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"When I give food to the poor, they call me a saint. When I ask why the poor have no food, they call me a communist".
(Dom Helder Camera -former archbishop of Olinda, Recife, Brasil)(1984)
Basic Knowledge on Economics.- by Róbinson Rojas Sandford
Notes: 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17
Session 3

            The History of Economic Thought [II]. Principles of neo-
            classical economic thought; price theory and allocation of
            resources. Post 1945 economic thought: the rise and fall
            of keynesianism and monetarism.
            Outline the main differences between the neo-classical,
            keynesian and monetarist schools of thought as related to
            inflation, unemployment, economic growth and state
            involvement in the economy.
                    Price determination, allocation of resources,
                    supply and demand, Say's law, aggregate demand
                    and aggregate supply, the quantity theory of
                    money, the public sector borrowing requirement.


While classical economics (Smith, Ricardo, Marx) was concerned with
long-run developments of economies as a whole, and in particular the
relationship between the distribution of the economic surplus and the
pattern of development, NEO-CLASSICAL value theory became essentially
a theory of the allocation of scarce resources in a static economy.

Neo-classical utilised Ricardo's economic model to extend it and create
the MARGINALIST MODEL (the concepts of 'marginal utility' and
'marginal productivity') to analyse the pricing of goods, services and
factors of production in competitive markets. The founders of the
neo-classical system were J. M. Clark, F. Y. Edgeworth, I. Fisher,
A. Marshall, V. Pareto, L. Walras and K. Wicksell

They emphasized that the market prices of goods and factors were related
to their scarcity. The neo-classical scheme is based on the idea of

Prices of commodities, derived from individual rational maximizing
behaviour in the markets, distinguish NEO-CLASSICAL approach from both

In common with many classical theorists the 19th century neo-classical
economists accepted that there exist market forces which tend to
maintain full employment. This contrast sharply with the Keynesian view
that involuntary unemployment may exist even in spite of market forces.


Three assumptions are made by neo-classical economists:

a) supply creates its own demand, because it is assumed that prices
   behave in such a way that the value of all commodities produced
   is just equal to the value of expenditure on commodities as a whole.
   This notion is known as the Say's law (from a French economist,

b) market always clear. That is, they are always in equilibrium. Supply
   equals demand.

c) both capital and labour create value. Therefore both capital and
   labour are "rightly" rewarded in the process of production. The
   relative mix of capital and labour will allow to treat economics
   as a set of mathematical equations forming 'the production

-from a), the conclusion is that there are no business cycles. Therefore,
 the economy is always in equilibrium and at full employment. Or, even
 better,  any level of unemployment in the economy is "voluntary".
 People unemployed are those who do not want to work or do not accept a
 given level of wages.

-from b), it follows that there is always a right price for everything,
 including factors of production (capital and labour)

-from c) two conclusions:
          1.- political: There is no contradiction between owners
              of capital and labourers, because both are fairly
              rewarded in the process of production.
          2.- economic: wages and gross profits are the outcome of a
              mathematical equation which will fix the right values
              for them. There is no room, then, for having labour
              organizing trade unions to fight for higher wages. This
              is "unscientific".

Moreover, the 'prices' of capital and labour are an outcome of two
separate markets: 
            the money market and the labour market

The money market will clear the right supply of money consistent with
the right demand for money. Thus, the price of money, which will be
'the interest rate', will become the PRICE OF CAPITAL.

The labour market will clear the right supply of labour consistent with
the right demand for labour. Thus, the price of labour will be equal
to the right level of wages for any economy.

Owners of capital will invest as long as the rate of profits is
higher than the interest rate. Thus, if a central bank keeps the
interest rate low, more investment will occur, and economic growth
will follow.

This model assumes NO INFLATION (because the money market will clear
all the time).

Assumes full employment, because if wages are too high less demand for
labour will follow as a "punishment by the market" against those who
interfere with it, creating "voluntary unemployment".

Because neo-classical school assumes perfect competition, it denies
any role by the government (state) in the economy, except fiddling with
interest rate to protect rate of profits.

Because wages and employment are determined by supply and demand, the
government does not have any role related to these economic variables.


