History of Economic Thought

Lecture 13
Giorgi Bakradze
 Monetarists
• Knut Wicksell

• Irving Fisher

• Ralph Hawtrey

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 Institutionalists
• Thorstein Veblen

• Wesley Clair Mitchell

• John Kenneth Galbraith

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 Knut Wicksell
• Several important contributions to economics:
– Evolution of the firm with size (increasing, constant, decreasing
returns)
– Theory of monopolistic competition
– Monetary economics
• Interest rates
• Potential contribution of government/central bank in price stability
• Saving-investment approach to macroeconomic equilibrium

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 Price level changes
• Why do prices collectively rise or fall?
• Analysis of interest rates
• Normal/natural vs bank rate of interest
• First depends on supply and demand for real capital not yet
invested
– Applies only to credit between individuals

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 Price level changes
• Banks complicate matter
– Not restricted to own fund
– Create credit and can extend loans even at very low rates
– Also need not lend out all of the funds
– Hence bank rate could be above of below the natural rate
– In which case the price level changes

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 Price level changes
• Bank rate < natural rate
– Saving is discouraged
– Demand for consumption g&s rises
– Investment increases
– Incomes increase
– Prices of consumption g&s rises
– Anticipation of price increases cause more inflation

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 Price level changes
• Bank rate > natural rate
– Saving increases
– Investment spending declines
– National income declines
– Prices of consumer g&s declines
– General price level falls

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 Implication for Public Policy
• Emphasis on the role of government/central bank
• Stabilizing wholesale prices by controlling discount and interest
rates
• Banks should establish rate that neither raises nor lowers
commodity prices
• Natural rate of interest is not fixed – hence bankers should take
care that natural rate=market rate

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 Implication for Public Policy
• Current level of commodity prices is a test
– If it rises – raise interest rates
– If it falls – reduce interest rates
• Growing production and stock of gold could inflate currency
• Therefore world should use international paper standard

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 Irving Fisher (1867-1947)
• The Rate of Interest, 1907
• The Theory of Interest, 1930
• The Purchasing Power of Money, 1911
• Mathematical Investigations in the Theory of Value
and Prices, 1925

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 Cardinal utility unnecessary
• He was the first to show that cardinal utility was unnecessary
for the theory of demand and that ordinal utility was all that
was needed.
– Vilfredo Pareto further elaborated on this idea more than a decade
after Fisher.

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 Diagrammatic Utility Maximization
• He introduced the familiar diagrammatic representation of the
maximization of utility subject to a budget constraint.
– Indifference curves themselves were introduced by Francis Ysidro
Edgeworth in his Mathematical Psychics, 1881.

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Diagrammatic Utility Maximization

Good Y

Indifference Curves

Consumer’s
Choice

Budget Constraint

Good X

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 Production Possibilities Frontier
• Fisher introduced the familiar graph Good Y

of the Production Possibilities Slope = Price of

Frontier X/Price of Y

Production
Possibilities
Frontier
Producer’s
Choice

Good X

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 Production
• For the case in which the amounts Good Y

used in production of the various

Slope = Price of
resources are fixed, Fisher showed X/Price of Y

that the producer maximizes profits Production

Possibilities
by producing at that point on the PPF Frontier

that has slope equal to the price of Producer’s

Choice
the good shown on the horizontal
axis in terms of the good shown on Good X

the vertical axis.

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 Taxation
• He showed that a consumption tax is a better policy than an
income tax (because it does not alter our incentives to save).

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 Aggregation
•  He derived an “ideal index” as the geometric mean of the
Laspeyres and Paasche indices and justified its superiority
through an axiomatic approach. 

