History of economic thought

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Contents

 1Overview: categories of economic thought

 2Classical Economics
o 2.1David Hume
o 2.2Adam Smith
o 2.3Jean-Baptiste Say
o 2.4Thomas Malthus
o 2.5David Ricardo
o 2.6Karl Marx
o 2.7Other contributors
 3Neoclassical Economics
o 3.1The neoclassical approach
o 3.2Marginal analysis
o 3.3Equilibrium and the Price Mechanism
o 3.4Welfare and Efficiency
o 3.5Competition
o 3.6The theory of the firm
o 3.7Economic growth
 4Keynesian macroeconomics
o 4.1The contribution of John Maynard Keynes
o 4.2Neo-Keynesianism
o 4.3Policy Implications
 5Monetarism and the Chicago School
 o 5.1The Chicago School
o 5.2Monetarism
o 5.3Expectations
o 5.4Policy implications and outcomes
 6Institutional Economics
o 6.1The Institutionalist School
o 6.2Modern institutional economics
o 6.3Mechanism design theory
o 6.4Public choice theory
 7International economics
o 7.1The gains from trade
o 7.2Infant industries
o 7.3Globalisation
 8Financial economics
o 8.1Overview
o 8.2The finance market
o 8.3Portfolio and asset price theory
o 8.4Corporate finance
 9Recent developments
o 9.1The Greenspan era
o 9.2Post-Great Recession thinking
 10References
Modern economic thought is generally considered to have originated in the late eighteenth
century with the work of David Hume and Adam Smith, the founders of classical economics.
The nineteenth and twentieth centuries saw major developments in the methodology and scope
of economic theory; and the early twenty-first century has seen a rethinking of some previously
accepted tenets.
Nineteenth- and early twentieth-century economists applied deductive reasoning to axioms
considered to be self-evident and simplified assumptions which were thought to capture the
essential features of economic activity. That methodology yielded concepts such
as elasticity and utility, tools such as marginal analysis, and theorems such as the law
of comparative advantage. An understanding of the relationships governing transactions between
consumers and producers was considered to provide all that was necessary to explain the
behaviour of the economic system.
The development, in the latter half of the 20th century, of systems of economic statistics enabled
economists to use inductive reasoning to test theoretical findings against observed economic
behaviour, and to develop new theories. By that time, the concept had emerged of the national
economy as a complex interactive system, and analysis of that concept provided explanations
of recessions, unemployment and inflation that were not previously available. The application of
empirical data and inductive reasoning enabled those theories to be refined, and led to the
development of forecasting models that could be used as tools of economic management.
The development of economic thought in the early 21st century has been stimulated by
the financial crisis and Great Recession, and the questions that these events raised concerning the
functioning of the global financial system and the part that it plays in the functioning of
the economic system generally.
The search for understanding continues.

Overview: categories of economic thought

Historians categorise economic thought into “periods” and “schools”, and tend to attribute each
innovation to one individual. This categorisation is helpful for the purpose of exposition, but the
reality has been a story of interwoven intellectual threads in which advances attributed to
particular individuals or schools have often prompted the work of others. For example, the
quantity theory of money, which achieved prominence in the twentieth century and is associated
with Milton Friedman, was first formulated at least three centuries earlier. Many of those
threads, that have permeated the categories referred to as "Classical economics" and
"Neoclassical economics", had earlier origins. "Classical", in economics, denotes the adoption in
the late eighteenth century of an approach that was inspired by the enlightenment and the
methodology of the physical sciences, and that had abandoned previous examinations of
economics in terms of ethics, religion and politics. Preoccupation with those threads was
overshadowed in the twentieth century by the responses of Keynesianism and monetarism to the
problems of unemployment and inflation, but the development of neoclassical economics started
before that time, and has continued thereafter. The introduction of new tools of exploration has
since led to the vigorous development of that, and other, threads, and an expansion in the scope
of economics into many new directions.

Classical Economics
David Hume
The Scottish philosopher David Hume was an early exponent of what was later known
as monetary economics, and was an opponent of "mercantilism". Mercanilist policy at the time,
regulated trade in ways that subsidised exports so as to promote inflows of gold and silver, and
restricted imports in order to discourage outflows. Hume contested the mercantilist thesis, partly
on the grounds that an inflow of money would cause inflation, and partly on the grounds that
nations would benefit from the international specialisation that would result from the
introduction of free trade. More generally, Hume argued that all government intervention in
commerce tended to obstruct economic progress.[1].
Adam Smith
A major advance in the development of economics occurred with the publication in 1776
of Adam Smith's An Inquiry into the Nature and Causes of The Wealth of Nations.[2]. Smith
wrote a comprehensive treatment of the subject, using deductive logic in a manner similar to its
use in the physical sciences. His main purpose was to recommend changes of economic policy in
the interests of economic growth. He argued that the division of labour was the main cause of
economic growth. His famous maxim was that the extent of the market is determined by the
division of labour. To thus expand markets, required that they should not be impeded by
governmental policies. He therefore opposed government intervention in commerce (as in
mercantilist trade regulation). But he did not oppose all governmental intervention into the
economy. He advocated government spending upon what are now termed public goods such as
defence, law enforcement, infrastructure, and education of the children of people who could not
afford it. He identified what he considered to be the economic drawbacks of all forms
of taxation (except the taxation of land values) and of public expenditure. He examined the
relation of price to value and concluded that the price of a product tends to equality with its cost
of production, which he termed its "natural price". He reasoned that "when the quantity brought
to market is just sufficient to supply the effectual demand and no more, the market price
naturally comes to be either exactly, or as nearly as can be judged of, the same with the natural
price" - an outcome which he took to be the normal result of market bargaining.
Jean-Baptiste Say
Jean-Baptiste Say[3] was an influential advocate of Adam Smith's teaching in French government
circles, but his best-known contribution was what came to be known as "Say's Law of Markets."
Later paraphrased as "supply creates its own demand," Say's law stated that, although there could
be an imbalance between the supply and the demand for particular products, no such imbalance
could exist in the economy as a whole. It was based upon the postulate that money plays no part
in the functioning of the economy beyond its role as a medium of exchange. (The claim that
money is nothing but a medium of exchange, is another way of saying that people use money
only for buying things (including stocks and bonds). Say justified that postulate by arguing that it
would be foolish to hold money out of circulation because that would mean needlessly going
without things (or without dividends or interest). Say's Law remained part of mainstream
classical economics until John Maynard Keynes drew attention to
the speculative and precautionary motives for holding money.
Thomas Malthus
In his influential Essay on the Principle of Population, Thomas Malthus postulated that the
population would grow at a geometric rate (2, 4, 8, 16...) while food production could only
increase arithmetically (1, 2, 3, 4 ....) and concluded that the food supply would eventually be
insufficient to support the population.[4] This theory led him to oppose the introduction of the
UK's Poor Law, and to advocate the protection of agriculture. In other respects, he followed
Adam Smith in opposing government intervention in commerce. Evidence in support of his
postulates was lacking at the time, and they have since been found to be mistaken[5], mainly
because they took no account of the benefits of technical change.
David Ricardo
With minor reservations, David Ricardo accepted and extended Adam Smith’s economics. In his
major work,The Principles of Political Economy and Taxation, he accepted the concept of a
value-determined “natural price”, although he considered value to be determined by labour value
added, rather than cost.[6] Following Adam Smith’s lead, he also developed the wage
fund concept that the amount available for the payment of wages is fixed at any particular level
of capital investment, so that an increase in the supply of labour would lead to a reduction in
wage rates. He pioneered a definition of rent as the difference between the produce of a unit of
labour on the land in question, and its produce on the least productive land in use. In a further
extension to Adam Smith’s work, he explored the incidence of taxation on wages, profits,
houses, and rent, identifying in each case (but with the exception of rent) its harm to the
economy. Probably his most influential contribution, however, was his development of his "Law
of Comparative advantage" that challenged the belief that the trading of a product is possible
only with those with a lesser ability to produce it. Ricardo produced a logical demonstration that
there can be mutually beneficial trade between two countries, one of which is better able than the
other to produce all of the commodities that are traded.
Karl Marx
Karl Marx[7] adapted Ricardo's concept of labour value and put it to an entirely different use. In
his analysis, as in Ricardo's, labour consumption determines value. This, Marx termed exchange
value. But Marx regarded each labourer as a product, whose exchange value is determined by the
labour inputs required to feed, clothe, and train him. He reasoned that what the employer
receives is the labourer's use value, which is determined by the utility of his products. Marx
noted that a labourer's use value normally exceeds his exchange value, and he termed the
difference surplus value, which was the employer's profit. Like Adam Smith and his classical
predecessors, Marx was preoccupied with the subject of economic growth but, unlike them, he
saw technical progress as a major contributor.
Marx was probably the first economist to make a systematic attempt to explain the fluctuations
in economic activity known as the business cycle. He considered that if technical progress were
to slow down, the only way to maintain growth would be to invest more and more in machinery
and buildings, as a result of which the rate of profit on new investment would fall, leading to a
further reduction in growth. Also, in his view, any departure from the conditions necessary for
steady growth would lead to the accumulation of unwanted stocks of goods, producing a
downturn in economic activity - until price-cutting, in order to get rid of surpluses, put the
process into reverse.
In his major work, Das Kapital[8] Marx puts his findings in an historical, concludes that
economic conditions shape history, and forecasts a breakdown of the capitalist system and its
replacement by socialism.
Other contributors
Among the many lesser contributors to classical economic theory, the best-known was John
Stuart Mill. His Principles of Political Economy[9], although intended by the author merely to
bring together the works of others, offered some fresh insights into increasing returns to
scale and their consequences for the development of monopolies, and anticipated (though not in
these terms) the neoclassical concepts of elasticity and the determination of price by the
interaction of supply and demand.
Written during the classical period, but without recognition at the time, was the Theory of the
Firm by the French economist and mathematician Antoine Augustin Cournot. Cournot used
differential calculus to demonstrate the profit-maximising requirement of equality between
marginal cost and marginal revenue, thus anticipating some of the more important developments
of neoclassical economics.

Neoclassical Economics
The neoclassical approach
The term "neoclassical" is commonly applied to all of the continuing developments in economic
thinking that followed the replacement of value-based concepts by the concept of markets that
are governed by the interaction of supply and demand. In that sense, the term denotes a period
rather than a consistent approach - although it is a period that overlaps the competing approaches
of Keynesianism and monetarism. It is nevertheless a period in which most economists have
deduced their findings from the same hypothetical postulates - including the assumption of
competitive markets in which consumers maximise utility and producers maximise profits.
Within that framework of postulates, neoclassical economists have explored a variety of aspects
of economic activity in a variety of different ways.
Marginal analysis
The neoclassical period is also marked by an expansion in the number of people applying their
minds to the problems of economics, as a result of which there have frequently been similar
contributions from a number of different thinkers. That was true of the innovative concepts of
marginal analysis, that are attributable to the contributions of William Stanley Jevons [10] , Carl
Menger [11] and Léon Walras [12]. Their contributions have been brought together by Alfred
Marshall in his Principles of Economics [13], which provides the reader with an accessible and
readable (and non-mathematical) account of those and other contributions. The concept of utility,
was given more prominence, and it was demonstrated logically (and mathematically) that a
rational consumer would continue to buy additional units of a product until its marginal utility
(the increase in utility obtainable from one additional unit of the product) became level with to
its price; and that a rational supplier would continue to offer additional units of a product until
its marginal cost became level with the marginal revenue that he would get from selling it. The
American economist, John Bates Clark, subsequently applied the concept to a market in which a
rational employer would continue to hire labour until its marginal product became level with the
prevailing wage rate.
Equilibrium and the Price Mechanism
The concept of "market equilibrium" is central to the neoclassical model. Léon Walras [14] thought
of it as the achievement of an imaginary auctioneer who adjusts a notional opening price in
response to a succession of bids by buyers and sellers, and permits transactions to take place only
when a price is reached at which buyers are willing to buy all that is offered for sale. That is the
process of price determination by supply and demand which marks the abandonment of the
concept of value-determined price, and which is examined in detail in Alfred
Marshall's Economics and in Milton Friedman's Price Theory[15]. Walras, and subsequently the
Italian economist Vilfredo Pareto [16], later developed the concept of a general equilibrium in
which supply is equal to demand in every market in a closed economy. The normal assumption
of neoclassical economics is that of a stable equilibrium to which the economy will automatically
return after a disturbance. In such an economy, unemployment does not persist because any
excess in the supply of labour, relative to its demand, is corrected by a reduction in wages.
Welfare and Efficiency
The most politically influential of the contributions of the neoclassical economists was probably
their development of the concept of welfare. In accordance with the precepts of representative
government, they assumed the criterion for the success of an economic system to be the welfare
of the individual, and they introduced the concept of economic efficiency as a measure of that
success. Vilfredo Pareto took the lead in defining efficiency as a state in which no-one could be
made better off without making someone worse off. The three types of efficiency were identified
as productive efficiency (the production of good at minimum cost), allocative efficiency (the
provision of the mix of goods that consumers want) and distributive efficiency (the distribution
of the goods in such a way as to maximise individual welfare). That work laid the foundations
for the subsequent development of the theory of welfare economics by Sir John Hicks and others.
(The subject of economic welfare is discussed extensively in Arthur Pigou's Economics of
Welfare [17], and the theorems of welfare economics are summarised in William
Baumol's Economic Theory and Operations Analysis [18])
Competition
The theorems of welfare economics establish a presumption that allocative efficiency - that is to
say that resources will be optimally allocated as between the production of alternative products -
will be achieved under the hypothetical conditions of perfect competition. (Those conditions
include the requirement that for each product there is no supplier large enough to influence
prices, that all producers supply identical products, and that all consumers are well informed and
behave rationally.) Despite the unreasonableness of those requirements, most economists
advocate a presumption that restrictions upon competition will result in a reduction in
efficiency . Those theoretical developments were the foundation for antitrust and other forms
of competition policy, the economics and politics of which have been developed by George
Stigler .
The theory of the firm
The tools of welfare economics were also used to develop the theory of the firm by Nicholas
Kaldor of the London School of Economics in his Equilibrium of the Firm [19] and Ronald Coase
in his "The Nature of the Firm [20]. (Those theoretical developments have been summarised in
William Baumol's Economic Theory and Operations Analysis [21]. An empirical study of the way
firms actually behave is provided by Cyert and March's Behavioral Theory of the Firm [22])
Economic growth
There has been succession of attempts to create models of economic growth that identify the
contributions of such factors as investment, productivity, innovation and institutional
environment; and that explain the differences in growth experienced by different regions of the
world. In the simple model proposed by Malthus in 1850, growth could not exceed population
growth, but it was not long before it became evident that it was doing so. The Harrod-Domar
model [23], and its successors, assume that there would be sufficient economic growth to enable
some to go into growth-enhancing investments. In a later development, the 1956 Solow
model [24] introduced the influence of the substitution of capital for labour that results from
investment in improved capital equipment. Solow also pioneered the technique of growth
accounting , which he used to estimate relative contributions to historical growth in the United
States; and he identified an unexplained residual which he termed total factor productivity, the
growth of which he attributed to technological change. Technological change was exogenous to
the Solow model, in that it was not the consequence of factors that were represented in the
model. As a result of subsequent research, notably that of Paul Romer [25] and Robert Lucas [26],
some of the factors believed to influence technological change, such as expenditure on R&D and
training, have since been embodied in the growth models, which are termed endogenous
growth models. The most recent work on the subject has sought to identify the contributions to
economic growth of institutional factors such as quality of governance, trust, and ethic diversity;
and to explore its links with geographical factors and globalisation.
Keynesian macroeconomics
The contribution of John Maynard Keynes
The most important contribution to economic thought by John Maynard Keynes was his
examination of the factors determining the levels of national income and employment, and the
causes of economic fluctuations. His major (and hard to read) work, the General Theory of
Employment, Interest and Money, contains a sustained attack on much of the thinking of classical
economics - mainly on the grounds that their postulates were unrealistic. His first target was
Say's law of markets with its denial of the possibility of a general deficiency of demand. He
challenged its implicit assumption that money is no more than a medium of exchange by drawing
attention to the speculative motive for holding money. Secondly, he attacked the classical
economists' contention that it was the interest rate that reconciled savings plans with investment
plans, claiming that the level of savings was largely determined by the level of national income.
Thirdly, he rejected the classical economists' assumption that any tendency for unemployment to
rise would be corrected by a reduction in the general level of wages, substituting the contention
that "wages are sticky downward". Having substituted his assumptions for those of his
predecessors, he advanced the thesis that a deficiency of demand could occur if there was an
excess of planned savings over planned investment, because such an excess could be removed
only by a reduction in national income. The implication of that thesis was that the economy
could settle down into a condition of high unemployment, lacking the self-righting mechanism
envisaged by the classical economists.
Neo-Keynesianism
Shortly after the publication of Keynes' General Theory, John Hicks published an article entitled
"Mr Keynes and the Classics"[27], in which he produced a synthesis between the Keynesian and
neoclassical models. Its main feature is the IS/LM diagram with its intersecting curves, one of
which (Investment/Savings) relates the demand for savings to the interest rate, and the other
(Liquidity/Money Supply) relates the demand for money to the interest rate - and in which the
point of intersection of the two curves represents an equilibrium level of demand. (The IS/LM
diagram subsequently came to be known as the Hicks-Hansen diagram in recognition of prior
work by the American economist Alvin Hansen . The important feature of the synthesised model
is that it can be made to depict behaviour in accordance with either the Keynesian model or the
neoclassical model, depending upon what is assumed concerning the slopes of the two curves. In
doing so it introduced a fundamental departure in the methodology of economics - a change from
an exclusive reliance upon logical deduction from a priori postulates, to the increasing use of
the inductive process of testing hypotheses against empirical evidence, that was made possible at
the time by the comparatively recent practice of systematically collecting economic statistics.
The work of a large body of economists was subsequently devoted to testing such hypotheses,
using the mathematical technique known as "econometrics". That work does not appear to have
resolved the controversy concerning the usefulness of the two models (except that some
economists now acknowledge that one or the other seems to have worked better from time to
time and in some countries' economies)
Policy Implications
A Keynesian consensus dominated the economic policies of the developed countries for two or
three decades following the second world war. Keynesian stabilisation policy required
governments to counter downturns in demand by cutting taxes or increasing public expenditure.
Since it takes some years for such actions to take effect, their timing had to be based upon
forecasts using computerised economic forecasting models, but forecasting errors and misguided
attempts to stimulate growth often had destabilising consequences. Measures that unwittingly
stimulated demand at a time when an economy was operating at its full capacity, frequently gave
rise to rising inflation - for which the only remedy appeared to be wage restraint - and the
situation was sometimes exacerbated by the operation of foreign exchange policies. Opposition
to those policy actions came from economists of the Austrian School, and from economists of
the Chicago School whose thinking is described below.

