ECN 3111

1. ECN 3111 History of Economic Thought THE CHICAGO SCHOOL

2. INTRODUCTION • The modern phase of the Chicago School begins in 1946.- when Milton Friedman joined the faculty at the University of Chicago. • He and George Stigler who arrived at the school in 1948, firmly established the school unique identity.

3. INTRODUCTION • The tenets of the Chicago school fit within the broader classical-neoclassical tradition. • But the Chicago perspectives is a variant of neoclassical and it is more referred to “new classicism”

4. INTRODUCTION • In the 1970s, there were several macroeconomic developments that could not be explained by the existing economic theory. • One of the anomalies was the phenomena of stagflation i.e. stagnation and inflation at the same time. • In Keynesian Economics, this is not possible – because according to Keynes inflation occurs when aggregate demand intersects aggregate supply at a point higher than the full-employment level. High aggregate demand means period of boom, not stagnation.

5. INTRODUCTION • Hence, the group of economist at Chicago University, led by Milton Friedman, began to challenge the main precepts in Keynesian economics in the 1970s. • The efforts of these economists resulted with what is known as the counterrevolution, in contrast to the Keynesian revolution.

6. THE MAIN TENETS OF THE CHICAGO SCHOOL (Brue, 1994) • Rejection of the Keynesian Economics: Monetarist do not believe in the effectiveness of the fiscal policy and monetary policies. • In fact they believe that active intervention by the government does more harm than good, because of the uncertainty of the effects of the fiscal and monetary policies. • There is the lagged period before these policies can take effect and very often policies are taken with political motives, like implementing expansionary policies just before election.

7. THE MAIN TENETS OF THE CHICAGO SCHOOL (Brue, 1994) • Optimizing Behavior: members of the school muse the principle of optimizing behavior in their economic models. • People attempt to maximize their well-being; i.e. they engage in optimizing behavior in making their decisions. • Basic unit is individual. Individual can be combined into larger units –families, political interest groups, business organizations – a way to achieve gains from specialization and exchange.

8. THE MAIN TENETS OF THE CHICAGO SCHOOL (Brue, 1994) • Preference tends to be stable and independent of prices. People make rational choices although such choice do not always produce expected result. • Benefits and cost are uncertain. To reduce this uncertainty, the decision maker seeks information equals the marginal cost of obtaining it. • Consumers, workers and firms respond to monetary incentives.

9. THE MAIN TENETS OF THE CHICAGO SCHOOL (Brue, 1994) • Prices and wages converge onto their long-run Equilibrium. • Observed prices and wages in general tend to be good approximations of their long-run competitive ones. • They believe that prices and wages will converge on to their long-run equilibrium values, given sufficient time. Even monopoly profits will eventually erode, provided that there are no barriers to entry erected by the government. • Externalities and market failure can be overcome by establishing clear property rights and encouraging private negotiations. • The efficacy of the free market mechanism should not be underestimated.

10. THE MAIN TENETS OF THE CHICAGO SCHOOL (Brue, 1994) 4. Limited government. – Government in inherently in efficient as an agent for achieving objectives, which be satisfied through private exchange. • Government officials tend to optimize their objectives and therefore divert part of the resources allocated for public projects for their own benefit. • Objectives can be achieved via private enterprises and private exchanges rather than through public programs.

11. THE MAIN TENETS OF THE CHICAGO SCHOOL (Brue, 1994) 5. Mathematical Orientation: they relies heavily on mathematical theorizing, using both Marshallian partial equilibrium method and the Walrasian general equilibrium approach. Empirical verification is stressed but sometimes left to others.

12. Leading Figures in the Chicago School • Milton Friedman (1912 -200…) leading figure. • Completed his undergraduate at Rutgers University and received his graduate degrees from University of Chicago and Columbia University. • While in Chicago he was greatly influenced by Frank Knight. • In 1948 he joined the faculty at Chicago, until his retirement in 1977. • Later he served as a senior fellow at the Hoover Institution at Stanford University.

13. Milton Friedman • He was the president of the American Economic Association in 1967 and won a Noble Prize in economics in 1976. • His ideas are known to a wide spectrum of the American Public. • He served as a columnist for Newsweek. • Written popular books in economics, participated in educational television series, and delivered addresses to numerous groups.

14. Milton Friedman • In 1957 he published his work on the consumption function in which he criticized Keynes’s consumption function for being too simple. • According to him the household consumption was determined by permanent income rather than current income. – this is now known as permanent income hypothesis.

15. Milton Friedman • Friedman is also best known for his work on the role of money in an economy. • He claimed that the demand for money is highly stable- more stable even than the consumption function that is used as a key relationship. • Inflation, according to him is always there and is everywhere, and a monetary phenomenon produced by too rapid growth of money supply. • He also put on a controversial conclusion that the great depression of the 1930s was due to monetary policy.

16. Chicago School in Contrast with Keynesian • The Keynesian School is an in interventionist approach in managing the economy but Monetarist feels that “best government is the least government”.