FINRA exam prep- schools of economic thought

In this article we are going to take a look at the impact Economic Policy can have on the overall health of the business cycle. Additionally, we will look at the approach taken by various schools of economic thought  to try to guide the economy through the business cycle.

Classical economics

Classical economics originated in the 18th century. Economists like Adam Smith believed that markets would adjust automatically to keep the economy in equilibrium. If there is unemployment, workers will quickly accept lower wages and price themselves back into the labor market. The equilibrium growth rate will be restored and prices will be lower too. If the economy is producing beyond capacity, prices and wages will increase. The increased prices will reduce demand.

Keynesian Economics

Keynesian economics was popular for a number of decades from the 1930s. Keynesians believe that it is the responsibility of governments to intervene in the economy as the “classical” corrections are not able to react quickly enough in a modern economy. Where there is unemployment, the government should intervene by increasing spending (or cutting taxes) to stimulate growth. Where the economy is in an inflationary period of over-capacity, governments should intervene by reducing spending or increasing taxes.

The Keynesian concept continues to some extent with the “golden rule” that governments can borrow in periods of low aggregate demand so long as the books are balanced over the business cycle. Borrowings incurred to grow the economy out of recessionary phases should be repaid from higher taxes levied during the expansionary phases.

Of course, arguments rage about whether Keynes was right. Higher government borrowing might simply push up interest rates, crowding out private sector investment. Keynes would say the government only borrows because the private sector does not. The higher interest rates might cause the currency to appreciate – as foreign capital flows in to get the higher interest rates. Keynes argues that this capital inflow provides the funds for the private sector that his opponents claimed the private sector would be crowded out of. The application of Keynesian policy during the ”60s and ”70s certainly did seem to be problematic. The problems were largely the result of the following time lags:

• Recognition Lag: Getting the information to where we are takes so long that it is out of date
• Administration Lag: It takes time to decide how to spend the increased government expenditure
• Operational Lag: There is a delay in implementing the spending plans

These lags can make fiscal policy pro-cyclical rather than counter-cyclical with money taken out when the economy needs it to be put in and vice versa.

Monetarist Economics

Monetarism is based on the quantity theory of money. Monetarists believe that economic management is better left to Central Banks such as the Federal Reserve (Fed) than governments. The Fed can stimulate the economy via interest rates. Interest rates can be targeted using the following methods:

• Open Market Operations: The Fed buying assets such as government bonds puts money into the economy (and selling them takes money out) much more quickly than by altering taxes or spending.
• Policy Rate: In the U.S. this is called the discount rate; it represents the rate at which banks can borrow from the Fed. A reduction in the rate would allow banks to lend more cheaply to individuals and businesses.
• Reserve Ratio: The Fed requires that banks only lend on a proportion of each deposit they receive. A decrease in the rate will allow banks to lend more money, which may stimulate the economy

Successful Central Bank Management

Successful management by central banks seems to require that:

• The central bank clearly states its intentions
• These intentions are in line with past actions
• People believe that the stated intentions will be implemented effectively

Given the problems experienced historically with active intervention, two feedback models have been proposed that might offer a steadier (and therefore overall more successful) approach to managing economies.

We hope this article helped you understand the impact of economic policy and has better prepared you to pass your upcoming exam.

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Good luck on your exam!

 The Securities Institute of America