Monetarism and the Chicago School

The Chicago School
The University of Chicago School of Economics [28] has enjoyed a reputation for economic
excellence since its foundation in 1892 However, the term Chicago School is usually taken to
refer to the outlook and methodology of its economists during the period that started in the 1960s
- including Milton Friedman, George Stigler, Ronald Coase, Robert Lucas, Cary Becker, Harry
Johnson and Merton Miller, and to some like-minded economists in other universities. It is best
known for its advocacy of monetarism but its economists have also made contributions on a wide
range of other topics, including international trade, rational expectations and institutional
economics. Their methodology embodies an approach, which philosophers term instrumentalist,
that gives the predictive value of a theory priority over the representativeness of its
assumptions [29]
Monetarism
The quantity theory of money, which is often attributed to the economist Irving Fisher, but which
undoubtedly had earlier origins, equated the volume of money in circulation multiplied by a
notional "velocity of circulation". to the volume of physical output multiplied by its unit price
(usually written as MV = PT). If the velocity of circulation were roughly constant, that would
imply an association between inflation and growth in the money supply. Milton Friedman found
that to have been the case during various periods in United States history [30], and that periods of
monetary expansion had been followed by periods of inflation, although with long and variable
time-lags. That led him to argue that Keynesian demand management would be ineffective in the
long run because it would be accompanied by a damaging rise in the money supply; and that
stability of demand and prices could better be achieved by control of the money supply. The
controversy that followed was mainly concerned with the nature of the transmission
mechanism (the question whether an excess of money would bid up the prices of goods, or
whether it would be invested in interest-bearing bonds without affecting the prices of goods).
A theory connecting the money supply and the balance of payments had previously been put
forward by Harry Johnson when he was a professor of economics at Manchester University. The
conventional view had been that the exchange rate is determined by the balance between the
supply and demand of exports and imports, but Harry Johnson treated it as the relative price of
the moneys in circulation in the two countries [31]. One of the implications of his theory is that if
the exchange rate is fixed, the money supply cannot be controlled - which was a consideration
that influenced the Chicago School's campaign to put an end to the system of fixed exchange
rates then in operation. Another is that if the money supply is held constant, the balance of
payments is self-correcting.
Expectations
Milton Friedman also attacked the thinking behind the Phillips curve (which had reflected the
observation that inflation tended to fall when there was a rise in unemployment) on the grounds
that it failed to take account of expectations. He proposed its replacement by the expectations-
augmented Phillips curve [32], and used that construction to counter fears that a reduction in
growth of the money supply would lead to a sustained increase in unemployment. To do so, he
introduced the concept of the non-accelerating-inflation rate of unemployment (NAIRU), which
is usually referred to as its natural rate, and which is the unemployment rate at which the
expected inflation rate is the same as its actual rate. He argued that if a reduction in money
supply growth caused unemployment to rise above its natural rate, the expected inflation rate
would fall, setting in motion a sequence of events that would cause unemployment to revert to its
natural rate. Conversely, a reduction in unemployment accompanying an increase in the money
supply would cause an increase in expected inflation, prompting wage demands which would
lead to an increase in actual inflation - a process which could continue indefinitely.
Applying the concept of "rational expectations"[33] formulated by his former colleague, John
Muth, to the operation of economic policy, Robert Lucas of the Chicago School put forward
what has become known as the Lucas Critique[34] . He argued that policy actions tend to change
people's expectations so that the same policy action could have future consequences that differ
from the consequences that it had in the past. That possibility has fundamental implications for
the construction of forecasting models, and the Lucas critique also raises the possibility that
public reactions could frustrate the achievement of policy objectives.
Policy implications and outcomes
The Chicago School's prescription for stabilisation problem was confined to the control
the money supply, and its prescription for the reduction of unemployment was to take measures
to improve wage - and price flexibility. Concern for rising inflation, and the failure of attempts to
control it by wage restraint, led to the widespread adoption of the first of those prescriptions in
the late 1970s. In the United States, the Congress passed The Full Employment and Balanced
Growth Act (known as the Humphrey-Hawkins Act) which required the Federal Reserve Bank to
set one-year target ranges for money supply growth twice a year and to report the targets to
Congress. In the United Kingdom, the Callaghan administration adopted a specific money supply
objective: a practice that was enthusiastically adopted by its successor Thatcher administration.
In both countries, attempts to keep the growth of the money supply within pre-set limits were
generally unsuccessful (and in the United Kingdom, money supply growth actually increased [35])
and were eventually abandoned. Some central bankers have said that they take account of long-
term money supply trends, but none consider control of the money supply to be a practicable
instrument of stabilisation policy. Consensus monetary policy since the late 1980s uses interest
rates as a means of stabilising both prices and output[36], and the median inflation rate in 13
industrialised countries has fallen from around 15 per cent in the mid 1970s and early 1980s to
around 2 per cent in 2005[37].

Institutional Economics
The Institutionalist School
The term Institutionalist refers to economists who argue that economic activity cannot properly
be understood except in the context of the public and social structure in which it takes place.
That approach to the can be traced back to the German Historical School, which included
Friedrich List and Max Weber, who is best known for his The Protestant Ethic and the Spirit of
Capitalism. But the term is more commonly applied to the views of a pre-war group of American
economists whose leading member was Thorstein Veblen - the man who coined the
term conspicuous consumption - and whose lasting contributions were the collection of economic
statistics and the study of business cycles.
Modern institutional economics
A major contributor to the theory of institutional economics has been Ronald Coase, who
summarised his approach in his 1991 Nobel Prize lecture [38]. Early in his career as an economist
he had formulated what came to be known as the Coase Theorem which was the proposition that
economic efficiency will be achieved provided that property rights are fully allocated and can
freely be traded; a proposition which he developed further in his 1960 paper The Problem of
Social Cost [39]. The development of institutional economics by economists at the University of
Chicago has taken them across the conventional borders of economics into the disciplines of law,
sociology and politics. (An extreme example has been the publication of the best-
selling Freakonomics that was jointly authored by the Chicago economist Steven Levitt and the
New York journalist Stephen Dubner, and which applies economic thinking to such questions as
cheating, drug dealing and the connection between crime and abortion.)
Mechanism design theory
A recent extension to institutional economics is concerned with how well different institutions
and allocation mechanisms achieve goals such as welfare and private profit. Contributions to that
subject by Leonid Hurwicz of the University of Minnesota, Eric Maskin of Princeton and Roger
Myerson of Chicago earned them the 2007 Nobel Prize in Economics.
Public choice theory
A different approach to the same questions [40] had previously been put forward under the
heading of public choice theory, the principle contribution to which had been James Buchanan
and Gordon Tullock's major treatise, The Calculus of Choice [41]. However, Buchanan and
Tullock are best known for their analysis of the behaviour of politicians, civil servants and voters
on the assumption that they are mainly motivated by personal gain, rather than a desire to serve
the public interest.

International economics
The gains from trade
David Ricardo's law of comparative advantage - and its implication that trade restrictions are
damaging to the interests of the country that imposes them - was the starting-point of the
historical development of trade theory [42]. The subsequent theoretical developments of
"classical" trade theory have mainly been attempts to create mathematical models of inter-
country trade. The best-known of those was the Heckscher-Ohlin Theory [43], which deduced
from a range of highly restrictive assumptions that a country will export those commodities that
are intensive in the factor of production in which it is most well-endowed. That theory was
extended by Paul Samuelson to conclude that, in the absence of productivity differences, trading
between two countries would tend to equalise wages and capital costs in those countries.
However, doubt was cast upon the relevance of the Heckscher-Ohlin theory by Wassily
Leontief's discovery that the United States, which is the world's most capital-intensive country,
had been exporting labour-intensive commodities and importing capital-intensive commodities.
The general conclusion has been that international trade is mainly driven by factors other than
labour-intensity and capital-intensity. "Modern" trade theory depends mainly upon the
econometric analysis of international trade statistics,and has produced a range of findings
concerning the influence of factors such as innovation and training.
Infant industries
There was opposition in the early nineteenth century to the proposition that trade restrictions
reduce welfare from a small group of economists, including Friedrich List of the German
Historical School, who argued that free trade should not be permitted until the government had
taken the measures necessary to establish the country's "productive powers". That was the
precursor of the argument for infant-industry protection that was politically influential in the
early twentieth century and which led to the introduction of the Smoot-Hartley system of
industrial tariffs in the United States. It has been given recent expression in Ha-Joon Chang's
book Kicking Away the Ladder [44] which suggests that industrial successes in Britain and the
United States (and later in creating an automobile industry in South Korea) were attributable to
the fact that they were protected from overseas competition until they were large enough to
benefit from economies of scale. The mainstream reaction among economists concedes that the
case for free trade does not take account of the benefits of scale economies, and that welfare
gains from temporary trade restrictions might in principle be possible if a government were
sufficiently successful in "picking winners" but that tax incentives and subsidies are more
effective than tariffs [45] .
Globalisation
Globalisation is seen by most economists as contributing to economic welfare by promoting
competition and the division of labour. But there are exceptions. Professor Joseph
Stiglitz [46] [47] of the Columbia Business School has advanced the infant industry case
for protection in developing countries and criticised the conditions imposed for help by the
International Monetary Fund [48]. And Professor Dani Rodrik of Harvard[49] has noted that the
benefits of globalisation are unevenly spread, leading to income inequalities that, in his view,
lead to damaging losses of social capital, and to the migration of labour causing social stresses in
receiving countries [50]

