Five Classical Economics Basics (Neo-Classical, Supply Side, Trickle Down, Monetarism, Free Trade)



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Five Classical Economics Basics

(Neo-Classical, Supply Side, Trickle Down, Monetarism, Free Trade)


  • In the long run, competition forces companies to be efficient and develop new technologies. If a company doesn’t, it will lose market shares to those that do.

  • In the long run, competition encourages companies to reduce prices. If a company doesn’t, it will lose market shares to those that do.

  • In the long run, competition encourages companies to create better wages and working conditions. If a company doesn’t, workers will move to companies that do.

  • In the long run, competition will create self correcting stability and prosperity.

  • If stability is lost, suppliers can correct the surpluses and shortages with new prices, production goals, and wage rates. For shortages: raise prices, produce more, pay more to extra workers. For surpluses: lower prices, produce less, pay less to fewer workers.


What is the Role of Government in Classical Economics?


  • Protect private property rights that allow the incentive to profit.

  • Protect economic law and order to allow competition without cheating.

  • Defend the nation to allow open competitive markets.

  • Promote free trade to allow competitive forces to benefit all nations.

  • Lower taxes to restrict governmental interference and encourage industrial development.


How will Classical Economics show up on the AP?


  • Flexible currency exchange rates

  • Long Run Aggregate Supply lines on the Aggregate Model

  • Straight Short Run Aggregate Supply lines on the Aggregate Model

  • Flexible price adjustments between the SRAS and the LRAS that return the shifts back to equilibrium (example: 2012 Q.3 parts C and D)

  • Comparative Advantage problems

  • The use of the Phillips Curve and logic behind a country’s Natural Rate of Unemployment

  • MV = PQ (The amount of money available times the velocity of money will be equal to the level of prices times the quantity of goods and services.


What are historic examples of Classical Economics?


  • Adam Smith published The Wealth of Nations in 1776 and gave the world the basic concepts and developed what became known as the “Invisible Hand” theory of constant economic improvement in market economies

  • Jean-Baptiste Say published Traite d’Economie Politique in 1804 and gave the concepts of what became known as “Say’s Law” or “supply creates its own demand” that explained how suppliers could balance shortages and surpluses back to full production.

  • Thomas Malthus published, and re-published, An Essay on the Principle of Population until 1826 which outlined the classical theory that excessive governmental assistance to the poor would only encourage more poverty and unrestrained population growth.

  • David Ricardo published Principles of Political Economy and Taxation in 1817 and developed theories of free trade, absolute advantages, and comparative advantages that are the fundamental principles of the majority of free trade discussions since WWII.

If every country focuses on what it can produce efficiently and then trade for other goods from partners that are doing the same, all trading partners get more of everything.

  • Alfred Marshall published Principles of Economics in 1890 and this became the standard work for the study of economics in its development of theories of supply and demand, marginal thinking, and costs of production.

  • Friedrich Hayek published The Road to Serfdom in 1944 and The Constitution of Liberty in 1960. Both works have seen a revival in popularity with Thatcher and Reagan conservatives, especially in the sharp attacks against government sponsored social programs and union restrictions against flexible wages and free trade.

  • Milton Friedman published Monetary History of the United States in 1963 and continued the arguments against excessive governmental regulations of the economy, the presence of a “natural rate of unemployment” for each nation, and the need for simpler monetary policies than provided by the Federal Reserve System. Friedman was an economic advisor to the Reagan administration. The Natural Rate of Unemployment assumes that public help to the unemployed will increase the number of unemployed, or at least keep them unemployed for longer periods of time.


Five Keynesian Economics Basics

(Protective Tariffs, Neo-Keynesian)


  • In the long run, competition can create better standards of living for market economies.

  • However, societies don’t live in the long run. The immediate, short run is critical for making a living, taking care of families, putting food on the table. In the short run, all competitive markets have flaws that create one crisis after another.

  • Businesses often are not efficient and many fail, therefore they always under-employ the workforce.

  • Say’s Law of suppliers balancing the economy is mythical. Businesses can’t always jettison workers, cut salaries, reduce prices because resources didn’t get more plentiful and society will reject these “solutions”. Wages are usually “sticky” when forced downward. This all is known as the “Ratchet Effect”.

  • Consumers will fear both inflation and unemployment. When they fear inflation, they will panic buy to beat the price increases, thus causing worse inflation. When they fear unemployment, they quit buying and cause surpluses, thus creating more unemployment.


What is the Role of Government in Keynesian Economics?


  • Focus on the short run. In the short run there will be flaws. “In the long run, we are all dead.”

  • Forget the Supply solutions to problems, create the correct amount of demand.

  • During the inevitable recessions, lower taxes to boost consumption spending and raise government spending to create jobs. Run deficits as needed (and assumed).

  • During the occasional inflation spirals, raise taxes to dampen consumption spending and decrease government spending to slow job growth. Run surpluses to pay off older debts and then get ready for the next recession.

  • Create stabilizers to dampen the effects of the next crisis. Protect the elderly with social security programs and slow the panic of the unemployed with compensation. Give subsidies to key industries to keep technology developing and keep jobs plentiful.


