New Classicals,

Monetarists and Supply

Siders
ECON 3008 History of Economic thought
By Diana Sanskar and Gabriel Alexis

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THE GREAT DEPRESSION AND STAGFLATION: 2

 The key period of dominance of Keynesian economics

can be roughly considered from the 1930s to the late
1970s.

 However, following the Great Depression (1929-1939), the

United States experienced a crippling period of stagflation.

 The supposed inability of Keynesian economics to address the

stagflation of the 1970’s gave rise to several new theories of
economics.

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 3 Keynesian Economics and
Stagflation:

So what's stagflation?

 Stagflation: A combination of high inflation and economic

stagnation. Inflation drives prices up, and purchasing power
decreases. Generally, stagflation is characterized by slow
economic growth, high unemployment rate, and is
accompanied by rising inflation.

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 The rise of new classical economics had a significant impact on
macroeconomic theory and policy. It challenged the dominant
Keynesian framework, which emphasized the role of aggregate
demand management through fiscal and monetary policies. New
classical economists argued that these policies could have limited
effectiveness in stabilizing the economy and that market forces and
the rational behaviour of individuals were crucial determinants of
economic outcomes. New classical economists emphasized the role of
rational expectations, market efficiency, equilibrium and the importance
of real factors in driving economic fluctuations.
4 Key Tenets of
New Classical  Rational Expectations
Economics:  Market Efficiency
 Equilibrium and Market Clearing
 Real Business Cycle Theory
 Policy Implications

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Key Tenets of New Classical Economics con’t: 5

 Rational Expectations: New classical economists emphasize

that individuals and firms form rational expectations about future
economic conditions. They argue that people make unbiased and
efficient predictions, taking into account all available
information, including their understanding of how
government policies will be implemented.

 Market Efficiency: New classical economics embraces the

efficient markets hypothesis, which suggests that financial
markets are efficient in incorporating all available information
into asset prices. This view implies that it is difficult to
consistently earn abnormal returns by exploiting mispriced assets,
as prices already reflect all relevant information.

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6 Key Tenets of New Classical Economics
con’t:
Equilibrium and Market Clearing: There is a strong emphasis on the concept of equilibrium and
market clearing. They argue that, in competitive markets, prices adjust quickly to ensure that the quantity
demanded equals the quantity supplied, resulting in efficient resource allocation. This perspective stands
in contrast to Keynesian economics, which allows for the possibility of persistent unemployment and market
failures.
Real Business Cycle Theory: This theory suggests that fluctuations in economic activity, including
recessions and booms, are primarily driven by real factors such as technological shocks and changes in
productivity, rather than by monetary policy or other nominal factors. It posits that business cycles arise from the
natural response of the economy to real shocks and that government intervention is unnecessary or even
counterproductive in stabilizing the economy.

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7 Key Tenets of New Classical Economics
con’t:
5. Policy Implications: New classical economics has
important policy implications. Advocates of this school of
thought argue against discretionary macroeconomic policies, such
as fine-tuning the economy through fiscal or monetary
interventions. They believe that such policies are ineffective in
improving economic outcomes and can introduce distortions and
unintended consequences. Instead, they favour a focus on long-term
structural policies, such as promoting free markets, reducing
government intervention, and allowing market forces to operate
efficiently.

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 The rational expectations hypothesis was a
byproduct of the microeconomic analysis of
Charles C. Holt, Franco Modigliani, John Muth
and Herbert Simon.

Muth proposed that it is reasonable to assume

that expectations are informed predictors of
8 John Muth: future events, they would essentially be
consistent with the relevant economic theory.
Rational
Expectations

Muth argued that existing economic models did

not assume enough rational behaviour.

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John Muth: Rational Expectations con’t 9

Muth’s hypothesis asserts three (3) key principles:

 Information is scarce and the economic system does not waste it.

 The way expectations are formed depends specifically on the

structure of the relevant system describing the economy.

 A ‘public prediction’ will have no substantial effect on the

economic system unless it is based on a factual premise.

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From John Muth to Robert Lucas: 10

 Muth published his article on rational

expectations in 1961, but this hypothesis did not
play a critical role in economic theory until it was
adapted by Robert Lucas into dynamic
macroeconomic models.

 Let's get a quick overview of the Rational

Expectations Theory :)

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ROBERT
LUCAS
(1937-2023)
11

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 Lucas was born on September 15, 1937.

