Economics 'schools of thought'

Classical School
The Classical school, which is regarded as the first school of economic thought, is associated with the 18th Century
Scottish economist Adam Smith, and those British economists that followed, such as Robert Malthus and David
Ricardo.
The main idea of the Classical school was that markets work best when they are left alone, and that there is nothing
but the smallest role for government. The approach is firmly one of laissez-faire and a strong belief in the efficiency
of free markets to generate economic development. Markets should be left to work because the price
mechanism acts as a powerful 'invisible hand' to allocate resources to where they are best employed.
In terms of explaining value, the focus of classical thinking was that it was determined mainly by scarcity and costs
of production.
In terms of the macro-economy, the Classical economists assumed that the economy would always return to the
full-employmentlevel of real output through an automatic self-adjustment mechanism.
It is widely recognised that the Classical period lasted until 1870.
Neo-classical
The neo-classical school of economic thought is a wide ranging school of ideas from which modern economic theory
evolved. The method is clearly scientific, with assumptions, and hypothesis and attempts to derive general rules or
principles about the behaviour of firms and consumers.
For example, neo-classical economics assumes that economic agents are rational in their behaviour, and that
consumers look to maximise utility and firms look to maximise profits. The contrasting objectives of maximising
utility and profits forms the basis of demand and supply theory. Another important contribution of neoclassical economics was a focus on marginal values, such as marginal cost and marginal utility.
Neo-classical economics is associated with the work of William Jevons, Carl Menger and Leon Walras.
New classical
New classical macro-economics dates from the 1970s, and is an attempt to explain macro-economic problems and
issues using micro-economic concepts like rational behaviour, and rational expectations. New classical economics is
associated with the work of Chicago economist, Robert Lucas.
Keynesian economics
Keynesian economists broadly follow the main macro-economic ideas of British economist John Maynard Keynes.
Keynes is widely regarded as the most important economist of the 20th Century, despite falling out of favour during
the 1970s and 1980s following the rise of new classical economics.
In essence, Keynesian economists are skeptical that, if left alone, free markets will inevitably move towards a full
employmentequilibrium.
KEY POINTS
o
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Classical economics focuses on the tendency of markets to move towards equilibrium and on
objective theories of value.
As the original form of mainstream economics of the 18th and 19th
centuries, classical economics served as the basis for many other schools of economic thought,
including neoclassical economics.

Marxism focuses on the labor theory of value and what Marx considered to be the exploitation
of labor by capital.

Keynesian economics derives from John Maynard Keynes, in particular his book, The General
Theory of Employment, Interest and Money (1936), which ushered in contemporary
macroeconomics as a distinct field.
The Chicago School of economics is best known for its free market advocacy and monetarist
ideas.

mainstream economics

Mainstream economics is a term used to refer to widely-accepted economics as it is taught across prominent
universities, and in contrast to heterodox economics.

School of thought

A school of thought is a collection or group of people who share common characteristics of opinion or outlook
regarding a philosophy, discipline, belief, social movement, cultural movement, or art movement.
Throughout the history of economic theory, several methods for approaching the topic are noteworthy enough, and
different enough from one another, to be distinguished as particular 'schools of economic thought. ' While economists
do not always fit into particular schools, especially in modern times, classifying economists into a particular school
of thought is common.
Mainstream modern economics can be broken down into four schools of economic thought:
Classical economics, also called classical political economy, was the original form of mainstream economics in the
18th and 19th centuries. Classical economics focuses on both the tendency of markets to move towards equilibrium
and on objective theories of value. Neo-classical economics derives from this school, but differs because it is
utilitarian in its value theory and because it uses marginal theory as the basis of its models and equations. Anders
Chydenius (17291803) was the leading classical liberalof Nordic history. A Finnish priest and member of
parliament, he published a book called The National Gain in 1765, in which he proposed ideas about the freedom of
trade and industry, explored the relationship between the economy and society, and laid out the principles
of liberalism. All of this happened eleven years before Adam Smith published a similar and more comprehensive
book, The Wealth of Nations. According to Chydenius, democracy, equality and a respect for human rights formed
the only path towards progress and happiness for the whole of society.
Marxian economics descends directly from the work of Karl Marx and Friedrich Engels. This school focuses on the
labor theory of value and what Marx considers to be the exploitation of labor by capital. Thus, in this school of
economic thought, the labor theory of value is a method for measuring the degree to which labor is exploited in a
capitalist society, rather than simply a method for calculating price.