How will Keynesian Economics show up on the AP?


  • Any use of the phrase Fiscal Policies will connect to Congressional/Keynesian decisions.

  • A segmented Short Run Aggregate Supply line (as found in older editions of texts still used in many states: horizontal range = Keynesian range)

  • The assumption that fiscal policies used to fight recessions will always create deficits

  • The concept of “crowding out” as a consequence of expansionary fiscal policies

  • Changes in the Money Demand line on the Money Market Graph


What are historic examples of Keynesian Economics?


  • Alexander Hamilton and other early US Federalists won many arguments for protective tariffs in the late 1700s. Tariff arguments dominated both Republican and Democratic policies for most of the 1800s and into the 1930s. Although these arguments existed before Keynes became famous, they continue to be used for some debates against free trade today.

  • John Maynard Keynes published the General Theory of Employment, Interest, and Money in 1936 and summarized his political programs and predictions that revolutionized the role of governments after the collapse of world markets during the Great Depression. All western republics have various forms of his theories in place to combat recessions and unemployment.

  • Paul Samuelson published Economics: An Introductory Analysis in 1948 which created the basic textbook format and explanations used in university programs ever since. Samuelson is also considered one of the major leaders in the mathematical applications to economic problems.

  • Paul Krugman published at least two major textbooks used in colleges today: International Economics: Theory and Policy (with Maurice Obstfeld) and Economics (with Robin Wells). He was also an advisor to the Reagan administration and still writes many influential essays for the New York Times. His works are the basis for much of the curriculum taught in AP macro economics courses.


Five Monetary Policy Basics

(Central Bank Policies, Federal Reserve Policies, Fine Tuning)


  • Competitive markets can flourish but need goals of stable growth and low inflation rates.

  • Keynesians policies fail to work quickly enough to help with tax cuts and job programs. By the time the “stimulus” plan is debated and passed by any legislative body, the recession that caused the policy debate has probably ended on its own.

  • Keynesian policies really collapse during times of inflation because legislative bodies won’t raise taxes and cut government job programs. The tax increases get leaders removed from office and the job programs are usually entrenched in fiercely protective bureaucracies and lobby groups.

  • Stagflation creates a crisis that no elected government can easily solve. Fight the excessive unemployment and increase the inflation even more. Fight the inflation and increase the excessive unemployment even more.

  • Inflation is always more damaging to any economy than unemployment. Unemployment hurts the jobless; inflation hurts everyone in the society.


What is the Role of Government in Monetary Policies?


  • A non-political agency can regulate banks, the money supply, and interest rates. It will be especially effective when painful and unpopular decisions need to be made and will make them in a timely manner. This can be the central banking system.

  • During recessions, impact the overall investment demand through tools that increase the incentive to borrow. This will be lower interest rates.

  • During inflation, impact the overall investment demand through tools that decrease the incentive to borrow. This will be higher interest rates.

  • During stagflation, when public officials don’t know what to do or are unwilling to do much, curtail the inflation first. Get the economy back to normal investment levels and then unemployment problems will be lessened.

  • Build central bank rules and tools that keep the overall growth rate steady and manageable. Keep banks from taking on too much risk and pushing the “correct” amounts of loanable funds into the economy.


How will Monetary Policies show up on the AP?


  • Any mention of central bank policies

  • Any mention of “open market operations” which will always connect to bond markets

  • The changes in the Supply of Money line on the Money Market graph

  • The general use of the Investment Demand graph and the Loanable Fund Market Graph

  • The use of domestic interest rates as the key to “borrowing money” for private gross investment (Ig). The use of international interest rates as an incentive for investment in a country’s markets.

What are historic examples of Monetary Policies?


  • The establishment of the Federal Reserve in the USA, 1913: Partially as a response to the private bailouts of banks during the Panic of 1907, Congress created the Federal Reserve under the leadership of Woodrow Wilson. Even though the Fed failed to stem the Great Depression, the central bank system was established.

  • Bretton Woods Conference, 1944: Numerous western nations agreed during WWII to avoid the tariff problems of the Great Depression, use central bank policies to promote market stability and increase international trade and cooperation.

  • Paul Volcker: Fed chairman Volcker was put into office during the end of the Carter administration and made it a primary goal to tackle the steep stagflation plaguing the economy. He very publically pushed interest rates up to record levels, severely limiting gross investment but shutting off many inflation factors. The recovery during the 1980’s helped make Fed policies very famous and very obvious to the general public.

  • Alan Greenspan: Fed chairman after Volcker, Mr. Greenspan was constantly in the news arguing Fed decisions and debates. He also made fighting inflation a key goal. The Fed crashed interest rates to record lows during the early 2000s, helping fight off constant recessionary pressures. Chairman Greenspan later wrote that the Fed possibly went too far with low rates, contributing to the housing market bubble and crash.

  • Ben Bernanke: The current Chairman has led the Fed during the significant downturn of 2009, helping rescue the banking system with money supply injections and new Fed tools to help banks keep stable without sparking inflation fears.



Created by Ulrich Kleinschmidt

Kempner HS, Sugar Land, TX

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