Economics

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alfred marshall,j.m. keynes,milton friedman.

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Economics

  1. 1. Dr. Alfred Marshall was one of the most influential economists of his time. His book, Principles ofEconomics (1890), was the dominant economic textbook in England for many years. It brings the ideas ofsupply and demand, marginal utility, and costs of production into a coherent whole. He is known as one of the founders of economics. 1|Page
  2. 2. Consumer’s Surplus•Marshall interpreted a demand curve as a willingness to pay atthe margin curve•Consumer is willing to pay more for the first few units of agood than for subsequent units•If the consumer pays a single price for all units bought then thetotal willingness to pay for those units will exceed the amountactually paid•This is consumer’s surplus 2|Page
  3. 3. Demand Theory•The demand curve is interpreted as a schedule of―Demand Prices‖•What is held constant along this demand curve?•Marshall assumes both constant money income andconstant real income (constant MU of income)•This rules out any significant income effects•Marshall’s ―Law of Demand 3|Page
  4. 4. Marshall on Production•Factors of production: land, labour, capital, and organization•Diminishing returns in agriculture•Diminishing returns can also occur with fixed factors other than land•Increasing returns in industry with concentration of industry inparticular localities•Increased productivity in industry due to larger scale of particularfirms--increased specialization of labour and machinery•Economies of buying and selling on a large scale•Forms of business organization and the problems of maintaining energyand efficiency•Joint stock companies and problems of agency•Distinction between external and internal economies –External economies are economies derived from the generaldevelopment of an industry (external to individual firms) –Internal economies derived from the size of individual firms(internal to the firm)•Tendency to decreasing returns in agriculture and natural resourceindustries•Tendency to increasing returns in other industries –An increase of labour and capital leads generally to improvedorganization which increases the efficiency of labour and capital•But limits to the size of particular firms•Biological analogy and the life cycle of firms•Concept of the representative firm--firm with average access to internaland external economies 4|Page
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  6. 6. Long Run Supply•In industries where external economies dominate, growth in industry size willlower the costs of all firms•Long run industry supply curve will be downward sloping (decreasing costindustry)•If external diseconomies dominate industry growth raises costs for all firms•Long run industry supply curve will be upward sloping (increasingcost industry)•If external economies and diseconomies just cancel each other out then the costsof firms will not be affected by industry growth•Long run supply curve will be horizontal (constant cost industry)•Marshall though most industries other than natural resource industries haddeclining long run costs•What might these external economies consist of? •Reduction in factor cost due toindustry growth creating a pool of trained labour in that locality 6|Page
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  8. 8. Marshall is considered to be one of the most influential economists ofhis time, largely shaping mainstream economic thought for the nextfifty years, and being one of the founders of the school of neoclassicaleconomics. Although his economics was advertised as extensions andrefinements of the work of Adam Smith, David Ricardo, Thomas RobertMalthus and John Stuart Mill, he extended economics away from itsclassical focus on the market economy and instead popularized it as astudy of human behavior. He downplayed the contributions of certainother economists to his work, such as Leon Walras, Vilfredo Pareto andJules Dupuit, and only grudgingly acknowledged the influence ofStanley Jevons himself.Marshalls influence on codifying economic thought is difficult to deny. He popularized the use of supply and demand functions as tools ofprice determination (previously discovered independently by Cournot); modern economists owe the linkage between price shifts and curve shifts to Marshall. Marshall was an important part of the "marginalist revolution;" the idea that consumers attempt to adjust consumption until marginal utility equals the price was another of his contributions. The price elasticity of demand was presented by Marshall as an extension of these ideas. Economic welfare, divided into producer surplus and consumer surplus, was contributed by Marshall, andindeed, the two are sometimes described eponymously as Marshalliansurplus. He used this idea of surplus to rigorously analyze the effect of taxes and price shifts on market welfare. 8|Page
  9. 9. He demonstrated the tremendous theoretical power of demand and supplycurves, and bequeathed to economics the critical distinction between the short run and the long run. 9|Page
  10. 10. Milton Friedman (July 31, 1912 – November 16, 2006)Friedman was a Marshallian,but he was a macroeconomist. He had his own researchAgenda:Money and Inflation.And he was out to counter Keynesian theory and policy. Milton Friedman was an American economist, statistician, and author who taught at theUniversity of Chicago for more than three decades. He was a recipient of the Nobel Memorial Prize in Economic Sciences, and is known for his research on consumption analysis,monetary history and theory, and the complexity of stabilization policy.[1] As a leader of the Chicago school of economics, he influenced the research agenda of the economics profession. 10 | P a g e
