price mechanism is the driving force of the economy. The concept value was explained in the premise of scarcity and cost of production. In connection with this, in the later period, Marxian philosophy focused on the labor theory of value and Karl Marx considered it to be the exploitation of labor by capital. He introduced the term surplus value to explain his labour theory of value. (It is important to note that the Marxian School directly descends from the works of Karl Marx and Friedrich Engels which focused on labour theory of value and the exploitation of labour class by the capitalists. Therefore, this school handles the labor theory of value as a method for measuring the degree to which labor is exploited in a capitalist society, rather than simply a method for calculating price).Classical economists believed in the inherent capacity of an economy and they considered that the best way to achieve allocative efficiency is to leave the economy free without any government intervention. This was the basis of the so called laissez faire capitalism which became the foundation of their theoretical frameworks. J.B.Say put forwarded the famous proposition that 'supply creates its own demand'. Classical economists immensely contributed to the fields of economic growth and international trade. In fact the starting point of international trade theories, the concepts of absolute advantage and comparative advantage were given by Adam Smith and David Ricardo respectively.
It is widely recognised that the Classical period lasted until 1870.
The neoclassicals followed the footsteps of Classical economists. The prominent economists of neoclassical school of thought are Alfred Marshall, Lionel Robbins, A.C.Pigou, William Jevons, Leon Walras, Clark, Pareto, Mrs.Joan Robinson etc. All of them have contributed immensely to the growth of economics in their own unique ways. Neoclassical economists evolved scientific methods with assumptions and hypotheses and attempted to derive general rules related to the behavior of consumers and firms. According to them the economics agents are rational, consumers try to maximize utility and producers try to maximize profits. Alfred Marshall defined economics as the science of material welfare. According to him wealth is only a means to achieve the ultimate objective of material welfare. Many economists following this school consider utility concept given by Marshall as his greatest contribution to the subject economics. A.C.Pigou studied the important aspects of wage structure. The importance of scarcity and the problem of choice as pointed out by Robbins paved the way for thinking in new lines. Marginal productivity theory given by Clark, the quantity theory of money by Fisher, Pareto optimality conditions, Walrasian general equilibrium model etc were some milestones of neoclassical school of thought. Mrs.Joan Robinson's contributions in the field of growth models have significant impact on economics of growth in the later periods.
The old monetarists like Irving Fisher, Marshall, Pigou etc have contributed significantly to the development of modern monetary theories. All of them contributed to the age old quantity theory of money which stated that money supply is the sole variable affecting the price level. Any change in the money supply has a direct and proportionate relationship with price level. Fisher gave the famous equation of exchange which says, MV=PT. The same idea had been conveyed by the Cambridge economists Pigou and Marshall through the equation Md=kPY.
The most important figure among modern monetarists is Milton Friedman of Chicago University. Other important names in USA include Anna Schwartz, Karl Brunner and Allan Meltzer. The prominent monetarists outside USA include David Laidler, Michael Parkin and Allan Walters. Modern monetarists explain not only the changes in general price level but also changes in output and employment. According to monetarists money supply is the prime determinant of nominal GDP in the short run and general price level in the long run. The output or real income is determined in the long run by the real factors like stock of capital, the level of technology, the propensity to save, natural resources, changes in human resources etc. However, inflation cannot occur without a more rapid increase in the quantity of money supply rather than an increase in output level. Monetarists refuted Keynesians argument that monetary policy is less effective in comparison with fiscal policies. According to them monetary policy should be conducted in a manner that money supply should grow at a constant rate. Money supply growth should be in line with economic growth targets. They believed in the inherent stability of the private sector and the cyclical fluctuations in the economy are mainly due to bad policies of the government. It is interesting to see that in monetarists' view point the severity of Great Depression (1929-33) was mainly due to the failure of Federal Reserve in preventing bank failures and the consequent reduction in money supply across the world. If a country suffers from inflationary pressures, it is mainly due to rapid expansion of money supply at a higher rate than the level of output.