Keynesian economics derives from John Maynard Keynes, and in particular his book, The General Theory of
Employment, Interest and Money (1936), which ushered in contemporary macroeconomics as a distinct field. The
book analyzed the determinants of national income, in the short run, during a period of time when prices are
relatively inflexible. Keynes attempted to explain, in broad theoretical detail, why high labor-market unemployment
might not be self-correcting due to low "effective demand," and why neither price flexibility

nor monetary policy could be counted on to remedy the situation. Because of its impact on economic analysis, this
book is often called "revolutionary.

A final school of economic thought, the Chicago School of economics, is best known for its free market advocacy
and monetarist ideas. According to Milton Friedman and monetarists, market economies are inherently stable so long
as the money supply does not greatly expand or contract. Ben Bernanke, current Chairman of the Federal Reserve, is
among the significant public economists today that generally accepts Friedman's analysis of the causes of the Great
Depression.

Differences Between Classical & Keynesian Economics

by Osmond Vitez

Economics is the quantitative and qualitative study on the allocation, distribution and production of economic
resources. Economics often studies the monetary policy of a government and other information using mathematical
or statistical calculations. Qualitative analysis is made by making judgments and inferences from fiscal information.
Two economic schools of thought are classical and Keynesian. Each school takes a different approach to the
economic study of monetary policy, consumer behavior and government spending. A few basic distinctions separate
these two schools.
Basic Theory
Classical economic theory is rooted in the concept of a laissez-faire economic market. A laissez-faire--also known as
free--market requires little to no government intervention. It also allows individuals to act according to their own self
interest regarding economic decisions. This ensures economic resources are allocated according to the desires of
individuals and businesses in the marketplace. Classical economics uses the value theory to determine prices in the
economic market. An item’s value is determined based on production output, technology and wages paid
to produce the item. Keynesian economic theory relies on spending and aggregate demand to define the economic
marketplace. Keynesian economists believe the aggregate demand is often influenced by public and private
decisions. Public decisions represent government agencies and municipalities. Private decisions include individuals
and businesses in the economic marketplace. Keynesian economic theory relies heavily on the fact that a
nation’s monetary policy can affect a company’s economy.
Government Spending
Government spending is not a major force in a classical economic theory. Classical economists believe that consumer
spending and business investment represents the more important parts of a nation’s economic growth.
Too much government spending takes away valuable economic resources needed by individuals and businesses. To
classical economists, government spending and involvement can retard a nation’s economic growth by
increasing the public sector and decreasing the private sector. Keynesian economics relies on government spending
to jumpstart a nation’s economic growth during sluggish economic downturns. Similar to classical
economists, Keynesians believe the nation’s economy is made up of consumer spending, business
investment and government spending. However, Keynesian theory dictates that government spending can improve or
take the place of economic growth in the absence of consumer spending or business investment.
Short Vs. Long-term Affects

Classical economics focuses on creating long-term solutions for economic problems. The effects of inflation,
government regulation and taxes can all play an important part in developing classical economic theories. Classical
economists also take into account the effects of other current policies and how new economic theory will improve or
distort the free market environment. Keynesian economics often focuses on immediate results in economic theories.
Policies focus on the short-term needs and how economic policies can make instant corrections to a
nation’s economy. This is why government spending is such a key cog of Keynesian economics. During
economic recessions and depressions, individuals and businesses do not usually have the resources for creating
immediate results through consumer spending or business investment. The government is seen as the only force to
end these downturns through monetary or fiscal policies providing instant economic results.

Keynesian vs Classical models and policies

Firstly, for AS economics, a knowledge of Keynesian and classical views is not essential (at least for the exam boards
I know). However, you should get credit if you use it for evaluation. It is definitely good to know for A level
economics. Ill start with easiest differences.
1. Shape of long run aggregate supply.
The most basic distinction between the Keynesian and classical view of macroeconomics, can be illustrated looking
at the long run aggregate supply.
The Classical view is that Long Run Aggregate Supply (LRAS) is inelastic.
Classical view of Long Run Aggregate Supply

This has important implications. The classical view suggests that Real GDP is determined by supply side factors
the level of investment, the level of capital and the productivity of labour e.t.c. Classical economists suggest that in
the long-term an increase in aggregate demand (faster than growth in LRAS) will just cause inflation.

