THEORIES
Classical Theory
Adam Smith
1776 – Wealth of Nations
The wealth of a nation depends on its ability to produce (which
depends on the quantity and quality of its land, labor and capital)
A Long Run theory
Pro-capitalism
Free markets generate full employment (in the long run)
Government’s role should be limited
Say’s Law – “Supply creates its own demand”
Supply matters more than demand
“… he intends only his own gain, and he is in this, as in
many other cases, led by an invisible hand to promote
an end which was no part of his intention.” Adam Smith
Communism
Karl Marx
Das Kapital (1867 – 1894)
Capitalism is based on the exploitation of labor and is
doomed to destruction, probably by a workers’ revolution.
Private individuals should not be allowed to own land or
capital. These should be owned by “the state” for the
common good.
“Workers of the world unite. You have nothing to lose but
your chains.”
“From each according to his ability; to each according to
his need.”
Karl Marx
Keynesian Theory
John Maynard Keynes
The General Theory of Employment, Interest & Money (1936)
A Short Run theory
Unemployment is a problem in the short run
Inflation is not a problem
The government has a role to play in creating full employment
Demand matters more than supply
(“Demand creates its own supply”)
Government spending can/should be used to create the
“right” amount of aggregate demand.
Printing money is not very effective at changing demand.
“In the long run we are all dead.” JM Keynes
Monetarist Theory
Milton Friedman
A Monetary History of the United States (1963)
Greater emphasis back to the Long Run*
Inflation is a problem.
Markets will create “full employment.”*
Government’s role should be limited – policies often do
more harm than good.*
The money supply is the primary determinant of Aggregate
Demand and changes of spending mainly affect inflation.
“Inflation is everywhere and always a monetary
phenomenon.” Milton Friedman
*These sound like classical theory
For our purposes we will consider two theories:
Classical/monetarist theory (CMT) and Keynesian theory (KT)
ISSUE
Time horizon
CMT
long
KT
short
Markets work …
well
poorly
Unemployment is
Gov’t should do…
real growth is
caused by …
low
as little as possible
Investment – more
capital - Supply
high
what is needed
more Spending -Demand
MD (CASH)
does not change
changes
Δx refers to changes of spending.