Economic Schools of Thought

Economic schools of thought appeared in the 17th and 18th centuries when the Western world started transforming from agrarian to industrial societies (Bheemaiah, 2017). Over the years of economic development, four major schools of thought have emerged. They are classical, Keynesian, supply-sider and Monetarist schools of thought. This essay looks at how each school of thought believes the government should use policy tools to fix the economy. 

How each school of thought believes the government should use policy tools to fix the economy 

Classical 

The classical theory is regarded as the first school of economic thought. The underlying concept of this school is that markets work best when they are left alone (Bheemaiah, 2017). This means that the government plays a very small role in fixing the economy. This approach is firmly based on the laissez-faire belief meaning that free markets will generate economic development. It argues that markets must be left to work on their own since the price system serves as a strong tool to allocate resources to areas where they are best used. Classical economists insist that the economy would often return to its full capacity of real-output via an automatic self-adjustment procedure (In Frydman & In Phelps, 2013). 

Keynesian 

Advocates of Keynesian school argue that though capitalism is a good system, it needs help at times. During good economic times, people work, get salaries, and spend the money on things they need. This spending then stimulates economic growth and therefore, everything runs in a smooth manner. However, during tougher economic times, things change. When the economy goes downhill, businesses are likely to close and fire employees (Keynes, 2018). When people are fired, they do not get salaries hence they do not have money to spend. Actually, they start saving the little money they have left. When spending stops, the economy loses its momentum and goes further downhill (Schiller & Gebhardt, 2019). Now that people are no longer spending, the government must step in and rescue the economy. The biggest problem is that the government does not have its own money. Therefore, it will have to use the available tools to take money away from companies and the public to spend it (Bheemaiah, 2017). The most common tool the government uses is higher taxes for businesses and individuals, which could otherwise be channeled to more investments to expand the business. 

Monetarist 

According to the Monetarist school, the government’s role in fixing the economy is controlling inflation by controlling the amount of money in supply (Wolff, 2012). This theory holds that the amount of money in supply is the key determinant of the country’s GDP and price levels of products in the end. Monetary policy is one tool the government could use. Using this tool the government can affect the overall economic performance through instruments like interest rates to adjust the money supply in the economy (Tsoulfidis, 2010). 

Supply-sider 

Supply-sider economists advocate for the use of fiscal policies to stimulate and fix the economy. They believe that the government should reduce tax rates to motivate citizens to work harder and offer investment tax credits to spur capital formation (Tsoulfidis, 2010). This school favors tax reductions over increments in transfer payments or increments in government purchase. In 1981, President Reagan announced tax cuts based on their supply-side effects. Together with the increase in defense spending in the 1980s, Reagan’s fiscal policies stimulated aggregate demand through increasing both investment and consumption (Banerjee & Warrier, 2017). During that period, accelerated growth and falling inflation are indicators that supply-side factors could also have contributed. In addition, the George Bush tax cuts encouraged economic growth, and they were later made permanent (Schiller & Gebhardt, 2019). 

Which School of Thought Would be Best During A Recession 

The Keynesian theory derives its name and principles from Maynard Keynes, a British economist (Keynes, 2018). Keynes did not only introduce new economic concepts but also transformed economics into a study of the flow of expenditures and incomes. This led to new methods of economic analysis. The Keynesian theory proved best during a recession in the 1930s Great Depression when the Classical theory failed to explain the causes of this global recession that saw increasing unemployment and falling prices coupled by widespread poverty (Clift, 2018). Keynesian school rejects the notion that free markets can automatically offer full employment (that each citizen who wants a job would get one given that employees were flexible in terms of their wage demands. The Keynesian school asserts that aggregate demand is the main driver of an economy. In times of a recession, free markets lack self-balancing mechanisms, which result in full employment (In Frydman & In Phelps, 2013). This is simply because, in real life, wages are never flexible. Therefore, the only solution is government intervention by using policy tools to increase spending to achieve price stability and full employment. During recessions, this school strongly advocates unbalanced government budgets (Keynes, 2018). The government can also use aggressive monetary policies for economic stimulation. For instance, the reduction of interest rates to motivate investment. These measures would expand the market. In turn, this would help businesses to increase investment, output, and employment to generate higher wages in the economy. Nevertheless, this theory could be ineffective during a liquidity trap, when increments in stock money fail to reduce interest rates and eventually fail to improve employment and output. 