  11. 11. MV = PQM is the money supply(outside the banking system).V is money’s velocity of circulation.P is the price level.Q is the economy’s output.PQ is total expenditures (E).MV is total income (Y)MV = PQ This is the “Equation of Exchange.” No economist, dead or living,has ever denied that MV actually does equal PQ... …because V is defined asPQ/M.MV = PQIn normal times:V doesn’t change much.Q changes in the low single digits.Keynes believed that the velocity of money was subject to dramatic andunpredictable change. He believed that people “hoard” money, more sosome times than others. (increased hoarding means a decrease in velocity.)In extreme episodes, people may be overcome by the “fetish of liquidity,”the fetish often accompanying the waning of animal spirits. 11 | P a g e
  12. 12. MV = PQ In the long run and with a constant V, the price level (P) moves inproportion to the money supply (M) in a no-growth (i.e., constant-Q)economy. This is “The Quantity Theory of Money.” A more descriptive namewould be: “The Quantity of Money Theory of the Price Level.”MV = PQMore generally,In the long run, money-supply growth in excess of real economic growthimpinges wholly on the price level (P) and not at all on the level of realoutput.Put bluntly: you can’t create real wealth by slapping green ink on paper. 12 | P a g e
  13. 13. MonetarismSome diagnostics: With the “Monetarist Rule” in effect (2 or 3%) and aconstant V, the rate of inflation would be zero—or very close to zero. Hasthe rate of inflation been zero?Some diagnostics:CPI for 1982-1984 = 100 CPI for January 2010 = 216 That is, prices onaverage are more than double now what they were in the early 1980s. 13 | P a g e
  14. 14. Some diagnostics:Has Q been falling for the past 25 years? Has V been rising for the past 25years? Has M been rising for the past 25 years?Do labor unions cause inflation?No. But they can cause the prices of goods made by unionized labor to riseand the prices of goods made by non-unionized labor to fall.However, if the central bank increases the money supply in an attempt toneutralize the effects of labor unions, the general price level will rise. 14 | P a g e
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  16. 16. JOHN MAYNARD KEYNES,(5 JUNE 1883–21 APRIL 1946) J.M. Keynes was a British economist whose ideas have profoundlyaffected the theory and practice of modern macroeconomics, as well as the economic policies of governments. He greatly refined earlier work on the causes of business cycles, and advocated the use of fiscal and monetary measures to mitigate the adverse effects of economic recessions and depressions. Keynes is widely considered to be one of the founders of modern macroeconomics, and to be the most influential economist of the 20th century. 16 | P a g e
  17. 17. THE INFLUENCE OF THE GENERAL THEORYTo return to the General Theory: its influence on both economic thinking and economicpractice was profound. The “Keynesian revolution” was far more than a figure of speech.From shortly after the publication of the book in 1936 to at least the 1960s, the majority ofprofessional economists, and certainly the most prominent, termed themselves“Keynesians.” Those who called themselves non- or anti-Keynesians were a beleagueredminority, supplemented, it must be said, by some important writers on economics who werenot members of the professional guild.The interest rate, in turn, he regarded as determined by “liquidity preference,”the third of his key concepts. “An individual’s liquidity-preferenceis given by a schedule of the amounts of his resources, valued in terms ofmoney or of wage-units, which he will wish to retain in the form of moneyin different sets of circumstances.” He regarded the amount of their assets thatindividuals would want to hold in the form of money as depending on bothincome and the interest rate—income because that would affect the amountheld for “transactions- and precautionary-motives,” the interest rate, becausethat would affect the amount held “to satisfy the speculative-motive.”If, as Keynes did, we let Y be income, identical with the value of output,C be consumption, I be investment, L liquidity preference, M the quantity ofMoney, and r the interest rate, then aggregate demand is given byY = C(Y) + I(r),(1)and the demand for money byM = L(Y, r). (2)In line with his implicit assumption about the relative speed of adjustmentof prices and output, Keynes regarded supply as essentially passive, expandingor contracting as demand expanded or contracted, subject only to the provisothat employment is less than “full,” which he defined as the point at which anincrease in aggregate demand would call forth no additional workers willing towork at the wage offered. This leads him to regard aggregate supply as givensimply by aggregate demand, orYS = YD, (3)and the level of aggregate supply and demand as affecting not a price but solelyemployment. 17 | P a g e