Financial economics
Overview
Economists and professional investors gave little attention to financial economics until the
adoption in the 1970s of models based upon the efficient markets hypothesis. That hypothesis
was the basis of risk analysis using the assumption that price variations on the markets for
financial assets could be treated as random variations, which could be represented by
established probability distributions. The international financial industry made use of the models
to select investments that were predicted to give the best return for a stipulated level of risk. It
was not until the 2008 financial crisis that it was widely recognised that the efficient market
hypothesis was no more than a statement of a general tendency, and that additional risks could
arise from statistically unpredictable patterns of investor conduct.
The finance market
The study of financial economics had its origin in a 1900 thesis entitled Theorie de la
Speculation by the French mathematician Louis Bachelier [51], according to which price
fluctuations in a speculative market are analogous to the Brownian Movement of physics
(the random walk of statistics theory), such that there is no combination of prices that offer the
prospect of a certain gain. In 1933, the American economist Alfred Cowles[52] developed a
similar thesis, which he published in a paper entitled Can Stock Market Forecasters Forecast?.
According to Cowles' efficient market hypothesis, all of the available information that was
relevant to an asset's prospects would already be embodied in its price (so that the answer to his
question was "no"). The hypothesis depended upon the assumptions that most traders behave
rationally, and that the activities of the others are mutually cancelling. Those assumptions were
widely accepted, and on their basis, financial markets were taken to be essentially stable. Hyman
Minsky's 1986 financial instability hypothesis, which suggested that financial markets are apt to
become unstable after a period of sustained economic growth, received little attention at the time.
A number of mathematical models of finance markets based upon the efficient markets
hypothesis were developed in the course of the 20th century and were widely applied as guides
to investment, but financial economics was then considered by most of the economics profession
to be a specialised subject of little general interest, regarding the financial system as a collection
of secondary markets whose internal characteristics do not affect the rest of the economy.
Portfolio and asset price theory
A sequence of Nobel Prize-winning advances concerning the problem of getting the best return
from an investment without exceeding a chosen level of risk, occurred during the period from the
1950s to the 1970s. The sequence started in the late 1950s, when James Tobin [53] and Harry
Markowitz laid the foundations of modern portfolio management. In his "Separation Theorem",
Tobin proposed a two-stage process in which the required risk ceiling could be maintained by
mixing risky and riskless assets, and Markowitz demonstrated the benefits of a diversified
portfolio in which the prices of it assets would not rise and fall together, using the statistical
concept of covariance. In 1970, William Sharpe[54] applied that concept to the tendency of the
price of an asset to rise and fall in concert with the all-share index, assigning the title "Beta" to
its mathematical definition, and used it to derive a pricing method know as the Capital Asset
Pricing Model, and in 1973, Fischer Black [55] and Myron Scholes [56] developed the Black-
Scholes model which made use of the fact that the expected volatility of an asset is reflected in
its price in the options market, which led to the development by Robert Merton [57] of the
"Contingency Claims Analysis" method of pricing assets.
Corporate finance
During the same period there was a sequence of advances in the economics of corporate finance.
It started with the demonstration by Franco Modigliani [58] and Merton Miller [59] that
shareholders should be indifferent to the level of a corporation's debts provided that it was
possible to repay them costlessly with money available at a riskless rate of interest. Other
economists subsequently augmented the Modigliani-Miller theory with allowances for the effects
of taxation and of information asymmetry.

Recent developments
The Greenspan era
Divergences of view about economic management persisted into the early 21st century, but a
consensus developed among those responsible for the management of the major economies,
along the lines of a speech by the then United States Federal Reserve Board Chairman, Alan
Greenspan[60]. The use of Keynesian fiscal policy to regulate output was considered to have
proved ineffective and inflationary, and monetarist attempts to control the money supply were
seen to have been unsuccessful. The new rôle of fiscal policy was the maintenance of fiscal
stability, responsibility for the management of the economy had become the exclusive function
of monetary policy, and monetary policy was confidently expected to prevent serious
interruption to economic growth (the President of the American Economic Association had
declared that "The central problem of depression-prevention [has] been solved, for all practical
purposes"[61]). The financial system was considered to be essentially stable, making financial
regulation unnecessary.
The conclusion of the era was marked by Alan Greenspan's 2008 congressional testimony:
"In recent decades, a vast risk management and
pricing system has evolved combining the best
insights of mathematicians and finance experts
supported by major advances in computer and
communications technology. A Nobel prize was
awarded for the discovery of the pricing model that
underpins much of the advance in the derivatives
markets. This modern risk management paradigm held
sway for decades. The whole intellectual edifice,
however, collapsed in the summer of last year."[62]
The shortcomings of economic theory in that respect have been
held [63] to have played a major role in the the financial crisis of
2008.
Post-Great Recession thinking
The financial crisis of 2008 and the resulting Great
Recession prompted much re-thinking of economic theory.
Professor Shin of Princeton University reported that the "race is
on" to add a new perspective to macroeconomics by the
incorporation into it of a new theory of financial economics[64],
and there was new thinking about the use of financial
regulation to reduce the risk of fresh financial shocks. A re-
examination of the rôle of fiscal policy had been triggered among
economists and politicians by a 2008 proposal by
Britain's Gordon Brown for a coordinated fiscal stimulus to
 counter the expected recessionary effects of the financial crisis.
The idea was dismissed as ineffective by some economists[65][66],
and as inflationary by others [67], and it was rejected by
Germany's Angela Merkel[68] and ridiculed by her finance
minister as "crass Keynesianism"[69] Although fiscal stimulus
packages were implemented during the recession of 2009, they
were not sustained by European governments to support the
faltering recovery in 2010, and programmes of fiscal
contraction were widely introduced in 2011. The main reason that
was given for that reversal of fiscal policy was the fear that
operators in the bond market would lose confidence in
governments' ability to service the levels of public debt that their
continuation would involve. The European Union's Fiscal
Compact (which places mandatory restrictions upon the use of
fiscal policy by its signatories) may gain political approval, but
its economic consequences are likely to remain a matter of
controversy. Unlike the European governments, the United States
government has not introduced a major programme of fiscal
contraction, and the Congress has not been able to agree on a
plan for the reduction of the government's budget deficit[70]. A
controversy also remains unresolved concerning the merit of
techniques known as quantitative easing by which central
banks seek to increase the money supply in order to relieve credit
crunches and stimulate economic activity[71][72].

History of economic thought

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 Contents

 1Overview: categories of economic thought

 2Classical Economics
o 2.1David Hume
o 2.2Adam Smith
o 2.3Jean-Baptiste Say
o 2.4Thomas Malthus
o 2.5David Ricardo
o 2.6Karl Marx
o 2.7Other contributors
 3Neoclassical Economics
o 3.1The neoclassical approach
o 3.2Marginal analysis
o 3.3Equilibrium and the Price Mechanism
o 3.4Welfare and Efficiency
o 3.5Competition
o 3.6The theory of the firm
o 3.7Economic growth
 4Keynesian macroeconomics
o 4.1The contribution of John Maynard Keynes
o 4.2Neo-Keynesianism
o 4.3Policy Implications
 5Monetarism and the Chicago School
o 5.1The Chicago School
o 5.2Monetarism
o 5.3Expectations
o 5.4Policy implications and outcomes
 6Institutional Economics
o 6.1The Institutionalist School
o 6.2Modern institutional economics
o 6.3Mechanism design theory
o 6.4Public choice theory
 7International economics
o 7.1The gains from trade
o 7.2Infant industries
o 7.3Globalisation
 8Financial economics
o 8.1Overview
o 8.2The finance market
o 8.3Portfolio and asset price theory
o 8.4Corporate finance
 9Recent developments
o 9.1The Greenspan era
o 9.2Post-Great Recession thinking
  10References
Modern economic thought is generally considered to have originated in the late eighteenth
century with the work of David Hume and Adam Smith, the founders of classical economics.
The nineteenth and twentieth centuries saw major developments in the methodology and scope
of economic theory; and the early twenty-first century has seen a rethinking of some previously
accepted tenets.
Nineteenth- and early twentieth-century economists applied deductive reasoning to axioms
considered to be self-evident and simplified assumptions which were thought to capture the
essential features of economic activity. That methodology yielded concepts such
as elasticity and utility, tools such as marginal analysis, and theorems such as the law
of comparative advantage. An understanding of the relationships governing transactions between
consumers and producers was considered to provide all that was necessary to explain the
behaviour of the economic system.
The development, in the latter half of the 20th century, of systems of economic statistics enabled
economists to use inductive reasoning to test theoretical findings against observed economic
behaviour, and to develop new theories. By that time, the concept had emerged of the national
economy as a complex interactive system, and analysis of that concept provided explanations
of recessions, unemployment and inflation that were not previously available. The application of
empirical data and inductive reasoning enabled those theories to be refined, and led to the
development of forecasting models that could be used as tools of economic management.
The development of economic thought in the early 21st century has been stimulated by
the financial crisis and Great Recession, and the questions that these events raised concerning the
functioning of the global financial system and the part that it plays in the functioning of
the economic system generally.
The search for understanding continues.

Overview: categories of economic thought

Historians categorise economic thought into “periods” and “schools”, and tend to attribute each
innovation to one individual. This categorisation is helpful for the purpose of exposition, but the
reality has been a story of interwoven intellectual threads in which advances attributed to
particular individuals or schools have often prompted the work of others. For example, the
quantity theory of money, which achieved prominence in the twentieth century and is associated
with Milton Friedman, was first formulated at least three centuries earlier. Many of those
threads, that have permeated the categories referred to as "Classical economics" and
"Neoclassical economics", had earlier origins. "Classical", in economics, denotes the adoption in
the late eighteenth century of an approach that was inspired by the enlightenment and the
methodology of the physical sciences, and that had abandoned previous examinations of
economics in terms of ethics, religion and politics. Preoccupation with those threads was
overshadowed in the twentieth century by the responses of Keynesianism and monetarism to the
problems of unemployment and inflation, but the development of neoclassical economics started
before that time, and has continued thereafter. The introduction of new tools of exploration has
since led to the vigorous development of that, and other, threads, and an expansion in the scope
of economics into many new directions.
Classical Economics
David Hume
The Scottish philosopher David Hume was an early exponent of what was later known
as monetary economics, and was an opponent of "mercantilism". Mercanilist policy at the time,
regulated trade in ways that subsidised exports so as to promote inflows of gold and silver, and
restricted imports in order to discourage outflows. Hume contested the mercantilist thesis, partly
on the grounds that an inflow of money would cause inflation, and partly on the grounds that
nations would benefit from the international specialisation that would result from the
introduction of free trade. More generally, Hume argued that all government intervention in
commerce tended to obstruct economic progress.[1].
Adam Smith
A major advance in the development of economics occurred with the publication in 1776
of Adam Smith's An Inquiry into the Nature and Causes of The Wealth of Nations.[2]. Smith
wrote a comprehensive treatment of the subject, using deductive logic in a manner similar to its
use in the physical sciences. His main purpose was to recommend changes of economic policy in
the interests of economic growth. He argued that the division of labour was the main cause of
economic growth. His famous maxim was that the extent of the market is determined by the
division of labour. To thus expand markets, required that they should not be impeded by
governmental policies. He therefore opposed government intervention in commerce (as in
mercantilist trade regulation). But he did not oppose all governmental intervention into the
economy. He advocated government spending upon what are now termed public goods such as
defence, law enforcement, infrastructure, and education of the children of people who could not
afford it. He identified what he considered to be the economic drawbacks of all forms
of taxation (except the taxation of land values) and of public expenditure. He examined the
relation of price to value and concluded that the price of a product tends to equality with its cost
of production, which he termed its "natural price". He reasoned that "when the quantity brought
to market is just sufficient to supply the effectual demand and no more, the market price
naturally comes to be either exactly, or as nearly as can be judged of, the same with the natural
price" - an outcome which he took to be the normal result of market bargaining.
Jean-Baptiste Say
Jean-Baptiste Say[3] was an influential advocate of Adam Smith's teaching in French government
circles, but his best-known contribution was what came to be known as "Say's Law of Markets."
Later paraphrased as "supply creates its own demand," Say's law stated that, although there could
be an imbalance between the supply and the demand for particular products, no such imbalance
could exist in the economy as a whole. It was based upon the postulate that money plays no part
in the functioning of the economy beyond its role as a medium of exchange. (The claim that
money is nothing but a medium of exchange, is another way of saying that people use money
only for buying things (including stocks and bonds). Say justified that postulate by arguing that it
would be foolish to hold money out of circulation because that would mean needlessly going
without things (or without dividends or interest). Say's Law remained part of mainstream
classical economics until John Maynard Keynes drew attention to
the speculative and precautionary motives for holding money.
Thomas Malthus
In his influential Essay on the Principle of Population, Thomas Malthus postulated that the
population would grow at a geometric rate (2, 4, 8, 16...) while food production could only
increase arithmetically (1, 2, 3, 4 ....) and concluded that the food supply would eventually be
insufficient to support the population.[4] This theory led him to oppose the introduction of the
UK's Poor Law, and to advocate the protection of agriculture. In other respects, he followed
Adam Smith in opposing government intervention in commerce. Evidence in support of his
postulates was lacking at the time, and they have since been found to be mistaken[5], mainly
because they took no account of the benefits of technical change.
David Ricardo
With minor reservations, David Ricardo accepted and extended Adam Smith’s economics. In his
major work,The Principles of Political Economy and Taxation, he accepted the concept of a
value-determined “natural price”, although he considered value to be determined by labour value
added, rather than cost.[6] Following Adam Smith’s lead, he also developed the wage
fund concept that the amount available for the payment of wages is fixed at any particular level
of capital investment, so that an increase in the supply of labour would lead to a reduction in
wage rates. He pioneered a definition of rent as the difference between the produce of a unit of
labour on the land in question, and its produce on the least productive land in use. In a further
extension to Adam Smith’s work, he explored the incidence of taxation on wages, profits,
houses, and rent, identifying in each case (but with the exception of rent) its harm to the
economy. Probably his most influential contribution, however, was his development of his "Law
of Comparative advantage" that challenged the belief that the trading of a product is possible
only with those with a lesser ability to produce it. Ricardo produced a logical demonstration that
there can be mutually beneficial trade between two countries, one of which is better able than the
other to produce all of the commodities that are traded.
Karl Marx
Karl Marx[7] adapted Ricardo's concept of labour value and put it to an entirely different use. In
his analysis, as in Ricardo's, labour consumption determines value. This, Marx termed exchange
value. But Marx regarded each labourer as a product, whose exchange value is determined by the
labour inputs required to feed, clothe, and train him. He reasoned that what the employer
receives is the labourer's use value, which is determined by the utility of his products. Marx
noted that a labourer's use value normally exceeds his exchange value, and he termed the
difference surplus value, which was the employer's profit. Like Adam Smith and his classical
predecessors, Marx was preoccupied with the subject of economic growth but, unlike them, he
saw technical progress as a major contributor.
Marx was probably the first economist to make a systematic attempt to explain the fluctuations
in economic activity known as the business cycle. He considered that if technical progress were
to slow down, the only way to maintain growth would be to invest more and more in machinery
and buildings, as a result of which the rate of profit on new investment would fall, leading to a
further reduction in growth. Also, in his view, any departure from the conditions necessary for
steady growth would lead to the accumulation of unwanted stocks of goods, producing a
downturn in economic activity - until price-cutting, in order to get rid of surpluses, put the
process into reverse.
In his major work, Das Kapital[8] Marx puts his findings in an historical, concludes that
economic conditions shape history, and forecasts a breakdown of the capitalist system and its
replacement by socialism.
Other contributors
Among the many lesser contributors to classical economic theory, the best-known was John
Stuart Mill. His Principles of Political Economy[9], although intended by the author merely to
bring together the works of others, offered some fresh insights into increasing returns to
scale and their consequences for the development of monopolies, and anticipated (though not in
these terms) the neoclassical concepts of elasticity and the determination of price by the
interaction of supply and demand.
Written during the classical period, but without recognition at the time, was the Theory of the
Firm by the French economist and mathematician Antoine Augustin Cournot. Cournot used
differential calculus to demonstrate the profit-maximising requirement of equality between
marginal cost and marginal revenue, thus anticipating some of the more important developments
of neoclassical economics.