Which School of Thought Would Be Best During a Period of Inflation? 

Monetarism school is associated with Milton Friedman. Advocates of this school consist of those economists who agree with the Keynesian principles but criticize if for emphasizing the importance of fiscal policy to fix economic problems. On the contrary, proponents of Monetarism emphasize that the government plays a major role in controlling money supply in the economy (Clift, 2018). According to this school, variations for money in circulation significantly influence national output and price levels for longer periods. In this view, Monetarist economists believe that to meet the objectives of monetary policy; the government should target the growth rate of the money in circulation instead of pursuing the discretionary monetary policy. Inflation has been and continues to be a monetary phenomenon, and therefore it can only be solved by a central bank policy that aims at keeping the demand and supply for money at equilibrium. This equilibrium would be measured by growth in demand and productivity (Schiller & Gebhardt, 2019). 

Which School of Thought Would Be Best During A Period of Stagflation? 

Stagflation refers to a mix of high unemployment, stagnant economic growth and high inflation (Banerjee & Warrier, 2017). This situation is unnatural because a weak economy is not supposed to experience inflation. Consumer demand goes downhill such that it prevents prices from rising. In a normal market economy, slow growth tends to prevent inflation. Though the monetarist theory and supply-sider theory are applicable during such a situation, solving stagflation comes with major trade-offs (Schiller & Gebhardt, 2019). 

The Monetarist School of Thought Solution 

According to the monetarist theory, the main macroeconomic goal is to reduce inflation. It is likely that a reduction in inflation could lead to lower economic growth and higher unemployment in the short term. However, these are a price worth suffering for higher inflation. In 1979-1084, the UK government applied this approach successfully (Schiller & Gebhardt, 2019). The government introduced deflationary policies, which helped in getting rid of inflation. 

Supply-Side School of Thought Solution 

One way to address stagflation is to boost aggregate supply by introducing supply-side policies. For instance, deregulation and privatization would help reduce the costs of production and increase efficiency. However, achieving these would require too much time (Schiller & Gebhardt, 2019). Moreover, given that cost-push inflation arises due to a global rise in the price of food and oil, there is very little that the government can do about the situation. However, cost-push inflation is often a temporary phenomenon; energy prices are not likely to increase forever. Hence, this is something that can be tolerated (Clift, 2018). The supply-sider school recommends that the government should employ monetary policy to reduce inflation. A rise in interest rates would increase the cost of borrowing which reduces aggregate demand. Though this is effective in curbing inflation, it triggers a bigger drop in GDP. Hence, the Central Bank would be reluctant to focus on inflation since growth is already down. A good example occurred in 2008/09 when the Bank of England tolerated 5% cost-push inflation because the country was interested in economic growth (Wolff, 2012). If a government cuts interest rates in an attempt to increase GDP, inflation will worse. Therefore, supply-sider theory struggles to address stagflation since it can only solve one specific aspect. 

Conclusion 

This paper has looked at the four different schools of economic thought namely Keynesian, Classical, Monetarist, and Supply-Sider with regard to how they can fix economic problems. The essay has looked at which school of thought is best during recession, inflation, and stagflation. 

References 

Banerjee, S., & Warrier, P. N. (2017).  Macroeconomics: Theories and applications for emerging economies . 

Bheemaiah, K. (2017).  The Blockchain alternative: rethinking macroeconomic policy and economic theory . http://resolver.library.cornell.edu/cgi-bin/EBookresolver?set=Books24x7&id=125509. 

Clift, B. (February 22, 2018). The IMF, Economic Schools of Thought, and Their Normative Underpinnings. 

In Frydman, R., & In Phelps, E. S. (2013).  Rethinking expectations: The way forward for macroeconomics . Princeton: Princeton University Press. 

Keynes, J. M. (2018).  The general theory of employment, interest, and money . http://search.ebscohost.com/login.aspx?direct=true&scope=site&db=nlebk&db=nlabk&AN=1855013. 

Schiller, B.S. & Gebhardt, K. (2019). Macro Economy Today - 15th edition. McGraw-Hill 

Tsoulfidis, L. (2010).  Competing schools of economic thought . Berlin: Springer. 

Wolff, R. D. (2012).  Contending Economic Theories: Neoclassical, Keynesian, and Marxian . http://sbiproxy.uqac.ca/login?url=http://international.scholarvox.com/book/88841790.