Before we American economist and one of the most influential figures

examine in the field of macroeconomics and New Classical
Economics.
Lucas’ work,
12
who is Received his Ph.D. in Economics from the University of
Robert Chicago in 1964, where he studied under Milton Friedman
and Gary Becker.
Lucas?
Robert Lucas was awarded the Nobel Prize in Economic
Sciences in 1995.

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 Lucas essentially combined the Friedman-Phelps analysis
of the Phillips Curve with the rational expectations
hypothesis of Muth.

13 Overview of
Robert However, it is important to note that Muth applied the
rational expectations hypothesis only to commodity
Lucas’ markets at the microeconomic level, while Lucas applied
this idea to the entire macroeconomy and combined it
Work: with the work being done in the micro-foundations of
macroeconomics.

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 14
KEY TENETS OF ROBERT LUCAS’
CONTRIBUTIONS:
1. Rational expectations: Lucas played a central role in introducing and popularizing
the
concept of rational expectations in macroeconomic analysis: Individuals form
expectations about future economic variables based on all available
information, including their understanding of the underlying economic structure.
2. Microeconomic foundations: Lucas emphasized the importance of
microeconomic incorporating
foundations into macroeconomic He argued
macroeconomic analysis should be grounded in themodels. principles
thatof neoclassical
economics, which focus on individual decision-making, market interactions, and the
efficient allocation of resources.

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KEY TENETS OF ROBERT LUCAS’ 15
CONTRIBUTIONS con't:

Business cycle theory: Lucas made significant contributions to our

understanding of business cycles within the New Classical framework.
He developed models that explained the fluctuations in output and
employment as the result of individual agents' responses to exogenous shocks
and changes in economic policies.
Lucas critique: Lucas developed the Lucas critique, which highlighted the
potential pitfalls of relying solely on historical relationships to guide policy
decisions. He argued that economic policies can have unintended
consequences if individuals anticipate and adjust their behaviour in response to
policy changes. The Lucas critique emphasized the need for policymakers
to consider the effects of their decisions on individual behaviour and to
adopt a more forward-looking approach to policy analysis.

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THOMAS J.
SARGENT
(1943 - Still Alive)
16

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 17 Before we examine Sargent’s work, who is Thomas
Sargent?

● Born July 19, 1943 in Pasadena California.

● American economist who made critical contributions to the fields of
macroeconomics, monetary economics and econometrics.
● He was awarded the Nobel Memorial Prize in Economic Sciences along with
Christopher SIms, for their empirical research on cause and effect in
macroeconomics and their contributions to understand the role of
expectations in economic decision making.
● Sargent received his Ph.D. on Economics from Harvard University in 1968.
● He is currently a professor at New York University and the Hoover Institution
at Stanford University.
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Sargent’s Key Contributions to the field of Economics: 18

Rational Expectations: Sargent played a crucial role in developing and

promoting the concept of rational expectations in macroeconomic analysis.
He, along with Robert Lucas, introduced the idea that economic agents form
expectations about future economic variables based on all available
information, including their understanding of the economic structure.
Dynamic Stochastic General Equilibrium (DSGE) Models: DSGE
models are macroeconomic models that incorporate rational
expectations, market imperfections, and various shocks to analyze the
behavior of key economic variables over time. Sargent's work advanced the
theoretical understanding and empirical applications of DSGE models,
which have become widely used in macroeconomic analysis.

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Sargent’s Key Contributions to the field of Economics con’t: 19

Policy Ineffectiveness Proposition: Sargent, in collaboration with Neil Wallace,

formulated the policy ineffectiveness proposition. This proposition challenged the
traditional Keynesian view that government intervention through fiscal and monetary
policy can effectively stabilize the economy. Sargent and Wallace argued that when
individuals have rational expectations, they anticipate and adjust their behavior in
response to policy changes, rendering those policies less effective in achieving their
intended outcomes.

Empirical Macroeconomics: Sargent has contributed to the empirical analysis of

macroeconomic phenomena. He developed innovative econometric techniques to estimate
and test macroeconomic models, providing insights into the empirical relevance and
validity of theoretical models. His work has helped bridge the gap between theory and
data, enhancing our understanding of macroeconomic relationships and dynamics.

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GARY S. BECKER
(1930 - 2014)
20

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● 21Gary S. Becker’s Background:
● Gary Stanley Becker was born on December 2, 1930 in
Pottsville Pennsylvania.
● He was educated at Princeton University and the University of CHicago,
where he earned his Ph.D. in 1955.
● He taught Economics at the University of Chicago until 1957, after which he
began to teach at the University of Columbia.
● In 1970, he returned to the University of Chicago as a Professor of Economics
as well as a Professor of Sociology.
● He was awarded the Nobel Prize for Economic Sciences in 1992.