Keynesian view of Long Run Aggregate Supply

The Keynesian view of long run aggregate supply is different. They argue that the economy can be below full
capacity in the long term.
Therefore, a Keynesian plays greater emphasis on the role of aggregate demand in causing and overcoming a
recession.
2. Demand deficient Unemployment
Because of the different opinions about the shape of the aggregate supply and the role of aggregate demand in
influencing economic growth, there are different views about the cause of unemployment

Classical economists argue that unemployment is caused by supply side factors real wage
unemployment, frictional unemployment and structural factors. They downplay the role of demand
deficient unemployment.

Keynesians place a greater emphasis on demand deficient unemployment. For example the current
situation in Europe (2014), a Keynesian would say that this unemployment is partly due to insufficient
economic growth and low growth of aggregate demand (AD)

3. Phillips Curve trade off

A classical view would reject the long run trade off between unemployment, suggested by the Phillips Curve.

Classical economists say that in the short term, you might be able to reduce unemployment below the natural rate by
increasing AD. But, in the long-term, when wages adjust, unemployment will return to the natural rate, and there will
be higher inflation. Therefore, there is no trade off in the long-run
Keynesians support the idea that there can be a trade off between unemployment and inflation. See: Phillips curve

4. Flexibility of prices and wages

In the classical model, there is an assumption that prices and wages are flexible, and in the long-term markets will be
efficient and clear. For example, suppose there was a fall in aggregate demand, in the classical model, this fall in
demand for labour would cause a fall in wages. This decline in wages would ensure that full employment was
maintained and markets clear.

A fall in demand for labour would cause wages to fall from W1 to W2

However, Keynesians argue that in the real world, wages are often inflexible. In particular, wages are sticky
downwards. Workers resist nominal wage cuts. For example, if there was a fall in demand for labour, trade unions
would reject nominal wage cuts, therefore, in the Keynesian model it is easier for labour markets to have
disequilibrium.Wages would stay at W1, and unemployment would result.
A Keynesian would argue in this situation, the best solution is to increase aggregate demand. In a recession, if the
government did force lower wages, this might be counter-productive because lower wages would lead to lower
spending and a further fall in aggregate demand.
5. Rationality and confidence
Another difference behind the theories is different believes about the rationality of people

Classical economics assumes that people are rational and not subject to large swings in confidence.

Keynesian economics suggests that in difficult times, the confidence of businessmen and consumers
can collapse causing a much larger fall in demand and investment. This fall in confidence can cause
a rapid rise in saving and fall in investment and it can last a long time without some change in policy.

Difference in policy recommendations

1. Government spending

The classical model is often termed laissez faire because there is little need for the government to
intervene in managing the economy.

The Keynesian model makes a case for greater levels of government intervention, especially in a
recession when there is a need for government spending to offset the fall in private sector investment.
(Keynesian economics is a justification for the New Deal programmes of the 1930s.)

2. Fiscal Policy

Classical economics places little emphasis on the use of fiscal policy to manage aggregate demand.
Classical theory is the basis for Monetarism, which only concentrates on managing money supply,
through monetary policy.

Keynesian economics suggests governments need to use fiscal policy, especially in a recession. (This
is an argument to reject austerity policies of 2008-13 recession.

3. Government borrowing.

A classical view will stress the importance of reducing government borrowing and balancing the
budget, because there is no benefit from higher government spending. Lower taxes will increase
economic efficiency. (e.g. at the start of the 1930s, the Treasury View argued the UK needed to
balance its budget by cutting unemployment benefits.

The Keynesian view suggests that government borrowing may be necessary because it helps to
increase overall aggregate demand.

4. Supply side policies

The classical view suggests the most important thing is enabling the free market to operate. This may
involve reducing the power of trade unions to prevent wage inflexibility. Classical economics is the
parent of supply side economics which emphasises the role of supply side policies in promoting
long term economic growth.

Keynesian dont reject supply side policies. They just say they may not always be enough. e.g. in a
deep recession, supply side policies cant deal with the fundamental problem of a lack of demand.