Neoclassical Economics
The neoclassical approach
The term "neoclassical" is commonly applied to all of the continuing developments in economic
thinking that followed the replacement of value-based concepts by the concept of markets that
are governed by the interaction of supply and demand. In that sense, the term denotes a period
rather than a consistent approach - although it is a period that overlaps the competing approaches
of Keynesianism and monetarism. It is nevertheless a period in which most economists have
deduced their findings from the same hypothetical postulates - including the assumption of
competitive markets in which consumers maximise utility and producers maximise profits.
Within that framework of postulates, neoclassical economists have explored a variety of aspects
of economic activity in a variety of different ways.
Marginal analysis
The neoclassical period is also marked by an expansion in the number of people applying their
minds to the problems of economics, as a result of which there have frequently been similar
contributions from a number of different thinkers. That was true of the innovative concepts of
marginal analysis, that are attributable to the contributions of William Stanley Jevons [10] , Carl
Menger [11] and Léon Walras [12]. Their contributions have been brought together by Alfred
Marshall in his Principles of Economics [13], which provides the reader with an accessible and
readable (and non-mathematical) account of those and other contributions. The concept of utility,
was given more prominence, and it was demonstrated logically (and mathematically) that a
rational consumer would continue to buy additional units of a product until its marginal utility
(the increase in utility obtainable from one additional unit of the product) became level with to
its price; and that a rational supplier would continue to offer additional units of a product until
its marginal cost became level with the marginal revenue that he would get from selling it. The
American economist, John Bates Clark, subsequently applied the concept to a market in which a
rational employer would continue to hire labour until its marginal product became level with the
prevailing wage rate.
Equilibrium and the Price Mechanism
The concept of "market equilibrium" is central to the neoclassical model. Léon Walras [14] thought
of it as the achievement of an imaginary auctioneer who adjusts a notional opening price in
response to a succession of bids by buyers and sellers, and permits transactions to take place only
when a price is reached at which buyers are willing to buy all that is offered for sale. That is the
process of price determination by supply and demand which marks the abandonment of the
concept of value-determined price, and which is examined in detail in Alfred
Marshall's Economics and in Milton Friedman's Price Theory[15]. Walras, and subsequently the
Italian economist Vilfredo Pareto [16], later developed the concept of a general equilibrium in
which supply is equal to demand in every market in a closed economy. The normal assumption
of neoclassical economics is that of a stable equilibrium to which the economy will automatically
return after a disturbance. In such an economy, unemployment does not persist because any
excess in the supply of labour, relative to its demand, is corrected by a reduction in wages.
Welfare and Efficiency
The most politically influential of the contributions of the neoclassical economists was probably
their development of the concept of welfare. In accordance with the precepts of representative
government, they assumed the criterion for the success of an economic system to be the welfare
of the individual, and they introduced the concept of economic efficiency as a measure of that
success. Vilfredo Pareto took the lead in defining efficiency as a state in which no-one could be
made better off without making someone worse off. The three types of efficiency were identified
as productive efficiency (the production of good at minimum cost), allocative efficiency (the
provision of the mix of goods that consumers want) and distributive efficiency (the distribution
of the goods in such a way as to maximise individual welfare). That work laid the foundations
for the subsequent development of the theory of welfare economics by Sir John Hicks and others.
(The subject of economic welfare is discussed extensively in Arthur Pigou's Economics of
Welfare [17], and the theorems of welfare economics are summarised in William
Baumol's Economic Theory and Operations Analysis [18])
Competition
The theorems of welfare economics establish a presumption that allocative efficiency - that is to
say that resources will be optimally allocated as between the production of alternative products -
will be achieved under the hypothetical conditions of perfect competition. (Those conditions
include the requirement that for each product there is no supplier large enough to influence
prices, that all producers supply identical products, and that all consumers are well informed and
behave rationally.) Despite the unreasonableness of those requirements, most economists
advocate a presumption that restrictions upon competition will result in a reduction in
efficiency . Those theoretical developments were the foundation for antitrust and other forms
of competition policy, the economics and politics of which have been developed by George
Stigler .
The theory of the firm
The tools of welfare economics were also used to develop the theory of the firm by Nicholas
Kaldor of the London School of Economics in his Equilibrium of the Firm [19] and Ronald Coase
in his "The Nature of the Firm [20]. (Those theoretical developments have been summarised in
William Baumol's Economic Theory and Operations Analysis [21]. An empirical study of the way
firms actually behave is provided by Cyert and March's Behavioral Theory of the Firm [22])
Economic growth
There has been succession of attempts to create models of economic growth that identify the
contributions of such factors as investment, productivity, innovation and institutional
environment; and that explain the differences in growth experienced by different regions of the
world. In the simple model proposed by Malthus in 1850, growth could not exceed population
growth, but it was not long before it became evident that it was doing so. The Harrod-Domar
model [23], and its successors, assume that there would be sufficient economic growth to enable
some to go into growth-enhancing investments. In a later development, the 1956 Solow
model [24] introduced the influence of the substitution of capital for labour that results from
investment in improved capital equipment. Solow also pioneered the technique of growth
accounting , which he used to estimate relative contributions to historical growth in the United
States; and he identified an unexplained residual which he termed total factor productivity, the
growth of which he attributed to technological change. Technological change was exogenous to
the Solow model, in that it was not the consequence of factors that were represented in the
model. As a result of subsequent research, notably that of Paul Romer [25] and Robert Lucas [26],
some of the factors believed to influence technological change, such as expenditure on R&D and
training, have since been embodied in the growth models, which are termed endogenous
growth models. The most recent work on the subject has sought to identify the contributions to
economic growth of institutional factors such as quality of governance, trust, and ethic diversity;
and to explore its links with geographical factors and globalisation.

Keynesian macroeconomics
The contribution of John Maynard Keynes
The most important contribution to economic thought by John Maynard Keynes was his
examination of the factors determining the levels of national income and employment, and the
causes of economic fluctuations. His major (and hard to read) work, the General Theory of
Employment, Interest and Money, contains a sustained attack on much of the thinking of classical
economics - mainly on the grounds that their postulates were unrealistic. His first target was
Say's law of markets with its denial of the possibility of a general deficiency of demand. He
challenged its implicit assumption that money is no more than a medium of exchange by drawing
attention to the speculative motive for holding money. Secondly, he attacked the classical
economists' contention that it was the interest rate that reconciled savings plans with investment
plans, claiming that the level of savings was largely determined by the level of national income.
Thirdly, he rejected the classical economists' assumption that any tendency for unemployment to
rise would be corrected by a reduction in the general level of wages, substituting the contention
that "wages are sticky downward". Having substituted his assumptions for those of his
predecessors, he advanced the thesis that a deficiency of demand could occur if there was an
excess of planned savings over planned investment, because such an excess could be removed
only by a reduction in national income. The implication of that thesis was that the economy
could settle down into a condition of high unemployment, lacking the self-righting mechanism
envisaged by the classical economists.
Neo-Keynesianism
Shortly after the publication of Keynes' General Theory, John Hicks published an article entitled
"Mr Keynes and the Classics"[27], in which he produced a synthesis between the Keynesian and
neoclassical models. Its main feature is the IS/LM diagram with its intersecting curves, one of
which (Investment/Savings) relates the demand for savings to the interest rate, and the other
(Liquidity/Money Supply) relates the demand for money to the interest rate - and in which the
point of intersection of the two curves represents an equilibrium level of demand. (The IS/LM
diagram subsequently came to be known as the Hicks-Hansen diagram in recognition of prior
work by the American economist Alvin Hansen . The important feature of the synthesised model
is that it can be made to depict behaviour in accordance with either the Keynesian model or the
neoclassical model, depending upon what is assumed concerning the slopes of the two curves. In
doing so it introduced a fundamental departure in the methodology of economics - a change from
an exclusive reliance upon logical deduction from a priori postulates, to the increasing use of
the inductive process of testing hypotheses against empirical evidence, that was made possible at
the time by the comparatively recent practice of systematically collecting economic statistics.
The work of a large body of economists was subsequently devoted to testing such hypotheses,
using the mathematical technique known as "econometrics". That work does not appear to have
resolved the controversy concerning the usefulness of the two models (except that some
economists now acknowledge that one or the other seems to have worked better from time to
time and in some countries' economies)
Policy Implications
A Keynesian consensus dominated the economic policies of the developed countries for two or
three decades following the second world war. Keynesian stabilisation policy required
governments to counter downturns in demand by cutting taxes or increasing public expenditure.
Since it takes some years for such actions to take effect, their timing had to be based upon
forecasts using computerised economic forecasting models, but forecasting errors and misguided
attempts to stimulate growth often had destabilising consequences. Measures that unwittingly
stimulated demand at a time when an economy was operating at its full capacity, frequently gave
rise to rising inflation - for which the only remedy appeared to be wage restraint - and the
situation was sometimes exacerbated by the operation of foreign exchange policies. Opposition
to those policy actions came from economists of the Austrian School, and from economists of
the Chicago School whose thinking is described below.

Monetarism and the Chicago School

The Chicago School
The University of Chicago School of Economics [28] has enjoyed a reputation for economic
excellence since its foundation in 1892 However, the term Chicago School is usually taken to
refer to the outlook and methodology of its economists during the period that started in the 1960s
- including Milton Friedman, George Stigler, Ronald Coase, Robert Lucas, Cary Becker, Harry
Johnson and Merton Miller, and to some like-minded economists in other universities. It is best
known for its advocacy of monetarism but its economists have also made contributions on a wide
range of other topics, including international trade, rational expectations and institutional
economics. Their methodology embodies an approach, which philosophers term instrumentalist,
that gives the predictive value of a theory priority over the representativeness of its
assumptions [29]
Monetarism
The quantity theory of money, which is often attributed to the economist Irving Fisher, but which
undoubtedly had earlier origins, equated the volume of money in circulation multiplied by a
notional "velocity of circulation". to the volume of physical output multiplied by its unit price
(usually written as MV = PT). If the velocity of circulation were roughly constant, that would
imply an association between inflation and growth in the money supply. Milton Friedman found
that to have been the case during various periods in United States history [30], and that periods of
monetary expansion had been followed by periods of inflation, although with long and variable
time-lags. That led him to argue that Keynesian demand management would be ineffective in the
long run because it would be accompanied by a damaging rise in the money supply; and that
stability of demand and prices could better be achieved by control of the money supply. The
controversy that followed was mainly concerned with the nature of the transmission
mechanism (the question whether an excess of money would bid up the prices of goods, or
whether it would be invested in interest-bearing bonds without affecting the prices of goods).
A theory connecting the money supply and the balance of payments had previously been put
forward by Harry Johnson when he was a professor of economics at Manchester University. The
conventional view had been that the exchange rate is determined by the balance between the
supply and demand of exports and imports, but Harry Johnson treated it as the relative price of
the moneys in circulation in the two countries [31]. One of the implications of his theory is that if
the exchange rate is fixed, the money supply cannot be controlled - which was a consideration
that influenced the Chicago School's campaign to put an end to the system of fixed exchange
rates then in operation. Another is that if the money supply is held constant, the balance of
payments is self-correcting.
Expectations
Milton Friedman also attacked the thinking behind the Phillips curve (which had reflected the
observation that inflation tended to fall when there was a rise in unemployment) on the grounds
that it failed to take account of expectations. He proposed its replacement by the expectations-
augmented Phillips curve [32], and used that construction to counter fears that a reduction in
growth of the money supply would lead to a sustained increase in unemployment. To do so, he
introduced the concept of the non-accelerating-inflation rate of unemployment (NAIRU), which
is usually referred to as its natural rate, and which is the unemployment rate at which the
expected inflation rate is the same as its actual rate. He argued that if a reduction in money
supply growth caused unemployment to rise above its natural rate, the expected inflation rate
would fall, setting in motion a sequence of events that would cause unemployment to revert to its
natural rate. Conversely, a reduction in unemployment accompanying an increase in the money
supply would cause an increase in expected inflation, prompting wage demands which would
lead to an increase in actual inflation - a process which could continue indefinitely.
Applying the concept of "rational expectations"[33] formulated by his former colleague, John
Muth, to the operation of economic policy, Robert Lucas of the Chicago School put forward
what has become known as the Lucas Critique[34] . He argued that policy actions tend to change
people's expectations so that the same policy action could have future consequences that differ
from the consequences that it had in the past. That possibility has fundamental implications for
the construction of forecasting models, and the Lucas critique also raises the possibility that
public reactions could frustrate the achievement of policy objectives.
Policy implications and outcomes
The Chicago School's prescription for stabilisation problem was confined to the control
the money supply, and its prescription for the reduction of unemployment was to take measures
to improve wage - and price flexibility. Concern for rising inflation, and the failure of attempts to
control it by wage restraint, led to the widespread adoption of the first of those prescriptions in
the late 1970s. In the United States, the Congress passed The Full Employment and Balanced
Growth Act (known as the Humphrey-Hawkins Act) which required the Federal Reserve Bank to
set one-year target ranges for money supply growth twice a year and to report the targets to
Congress. In the United Kingdom, the Callaghan administration adopted a specific money supply
objective: a practice that was enthusiastically adopted by its successor Thatcher administration.
In both countries, attempts to keep the growth of the money supply within pre-set limits were
generally unsuccessful (and in the United Kingdom, money supply growth actually increased [35])
and were eventually abandoned. Some central bankers have said that they take account of long-
term money supply trends, but none consider control of the money supply to be a practicable
instrument of stabilisation policy. Consensus monetary policy since the late 1980s uses interest
rates as a means of stabilising both prices and output[36], and the median inflation rate in 13
industrialised countries has fallen from around 15 per cent in the mid 1970s and early 1980s to
around 2 per cent in 2005[37].

