1776 is the year that we associate with the signing of the Declaration of Independence, also marked the publication in England of one of the most influential books of our time “The Wealth of the Nations” written by Adam Smith. It earned the author the title “the father of economics”.
The heart of Smith’s economic philosophy was his belief that the economy would work best if left to function on its own without government regulation. In those circumstances, self-interest would lead business firms to produce only those products that consumers wanted and to produce them at the lowest possible cost. They would do this, not as a means of benefiting society, but in an effort to outperform their competitors and gain the greatest profit. He insisted that natural forces such as individual self-interest and competition naturally determine prices and incomes.
It was argued that a perfectly competitive economy would produce a general equilibrium. This is turn would lead to “allocative efficiency”, the point at which all the resources of an economy are being fully and efficiently employed, so that no particular output can be increased unless another is reduced, and no-one can become better off without making someone else worse off.
During the Great Depression of the 1930s as many as 13 million Americans were out of work. They were capable people and eager to work. But no one would hire them. The Great Depression of the 1930s demonstrated that, at least in the short term, the market system does not automatically lead to full employment. If people are pessimistic about the future, they will save more money and consume less, leading to a fall in production and employment. John Maynard Keynes recommended governmental intervention in the economy, to counter the business cycle: an increase in government spending or a decrease in taxation during a recession, to stimulate the economy and increase output, investment, consumption and employment; and a decrease in government spending or an increase in taxation in a period of inflation. To the classical argument that in the long run economies tend to settle at full employment equilibrium, Keynes replied that “in the long run we are all dead”.
In his General Theory of Employment, Interest and Money (1936), Keynes argued that people’s economic expectations about the future were generally erratic and random and could consequently be systematically wrong. His theory of instability was developed in nominal terms, not the real values used in aggregate supply and demand graphs. Keynes focused on how many dollars we spend, not on the quantity of output we purchase. Keynes asked how many dollars people will spend and how that rate of expenditure is related to income. This is Keynesian concept of aggregate spending.
Monetarists such as Milton Friedman argue that the average levels of prices, wages and economic activity are determined by the quantity of money in circulation and its velocity of circulation, and that inflation is caused by excessive monetary growth. Other economists have used the same date to argue follows prices, and not vice versa. Monetarists claim that Keynesian attempts to stabilize the business cycle only lead to rising prices and the crowding out of private investment, and that the business cycle, inflation and unemployment are the unintended results of misconceived government interventions and of exogenous variables. They insist that free markets and competition are efficient and should be allowed to operate with a minimum of governmental intervention. If money supply, rather than fiscal policy, is the major determinant of nominal GNP growth, the role of the government should be to ensure a fixed growth rate for the money supply.