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 Interest rate
• Fisher built on the ideas of John Rae and Eugen von Böhm-
Bawerk to construct the modern theory of interest.
• He did this by inserting the production possibilities frontier, the
maximum value line, and the indifference curves in the same
graph and re-labeling the two goods as consumption now and
consumption later.
• Along the way, he showed how the Walrasian general
equilibrium model could contain behavior such as saving and
investment.
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 Interest Rate
• Two factors
• Impatience rate
– Extent of community’s willingness to obtain present consumption (income) by
giving up future consumption (income)
– Trade off is determined by impatience
• Investment opportunity rate
– Determined by real factors – quality and quantity of resources; technology
– Trade off between producing for consumption today, or capital goods – for
tomorrow
• Equilibrium interest rate – where the two are equal
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 Fisher Effect
• Fisher showed that expected changes in asset prices have no
effect on the economy
– But unexpected changes might have an effect.
• Fisher clearly distinguished between real and nominal interest
rates, and between expected and actual inflation in deriving the
Fisher equation:
– nominal interest rate = real interest rate + expected inflation.
• He also made the argument that in the long run expected and
actual inflation would be equal.
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 Fisher Effect
• Fisher’s equation leads, by way of monetary neutrality, to what
is known as the Fisher Effect
• It is the prediction that an x percentage point change in the
inflation rate will cause an identical x percentage point change
in the nominal interest rate.
• Fisher had argued—on empirical grounds—that the Fisher
Effect would be true only in the very long run.

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 Quantity theory of money
• Fisher expanded the equation of exchange
M  V + M’  V’ = P  T.
• M is the quantity of currency, V is its velocity of circulation, M’
is the quantity of demand deposits, V’ is its velocity of
circulation, P is the average level of prices, and T is the quantity
of goods and services transacted or sold, with each unit being
counted each time it is sold or resold.

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 Quantity theory of money
• For Fisher M’ is a relatively fixed multiple of M
– Bank reserves are a fixed ration of deposits
– Agents maintain stable ratios between their currency and deposit
balances
– The deviations are just temporary
• Velocity of circulation and volume of trade are constant as well
– They fluctuate during the business cycle, but return to equilibrium
level
• Direct link between money and prices (Wicksell – indirect)
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 ‘Phillips Curve’
• Also, based on his statistical calculations, Fisher had argued
that there was a negative correlation between the rate of
inflation and the unemployment rate, as far back as 1926.
– This is the so-called Phillips Curve credited to A.W. Phillips,
apparently in error.

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 Debt-Deflation Theory of Economic Depressions

• Unexpected deflation transfers wealth from borrowers to

lenders
• Borrowers’ spending falls more than lenders’ spending
increases
• Therefore, overall spending decreases, causing a depression
• This implies that price declines may not cure a recession; they
may make things worse

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 Institutionalist School
• The reformist approach to social problems
• Influenced by German historical school
• In turn influenced New Deal policies

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 Major Tenets
• Holistic, broad perspective
– Economic activity is not a sum of the activities of separate agents
– Economics is intertwined with politics, sociology, law, custom etc.
• Focus on institutions
– An institution is not merely an organization or establishment for the
promotion of a particular objective
– It is also an organized pattern of group behavior. It includes customs,social
habits, laws, modes of thinking, and ways of living.
• Slavery, laissez-faire, unionism, etc
– Institutions regulate economic life
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 Major Tenets
• Darwinian, evolutionary approach
– The evolution and functioning of economic institutions should be the central
theme in economics
• Rejection of the idea of normal equilibrium
– Maladjustments in economic life are not departures from normal equilibrium but
rather are themselves normal
• Clashes of interest
– Big business against small business, consumers against producers, etc.
• Liberal, democratic reform
• Rejection of pleasure-pain psychology
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 How Was the Institutionalist School Valid,
Useful, or Correct in Its Time?
• Many of their criticisms of orthodox theory were valid and
helped to revise that type of theory to make it more tenable
• The holistic approach added elements of realism to economic
analysis
• Belated, but deep and lasting, concern over business cycles
and monopolies
• The emphasis on inductive studies reduced the gap between
economic theory and practice

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 Which Tenets of the Institutionalist School
Became Lasting Contributions?
• Reform movements
• Legal protection of unionism, social insurance
• Study of influence of the institutional environment on
economic relations
– Property rights, seniority, retirement policies, family

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 Thorstein Bunde Veblen (1857-1929)
• The Theory of the Leisure Class (1899)
• Theory of the Business Enterprise (1904)
• The Engineers and the Price System (1921)