  18. 18. If we regard the interest rate as fixed, along with other prices, then equations(1) and (3) define the famous Keynesian “multiplier” (attributed by Keynes toRichard Kahn). For a simple version, assume that the consumption function islinear:C = a + bY, (4)withb, of course, less than one. Substituting (4) in (1) and solving for Y, wehaveY=a + I (r )1−b=µ11 − b¶[a + I(r)]. (5)The multiplier is 1/(1 − b), which, given that b is between zero and unity,is necessarily greater than unity. The multiplicand, (a + I), came to be termed“autonomous” spending, i.e., spending not dependent on the level of income. Inaddition, once government was introduced into the analysis, autonomous spendingwas regarded as including not only autonomous consumption spending (a)and investment (I ) but also government spending.Equations (1) and (3) define also the equally famous “Keynesian cross,” 18 | P a g e
  19. 19. Marvelously simple. A key that apparently unlocks the mystery ofLong-continued unemployment: inadequate autonomous spending or too low aPropensity to consume. Increase either, or both, being careful simply not to goToo far, and full employment could be attained. What a wonderful prescription:for consumers, spend more out of your income, and your income will rise;for governments, spend more, and aggregate income will rise by a multiple ofyour additional spending; tax less, and consumers will spend more with thesame result. Though Keynes himself, and even more, his disciples, producedMuch more sophisticated and subtle versions of the theory, this simple versionContains the essence of its great appeal to non-economists and especially governments.Here was one of the most famous and respected economists in theWorld informing governments that the way to full employment was paved with 19 | P a g e
  20. 20. higher spending and lower taxes.Of course, Keynes recognized that changes in prices, interest rates, andquantity of money did have effects that provided alternative avenues of escapefrom the so-called “underemployment equilibrium.” At best, it was a transitoryequilibrium position, the existence of which would set in motion self-correctiveforces. But Keynes tended to rule out these alternative avenues of escape as ofno practical significance because of his empirical judgment that prices, wages,and interest rates were highly sluggish. Indeed, some commentators on Keynesmaintain that he deliberately overstated his case in order to shock the economicsprofession into paying attention—a tactic that is common to every innovator,whether it be of an idea or a product.Only one alternative avenue of adjustment is explicitly present in equations(1) and (2)—via the interest rate and the quantity of money. This avenue,analyzed at some length in the General Theory, and found wanting to produce,by itself, a full employment equilibrium, also was rapidly incorporated in analternative, more sophisticated graphical representation of the Keynesian systemdeveloped almost simultaneously by John Hicks and Roy Harrod.11 Figure2 presents Hicks’s IS-LM version, which very quickly became the orthodoxversion.In this diagram, the vertical axis is the interest rate. The horizontal axis isincome expressed in wage-units, so that it is also output and employment. TheIS curve traces equation (5), i.e., it shows the combinations of interest rate andoutput that would satisfy equation (1): the higher the interest rate, the lowerinvestment and hence income, and conversely, which is why the IS curve hasa negative slope. Put differently, it shows the combinations of interest rate andoutput at which the amount some people wish to invest is equal to the amountother people wish to save, which is what explains the S in IS. But note that theaccommodation of saving to investment is produced not by the direct effect ofthe interest rate on saving, but by the effect of the level of income on saving,via the propensity to consume.The LM curve traces equation (2) for a fixed quantity of money. 20 | P a g e
  21. 21. The intersection of the IS and LM curve at YO is the counterpart of theintersection of the aggregate demand and supply curves in Figure 1 at YO. Similarly,the IS0 curve is the counterpart of the Y0O curve in Figure 1, reflecting ahigher level of investment. It is the IS curve moved to the right by the changein income assumed to be produced by the increase in investment—the changein investment times the investment multiplier.What is new in Figure 2 are the LM curves. Each LM curve is for a specificquantity of money: the LM curve for M = MO, the (LM)0 curve for M = M0O,which is larger than MO. For the community to hold the larger quantity ofmoney willingly, either the interest rate must be lower for a given income orincome higher for a given interest rate, which is why the (LM)0 curve is to theright of the LM curve.The IS curve in the diagram embodies a possible Keynesian escape fromunderemployment via increases in investment (or, more generally, autonomousspending including government spending). Let autonomous spending be high 21 | P a g e
  22. 22. enough so that the IS curve intersects the LM curve at point F, and full employmentwould be attained with the initial quantity of money.Figure 3 shows an extreme version of these assumptions: perfectly inelasticinvestment and perfectly elastic liquidity preference.We are back to the Keynesiancross of Figure 1. No changes in the quantity of money can produce a fullemployment equilibrium. This LM curve depicts a “liquidity trap,” of whichKeynes wrote, “whilst the limiting case might become practically important infuture, I know of no example of it hitherto. 22 | P a g e

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