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 Gary Becker’s Contributions to the Field of Economics: 22

Becker’s work shares some commonalities with new classical economics, such
as a focus on rational decision making. However his contributions are
generally associated with a much broader school of thought, rather than specifically
within the new classical economic framework.

Becker’s Central Premise: Often referred to as “Beckerian Economics” or the

“economic approach to human behaviour” is that rational economic choices,
based on self-interest govern most aspects of human behaviour - not just the
purchasing and investment decisions traditionally thought to influence economic
behaviour.

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23 Gary Becker’s Contributions to the
Field of Economics cont’d:
 Human Capital Theory

 Economic Analysis of Discrimination

 Household Economics

 Economic Approach to Crime

 Social Economics

 Economic Theory of Time Use

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24

CRITIQUE OF
NEW
CLASSICAL
ECONOMICS
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 THE ASSUMPTION FINANCIAL MONETARY POLICY
OF RATIONAL MARKETS ARE NOT AND ITS ROLE AND
EXPECTATIONS IS ALWAYS EFFICIEN EFFECT IS
UNREALISTIC. DOWNPLAYED AND
UNDERREPRESENTE
D. 25

Critique of
New Classical
Economics:
THERE IS A FAILURE THE POLICIES OF FAILURE TO
TO ADDRESS THE NEW CLASSICAL CAPTURE THE REAL
ROLE OF ECONOMICS MAY COMPLEXITIES OF
AGGREGATE OVERLOOK MARKET THE ECONOMY.
DEMAND. FAILURES AND
EXTERNALITIES. 06/23/2023
Monetarism
A History and Background
26

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27

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The Genesis of Monetarist theory: Stigler & Hayek 28

 In 1947 Friedrich Hayek organized a meeting of 39 scholars alongside

George Stigler
 A young 35-year-old, Milton Friedman was in attendance starting a
lifelong friendship with Friedrich Hayek.
 The group meet to discuss their opposition to Marxist and Keynesian
collectivist economics.
 The Scholars in attendance were of the firm belief that government
intervention within the market curtailed freedoms and stifled
innovation
 This society and their meetings would both heavily influence and be
influenced by Milton Friedman.

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Clark Warburton 1896-1979 29

American Formulated his Employed by the Upheld a strictly

Institutionalist, Monetarist theory Federal Deposit monetary theory of
Economist and in a post-World Insurance business
considered the War II society. Corporation fluctuations.
pioneer Monetarist. (FDIC).

The reviver of Warburton's principal contribution was He criticized

classic monetary- in identifying erratic changes in the Keynesian
disequilibrium money supply & its primary role in economics for
theory and the affecting the demand in an economy. "misplaced
quantity theory of emphasis" on
money. investment. 06/23/2023
30 Milton Friedman
1912-2006
 Milton Friedman is recognized as the primary advocate of
modern-day monetarism.
 His work on money which made him famous began in 1951,
initially by testing and restating the quantity theory of money as a
theory of the demand for money
 He maintained that there is a close and stable association
between inflation and the money supply.
 Mainly that inflation could be avoided with proper regulation of
the monetary base's growth rate
 Friedman's arguments were designed to counter the popular
concept of cost-push inflation.

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 Anna Schwartz
1915-2012
 An American economist who helped
pioneer the theory of Monetarism
alongside Milton Friedman.
 Prior to the monetarist revolution,
most economists believed:
 The quantity of money circulating in
the economy had no influence on
prices or on growth.
 History showed otherwise, which
Friedman and Schwartz argued

31 06/23/2023
32 Schwartz & Friedman’s
Revolution
During the 1960s, alongside Milton Friedman, she wrote “A Monetary
History of the United States”.

This literature forever changed our conceptualization of economics and the

way that governments operate.

Schwartz dedicated herself to a decade of research founding the monetarist

theory of economics.

Both, argued that the Great Depression of the 1930’s was caused by a
massive contraction of the money supply “the Great Contraction”.

They also maintained that post-war inflation was caused by an over-

expansion of the money supply

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33 Monetarist Revolution 2/3

 This inflation mainly occurred when the Federal Reserve (and the central banks before it) created an
excess of money.
 Done either by keeping interest rates too low or by injecting liquidity into banks, prices inflated.
 At first it may have appeared beneficial, however, sellers eventually raised prices to match
purchasing power .
 Investors would then speculate bets to beat expected inflation.
 This would begin replacing long-term investment, thus destroying entrepreneurship and harming
economic growth.