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 Institutionalist
• Veblen was the founder of the American Institutionalist School
• He was a major critic of capitalism and of the analysis of
capitalism in neoclassical economics

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 Historical Background
• Veblen’s criticism of capitalism may be seen as a response to  
– the rough, violent, predatory, lawless, and monopolistic nature of
American capitalism between the end of the Civil War and the
beginning of World War I, and also to
– the inability of neoclassical (or, marginalist) economics to reflect the
realities of contemporary capitalism
• Veblen coined the term ‘neoclassical economics’ to refer to the economics of
Alfred Marshall and likeminded economists

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 Rationality
• Neoclassical economists saw consumer behavior as rational
behavior by people with stable tastes
• Veblen instead saw non-rational or instinctual behavior of
people under the sway of instincts that evolve according to
Darwinian rules

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 Business Motivations
• Neoclassical economists saw firms engaged in a clear-sighted
but honest and by-the-book pursuit of profit maximization
• Veblen instead saw deep conflicts within firms between
businessmen, who wanted profits by hook or by crook, and
engineers and other technical people who were mainly
interested in making a good product.

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 Leisure Class
• Veblen’s analysis of consumer behavior went along the
following lines:
• We instinctively seek high social status.
• We achieve high social status when our peers admire us, when
they regard us as winners and not losers.
• To be considered a winner we need to show that we have
stronger predatory abilities than others.

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 Leisure Class
• To show our predatory abilities, we need to amass more
wealth than our peers.
• Moreover, that wealth must be acquired by force or by cunning
and not by hard work
– because the acquisition of wealth by hard work does not show any
evidence of one’s predatory abilities
– hard work is for wimps and losers.

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 Leisure Class
• Consequently, capitalist societies tend to generate a leisure
class that rises to the top of the food chain by making money
without having worked for the money.

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 Conspicuous Consumption
• Not only must we acquire wealth without doing any labor, we
must make sure everybody knows how wealthy we are.
• This leads to
– conspicuous consumption,
– conspicuous waste, and
– conspicuous leisure.

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 Conspicuous Consumption
• An act of consumption creates more utility when that
consumption is observed by one’s peers than when it is done in
private: what’s the point of drinking an expensive wine if no
one sees you doing so?
– To a neoclassical economist who swears by rational consumer
behavior, this way of thinking would be considered perverse.
– But to Veblen, this way of thinking about consumer behavior is a lot
more realistic.

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 Conspicuous Consumption
• Ostentatious waste—as in arranging a lavish wedding for one’s
pet cats—would also help convince people that a lot of
unearned wealth lies at the source of all the waste.
• Similarly, a visibly leisurely lifestyle would also serve the same
purpose.

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 Conspicuous Consumption: Fashion
• Women’s clothing needs to be highly elaborate and obviously
unsuitable for work in order to be regarded as fashionable

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 Business Enterprise
• Businessmen see the bizarre behavior of the leisure class and
realize that the way to make money is by taking advantage of
the whims of the leisure class and ripping them off.
• Moreover, the general social admiration of predatory behavior
leads businessmen to unscrupulous behavior.
– For example, they sabotage their rival producers so that reduced
overall output would create an artificial scarcity that would lead to
high prices.

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 Business Enterprise
• On the other hand, the engineers who do the technical work in
the manufacturing industries are interested only in the quality
of their products.
– Their job satisfaction derives from simply doing a good job and
producing products that serve some genuine need.

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 Business Enterprise
• Veblen speculated that
– these conflicts between the corrupt ideas of the businessmen and
the sense of excellence of the engineers may be irreconcilable
– the only hope for capitalism lay in the engineers taking over.

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 Unions
• Veblen’s view of labor unions wasn’t very positive either.
• He argued that unions would be quite happy to procure gains
for their members even if those gains come at the expense of
non-union workers.
• This idea was later formalized as the so-called insider-outsider
theory of labor unions.