In the 1930s, when the market system collapsed into dramatic rates of
unemployment (20-30 percent in the U.S. and Western Europe) and negative
economic growth, a British economist, J. M. Keynes, criticised the
neo-classical school as follows:

a) Say's law was an error, because production and consumption are
   the outcome of economic actions by different individuals. Keynes
   said that Say's law is only true in a society of one individual
   where supply and consumption will be about goods for USE and not
   goods for THE MARKET.

b) in a national economy, aggregate demand is not homogeneous, because
   is made of:
               private consumption
               government consumption
               investment by business persons
               and international trade (exports minus imports)

c) markets do not always clear, and there exist instances of
   overproduction and underproduction because supply is disorganized
   driven by individual efforts to maximize profits producing
   commodities for the market;

d) the economy can reach equilibrium at any level of employment,
   therefore there can be periods of high unemployment with businesses
   not interested in investing more. Keynes developed an equilibrium
   condition defined as follows:
        If the sum of savings plus taxation plus imports EQUALS
           the sum of investment plus government expenditure plus
           exports, THEN, the national economy is in equilibrium
           and will tend to keep the corresponding level of national
           output (and level of employment)

e) from the above it follows that in times of high unemployment, the
   government must manage aggregate demand utilizing two main tools:
        monetary policy and fiscal policy

   the government can manage aggregate demand as follows:

1.- Private consumption. Through reducing taxation more income will
    be in the hands of individuals, etc
2.- Government expenditure. Government investments in schools,
    hospitals, low-price dwellings, public transport and public
    utilities will increase private investment and push the economy
    to higher levels of employment.
3.- Investments and international trade. Through monetary policies
    such us 'managing' exchange rate and interest rates, and fiscal
    policies such as taxation and subsidies, the government could
    entice private businesses to invest more, and then, to export

Therefore, Keynesian economics was about managing aggregate demand
to boost employment and economic growth.

All industrial countries adopted some form of Keynesian economic
policies since 1940s until the 1970s. In the 1970s, suddenly, the
price of oil went up several times raising costs of production.
The immediate effect was high levels of unemployment parallel to
very high rates of inflation.


Keynesian economics came under heavy criticism by some economists
(M. Friedman, F. Von Hayek and others) who create a new school of
thought called "monetarism".

The main tenet of this theory is that INFLATION IS A MONETARY
PHENOMENON created by excess of money supply (money defined loosely
as banknotes and coins in circulation plus credit). This is known

Too much inflation, monetarists will say, stop businesses from 
investing, and, therefore, economic growth will slow down.

The only role of the government, they say, was keeping inflation
down through controlling money supply, and, particularly, through
reducing government/state expenditures.

Because of the above, government spending in welfare state, in
education, in health, housing and public utilities should be
reduced to nil. In order to do that, all those services should be
privatized. Thus the public sector borrowing requirement will be
reduced to nil, another correct measure to put inflation down.

Monetarist economics accepts all the neo-classical tenets about
the market, and, therefore, assumes that markets always clear.

Because of the above, they see unemployment as VOLUNTARY. Moreover,
they create the concept of NATURAL RATE OF UNEMPLOYMENT, which is
the rate of unemployment that occurs when the labour market
clears. This is rather comfortable, because technically, any rate
of unemployment will appear as a 'natural rate'.

In the last twenty years, a period of monetarist approach, with the
market taking over all sectors in the economy, one major indicator
of social welfare, unemployment, have been rising constantly, at
a faster pace than employment, which worries industrialized societies.

The following tables, built from "Employment in Europe", European
Commission, 1996, and "Employment Outlook 1996", OECD, 1997, 
illustrates long-term tendencies:


Country            1975        1995     Total growth (%)

United States     85062       124900         46.8
Canada             8761        13505         54.1
Japan             52570        64556         22.8

Belgium            3565         3793          6.4
Denmark            2365         2639         11.6
Germany           26020        34864         33.9
Greece             3262         3821         17.1
Spain             12383        12042         -2.8
France            21409        22326          4.3
Ireland            1073         1262         17.6
Italy             19300        19939          3.3
Luxembourg          158          213         34.8   
Netherlands        5250         6713         27.9
Austria            3087         3759         21.8
Portugal           3889         4407         13.3
Finland            2224         2059         -7.4
Sweden             4062         3985        -18.9
United Kingdom    24589        26172          6.4
TOTAL            278966       350955         25.8
of which:
  EU (15)        132573       147994         11.6

Country            1975        1995      Total growth (%)

United States      4365        7404          70.0
Canada              515        1422         176.1
Japan              1303        2877         120.8