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34

Monetarist
Revolution
3/3

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 Theoretical Standpoint
35

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36 Importance of the money supply

 According to monetarist theory, the money supply is the most important determinant of the rate of
economic growth.
 Monetarist theory is governed by the quantity theory.
 M*V= P*Q
 Based on the Quantity Theory of Money, Milton Friedman argued that the government should keep
the money supply fairly steady and expand it slightly yearly to allow for a natural growth of the
economy.
 Milton Friedman, in one of his works; A Monetary History of the United States, suggested a fixed
growth rate called K-percent rule. This is where the money supply grows at a constant annual rate
with the growth of nominal GDP and expressed as a fixed percentage per year.

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37 Monetarist vs Keynesian

The main objective of both parties is the stabilize the economy or to stabilize
the aggregate demand in the economy.

Monetarist economics involves the control of the money supply in the economy
whereas the Keynesian economics involves government expenditures.

Monetarists believe in controlling the money supply in the economy while the
market to fix itself. Keynesian economists believe that a struggling economy
will not improve unless there is an intervention that drives consumers to buy
more goods and services.

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38 Monetarist vs Keynesian

 Keynesian
 They believe that the economy is best controlled by the manipulation of demand for goods
and services with no regard for the role of the money supply.
 John Maynard Keynes, promoted that economic stability is achieved by government
intervention through fiscal policies.
 Monetarist
 They believe that by controlling the money supply, it will influence inflation and interest
rates in the future.
 Milton Friedman promoted that economic stability can be achieved by the free market
economy through monetary policies

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39 Monetarist vs
Keynesian

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40 Monetarist vs
Keynesian

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Margaret Thatcher 1925-2013 41

 Margaret Thatcher was the first adopt monetarism .

 It served as the foundation for her macroeconomic policymaking.
 Using the theory as a guideline during her tenure as prime minister.
 She implemented monetarism through:
1. Higher interest rates
2. Higher taxes and spending cuts.
 Her policies lead to mass unemployment and hardship before eventually
showing results at cubing inflation and economic stagnation.

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Monetarist Criticism 42

It ignores the importance of fiscal policy in stabilizing the

economy.

It assumes that the velocity of money is constant.

Its too focused on short-term economic outcomes and does not take
into account the long-term effects of monetary policy.

It is too ideological and does not consider the political realities of

policy making.

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S UP PLY S I D E
ECONOMICS

43

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 We recall that the new classical school of economic thought
emerged as a response to the alleged inability of the
Keynesian school of thought to address the challenges of the
stagflation of the 1970s.

44 How did we get

to Supply Side Supply-side economics gained prominence in
Economics? the late 1970s and early 1980s, similar to the
new classical school of economic thought
emerged as a response to the economic
challenges of the 1970s.

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Influential Supply-Siders: 45

 Arthur Laffer: Credited with popularizing the concept of the Laffer Curve.
 Robert Mundell: Nobel Laureate economist who emphasized the importance
of fiscal policies .
 Milton Friedman: While not exclusively associated with supply-
side economics, Friedman’s ideas regarding the importance of monetary
stability and the role of market forces aligned with supply-sider principles.
 Jude Wanniski: Journalist and economist coined the term “supply-side
economics and heavily promoted the idea that lower tax rates could spur
economic growth and increase government revenue.
What is the Laffer Curve?

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46 Key Tenets of Supply
Side Economics:
 Advocacy for lower tax rate

 Reduction of regulations and government interventions.

 Incentives for Investment and Savings

 Policies that support Entrepreneurship and Innovation

 The Laffer Curve

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47 Critique of Supply-SIde Economics:

Critics claim that

trickle-down Substantial revenue
Liz Truss' catastrophic ta
x cuts economics DO NOT loss from tax cuts
work

Significant negative
impact on social safety
Very limited impact on nets Inefficiency and
investment Market Concentration
• Neglect of demand side
factors

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48 References

 Tooke on Monetary Reform.” in Essays in Honour of Lord

Robins, Macmillan, London.Google Scholar
 Smith, Vera C. 1936. The Rationale of Central Banking, P. S. King, London.
Google Scholar
 WhiteLawrence, H. Lawrence, H. 1984. Free Banking in Britain: Theory,
Experience, and Debate, 1800–1845, Cambridge University Press, New York.
Google Scholar

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