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 Darwin and Veblen
• According to Veblen, our instincts—such as the instinct to
admire predatory people—may have evolved according to
Darwinian laws during a primitive phase of human society
when might actually made right.
• The problem, however, is that our instincts, once they are
embedded in us, are hard to get rid of even after the
conditions that once made them helpful give way to a new set
of conditions under which they are a hindrance.

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 Marx and Veblen
• Veblen’s view of the evolution of our instincts is somewhat similar to Karl
Marx’s conception of the inertial tendencies of the ideological
superstructure.
• Veblen’s views on the business cycle were also very similar to those of
Marx.
• However, Veblen did not believe in any deadly conflict, such as that
envisioned by Marx, between the leisure class and the working class.
• In fact, Veblen’s working class people admire the predatory prowess of
the leisure class and hope to one day become members of the leisure
class themselves.
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 A rising demand curve!
• In 1950, Harvey Leibenstein introduced Veblen’s ideas on
conspicuous consumption into formal demand theory and
showed the possibility of a rising demand curve.
• The leisure class does not want to be seen consuming cheap
stuff.
• Therefore, as the price of a product rises, it might become
more popular with such people!

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 Behavioral Economics
• Veblen could be seen as a pioneer of the relatively new
discipline of behavioral economics

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 John Kenneth Galbraith (1908-2006)
• Modern Competition and Business Policy, 1938.
• A Theory of Price Control, 1952.
• American Capitalism: The concept of countervailing power, 1952.
• The Great Crash, 1929, 1954.
• The Affluent Society, 1958.
• The New Industrial State, 1967.
• Economics and the Public Purpose, 1973
• Money, 1975.
• The Age of Uncertainty, 1977.
 Countervailing Power
• Galbraith argued that capitalism does not lead to greater and
greater levels of competition among producers.
• Instead, it leads to the gradual emergence of monopoly (a
market with one seller) or oligopoly (a market with a handful of
sellers).
 Countervailing Power
• However, the monopolists and oligopolists do not get to do
whatever they want.
• Workers form unions, buyers form retail cooperatives and
retailers form large chain stores, all to balance the huge power
of the producers.
• Capitalism, in other words, fights monopoly with monopoly.
 Countervailing Power
• Galbraith went on to argue that it was pointless for the
government to try to encourage competition through its anti-
trust policies.
• That approach would not work because modern capitalism has
a tendency towards monopolization.
• A more practical approach would be for the government to
encourage and strengthen all sources of countervailing power.
 Dependence Effect
• Galbraith argued that the notion of consumer sovereignty—
central to neoclassical economics—is largely untrue.
• Large corporations with huge advertising budgets are by and
large able to persuade consumers to buy whatever they want
to sell.
 Dependence Effect
• One consequence of the power of advertising in determining
our tastes is the existence of “public squalor amidst private
affluence”.
• We pay too much attention to goods that are advertised and
ignore those that aren’t, including public amenities such as
good roads, clean subways, etc.
• We end up with nice and clean homes on the one hand and
nasty subways and broken highways and bridges on the other.
 The Modern Corporation
• The modern corporation is characterized by the separation of ownership
and control in business firms.
• Galbraith argued that modern economies are dominated not by small
mom-and-pop stores but by large corporations.
• These corporations are owned by millions of shareholders who each own a
tiny portion of the firm.
• It is not possible for them to run the day to day operations of the firm
directly.
• Therefore, they typically hire a professional manager (the CEO) to run the
company.
 The Modern Corporation
• As the person who controls the firm does not own the firm, it
no longer makes sense, according to Galbraith, to assume—as
neoclassical economics does—that firms maximize profits.
• Modern corporations tend to be more interested in maximizing
sales, not profits
 The Modern Corporation
• Of course, the CEO cannot ignore profitability altogether for
fear of being sacked by the shareholders.
• But the CEO does not have to maximize profits either.
• All that the CEO has to do is ensure an adequate level of profits
to keep the shareholders happy.
• Galbraith argued that after reaching that adequate level of
profitability, the CEO turns his or her attention to other goals,
such as the firm’s sales, size or market share.
 Readings
• Brue, Grant, chapters 16 and 19

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