Institutional Economics
The Institutionalist School
The term Institutionalist refers to economists who argue that economic activity cannot properly
be understood except in the context of the public and social structure in which it takes place.
That approach to the can be traced back to the German Historical School, which included
Friedrich List and Max Weber, who is best known for his The Protestant Ethic and the Spirit of
Capitalism. But the term is more commonly applied to the views of a pre-war group of American
economists whose leading member was Thorstein Veblen - the man who coined the
term conspicuous consumption - and whose lasting contributions were the collection of economic
statistics and the study of business cycles.
Modern institutional economics
A major contributor to the theory of institutional economics has been Ronald Coase, who
summarised his approach in his 1991 Nobel Prize lecture [38]. Early in his career as an economist
he had formulated what came to be known as the Coase Theorem which was the proposition that
economic efficiency will be achieved provided that property rights are fully allocated and can
freely be traded; a proposition which he developed further in his 1960 paper The Problem of
Social Cost [39]. The development of institutional economics by economists at the University of
Chicago has taken them across the conventional borders of economics into the disciplines of law,
sociology and politics. (An extreme example has been the publication of the best-
selling Freakonomics that was jointly authored by the Chicago economist Steven Levitt and the
New York journalist Stephen Dubner, and which applies economic thinking to such questions as
cheating, drug dealing and the connection between crime and abortion.)
Mechanism design theory
A recent extension to institutional economics is concerned with how well different institutions
and allocation mechanisms achieve goals such as welfare and private profit. Contributions to that
subject by Leonid Hurwicz of the University of Minnesota, Eric Maskin of Princeton and Roger
Myerson of Chicago earned them the 2007 Nobel Prize in Economics.
Public choice theory
A different approach to the same questions [40] had previously been put forward under the
heading of public choice theory, the principle contribution to which had been James Buchanan
and Gordon Tullock's major treatise, The Calculus of Choice [41]. However, Buchanan and
Tullock are best known for their analysis of the behaviour of politicians, civil servants and voters
on the assumption that they are mainly motivated by personal gain, rather than a desire to serve
the public interest.

International economics
The gains from trade
David Ricardo's law of comparative advantage - and its implication that trade restrictions are
damaging to the interests of the country that imposes them - was the starting-point of the
historical development of trade theory [42]. The subsequent theoretical developments of
"classical" trade theory have mainly been attempts to create mathematical models of inter-
country trade. The best-known of those was the Heckscher-Ohlin Theory [43], which deduced
from a range of highly restrictive assumptions that a country will export those commodities that
are intensive in the factor of production in which it is most well-endowed. That theory was
extended by Paul Samuelson to conclude that, in the absence of productivity differences, trading
between two countries would tend to equalise wages and capital costs in those countries.
However, doubt was cast upon the relevance of the Heckscher-Ohlin theory by Wassily
Leontief's discovery that the United States, which is the world's most capital-intensive country,
had been exporting labour-intensive commodities and importing capital-intensive commodities.
The general conclusion has been that international trade is mainly driven by factors other than
labour-intensity and capital-intensity. "Modern" trade theory depends mainly upon the
econometric analysis of international trade statistics,and has produced a range of findings
concerning the influence of factors such as innovation and training.
Infant industries
There was opposition in the early nineteenth century to the proposition that trade restrictions
reduce welfare from a small group of economists, including Friedrich List of the German
Historical School, who argued that free trade should not be permitted until the government had
taken the measures necessary to establish the country's "productive powers". That was the
precursor of the argument for infant-industry protection that was politically influential in the
early twentieth century and which led to the introduction of the Smoot-Hartley system of
industrial tariffs in the United States. It has been given recent expression in Ha-Joon Chang's
book Kicking Away the Ladder [44] which suggests that industrial successes in Britain and the
United States (and later in creating an automobile industry in South Korea) were attributable to
the fact that they were protected from overseas competition until they were large enough to
benefit from economies of scale. The mainstream reaction among economists concedes that the
case for free trade does not take account of the benefits of scale economies, and that welfare
gains from temporary trade restrictions might in principle be possible if a government were
sufficiently successful in "picking winners" but that tax incentives and subsidies are more
effective than tariffs [45] .
Globalisation
Globalisation is seen by most economists as contributing to economic welfare by promoting
competition and the division of labour. But there are exceptions. Professor Joseph
Stiglitz [46] [47] of the Columbia Business School has advanced the infant industry case
for protection in developing countries and criticised the conditions imposed for help by the
International Monetary Fund [48]. And Professor Dani Rodrik of Harvard[49] has noted that the
benefits of globalisation are unevenly spread, leading to income inequalities that, in his view,
lead to damaging losses of social capital, and to the migration of labour causing social stresses in
receiving countries [50]

Financial economics
Overview
Economists and professional investors gave little attention to financial economics until the
adoption in the 1970s of models based upon the efficient markets hypothesis. That hypothesis
was the basis of risk analysis using the assumption that price variations on the markets for
financial assets could be treated as random variations, which could be represented by
established probability distributions. The international financial industry made use of the models
to select investments that were predicted to give the best return for a stipulated level of risk. It
was not until the 2008 financial crisis that it was widely recognised that the efficient market
hypothesis was no more than a statement of a general tendency, and that additional risks could
arise from statistically unpredictable patterns of investor conduct.
The finance market
The study of financial economics had its origin in a 1900 thesis entitled Theorie de la
Speculation by the French mathematician Louis Bachelier [51], according to which price
fluctuations in a speculative market are analogous to the Brownian Movement of physics
(the random walk of statistics theory), such that there is no combination of prices that offer the
prospect of a certain gain. In 1933, the American economist Alfred Cowles[52] developed a
similar thesis, which he published in a paper entitled Can Stock Market Forecasters Forecast?.
According to Cowles' efficient market hypothesis, all of the available information that was
relevant to an asset's prospects would already be embodied in its price (so that the answer to his
question was "no"). The hypothesis depended upon the assumptions that most traders behave
rationally, and that the activities of the others are mutually cancelling. Those assumptions were
widely accepted, and on their basis, financial markets were taken to be essentially stable. Hyman
Minsky's 1986 financial instability hypothesis, which suggested that financial markets are apt to
become unstable after a period of sustained economic growth, received little attention at the time.
A number of mathematical models of finance markets based upon the efficient markets
hypothesis were developed in the course of the 20th century and were widely applied as guides
to investment, but financial economics was then considered by most of the economics profession
to be a specialised subject of little general interest, regarding the financial system as a collection
of secondary markets whose internal characteristics do not affect the rest of the economy.
Portfolio and asset price theory
A sequence of Nobel Prize-winning advances concerning the problem of getting the best return
from an investment without exceeding a chosen level of risk, occurred during the period from the
1950s to the 1970s. The sequence started in the late 1950s, when James Tobin [53] and Harry
Markowitz laid the foundations of modern portfolio management. In his "Separation Theorem",
Tobin proposed a two-stage process in which the required risk ceiling could be maintained by
mixing risky and riskless assets, and Markowitz demonstrated the benefits of a diversified
portfolio in which the prices of it assets would not rise and fall together, using the statistical
concept of covariance. In 1970, William Sharpe[54] applied that concept to the tendency of the
price of an asset to rise and fall in concert with the all-share index, assigning the title "Beta" to
its mathematical definition, and used it to derive a pricing method know as the Capital Asset
Pricing Model, and in 1973, Fischer Black [55] and Myron Scholes [56] developed the Black-
Scholes model which made use of the fact that the expected volatility of an asset is reflected in
its price in the options market, which led to the development by Robert Merton [57] of the
"Contingency Claims Analysis" method of pricing assets.
Corporate finance
During the same period there was a sequence of advances in the economics of corporate finance.
It started with the demonstration by Franco Modigliani [58] and Merton Miller [59] that
shareholders should be indifferent to the level of a corporation's debts provided that it was
possible to repay them costlessly with money available at a riskless rate of interest. Other
economists subsequently augmented the Modigliani-Miller theory with allowances for the effects
of taxation and of information asymmetry.

Recent developments
The Greenspan era
Divergences of view about economic management persisted into the early 21st century, but a
consensus developed among those responsible for the management of the major economies,
along the lines of a speech by the then United States Federal Reserve Board Chairman, Alan
Greenspan[60]. The use of Keynesian fiscal policy to regulate output was considered to have
proved ineffective and inflationary, and monetarist attempts to control the money supply were
seen to have been unsuccessful. The new rôle of fiscal policy was the maintenance of fiscal
stability, responsibility for the management of the economy had become the exclusive function
of monetary policy, and monetary policy was confidently expected to prevent serious
interruption to economic growth (the President of the American Economic Association had
declared that "The central problem of depression-prevention [has] been solved, for all practical
purposes"[61]). The financial system was considered to be essentially stable, making financial
regulation unnecessary.
The conclusion of the era was marked by Alan Greenspan's 2008 congressional testimony:
 "In recent decades, a vast risk management and
pricing system has evolved combining the best
insights of mathematicians and finance experts
supported by major advances in computer and
communications technology. A Nobel prize was
awarded for the discovery of the pricing model that
underpins much of the advance in the derivatives
markets. This modern risk management paradigm held
sway for decades. The whole intellectual edifice,
however, collapsed in the summer of last year."[62]
The shortcomings of economic theory in that respect have been
held [63] to have played a major role in the the financial crisis of
2008.
Post-Great Recession thinking
The financial crisis of 2008 and the resulting Great
Recession prompted much re-thinking of economic theory.
Professor Shin of Princeton University reported that the "race is
on" to add a new perspective to macroeconomics by the
incorporation into it of a new theory of financial economics[64],
and there was new thinking about the use of financial
regulation to reduce the risk of fresh financial shocks. A re-
examination of the rôle of fiscal policy had been triggered among
economists and politicians by a 2008 proposal by
Britain's Gordon Brown for a coordinated fiscal stimulus to
counter the expected recessionary effects of the financial crisis.
The idea was dismissed as ineffective by some economists[65][66],
and as inflationary by others [67], and it was rejected by
Germany's Angela Merkel[68] and ridiculed by her finance
minister as "crass Keynesianism"[69] Although fiscal stimulus
packages were implemented during the recession of 2009, they
were not sustained by European governments to support the
faltering recovery in 2010, and programmes of fiscal
contraction were widely introduced in 2011. The main reason that
was given for that reversal of fiscal policy was the fear that
operators in the bond market would lose confidence in
governments' ability to service the levels of public debt that their
continuation would involve. The European Union's Fiscal
Compact (which places mandatory restrictions upon the use of
fiscal policy by its signatories) may gain political approval, but
its economic consequences are likely to remain a matter of
controversy. Unlike the European governments, the United States
government has not introduced a major programme of fiscal
contraction, and the Congress has not been able to agree on a
plan for the reduction of the government's budget deficit[70]. A
controversy also remains unresolved concerning the merit of
techniques known as quantitative easing by which central
banks seek to increase the money supply in order to relieve credit
crunches and stimulate economic activity[71][72].
The history of economic thought has taken an unexpected turn,
and a new consensus on economic management has not yet
emerged.

References
1. ↑ David Hume David Hume Essays, Moral and Political, 1742,
Vol 2 "Of the Balance of Trade" (published by Liberty Fund,
1985).
2. ↑ Adam Smith, The Wealth of the Nations (Modern Library, 2000).
3. ↑ Jean-Baptiste Say
4. ↑ Thomas Malthus, Essay on the Principle of Population.
5. ↑ Nicolas Wade Why Malthus Was Mistaken, New York Times,
September 19, 1999
6. ↑ David Ricardo, The Principles of Political Economy and
Taxation (John Murray, 1821).
7. ↑ Karl Marx
8. ↑ Karl Marx, Das Kapital (abridged).
9. ↑ John Stuart Mill, Principles of Political Economy, (Longmans
Green, 1926.
10. ↑ William Stanley Jevons, 1835-1882
11. ↑ Carl Menger, 1841-1921
12. ↑ Marie Esprit Léon Walras (1834-1910)
13. ↑ Alfred Marshall Principles of Economics Macmillan 1890
14. ↑ Léon Walras
15. ↑ Milton Friedman: Price Theory, Transaction Publishers, 2007
16. ↑ Vilfredo Pareto
17. ↑ Arthur C Pigou The Economics of Welfare Macmillan 1920,
18. ↑ William Baumol Economic Theory and Operations
Analysis Chapter 13, Prentice-Hall 1961
19. ↑ Nicholas Kaldor The Equilibrium of the Firm the Economic
Journal 1934
20. ↑ Ronald Coase: The Nature of the Firm, Economica, November
1937
21. ↑ William Baumol Economic Theory and Operations
Analysis Chapters 9 and 10, Prentice-Hall 1961
22. ↑ Richard Cyert and James G March The Behavioral Theory of the
Firm Prentice-Hall 1963
23. ↑ Roy Harrod An essay in dynamic theory Economic Journal
March 1939
24. ↑ Robert Solow A Contribution to the Theory of Economic
Growth Quarterly Journal of Economics 70 1956
25. ↑ Paul Romer Endogenous Technological Change Journal of
Political Economy October 1986
26. ↑ Robert Lucas Jr On the Mechanics of Economic
Development Journal of Monetary Economics July 1988
27. ↑ John Hicks Mr Keynes and the Classics(Econometrica, April
1937)
28. ↑ The University of Chicago Department of Economics
29. ↑ Milton Friedman The Methodology of Positive Economics
30. ↑ Friedman and Meiselman The relative stability of monetary
velocity and the Investment Multiplier in the United States 1897-
 1958 in Stabilisation Policies, CMC Research Papers p165
Prentice-Hall 1964
31. ↑ Harry G Johnson International Trade and Economic
Growth Chapter 6 Harvard UP 1958
32. ↑ Edmund Phelps Money wage dynamics and labor market
equilibrium. Journal of Political Economy 1968
33. ↑ John Muth "Rational Expectations and the Theory of Price
Movements" Econometrica, Vol. 29, No. 3, July 961)
34. ↑ Robert Lucas Econometric Policy Evaluation: A
Critique. Carnegie-Rochester Conference Series on Public Policy
1: 19–46 1976
35. ↑ Nick Gardner Decade of Discontent p207 Basil Blackwell 1987
36. ↑ Charles Bean Is There a Consensus in Monetary Policy?
37. ↑ Kenneth Kuttner and Adam Posen Do Markets Care Who Chairs
the Central Bank NBER Working Paper 13101 02007
38. ↑ Ronald Coase The Institutional Structure of Production The
Nobel Prizes 1991, Nobel Foundation 1992
39. ↑ Ronald Coase The Problem of Social Cost Journal of Law and
Economics October 1960
40. ↑ Public Choice
41. ↑ James Buchanan and Gordon Tullock The Calculus of Consent
42. ↑ Douglas Irwin Against the Tide: An Intellectual History of Free
Trade Princeton University Press 1997
43. ↑ Eli Heckscher and Bertil Ohlin Heckscher-Ohlin Trade Theory
(Ed Harry Flam and . June Flanders) MIT Press
44. ↑ Ha-Joon Chang Kicking Away the Ladder
45. ↑ Bhagwati and Ramaswami. Domestic Distortions, Tariffs and
the Theory of Optimum Subsidy - Some Further Results Journal of
Political Economy, 1969, vol. 77, issue 6, pages 1005-10' (1963)
46. ↑ Joseph Stiglitz website
47. ↑ Interview with Joseph Stiglitz
48. ↑ Joseph Stiglitz Globalization and its Discontents" Norton 2002
49. ↑ Dani Rodrik's website
50. ↑ Dani Rodrik Has Globalization Gone Too Far?. Institute for
International Economics 1997.
51. ↑ Jean-Michel Courtault, Yuri Kabarov And Bernard Bru: "Louis
Bachelier and the Centenary of the Theorie de la
Speculation", Mathematical Finance Vol10 No3 July 2000
52. ↑ Alfred Cowles
53. ↑ James Tobin
54. ↑ William Sharpe
55. ↑ Fischer Black
56. ↑ Myron Scholes
57. ↑ Robert Merton
58. ↑ Franco Modigliani
59. ↑ Merton Miller
60. ↑ Alan Greenspan: The Challenge of Central Banking in a
Democratic Society, (lecture to The American Enterprise Institute
for Public Policy Research, December 5, 1996, Federal Reserve
Board 1996
61. ↑ Robert E. Lucas, Jr: Presidential Address to the American
Economic Association, January 10, 2003
62. ↑ Testimony of Dr. Alan Greenspan before the Committee of
Government Oversight and Reform October 23, 2008
63. ↑ for example by Professor Shin of Princeton University Hyun
Song Shin: Interview with Ramesh Vatilingam, 4 September 2009
64. ↑ Hyun Song Shin: Interview with Ramesh Vatilingam, 4
September 2009
 65. ↑ Eugene Fama: Bailouts and Stimulus Plans January 2009
66. ↑ Keynesian over-spending won't rescue the economy, Letter by
IEA economists in the Sunday Telegraph, 26 October 2008
67. ↑ Allan Meltzer: Inflation Nation, New York Times op-ed, 3rd
May 2009
68. ↑ Catherine Mayer: Behind a Merkel Snub, Euro Economic
Discord, Time, 9 December 2008
69. ↑ Tristana Moore: Steinbrueck 'shouldn't scare UK'BBC News 12
December 2008
70. ↑ Joint Select Committee on Deficit Reduction (Deficit "Super
Committee"), New York Times, 22 March, 2012
71. ↑ Lori Ann LaRocco: CEOs Debate the Merits of QE2, CNBC
News, 21 Oct 2010
72. ↑ Open Letter to Ben Bernanke, 15 November 2010
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 Contents

