In my previous post, I explained how the 7 schools of macroeconomic thought are useful for understanding the US economy. In this post, I will explain why each school is important to understand the US economy better. The first school of macroeconomic thought, called the liquidity school, maintains that the supply of money determines the demand for it. The idea behind this school is that when a large pool of money is accessible, there will be rapid inflation, and large companies and unemployed individuals will take advantage of the situation to purchase large amounts of money. This form of inflationary pressures will cause business cycles to occur, such as the stagflation noted in the Great Depression. Because the liquidity school believes that changes in the supply of money will have a significant effect on demand, this school is very anti-deflationary.
The second school, known as the demand-side school, believes that changes in the supply of money have little effect on business cycles and so do not contribute to high unemployment rates. It also discounts the potential effects of changes in the supply of aggregate demand because they believe that the effects of changes in aggregate demand are likely to be transitory. For this school, unemployment rates are based on changing expectations about the future path of aggregate demand. The demand-side school tends to be more pessimistic about the outlook for the supply of money. Because of this, it is skeptical about the reliability of the Phillips curve and considers fluctuations on the unemployment rate on a case by case basis.
The third school, called the demand-side school, assumes that changes in aggregate demand will affect prices, but does not depend on the supply of money to determine them. Consequently, it is pessimistic about the accuracy of the Phillips Curve and thus tends to be flabby about forecasts of the unemployment rate. The demand-side school can also be considered to be a relic from the gold standard days when it downplayed the role of demand. The modern version of the demand-side school is represented by the monetarism school which, following the work of Milton Friedman, holds that taxation has too much of an adverse affect on the level of output.
The fourth school, referred to as the supply-side school, believes that increases in aggregate demand do have an effect on the level of employment. It bases its beliefs on the notion that businesses expand to allow for increases in demand, driving up the supply of labor. Because of this, the supply-side school sees unemployment as the natural response of the business cycle to be felt by the worker when the demand for his or her labor is above or beyond what he or she can readily supply. For this reason, the supply-side school is pessimistic about recessions. However, the Phillips Curve shows that there are times when increases in aggregate demand do push up unemployment to levels beyond those of full employment.
The fifth school, named after the famous G.D. Philips, is sometimes called the demand-side school. Like Phillips, the members of this school believe that increases in aggregate demand do have an effect on employment. Phillips argued that employment tends to increase when the demand for something rises above and beyond what it can supply. The demand-side school of macroeconomics believes that unemployment tends to fall when there is an increase in aggregate demand.
The seventh school, named after Nobel Prize . . . . . . winner Sir Alfred Beveridge, thinks that changes in the state of mind of individuals have a profound impact on the state of the economy. According to this school, unemployment is caused by a mental recession, which is worsened by changes in the economic environment. Sir Beveridge believed that people tend to look at the brighter side of any issue and choose to focus on that issue rather than the more complex arguments. Therefore, he believed that unemployment was caused by a failing economy. His seven economic principles were adopted by the British government as a guide to prevent changes in the financial and credit environment that might harm the economy.