Belgium             137         416         203.6
Denmark              93         198         112.9
Germany             915        3209         250.7
Greece               50         380         660.0
Spain               580        3574         516.2
France              863        2850         230.2
Ireland              83         178         114.5
Italy               979        2683         174.1
Luxembourg            0.5         4.8       860.0
Netherlands         206         535         159.7
Austria              52         147         182.7
Portugal            179         347          93.9
Finland              61         430         604.9
Sweden               74         404         445.9
United Kingdom      817        2501         206.1
TOTAL             11271       29559         162.3
of which:
  EU(15)           5088       17856         250.9
Marginal utility: is the extra utility obtained from an extra unit
                  of any GOOD. 
Marginal productivity theory: the hypothesis states that an employer
                              who seeks to maximize his profits will be
                              guided by the LAW OF DIMINISHING MARGINAL
                              PRODUCTIVITY whereby successive units of
                              LABOUR hired yield successively
                              diminishing returns to OUTPUT. At a given
                              level of wages, the employer will continue
                              to hire labour until the contribution of
                              the last unit employed is equal to the
                              wage paid.
Price determination: as an outome of the 'price mechanism'. The latter
                     notion is used with reference to the free market
                     system and the way in which prices "act as
                     automatic signals which coordinate the actions of
                     individual decision-making units". Capitalist
                     economic theory assumes that
                     "by means of the role of the free market, the
                      price system provides a mechanism whereby
                      changes in demand and supply conditions can affect
                      the allocative efficiency of resources".
allocation of resources: the allocation of particular amounts of capital
                         and labour to produce a particular commodity
                         in such a way that there is no waste of
                         resources. From the latter, the notion of
                         allocative efficiency, which is the
                         production of the best or optimal combination
                         of outputs by means of the most efficient
                         combination of inputs.
                         Optimal output might be determined in various
                         ways, but in welfare economics it is generally
                         held to be that output combination which would
                         be chosen by individual consumers responding
                         in perfect markets to prices which reflect
                         true costs of production.
supply: refers to the supply of a commodity and its relation with
        its price. It is assumed that there is a positive relationship
        between both, that is, larger supply will occur at higher price
        per unit supplied.
demand: refers to the demand for a commodity and its relation with its
        price. It is assumed that there is a negative relationship
        between both, that is, more demand for a commodity will occur
        if the price per unit decreases.
Say's law: J-B. Say, in his "Trait d'economie politique" (1803) developed
           his theory of the markets which is based on the simple
           concept that exchange between two parties involves both a
           purchase and a sale. Say extended this interdependency of
           supply and demand from the barter economy, where every sale
           involves a demand of equal value, no excess demand or supply
           can exist and no commodity will be produced without a
           corresponding level of demand for its consumption, to a
           general theory of markets. Say denied that there could ever
           be a general glut of commodities. Thus, Say was a forerunner
           of the neo-classical school and their equilibrium analysis,
           which assumes perfect competition.
aggregate demand: (also known as aggregate expenditure), is the sum
                  total of nominal expenditures on goods and services
                  in the economy. That is
                  consumption (C), investment (I), and government
                  expenditure (G) together with exports (X) and
                  imports (M).
                  In the short-run the volume of aggregate demand
                  determines the volume of output and employment.
                  In textbooks is expressed as follows:
                     Y = C + I + G + (X-M) 
aggregate supply: the total amount of good and services produced by
                  a particular economy during one year. In general,
                  is conceptualized as the quantity of net national
the quantity theory of money: a theory of demand for money which formed
the most important component of macroeconomic analysis before Keynes'
"General Theory of Employment, Interest and Money", 1936. This same
theory is now enjoying a revival in more sophisticated forms.
By and large, the quantity theory of money relates the quantity of
money, the velocity of circulation of each unit of money , to price
level and volume of transactions. All different versions of this theory,
including M. Friedman's statement that inflation is always a monetary
phenomenon, assume the following:
            the economy will always tend to full employment,
            national income and the stability of the
               velocity of circulation of each unit of money arises
               from the technological and institutional framework;
            monetarists introduced the notion of
            'natural rate of unemployment' to justifiy the
                assumption that the economy will always tend to
                full employment.
the public sector borrowing requirement: the amount by which the
        revenue of public sector organizations falls short of
        For purposes of the definition of public sector borrowing
        requirement, coverage includes central government, local
        authorities and nationalized industries.
        The relevant revenues include taxes on both current and
        capital accounts, trading surpluses and rent, interest and
        Expenditure includes grants, spending on goods and gross
        capital formation and debt interest.
        The deficit is financed by sales of securities to the non-bank
        private sector, increases in currency, borrowing from overseas
        and bank lending to the public sector.
        The effects of borrowing are more likely to be inflationary
        if the financing takes the form of new currency coming into
        circulation than if genuine borrowing from the non-bank private
        sector takes place, as the money supply is obviously increased
        by the first process but not by the second.
        Public sector borrowing raises interest rates through the
        increased sales of bonds and so makes borrowing by companies
        more expensive with possible adverse effects on investments.
        This is known as financial crowding out.