 1Overview: categories of economic thought

 2Classical Economics
o 2.1David Hume
o 2.2Adam Smith
o 2.3Jean-Baptiste Say
o 2.4Thomas Malthus
o 2.5David Ricardo
o 2.6Karl Marx
o 2.7Other contributors
 3Neoclassical Economics
o 3.1The neoclassical approach
o 3.2Marginal analysis
o 3.3Equilibrium and the Price Mechanism
o 3.4Welfare and Efficiency
o 3.5Competition
o 3.6The theory of the firm
o 3.7Economic growth
 4Keynesian macroeconomics
o 4.1The contribution of John Maynard Keynes
o 4.2Neo-Keynesianism
o 4.3Policy Implications
 5Monetarism and the Chicago School
o 5.1The Chicago School
o 5.2Monetarism
o 5.3Expectations
o 5.4Policy implications and outcomes
 6Institutional Economics
o 6.1The Institutionalist School
o 6.2Modern institutional economics
o 6.3Mechanism design theory
o 6.4Public choice theory
 7International economics
o 7.1The gains from trade
o 7.2Infant industries
o 7.3Globalisation
 8Financial economics
o 8.1Overview
o 8.2The finance market
o 8.3Portfolio and asset price theory
o 8.4Corporate finance
 9Recent developments
o 9.1The Greenspan era
 o 9.2Post-Great Recession thinking
 10References
Modern economic thought is generally considered to have originated in the late eighteenth
century with the work of David Hume and Adam Smith, the founders of classical economics.
The nineteenth and twentieth centuries saw major developments in the methodology and scope
of economic theory; and the early twenty-first century has seen a rethinking of some previously
accepted tenets.
Nineteenth- and early twentieth-century economists applied deductive reasoning to axioms
considered to be self-evident and simplified assumptions which were thought to capture the
essential features of economic activity. That methodology yielded concepts such
as elasticity and utility, tools such as marginal analysis, and theorems such as the law
of comparative advantage. An understanding of the relationships governing transactions between
consumers and producers was considered to provide all that was necessary to explain the
behaviour of the economic system.
The development, in the latter half of the 20th century, of systems of economic statistics enabled
economists to use inductive reasoning to test theoretical findings against observed economic
behaviour, and to develop new theories. By that time, the concept had emerged of the national
economy as a complex interactive system, and analysis of that concept provided explanations
of recessions, unemployment and inflation that were not previously available. The application of
empirical data and inductive reasoning enabled those theories to be refined, and led to the
development of forecasting models that could be used as tools of economic management.
The development of economic thought in the early 21st century has been stimulated by
the financial crisis and Great Recession, and the questions that these events raised concerning the
functioning of the global financial system and the part that it plays in the functioning of
the economic system generally.
The search for understanding continues.

Overview: categories of economic thought

Historians categorise economic thought into “periods” and “schools”, and tend to attribute each
innovation to one individual. This categorisation is helpful for the purpose of exposition, but the
reality has been a story of interwoven intellectual threads in which advances attributed to
particular individuals or schools have often prompted the work of others. For example, the
quantity theory of money, which achieved prominence in the twentieth century and is associated
with Milton Friedman, was first formulated at least three centuries earlier. Many of those
threads, that have permeated the categories referred to as "Classical economics" and
"Neoclassical economics", had earlier origins. "Classical", in economics, denotes the adoption in
the late eighteenth century of an approach that was inspired by the enlightenment and the
methodology of the physical sciences, and that had abandoned previous examinations of
economics in terms of ethics, religion and politics. Preoccupation with those threads was
overshadowed in the twentieth century by the responses of Keynesianism and monetarism to the
problems of unemployment and inflation, but the development of neoclassical economics started
before that time, and has continued thereafter. The introduction of new tools of exploration has
since led to the vigorous development of that, and other, threads, and an expansion in the scope
of economics into many new directions.
Classical Economics
David Hume
The Scottish philosopher David Hume was an early exponent of what was later known
as monetary economics, and was an opponent of "mercantilism". Mercanilist policy at the time,
regulated trade in ways that subsidised exports so as to promote inflows of gold and silver, and
restricted imports in order to discourage outflows. Hume contested the mercantilist thesis, partly
on the grounds that an inflow of money would cause inflation, and partly on the grounds that
nations would benefit from the international specialisation that would result from the
introduction of free trade. More generally, Hume argued that all government intervention in
commerce tended to obstruct economic progress.[1].
Adam Smith
A major advance in the development of economics occurred with the publication in 1776
of Adam Smith's An Inquiry into the Nature and Causes of The Wealth of Nations.[2]. Smith
wrote a comprehensive treatment of the subject, using deductive logic in a manner similar to its
use in the physical sciences. His main purpose was to recommend changes of economic policy in
the interests of economic growth. He argued that the division of labour was the main cause of
economic growth. His famous maxim was that the extent of the market is determined by the
division of labour. To thus expand markets, required that they should not be impeded by
governmental policies. He therefore opposed government intervention in commerce (as in
mercantilist trade regulation). But he did not oppose all governmental intervention into the
economy. He advocated government spending upon what are now termed public goods such as
defence, law enforcement, infrastructure, and education of the children of people who could not
afford it. He identified what he considered to be the economic drawbacks of all forms
of taxation (except the taxation of land values) and of public expenditure. He examined the
relation of price to value and concluded that the price of a product tends to equality with its cost
of production, which he termed its "natural price". He reasoned that "when the quantity brought
to market is just sufficient to supply the effectual demand and no more, the market price
naturally comes to be either exactly, or as nearly as can be judged of, the same with the natural
price" - an outcome which he took to be the normal result of market bargaining.
Jean-Baptiste Say
Jean-Baptiste Say[3] was an influential advocate of Adam Smith's teaching in French government
circles, but his best-known contribution was what came to be known as "Say's Law of Markets."
Later paraphrased as "supply creates its own demand," Say's law stated that, although there could
be an imbalance between the supply and the demand for particular products, no such imbalance
could exist in the economy as a whole. It was based upon the postulate that money plays no part
in the functioning of the economy beyond its role as a medium of exchange. (The claim that
money is nothing but a medium of exchange, is another way of saying that people use money
only for buying things (including stocks and bonds). Say justified that postulate by arguing that it
would be foolish to hold money out of circulation because that would mean needlessly going
without things (or without dividends or interest). Say's Law remained part of mainstream
classical economics until John Maynard Keynes drew attention to
the speculative and precautionary motives for holding money.
Thomas Malthus
In his influential Essay on the Principle of Population, Thomas Malthus postulated that the
population would grow at a geometric rate (2, 4, 8, 16...) while food production could only
increase arithmetically (1, 2, 3, 4 ....) and concluded that the food supply would eventually be
insufficient to support the population.[4] This theory led him to oppose the introduction of the
UK's Poor Law, and to advocate the protection of agriculture. In other respects, he followed
Adam Smith in opposing government intervention in commerce. Evidence in support of his
postulates was lacking at the time, and they have since been found to be mistaken[5], mainly
because they took no account of the benefits of technical change.
David Ricardo
With minor reservations, David Ricardo accepted and extended Adam Smith’s economics. In his
major work,The Principles of Political Economy and Taxation, he accepted the concept of a
value-determined “natural price”, although he considered value to be determined by labour value
added, rather than cost.[6] Following Adam Smith’s lead, he also developed the wage
fund concept that the amount available for the payment of wages is fixed at any particular level
of capital investment, so that an increase in the supply of labour would lead to a reduction in
wage rates. He pioneered a definition of rent as the difference between the produce of a unit of
labour on the land in question, and its produce on the least productive land in use. In a further
extension to Adam Smith’s work, he explored the incidence of taxation on wages, profits,
houses, and rent, identifying in each case (but with the exception of rent) its harm to the
economy. Probably his most influential contribution, however, was his development of his "Law
of Comparative advantage" that challenged the belief that the trading of a product is possible
only with those with a lesser ability to produce it. Ricardo produced a logical demonstration that
there can be mutually beneficial trade between two countries, one of which is better able than the
other to produce all of the commodities that are traded.
Karl Marx
Karl Marx[7] adapted Ricardo's concept of labour value and put it to an entirely different use. In
his analysis, as in Ricardo's, labour consumption determines value. This, Marx termed exchange
value. But Marx regarded each labourer as a product, whose exchange value is determined by the
labour inputs required to feed, clothe, and train him. He reasoned that what the employer
receives is the labourer's use value, which is determined by the utility of his products. Marx
noted that a labourer's use value normally exceeds his exchange value, and he termed the
difference surplus value, which was the employer's profit. Like Adam Smith and his classical
predecessors, Marx was preoccupied with the subject of economic growth but, unlike them, he
saw technical progress as a major contributor.
Marx was probably the first economist to make a systematic attempt to explain the fluctuations
in economic activity known as the business cycle. He considered that if technical progress were
to slow down, the only way to maintain growth would be to invest more and more in machinery
and buildings, as a result of which the rate of profit on new investment would fall, leading to a
further reduction in growth. Also, in his view, any departure from the conditions necessary for
steady growth would lead to the accumulation of unwanted stocks of goods, producing a
downturn in economic activity - until price-cutting, in order to get rid of surpluses, put the
process into reverse.
In his major work, Das Kapital[8] Marx puts his findings in an historical, concludes that
economic conditions shape history, and forecasts a breakdown of the capitalist system and its
replacement by socialism.
Other contributors
Among the many lesser contributors to classical economic theory, the best-known was John
Stuart Mill. His Principles of Political Economy[9], although intended by the author merely to
bring together the works of others, offered some fresh insights into increasing returns to
scale and their consequences for the development of monopolies, and anticipated (though not in
these terms) the neoclassical concepts of elasticity and the determination of price by the
interaction of supply and demand.
Written during the classical period, but without recognition at the time, was the Theory of the
Firm by the French economist and mathematician Antoine Augustin Cournot. Cournot used
differential calculus to demonstrate the profit-maximising requirement of equality between
marginal cost and marginal revenue, thus anticipating some of the more important developments
of neoclassical economics.

