The Debate between the Different Schools of Economics - Essay Example

? The debate between the different schools of economics is not over yet. And each school of thought got its own theories in interpreting and dealing with the different economic conditions. Two of these schools of thought are the neoclassical economists and the Keynesians. But before we present their differences, we should get to know each school of thought. The term classical refers to a group of economists in the 18th and 19th centuries who worked on developing theories about the way markets and market economies work. Adam Smith, David Ricardo, Thomas Robert Malthus, John Stuart Mill, and Karl Marx were the ones responsible for the development of these classical economic theories. However, much of their works have subsequently been updated by modern economists and they are generally termed neo-classical economists because the word neo means 'new' (BizEd.co.uk, (Neo)Classical Theory- Introduction, n.d.). Neoclassical economists like Stanley Jevons, Leon Walras, Francis Ysidro Edgeworth, and Vilfredo Pareto belonged to this group. They were credited because of transforming the study of economics into a rigorously mathematical scientific discipline (EncyclopediaOfEarth.org, n.d.). They have adapted the physics equations from the mid-ninteenth century and just changed the variables used like energy to utility. On the other hand, new Keynesian economics is the school of thought in modern macroeconomics that evolved from the ideas of John Maynard Keynes (Mankiw, New Keynesian Economics, n.d.). It was labeled new Keynesian to describe those economists who responded to the new classical critic like Robert Lucas, Thomas J. Sargent, and Robert Barro in the 1980’s. The neoclassical economists can be distinguished from the followers of Sir John Maynard Keynes through the way they interpret the issues in the economy. Although at present times, they are considered as separate schools of thought; both have influences on each other. Both schools have developed and used different theories to analyze and solve the problems in the economy. Their main differences are evident in terms of the causal direction of economic production, the behavior of markets and the behavior of economic agents such as firms/entrepreneurs and households. New classical economics is also called the real-business-cycle theory because it uses the assumptions of the classical model – especially flexible prices and monetary neutrality – to study short-run economic fluctuations (Mankiw, Macroeconomics, 1997). They assume that prices and wages will always adjust quickly to clear markets and believe that the market imperfections due to sticky wages and prices are not that important for understanding economic fluctuations. This is where the primary disagreement between new classical economists and Keynesian economists will start. As new classical economists based their macroeconomic theories such as the free market theory on the flexibility of prices, they believed that prices and wages will clear markets as they balance supply and demand. And as the law developed by Jean Baptiste Say says, supply creates it own demand. Say’s law provides the justification to classical view that the economy will tend to full employment and there will be no any shortage in demand and there will always be jobs for all workers (BizEd.co.uk, (Neo)Classical Theory- Theories, n.d.). So, if unemployment will occur, it will be purely voluntary. On the contrary, Keynesian theory rejects Say’s law and the notion that the economy is self-regulating. The advocates of Keynesian economics believe that prices, and especially wages, respond slowly to changes in supply and demand, resulting in periodic shortages and surpluses, especially of labor (Blinder, n.d.). The stickiness of prices and wages prevents the resources available in the economy to be fully employed, thus involuntary unemployment exists. For the classical economists, inflation is due to the increase in the money supply as explained in the Quantity Theory of Money. They believed that the anticipated changes in the money supply do not affect real output (Blinder, n.d.). This is also in line with the rational expectations theory or the idea that businesses, consumers and workers expect changes in policies or circumstances to have certain effects on the economy and in pursuing their self-interest, take actions to make sure those changes affect them as little as possible. But Keynesians have doubts about this because they believe that rational expectations do not preclude prices and prices are staggered. Staggering complicates the setting of prices because firms care about their prices relative to those charged by other firms (Mankiw, New Keynesian Economics, n.d.). This will make the adjustment of over-all prices slow. For their point of view, changes in aggregate demand, whether anticipated or not, have their greatest short-run effect on real output and employment and not on prices. The differences between the two schools of economics have implications in the macroeconomic policy to be used by the government. As for the neoclassical economists, the market is free and there are invisible hands that will clear the market quickly and they believe that if the government will leave the economy by itself, it will reach its full employment. So this only means that there is really no need for any form of government intervention, be it fiscal or monetary policy. But the Keynesian economists believe otherwise. Because of the sticky wages and staggering prices, market fails to correct itself and government has to intervene by imposing either monetary or fiscal policy. National economic policy has been influenced by the neoclassical and Keynesian macroeconomic theory. The case of United States in relation to Great Depression is a good example for this. As economists continue to debate for the cause of the major economic downturn, many believe that it started with the crashed of US stock market followed by failures of the banks. These events led to a decline in consumption and reduced investment. Production was at very low rate as factories and shops had to stop their operations causing local governments faced difficulties in their tax collection. Because of these, Keynesian economists believe that business cycles are inefficient contrary to the belief of the neoclassical economists. Politicians during the Great Depression were more concerned with balancing the budget than with using fiscal policy to stimulate the economy (Mankiw, Macroeconomics, 1997). They searched for ways for taxes to be raised and the government spending to be reduced. They increased the country’s credit facilities and strengthen the banking system. But still the Depression persisted and its effects spread worldwide. Keynesian economics became widely regarded by economists and political institutions, with it influencing economic decisions from the Great Depression until the 1970s where greater attention was paid again to free market and neoclassical economics theory (Neoclassic.com, 2009). But as of now, leaders such as US President Barack Obama, are returning to the principles of Keynesian and macro-economics in order to stabilize the global economy because of the economic recession in 2008. Neoclassical and Keynesian economics may present us their different views about our economy but both schools worked and are working to attain economics full employment. The lesson here is that each individual in an economy is related to one another and that each action will affect the other’s decision making. So, proper coordination plays an important role. This applies for the consumers or households, producers or firms and the government. At the end of the day, all things will be better when taken and done in moderation. Bibliography BizEd.co.uk. (n.d.). (Neo)Classical Theory- Introduction. Retrieved March 14, 2011, from BizEd.co.uk: http://www.bized.co.uk/virtual/economy/library/theory/classical.htm BizEd.co.uk. (n.d.). (Neo)Classical Theory- Theories. Retrieved March 14, 2011, from BizEd.co.uk: http://www.bized.co.uk/virtual/economy/library/theory/classical2.htm Blinder, A. S. (n.d.). Keynesian Economics. Retrieved March 14, 2011, from The Concise Encyclopedia of Economics: http://www.econlib.org/library/Enc/KeynesianEconomics.html CliffNotes.com. (n.d.). The Keynesian Theory. Retrieved March 14, 2011, from CliffNotes.com: . Economictheories.org. (2008). Keynesian Monetarist Monetarism Theory. 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