Brief History of Macroeconomic Thought and Policy

Read this chapter to examine macroeconomic attitudes towards economic policies of the three main schools of economic thought: Classical, Keynesian, and Monetarist. Also, learn about modern day interpretations of the main ideas.

1. The Great Depression and Keynesian Economics

The Classical School and the Great Depression

The Great Depression came as a shock to what was then the conventional wisdom of economics. To see why, we must go back to the classical tradition of macroeconomics that dominated the economics profession when the Depression began.

Classical economics is the body of macroeconomic thought associated primarily with 19th-century British economist David Ricardo. His Principles of Political Economy and Taxation, published in 1817, established a tradition that dominated macroeconomic thought for over a century. Ricardo focused on the long run and on the forces that determine and produce growth in an economy's potential output. He emphasized the ability of flexible wages and prices to keep the economy at or near its natural level of employment.

According to the classical school, achieving what we now call the natural level of employment and potential output is not a problem; the economy can do that on its own. Classical economists recognized, however, that the process would take time. Ricardo admitted that there could be temporary periods in which employment would fall below the natural level. But his emphasis was on the long run, and in the long run all would be set right by the smooth functioning of the price system.

Economists of the classical school saw the massive slump that occurred in much of the world in the late 1920s and early 1930s as a short-run aberration. The economy would right itself in the long run, returning to its potential output and to the natural level of employment.