Neoclassical Economics
The neoclassical approach
The term "neoclassical" is commonly applied to all of the continuing developments in economic
thinking that followed the replacement of value-based concepts by the concept of markets that
are governed by the interaction of supply and demand. In that sense, the term denotes a period
rather than a consistent approach - although it is a period that overlaps the competing approaches
of Keynesianism and monetarism. It is nevertheless a period in which most economists have
deduced their findings from the same hypothetical postulates - including the assumption of
competitive markets in which consumers maximise utility and producers maximise profits.
Within that framework of postulates, neoclassical economists have explored a variety of aspects
of economic activity in a variety of different ways.
Marginal analysis
The neoclassical period is also marked by an expansion in the number of people applying their
minds to the problems of economics, as a result of which there have frequently been similar
contributions from a number of different thinkers. That was true of the innovative concepts of
marginal analysis, that are attributable to the contributions of William Stanley Jevons [10] , Carl
Menger [11] and Léon Walras [12]. Their contributions have been brought together by Alfred
Marshall in his Principles of Economics [13], which provides the reader with an accessible and
readable (and non-mathematical) account of those and other contributions. The concept of utility,
was given more prominence, and it was demonstrated logically (and mathematically) that a
rational consumer would continue to buy additional units of a product until its marginal utility
(the increase in utility obtainable from one additional unit of the product) became level with to
its price; and that a rational supplier would continue to offer additional units of a product until
its marginal cost became level with the marginal revenue that he would get from selling it. The
American economist, John Bates Clark, subsequently applied the concept to a market in which a
rational employer would continue to hire labour until its marginal product became level with the
prevailing wage rate.
Equilibrium and the Price Mechanism
The concept of "market equilibrium" is central to the neoclassical model. Léon Walras [14] thought
of it as the achievement of an imaginary auctioneer who adjusts a notional opening price in
response to a succession of bids by buyers and sellers, and permits transactions to take place only
when a price is reached at which buyers are willing to buy all that is offered for sale. That is the
process of price determination by supply and demand which marks the abandonment of the
concept of value-determined price, and which is examined in detail in Alfred
Marshall's Economics and in Milton Friedman's Price Theory[15]. Walras, and subsequently the
Italian economist Vilfredo Pareto [16], later developed the concept of a general equilibrium in
which supply is equal to demand in every market in a closed economy. The normal assumption
of neoclassical economics is that of a stable equilibrium to which the economy will automatically
return after a disturbance. In such an economy, unemployment does not persist because any
excess in the supply of labour, relative to its demand, is corrected by a reduction in wages.
Welfare and Efficiency
The most politically influential of the contributions of the neoclassical economists was probably
their development of the concept of welfare. In accordance with the precepts of representative
government, they assumed the criterion for the success of an economic system to be the welfare
of the individual, and they introduced the concept of economic efficiency as a measure of that
success. Vilfredo Pareto took the lead in defining efficiency as a state in which no-one could be
made better off without making someone worse off. The three types of efficiency were identified
as productive efficiency (the production of good at minimum cost), allocative efficiency (the
provision of the mix of goods that consumers want) and distributive efficiency (the distribution
of the goods in such a way as to maximise individual welfare). That work laid the foundations
for the subsequent development of the theory of welfare economics by Sir John Hicks and others.
(The subject of economic welfare is discussed extensively in Arthur Pigou's Economics of
Welfare [17], and the theorems of welfare economics are summarised in William
Baumol's Economic Theory and Operations Analysis [18])
Competition
The theorems of welfare economics establish a presumption that allocative efficiency - that is to
say that resources will be optimally allocated as between the production of alternative products -
will be achieved under the hypothetical conditions of perfect competition. (Those conditions
include the requirement that for each product there is no supplier large enough to influence
prices, that all producers supply identical products, and that all consumers are well informed and
behave rationally.) Despite the unreasonableness of those requirements, most economists
advocate a presumption that restrictions upon competition will result in a reduction in
efficiency . Those theoretical developments were the foundation for antitrust and other forms
of competition policy, the economics and politics of which have been developed by George
Stigler .
The theory of the firm
The tools of welfare economics were also used to develop the theory of the firm by Nicholas
Kaldor of the London School of Economics in his Equilibrium of the Firm [19] and Ronald Coase
in his "The Nature of the Firm [20]. (Those theoretical developments have been summarised in
William Baumol's Economic Theory and Operations Analysis [21]. An empirical study of the way
firms actually behave is provided by Cyert and March's Behavioral Theory of the Firm [22])
Economic growth
There has been succession of attempts to create models of economic growth that identify the
contributions of such factors as investment, productivity, innovation and institutional
environment; and that explain the differences in growth experienced by different regions of the
world. In the simple model proposed by Malthus in 1850, growth could not exceed population
growth, but it was not long before it became evident that it was doing so. The Harrod-Domar
model [23], and its successors, assume that there would be sufficient economic growth to enable
some to go into growth-enhancing investments. In a later development, the 1956 Solow
model [24] introduced the influence of the substitution of capital for labour that results from
investment in improved capital equipment. Solow also pioneered the technique of growth
accounting , which he used to estimate relative contributions to historical growth in the United
States; and he identified an unexplained residual which he termed total factor productivity, the
growth of which he attributed to technological change. Technological change was exogenous to
the Solow model, in that it was not the consequence of factors that were represented in the
model. As a result of subsequent research, notably that of Paul Romer [25] and Robert Lucas [26],
some of the factors believed to influence technological change, such as expenditure on R&D and
training, have since been embodied in the growth models, which are termed endogenous
growth models. The most recent work on the subject has sought to identify the contributions to
economic growth of institutional factors such as quality of governance, trust, and ethic diversity;
and to explore its links with geographical factors and globalisation.

Keynesian macroeconomics
The contribution of John Maynard Keynes
The most important contribution to economic thought by John Maynard Keynes was his
examination of the factors determining the levels of national income and employment, and the
causes of economic fluctuations. His major (and hard to read) work, the General Theory of
Employment, Interest and Money, contains a sustained attack on much of the thinking of classical
economics - mainly on the grounds that their postulates were unrealistic. His first target was
Say's law of markets with its denial of the possibility of a general deficiency of demand. He
challenged its implicit assumption that money is no more than a medium of exchange by drawing
attention to the speculative motive for holding money. Secondly, he attacked the classical
economists' contention that it was the interest rate that reconciled savings plans with investment
plans, claiming that the level of savings was largely determined by the level of national income.
Thirdly, he rejected the classical economists' assumption that any tendency for unemployment to
rise would be corrected by a reduction in the general level of wages, substituting the contention
that "wages are sticky downward". Having substituted his assumptions for those of his
predecessors, he advanced the thesis that a deficiency of demand could occur if there was an
excess of planned savings over planned investment, because such an excess could be removed
only by a reduction in national income. The implication of that thesis was that the economy
could settle down into a condition of high unemployment, lacking the self-righting mechanism
envisaged by the classical economists.
Neo-Keynesianism
Shortly after the publication of Keynes' General Theory, John Hicks published an article entitled
"Mr Keynes and the Classics"[27], in which he produced a synthesis between the Keynesian and
neoclassical models. Its main feature is the IS/LM diagram with its intersecting curves, one of
which (Investment/Savings) relates the demand for savings to the interest rate, and the other
(Liquidity/Money Supply) relates the demand for money to the interest rate - and in which the
point of intersection of the two curves represents an equilibrium level of demand. (The IS/LM
diagram subsequently came to be known as the Hicks-Hansen diagram in recognition of prior
work by the American economist Alvin Hansen . The important feature of the synthesised model
is that it can be made to depict behaviour in accordance with either the Keynesian model or the
neoclassical model, depending upon what is assumed concerning the slopes of the two curves. In
doing so it introduced a fundamental departure in the methodology of economics - a change from
an exclusive reliance upon logical deduction from a priori postulates, to the increasing use of
the inductive process of testing hypotheses against empirical evidence, that was made possible at
the time by the comparatively recent practice of systematically collecting economic statistics.
The work of a large body of economists was subsequently devoted to testing such hypotheses,
using the mathematical technique known as "econometrics". That work does not appear to have
resolved the controversy concerning the usefulness of the two models (except that some
economists now acknowledge that one or the other seems to have worked better from time to
time and in some countries' economies)
Policy Implications
A Keynesian consensus dominated the economic policies of the developed countries for two or
three decades following the second world war. Keynesian stabilisation policy required
governments to counter downturns in demand by cutting taxes or increasing public expenditure.
Since it takes some years for such actions to take effect, their timing had to be based upon
forecasts using computerised economic forecasting models, but forecasting errors and misguided
attempts to stimulate growth often had destabilising consequences. Measures that unwittingly
stimulated demand at a time when an economy was operating at its full capacity, frequently gave
rise to rising inflation - for which the only remedy appeared to be wage restraint - and the
situation was sometimes exacerbated by the operation of foreign exchange policies. Opposition
to those policy actions came from economists of the Austrian School, and from economists of
the Chicago School whose thinking is described below.

Monetarism and the Chicago School

The Chicago School
The University of Chicago School of Economics [28] has enjoyed a reputation for economic
excellence since its foundation in 1892 However, the term Chicago School is usually taken to
refer to the outlook and methodology of its economists during the period that started in the 1960s
- including Milton Friedman, George Stigler, Ronald Coase, Robert Lucas, Cary Becker, Harry
Johnson and Merton Miller, and to some like-minded economists in other universities. It is best
known for its advocacy of monetarism but its economists have also made contributions on a wide
range of other topics, including international trade, rational expectations and institutional
economics. Their methodology embodies an approach, which philosophers term instrumentalist,
that gives the predictive value of a theory priority over the representativeness of its
assumptions [29]
Monetarism
The quantity theory of money, which is often attributed to the economist Irving Fisher, but which
undoubtedly had earlier origins, equated the volume of money in circulation multiplied by a
notional "velocity of circulation". to the volume of physical output multiplied by its unit price
(usually written as MV = PT). If the velocity of circulation were roughly constant, that would
imply an association between inflation and growth in the money supply. Milton Friedman found
that to have been the case during various periods in United States history [30], and that periods of
monetary expansion had been followed by periods of inflation, although with long and variable
time-lags. That led him to argue that Keynesian demand management would be ineffective in the
long run because it would be accompanied by a damaging rise in the money supply; and that
stability of demand and prices could better be achieved by control of the money supply. The
controversy that followed was mainly concerned with the nature of the transmission
mechanism (the question whether an excess of money would bid up the prices of goods, or
whether it would be invested in interest-bearing bonds without affecting the prices of goods).
A theory connecting the money supply and the balance of payments had previously been put
forward by Harry Johnson when he was a professor of economics at Manchester University. The
conventional view had been that the exchange rate is determined by the balance between the
supply and demand of exports and imports, but Harry Johnson treated it as the relative price of
the moneys in circulation in the two countries [31]. One of the implications of his theory is that if
the exchange rate is fixed, the money supply cannot be controlled - which was a consideration
that influenced the Chicago School's campaign to put an end to the system of fixed exchange
rates then in operation. Another is that if the money supply is held constant, the balance of
payments is self-correcting.
Expectations
Milton Friedman also attacked the thinking behind the Phillips curve (which had reflected the
observation that inflation tended to fall when there was a rise in unemployment) on the grounds
that it failed to take account of expectations. He proposed its replacement by the expectations-
augmented Phillips curve [32], and used that construction to counter fears that a reduction in
growth of the money supply would lead to a sustained increase in unemployment. To do so, he
introduced the concept of the non-accelerating-inflation rate of unemployment (NAIRU), which
is usually referred to as its natural rate, and which is the unemployment rate at which the
expected inflation rate is the same as its actual rate. He argued that if a reduction in money
supply growth caused unemployment to rise above its natural rate, the expected inflation rate
would fall, setting in motion a sequence of events that would cause unemployment to revert to its
natural rate. Conversely, a reduction in unemployment accompanying an increase in the money
supply would cause an increase in expected inflation, prompting wage demands which would
lead to an increase in actual inflation - a process which could continue indefinitely.
Applying the concept of "rational expectations"[33] formulated by his former colleague, John
Muth, to the operation of economic policy, Robert Lucas of the Chicago School put forward
what has become known as the Lucas Critique[34] . He argued that policy actions tend to change
people's expectations so that the same policy action could have future consequences that differ
from the consequences that it had in the past. That possibility has fundamental implications for
the construction of forecasting models, and the Lucas critique also raises the possibility that
public reactions could frustrate the achievement of policy objectives.
Policy implications and outcomes
The Chicago School's prescription for stabilisation problem was confined to the control
the money supply, and its prescription for the reduction of unemployment was to take measures
to improve wage - and price flexibility. Concern for rising inflation, and the failure of attempts to
control it by wage restraint, led to the widespread adoption of the first of those prescriptions in
the late 1970s. In the United States, the Congress passed The Full Employment and Balanced
Growth Act (known as the Humphrey-Hawkins Act) which required the Federal Reserve Bank to
set one-year target ranges for money supply growth twice a year and to report the targets to
Congress. In the United Kingdom, the Callaghan administration adopted a specific money supply
objective: a practice that was enthusiastically adopted by its successor Thatcher administration.
In both countries, attempts to keep the growth of the money supply within pre-set limits were
generally unsuccessful (and in the United Kingdom, money supply growth actually increased [35])
and were eventually abandoned. Some central bankers have said that they take account of long-
term money supply trends, but none consider control of the money supply to be a practicable
instrument of stabilisation policy. Consensus monetary policy since the late 1980s uses interest
rates as a means of stabilising both prices and output[36], and the median inflation rate in 13
industrialised countries has fallen from around 15 per cent in the mid 1970s and early 1980s to
around 2 per cent in 2005[37].

Institutional Economics
The Institutionalist School
The term Institutionalist refers to economists who argue that economic activity cannot properly
be understood except in the context of the public and social structure in which it takes place.
That approach to the can be traced back to the German Historical School, which included
Friedrich List and Max Weber, who is best known for his The Protestant Ethic and the Spirit of
Capitalism. But the term is more commonly applied to the views of a pre-war group of American
economists whose leading member was Thorstein Veblen - the man who coined the
term conspicuous consumption - and whose lasting contributions were the collection of economic
statistics and the study of business cycles.
Modern institutional economics
A major contributor to the theory of institutional economics has been Ronald Coase, who
summarised his approach in his 1991 Nobel Prize lecture [38]. Early in his career as an economist
he had formulated what came to be known as the Coase Theorem which was the proposition that
economic efficiency will be achieved provided that property rights are fully allocated and can
freely be traded; a proposition which he developed further in his 1960 paper The Problem of
Social Cost [39]. The development of institutional economics by economists at the University of
Chicago has taken them across the conventional borders of economics into the disciplines of law,
sociology and politics. (An extreme example has been the publication of the best-
selling Freakonomics that was jointly authored by the Chicago economist Steven Levitt and the
New York journalist Stephen Dubner, and which applies economic thinking to such questions as
cheating, drug dealing and the connection between crime and abortion.)
Mechanism design theory
A recent extension to institutional economics is concerned with how well different institutions
and allocation mechanisms achieve goals such as welfare and private profit. Contributions to that
subject by Leonid Hurwicz of the University of Minnesota, Eric Maskin of Princeton and Roger
Myerson of Chicago earned them the 2007 Nobel Prize in Economics.
Public choice theory
A different approach to the same questions [40] had previously been put forward under the
heading of public choice theory, the principle contribution to which had been James Buchanan
and Gordon Tullock's major treatise, The Calculus of Choice [41]. However, Buchanan and
Tullock are best known for their analysis of the behaviour of politicians, civil servants and voters
on the assumption that they are mainly motivated by personal gain, rather than a desire to serve
the public interest.

