Download 2nd ed Chapter 10

Chapter 10 – Economic Theory
10.1 Classical Economics
10.2 Keynesian Economics
10.3 Monetarism
10.4 Supply Side Economics
10.5 The Global Financial Crisis
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Classical Economics
Pioneered by Adam Smith in The Wealth of Nations published in 1776.
• People acting in their own self-interest will often produce the best social
outcome.
• Also known as laissez-faire economics which literally means “let it be” or
“leave it alone”.
• Argues for “small government” which means very little government
intervention.
Adam
Smith
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The Classical View of Unemployment
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The Classical View of Unemployment
• Individuals (households) supply labour.
• Supply curve is upward sloping because the higher the wage, the
more attractive it is to work, therefore the more people will be
willing to work.
• Firms demand labour.
• Demand for labour downward sloping because the higher the
wage the more costly it is to hire employees, so firms hire less
employees as the wage increases.
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The Classical View of Unemployment
In the long run the
economy should
naturally move towards
Classical economists full employment (where
held the view that demand and supply for
unemployment was labour are in
either voluntary or equilibrium).
frictional or the
result of some short
run shock.
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Unemployed workers
will compete for jobs
and therefore drive
down the cost of labour.
This should result in an
increase in hiring.
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The Classical View of Unemployment
Questions:
What is meant by frictional unemployment?
What is meant by structural unemployment?
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The Great Depression
The Great Depression was the worst recession or economic downturn in
modern history.
Nearly every country in the world affected during the 1930s.
Unemployment in the USA was over 25% and over 20% in the UK,
higher rates than have ever been seen since.
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The Great Depression
What caused the great depression??
What happens when people get worried about
the economy?
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Keynesian Economics
The dramatic nature of the Great Depression and the hardships
that were felt during it caused an economic re-think.
The market, left to its own devices, had failed.
John Maynard Keynes argued that the government should use
fiscal and monetary policy to actively ward off recessions.
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Keynesian Economics
Keynes argued that simply waiting for the economy to tend
towards full employment would take far too long.
“In the long run, we are all dead”
High rate of unemployment was the result of market failure
and a deficiency in aggregate demand.
The government could rectify the market failure by
intervening and using expansionary fiscal policy to stimulate
demand.
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The Phillips Curve
Inverse relationship between inflation and unemployment.
The implication is that governments could control
unemployment and inflation with monetary and fiscal policy.
Government’s could trade-off increased inflation in order to
lower unemployment, or trade-off lower inflation for some extra
unemployment.
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The Phillips Curve
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Stagflation
High unemployment and high inflation at the same time.
In 1973 the first oil price shock contributed to this new
phenomenon.
Higher oil prices caused prices in general to rise, resulting
in inflation.
Higher oil prices also caused production costs to increase,
lowering profits for firms, which slowed down world
economies and increased unemployment.
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Stagflation
Keynesian theory was challenged by stagflation.
Before the 1970’s inflation and unemployment were thought to be mutually
exclusive.
You could treat one at the expense of the other but not both at the same
time.
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Monetarism
Gained popularity in the mid-1970s due to stagflation and the failure
of Keynesian theory to deal with it.
Argues that inflation is caused by excess money supply.
Monetarists argued that tight control of the money supply would bring
stability to inflation and the economy.
The Federal Reserve implemented monetarist theory in the late 1970’s
with little success. After a series of recessions the theory was
discredited.
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Supply Side Economics
In the 1980s, after monetarism was discredited, governments
began to follow a policy of economic rationalism or supply side
economics.
This meant smaller governments and more effective market
mechanisms.
In Australia, the Hawke government began the process of
deregulation and microeconomic reform.
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The Mid-1990s to 2007 — The
Howard Years
From the mid-1990s to 2008 most parts of the world and particularly Australia
experienced a long period of fairly stable and healthy economic growth.
Microeconomic reform seemed to be paying off.
Many thought the business cycle had finally been conquered.
Australian Economic Growth 1980-2008
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The Global Financial Crisis
Triggered by the collapse of the sub-prime mortgage market in
the USA.
The US housing market price bubble burst in late 2006.
Widespread loan defaults meant banks took ownership of nearly
worthless houses, leaving them at a loss.
As a result, the banking market collapsed.
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The Global Financial Crisis
Banks became reluctant to lend both to the public and to
each other for fear of not being paid back. This is known
as a credit crunch.
During 2008 the credit crunch ballooned into a financial
crisis where:
–Hundreds of billions in mortgage related investments went bad.
–Leading investment banks went bankrupt.
–Share markets crashed globally.
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The Impact on Australia
Relatively small on a global scale due to:
–
–
–
–
Rudd Government’s stimulus package
RBA slashing the cash rate
Strength of the Australian economy
Resilience of the Chinese economy
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Post-GFC
• Keynesian economics argued that during the crisis governments should
increase spending to boost economic growth, so that is what they did.
• Central banks slashed interest rates to boost consumers spending.
• This resulted in governments going into huge amounts of debt. Which is
what has caused the current European debt crisis.
What is the solution?
What is meant by austerity measures?
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