Chapter 3 Motivation


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Chapter 3 Motivation

The term

originated in the 1930’s. That decade witnessed substantial progress in the
study of aggregative economic questions. The forces that determine income, employment, and prices
had been receiving greater attention since the turn of the 20

century, after
a long period in which
microeconomic questions dominated the field of economics. The world Depression that began in 1929
added urgency to the study of macroeconomic questions. The products of this research were theories
of the “business cycle” and policy

prescriptions for stabilizing economic activity. One theory and set of
policy conclusions swept the field and became a new orthodoxy in macroeconomic thought. The book
containing this theory was
The General Theory of Employment, Interest and Money
, by J
ohn Maynard
Keynes, and the process of change in economic thinking that resulted from this work has been called
Keynesian revolution
. But revolution against what? What was the old orthodoxy? Keynes termed
it “classical economics,” and it is this bod
y of macroeconomic thought that we study in this chapter and
the next.

The ideas that formed the Keynesian revolution, as well as the evolution of these ideas in the post
Keynesian period, are central to our analysis. A prerequisite for this analysis is k
nowledge of the
classical system that Keynes attacked. Classical theory also plays a positive role in the later
development of macroeconomics. Although many early Keynesian writers viewed the classical theory
as ready for the scrap heap of outmoded ideas
, overreaction subsided with time, and modern
Keynesian economics contains many ideas that originated with the classical economists. The classical
model also provides the starting point for challenges that have been mounted against the Keynesian
theory by

new classical economists
, and
real business cycle theorists

Keynes used the term

to refer to virtually all economists who had written on macroeconomic
questions before 1936. More conventional terminology distinguishes between two
periods in the
development of economic theory before 1930. The first, termed
, is the period dominated by
the work of Adam Smith (
Wealth of Nations
, 1776), David Ricardo (
Principles of Political Economy
, 1

ed., 1817), and John Stuart Mill (
ciples of Political Economy
, 1

ed., 1848). The second, termed the
neoclassical period, had as its most prominent English representative Alfred Marshall (
Principles of
, 8

ed., 1920) and A.C. Pigou (
The Theory of Unemployment
, 1933). Keynes b
elieved that
the macroeconomic theory of the two periods was homogeneous enough to be dealt with as a whole.

To classical economists, the equilibrium level of output at any time was a point of
full employment

in terms of the variables described in Chap
ter 2, a point when actual output was equal to potential
output. Equilibrium for a variable refers to a state in which all forces acting on that variable are in
balance and, consequently, there is no tendency for the variable to move from that point. It
was an
important tenet of classical economists that only full
employment points could be positions of even
run equilibrium. Absent full employment, classical economists assumed that forces not in
balance were acting to bring output to the full
yment level. Classical equilibrium economics
examined the factors that determined the level of full
employment output along with the associated
levels of other important aggregates, such as employment, prices, wages, and interest rates.

Classical economic
s emerged as a revolution against a body of economic doctrines known as
. Mercantilist thought was associated with the rise of the nation
state in Europe during
the sixteenth and seventeenth centuries. Two tenets of mercantilism were (1) bull
ionism, a belief that
the wealth and power of a nation were determined by its stock of previous metals, and (2) the belief in
the need for state action to direct the development of the capitalist system.

Adherence to bullionism led countries to attempt to
secure an excess of exports over imports in order
to earn gold and silver through foreign trade. Methods used to secure this favorable balance of trade
included export subsidies, import duties, and development of colonies to provide export markets.

action was believed to be necessary to cause the developing capitalist system to further the
interests of the state. Foreign trade was carefully regulated, and the export of bullion was prohibited
to serve the ends of bullionism. The use of state action

was also advocated on a broader front to
develop home industry, the reduce consumption of imported goods, and to develop both human and
natural resources.

In contrast to the mercantilists, classical economists emphasized the importance of

factors in
determining the “wealth of nations” and stressed the optimizing tendencies of the free market in the
absence of state control. Classical analysis was primarily

analysis; the growth of an economy was
the result of increased stocks of the factors of pr
oduction and advances in techniques of production.
Money played a role only in facilitating transactions as a
means of exchange
. Most questions in
economics could be answered without analyzing the role of money. Classical economists mistrusted
t and stressed the harmony of individual and national interests when the market was left
unfettered by government regulations, except those necessary to ensure that the market remained
competitive. Both of these aspects of classical economics

the stress

on real factors and the belief in
the efficacy of the free
market mechanism

developed in the course of controversies over long
questions concerning the determinants of economic development. These classical positions on long
run issues were, however
, important in shaping classical economists’ views on short
run questions.

The attack on bullionism led classical economists to stress that money had no intrinsic value. Money
was important only for the sake of the goods it could purchase. Classical econ
omists focused on the
rule of money as a means of exchange. Another role money had played in the mercantilist view was as
a spur to economic activity. In the short run, mercantilists argued, an increase in the quantity of
money would lead to an increase
in demand for commodities and would stimulate production and
employment. For classical economists to ascribe this role to money in determining real variables, even
in the short run, was dangerous in light of their deemphasis of the importance of money.

e classical attack on the mercantilist view of the need for state action to regulate the capitalist
system also had implications for short
run macroeconomic analysis. One role for state action in the
mercantilist view was to ensure that markets existed fo
r all goods produced. Consumption, both
domestic and foreign, must be encouraged to the extent that production advanced. The classical
response is stated by John Stuart Mill:

In opposition to these palpable absurdities it was triumphantly established by
economists that consumption never needs encouragement.

As in other areas, classical economists felt that the free
market mechanism would work to provide
markets for any goods that were produced: “The legislator, therefore, need not give himself
concern about consumption.”

The classical doctrine was that, in the aggregate, production of a given
quantity of output will generate sufficient demand for that output; there could never be a “want of
buyers for all commodities.”

Consequently, clas
sical economists gave little explicit attention to factors
that determine the overall demand for commodities, i.e., aggregate demand.

Thus, two features of the classical analysis arose as part of the attack on mercantilism:


Classical economics stressed the

role of real as opposed to monetary factors in determining
output and employment. Money had a role in the economy only as a means of exchange.


Classical economics stressed the self
adjusting tendencies of the economy. Government
policies to ensure an ad
equate demand for output were considered by classical economists to
be unnecessary and generally harmful.

We turn now to the model constructed by classical economists to support these propositions.


J.S. Mill, “On the Influence of Consumption on Production,” in
Essays on Economics and Society
, vol. 4 of
Collected Works

(Toronto: University of Toronto Press, 1967), p. 263.


Ibid., p. 263.


Ibid., p. 276.