International economics
The gains from trade
David Ricardo's law of comparative advantage - and its implication that trade restrictions are
damaging to the interests of the country that imposes them - was the starting-point of the
historical development of trade theory [42]. The subsequent theoretical developments of
"classical" trade theory have mainly been attempts to create mathematical models of inter-
country trade. The best-known of those was the Heckscher-Ohlin Theory [43], which deduced
from a range of highly restrictive assumptions that a country will export those commodities that
are intensive in the factor of production in which it is most well-endowed. That theory was
extended by Paul Samuelson to conclude that, in the absence of productivity differences, trading
between two countries would tend to equalise wages and capital costs in those countries.
However, doubt was cast upon the relevance of the Heckscher-Ohlin theory by Wassily
Leontief's discovery that the United States, which is the world's most capital-intensive country,
had been exporting labour-intensive commodities and importing capital-intensive commodities.
The general conclusion has been that international trade is mainly driven by factors other than
labour-intensity and capital-intensity. "Modern" trade theory depends mainly upon the
econometric analysis of international trade statistics,and has produced a range of findings
concerning the influence of factors such as innovation and training.
Infant industries
There was opposition in the early nineteenth century to the proposition that trade restrictions
reduce welfare from a small group of economists, including Friedrich List of the German
Historical School, who argued that free trade should not be permitted until the government had
taken the measures necessary to establish the country's "productive powers". That was the
precursor of the argument for infant-industry protection that was politically influential in the
early twentieth century and which led to the introduction of the Smoot-Hartley system of
industrial tariffs in the United States. It has been given recent expression in Ha-Joon Chang's
book Kicking Away the Ladder [44] which suggests that industrial successes in Britain and the
United States (and later in creating an automobile industry in South Korea) were attributable to
the fact that they were protected from overseas competition until they were large enough to
benefit from economies of scale. The mainstream reaction among economists concedes that the
case for free trade does not take account of the benefits of scale economies, and that welfare
gains from temporary trade restrictions might in principle be possible if a government were
sufficiently successful in "picking winners" but that tax incentives and subsidies are more
effective than tariffs [45] .
Globalisation
Globalisation is seen by most economists as contributing to economic welfare by promoting
competition and the division of labour. But there are exceptions. Professor Joseph
Stiglitz [46] [47] of the Columbia Business School has advanced the infant industry case
for protection in developing countries and criticised the conditions imposed for help by the
International Monetary Fund [48]. And Professor Dani Rodrik of Harvard[49] has noted that the
benefits of globalisation are unevenly spread, leading to income inequalities that, in his view,
lead to damaging losses of social capital, and to the migration of labour causing social stresses in
receiving countries [50]

Financial economics
Overview
Economists and professional investors gave little attention to financial economics until the
adoption in the 1970s of models based upon the efficient markets hypothesis. That hypothesis
was the basis of risk analysis using the assumption that price variations on the markets for
financial assets could be treated as random variations, which could be represented by
established probability distributions. The international financial industry made use of the models
to select investments that were predicted to give the best return for a stipulated level of risk. It
was not until the 2008 financial crisis that it was widely recognised that the efficient market
hypothesis was no more than a statement of a general tendency, and that additional risks could
arise from statistically unpredictable patterns of investor conduct.
The finance market
The study of financial economics had its origin in a 1900 thesis entitled Theorie de la
Speculation by the French mathematician Louis Bachelier [51], according to which price
fluctuations in a speculative market are analogous to the Brownian Movement of physics
(the random walk of statistics theory), such that there is no combination of prices that offer the
prospect of a certain gain. In 1933, the American economist Alfred Cowles[52] developed a
similar thesis, which he published in a paper entitled Can Stock Market Forecasters Forecast?.
According to Cowles' efficient market hypothesis, all of the available information that was
relevant to an asset's prospects would already be embodied in its price (so that the answer to his
question was "no"). The hypothesis depended upon the assumptions that most traders behave
rationally, and that the activities of the others are mutually cancelling. Those assumptions were
widely accepted, and on their basis, financial markets were taken to be essentially stable. Hyman
Minsky's 1986 financial instability hypothesis, which suggested that financial markets are apt to
become unstable after a period of sustained economic growth, received little attention at the time.
A number of mathematical models of finance markets based upon the efficient markets
hypothesis were developed in the course of the 20th century and were widely applied as guides
to investment, but financial economics was then considered by most of the economics profession
to be a specialised subject of little general interest, regarding the financial system as a collection
of secondary markets whose internal characteristics do not affect the rest of the economy.
Portfolio and asset price theory
A sequence of Nobel Prize-winning advances concerning the problem of getting the best return
from an investment without exceeding a chosen level of risk, occurred during the period from the
1950s to the 1970s. The sequence started in the late 1950s, when James Tobin [53] and Harry
Markowitz laid the foundations of modern portfolio management. In his "Separation Theorem",
Tobin proposed a two-stage process in which the required risk ceiling could be maintained by
mixing risky and riskless assets, and Markowitz demonstrated the benefits of a diversified
portfolio in which the prices of it assets would not rise and fall together, using the statistical
concept of covariance. In 1970, William Sharpe[54] applied that concept to the tendency of the
price of an asset to rise and fall in concert with the all-share index, assigning the title "Beta" to
its mathematical definition, and used it to derive a pricing method know as the Capital Asset
Pricing Model, and in 1973, Fischer Black [55] and Myron Scholes [56] developed the Black-
Scholes model which made use of the fact that the expected volatility of an asset is reflected in
its price in the options market, which led to the development by Robert Merton [57] of the
"Contingency Claims Analysis" method of pricing assets.
Corporate finance
During the same period there was a sequence of advances in the economics of corporate finance.
It started with the demonstration by Franco Modigliani [58] and Merton Miller [59] that
shareholders should be indifferent to the level of a corporation's debts provided that it was
possible to repay them costlessly with money available at a riskless rate of interest. Other
economists subsequently augmented the Modigliani-Miller theory with allowances for the effects
of taxation and of information asymmetry.

Recent developments
The Greenspan era
Divergences of view about economic management persisted into the early 21st century, but a
consensus developed among those responsible for the management of the major economies,
along the lines of a speech by the then United States Federal Reserve Board Chairman, Alan
Greenspan[60]. The use of Keynesian fiscal policy to regulate output was considered to have
proved ineffective and inflationary, and monetarist attempts to control the money supply were
seen to have been unsuccessful. The new rôle of fiscal policy was the maintenance of fiscal
stability, responsibility for the management of the economy had become the exclusive function
of monetary policy, and monetary policy was confidently expected to prevent serious
interruption to economic growth (the President of the American Economic Association had
declared that "The central problem of depression-prevention [has] been solved, for all practical
purposes"[61]). The financial system was considered to be essentially stable, making financial
regulation unnecessary.
The conclusion of the era was marked by Alan Greenspan's 2008 congressional testimony:
 "In recent decades, a vast risk management and
pricing system has evolved combining the best
insights of mathematicians and finance experts
supported by major advances in computer and
communications technology. A Nobel prize was
awarded for the discovery of the pricing model that
underpins much of the advance in the derivatives
markets. This modern risk management paradigm held
sway for decades. The whole intellectual edifice,
however, collapsed in the summer of last year."[62]
The shortcomings of economic theory in that respect have been
held [63] to have played a major role in the the financial crisis of
2008.
Post-Great Recession thinking
The financial crisis of 2008 and the resulting Great
Recession prompted much re-thinking of economic theory.
Professor Shin of Princeton University reported that the "race is
on" to add a new perspective to macroeconomics by the
incorporation into it of a new theory of financial economics[64],
and there was new thinking about the use of financial
regulation to reduce the risk of fresh financial shocks. A re-
examination of the rôle of fiscal policy had been triggered among
economists and politicians by a 2008 proposal by
Britain's Gordon Brown for a coordinated fiscal stimulus to
counter the expected recessionary effects of the financial crisis.
The idea was dismissed as ineffective by some economists[65][66],
and as inflationary by others [67], and it was rejected by
Germany's Angela Merkel[68] and ridiculed by her finance
minister as "crass Keynesianism"[69] Although fiscal stimulus
packages were implemented during the recession of 2009, they
were not sustained by European governments to support the
faltering recovery in 2010, and programmes of fiscal
contraction were widely introduced in 2011. The main reason that
was given for that reversal of fiscal policy was the fear that
operators in the bond market would lose confidence in
governments' ability to service the levels of public debt that their
continuation would involve. The European Union's Fiscal
Compact (which places mandatory restrictions upon the use of
fiscal policy by its signatories) may gain political approval, but
its economic consequences are likely to remain a matter of
controversy. Unlike the European governments, the United States
government has not introduced a major programme of fiscal
contraction, and the Congress has not been able to agree on a
plan for the reduction of the government's budget deficit[70]. A
controversy also remains unresolved concerning the merit of
techniques known as quantitative easing by which central
banks seek to increase the money supply in order to relieve credit
crunches and stimulate economic activity[71][72].
The history of economic thought has taken an unexpected turn,
and a new consensus on economic management has not yet
emerged.

References
1. ↑ David Hume David Hume Essays, Moral and Political, 1742,
Vol 2 "Of the Balance of Trade" (published by Liberty Fund,
1985).
2. ↑ Adam Smith, The Wealth of the Nations (Modern Library, 2000).
3. ↑ Jean-Baptiste Say
4. ↑ Thomas Malthus, Essay on the Principle of Population.
5. ↑ Nicolas Wade Why Malthus Was Mistaken, New York Times,
September 19, 1999
6. ↑ David Ricardo, The Principles of Political Economy and
Taxation (John Murray, 1821).
7. ↑ Karl Marx
8. ↑ Karl Marx, Das Kapital (abridged).
9. ↑ John Stuart Mill, Principles of Political Economy, (Longmans
Green, 1926.
10. ↑ William Stanley Jevons, 1835-1882
11. ↑ Carl Menger, 1841-1921
12. ↑ Marie Esprit Léon Walras (1834-1910)
13. ↑ Alfred Marshall Principles of Economics Macmillan 1890
14. ↑ Léon Walras
15. ↑ Milton Friedman: Price Theory, Transaction Publishers, 2007
16. ↑ Vilfredo Pareto
17. ↑ Arthur C Pigou The Economics of Welfare Macmillan 1920,
18. ↑ William Baumol Economic Theory and Operations
Analysis Chapter 13, Prentice-Hall 1961
19. ↑ Nicholas Kaldor The Equilibrium of the Firm the Economic
Journal 1934
20. ↑ Ronald Coase: The Nature of the Firm, Economica, November
1937
21. ↑ William Baumol Economic Theory and Operations
Analysis Chapters 9 and 10, Prentice-Hall 1961
22. ↑ Richard Cyert and James G March The Behavioral Theory of the
Firm Prentice-Hall 1963
23. ↑ Roy Harrod An essay in dynamic theory Economic Journal
March 1939
24. ↑ Robert Solow A Contribution to the Theory of Economic
Growth Quarterly Journal of Economics 70 1956
25. ↑ Paul Romer Endogenous Technological Change Journal of
Political Economy October 1986
26. ↑ Robert Lucas Jr On the Mechanics of Economic
Development Journal of Monetary Economics July 1988
27. ↑ John Hicks Mr Keynes and the Classics(Econometrica, April
1937)
28. ↑ The University of Chicago Department of Economics
29. ↑ Milton Friedman The Methodology of Positive Economics
30. ↑ Friedman and Meiselman The relative stability of monetary
velocity and the Investment Multiplier in the United States 1897-
 1958 in Stabilisation Policies, CMC Research Papers p165
Prentice-Hall 1964
31. ↑ Harry G Johnson International Trade and Economic
Growth Chapter 6 Harvard UP 1958
32. ↑ Edmund Phelps Money wage dynamics and labor market
equilibrium. Journal of Political Economy 1968
33. ↑ John Muth "Rational Expectations and the Theory of Price
Movements" Econometrica, Vol. 29, No. 3, July 961)
34. ↑ Robert Lucas Econometric Policy Evaluation: A
Critique. Carnegie-Rochester Conference Series on Public Policy
1: 19–46 1976
35. ↑ Nick Gardner Decade of Discontent p207 Basil Blackwell 1987
36. ↑ Charles Bean Is There a Consensus in Monetary Policy?
37. ↑ Kenneth Kuttner and Adam Posen Do Markets Care Who Chairs
the Central Bank NBER Working Paper 13101 02007
38. ↑ Ronald Coase The Institutional Structure of Production The
Nobel Prizes 1991, Nobel Foundation 1992
39. ↑ Ronald Coase The Problem of Social Cost Journal of Law and
Economics October 1960
40. ↑ Public Choice
41. ↑ James Buchanan and Gordon Tullock The Calculus of Consent
42. ↑ Douglas Irwin Against the Tide: An Intellectual History of Free
Trade Princeton University Press 1997
43. ↑ Eli Heckscher and Bertil Ohlin Heckscher-Ohlin Trade Theory
(Ed Harry Flam and . June Flanders) MIT Press
44. ↑ Ha-Joon Chang Kicking Away the Ladder
45. ↑ Bhagwati and Ramaswami. Domestic Distortions, Tariffs and
the Theory of Optimum Subsidy - Some Further Results Journal of
Political Economy, 1969, vol. 77, issue 6, pages 1005-10' (1963)
46. ↑ Joseph Stiglitz website
47. ↑ Interview with Joseph Stiglitz
48. ↑ Joseph Stiglitz Globalization and its Discontents" Norton 2002
49. ↑ Dani Rodrik's website
50. ↑ Dani Rodrik Has Globalization Gone Too Far?. Institute for
International Economics 1997.
51. ↑ Jean-Michel Courtault, Yuri Kabarov And Bernard Bru: "Louis
Bachelier and the Centenary of the Theorie de la
Speculation", Mathematical Finance Vol10 No3 July 2000
52. ↑ Alfred Cowles
53. ↑ James Tobin
54. ↑ William Sharpe
55. ↑ Fischer Black
56. ↑ Myron Scholes
57. ↑ Robert Merton
58. ↑ Franco Modigliani
59. ↑ Merton Miller
60. ↑ Alan Greenspan: The Challenge of Central Banking in a
Democratic Society, (lecture to The American Enterprise Institute
for Public Policy Research, December 5, 1996, Federal Reserve
Board 1996
61. ↑ Robert E. Lucas, Jr: Presidential Address to the American
Economic Association, January 10, 2003
62. ↑ Testimony of Dr. Alan Greenspan before the Committee of
Government Oversight and Reform October 23, 2008
63. ↑ for example by Professor Shin of Princeton University Hyun
Song Shin: Interview with Ramesh Vatilingam, 4 September 2009
64. ↑ Hyun Song Shin: Interview with Ramesh Vatilingam, 4
September 2009
 65. ↑ Eugene Fama: Bailouts and Stimulus Plans January 2009
66. ↑ Keynesian over-spending won't rescue the economy, Letter by
IEA economists in the Sunday Telegraph, 26 October 2008
67. ↑ Allan Meltzer: Inflation Nation, New York Times op-ed, 3rd
May 2009
68. ↑ Catherine Mayer: Behind a Merkel Snub, Euro Economic
Discord, Time, 9 December 2008
69. ↑ Tristana Moore: Steinbrueck 'shouldn't scare UK'BBC News 12
December 2008
70. ↑ Joint Select Committee on Deficit Reduction (Deficit "Super
Committee"), New York Times, 22 March, 2012
71. ↑ Lori Ann LaRocco: CEOs Debate the Merits of QE2, CNBC
News, 21 Oct 2010
72. ↑ Open Letter to Ben Bernanke, 15 November 2010
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