Keynesian School and the Emergence of Macroeconomics
Before the so called 'Keynesian revolution' which led to the development of a separate branch of study in macroeconomics, it was existed under the name monetary theory. John Meynard Keynes has rewritten the history of economics and brought revolutionary changes in the field of economics. His teachers, including Alfred Marshall from the neoclassical school, taught the principles based on full employment, Say's law of markets and Laissez faire capitalism. But he challenged all of them and proved that what they believed was not right. The Great Depression (1929-33) was a period of great turmoil in Europe and America. Their economies were shattered and unemployment mounted to unprecedented levels. Several economists attempted to analyse the scenario and came up with theories and solutions. Keynes, in his famous book, A General Theory of Employment, Interest and Money was published in 1936, in which he had analysed the Great Depression of 1930s in a very convincing way. According to him the Great Depression was caused by the fall in aggregate demand which he referred to as effective demand. As a result of fall in aggregate demand recessionary trend appears which culminated in a depression. Keynes refute the Classical economists' viewpoints including full employment theory, monetary neutrality, Say's law, saving investment equality and so on. According to him, during recession, monetary policy would be highly unsuccessful because the increase in money supply would be trapped in the economy as the interest rate is low. Keynes called it as liquidity trap in his theory of liquidity preference. Keynes advocated for massive Government intervention in reviving aggregate demand in the economy. Keynes emphasized the role of Government spending and private investment in determining the level of income and employment in the economy. For him, full employment equilibrium is only an ideal situation, but not common as Classicals believed. It can also be at below or above full employment levels. He considered that the major cause of inflation is the increase in aggregate demand above the full employment level, aggregate supply remaining constant. He has given the famous quote, 'In the long run we all are dead'. His analyses are mostly based on short term in mind.
The success of Keynesian policy framework helped almost all economies to rebuild the economies after such a disastrous depression period. It led to the development of a separate branch of economics that is the so called macroeconomics. The Keynesian legacy was continued by his followers extending his principles to other areas of study. Economists like Hansen and Samuelson studied the application of Keynesian principles in different aspects. Harrod and Domar extended the Keynesian growth models into the long run development aspects of developed economies. For many years it was widely believed that Keynesian solutions are the ultimate end of it which can resolve all the problems of modern economies. In 1970s an unprecedented phenomenon appeared in advanced economies, the existence of inflationary trend along with mounting unemployment. It is referred to as stagflation, since inflation is present when the growth is stagnant. Till that time it was believed that during high inflation unemployment tends to be low because of better productivity and higher profitability. Besides, Keynesian policy suggestions didn't seem to be effective in this context and they were proved to bring more acute negative consequences. For instance, if Government spends more to curtail unemployment, inflation would increase further and the situation would be worse. Thus economics has grown much beyond Keynesian School of thought giving room for Post Keynesian Schools of economic thinking.
Supply side Economics
The supply side economics was emerged as an alternative to Keynesian demand management policies which were proved unsuccessful during the stagflation period. The supply side economists emphasized the role of managing the aggregate supply instead of aggregate demand. According to them stagflation is mainly caused due to leftward shift in aggregate supply curve cost push factors which increases the price level and curtails the output level. The problem can be resolved if we can raise the level of aggregate supply so that the aggregate supply curve would be shifted back to the previous level. Arthur Laffer has given the most important contributions in this field through drawing a connection between low marginal tax rates and high tax revenue. The provisions of supply side economists include deregulation and delicensing, reduction of marginal tax rates and its positive effects on output, saving, investment and tax revenue, liberalization policies etc. It is better known to some people as 'Reagonomics', since US president Ronald Reagon popularized greater tax cuts to boost the economy.
New classical Economics
New classical macroeconomics dates from the 1970s. It uses the neoclassical microeconomic foundations for macroeconomic analysis. The original idea of rational expectations was developed by John.F.Muth, but it was popularized by Robert Lucas. It is an attempt to explain macroeconomic problems and issues using micro-economic concepts like rational behaviour, and rational expectations. In Friedman's theory when aggregate demand increases, in the short run general price level increases, which induce firms to expand output and employment. In this nominal wages lag behind the changes in the general price level. According to Robert Lucas, a prominent figure associated with New Classical School, there is no reduction in unemployment rate since the increase in price level is correctly anticipated and incorporated by the workers and business firms into the wages. It is only the price level that rises, leaving the real output and unemployment unchanged. The other leading economists who have worked immensely in this field are Thomas Sargent, Neil Wallace and Edward Prescott.
In a closer analysis we can see that the growth and evolution of the subject economics happened systematically over a long period through additions and deletions by numerous economists, philosophers and policy makers. It is very important to note that economics is still an evolving subject as it deals with society and human behavior. It is the reason by which the domains of economics have been extended to new horizons. Interdisciplinary researches have been increasingly important in modern days. It also contributes to new thinking and new ways of finding solutions to existing problems. The issues pertaining to developing world are also widely addressed. The globalization and market integration moves have made it important to address issues globally rather than looking at issues at a micro level. The science of economics is still awaiting revolutionary changes that suit the current needs of the economies. It is nothing but the growth of the discipline under consideration.
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