Evolution of Economics

The theory of economics traces back its origin to the times of Adam Smith, who is known as the Father of Economics. His book ‘The Wealth of nations’, which was written in 1776, had laid the groundwork for the theory of Economics. The crux of the book lies around his propositions such as that an economy in order to bolster its position must increase its exports and resist its imports, an economic system is self balancing and independent in nature and the state need not involve in regulating measures such as price regulation, provision of subsidies. This idea of economic thought is known as Classical school of Economics. Prominent classical school economists are Adam Smith, J.B. Say, and David Ricardo. The classical school of economic thought could even be better illustrated through Say’s law that is popularly given as ‘Supply creates its own demand’. This means that whatever an organization produces would be bought in the market. This proposition is based on the ground that the organization in the course of its production would employ its labour. The reward that they give to the labour in the form of wages would be used by them to purchase from the market whatever the organization produces.
 

The validity of the ideas of the classical school of economics was questioned in 1930-s when the capitalist economies experienced economic crisis popularly termed as Great depression. The classical school of economics was unable to provide an explanation to the widespread prevalence of unemployment during the 1930-s. Classical thought was questioned on the footing that ‘If Supply could create its own demand, why is the question of over production arises..?’ At that point emerged another theory that was propounded by the British economist John Maynard Keynes as an answer to the puzzle. Contrary to the theory of Classical economists that the system is self regulating, Keynes made his proposition that it is not the inherent characteristic of a capitalist economy to maintain the economy at full employment. Over production of output does occur and as a result unemployment problem could arise.

The understanding of the grounds of rebuttal of theory of Classical economists by Keynes demands a finer understanding of the operational dynamics of the classical thought.  Classical economists justified their stance that full employment equilibrium tends to be natural state of existence of a capitalist economy through positing that the system is self adjusting so that the labour market and the capital market would act within itself to maintain full employment. The explanation to the self adjustment is two pronged.

The income of any individual could either be spent on goods that he consumes or saved. If the income is spent entirely on consumption, as long as the demand, which is backed by the individual’s earning, is strong enough to absorb the production of an organization, there won’t be any problem about the stability of the employment level. But if the demand falls short of the supply then the equilibrium in the employment level would be lost. The classical economists formulated a theory that the prices and the real wage rate would react among themselves to restore full employment, if the potency of demand falls short failing to absorb the entire production .  

On the other hand if an individual would have saved a part of his income, an element called savings needs to be factored in to articulate the mesh. They proposed that all the money that is saved would be invested with banks or other financial intermediaries, from where, the entrepreneurs would borrow and spend their borrowings on capital investments such as machinery, land etc... This capital investment will employ its own chunk of labour force. Thus the level of employment could be increased. The question how system could ensure all the money saved will be invested was addressed by a factor called as Rate of interest. When the rate of interest is high, people will be more willing to deposit their money as deposits in banks and will be more hesitant to borrow money from the bank. On the other hand, if the rate of interest stands low, lesser amount of money would be deposited since banks offer them lesser returns on their savings whereas more money would be borrowed since the cost of such borrowings is less now. The Central bank of a country would fix the interest rate in such a way that the deposits and borrowings strike a balance i.e., No surplus or deficit of deposits or borrowings. Thus all the money saved would be made to be invested. Therefore the question of unemployment is eliminated. Thus the classical economic thought was sailing comfortably, on the hypothesis that no matter what one earns and what one saves, the inherent nature of the system will ensure that economy remains balanced with no massive turbulence in terms of unemployment until the Great depression of 1930-s. But the inability of the classical thought to provide an explanation to the depression warranted an alternative economics to develop. 

Keynesian economics offered a solution to the conundrum. His attack on classical economics was on two fronts – The so called adjusting factors namely Real wage rate, Prices and Interest rate would not always provide for the system to strike a balance. Contrary to classical economist’s proposition that all the money saved would be made to be invested by the system, Keynes said that the system may fail to plough back the savings into investments. 

In his book ‘General Theory on Employment, Interest and Money’ he states that when a sense of pessimism takes over in the minds of the people about the business expectations, no matter however much the interest rate is brought down, the investment would not surge. Apart from rate of interest, he said, people’s attitude about business expectation plays a major role in bringing savings and investment to equilibrium. On the other hand, classical thought conceived that interest rate cuts could promote business expansion in every scenario. But the Second World War (1929-35), which was on at that time, prevented the business expectations to pick up. As a way out, Keynes proposed that the government through its fiscal policy mechanism (Tax regime) should ensure that public expenditure should be increased to create increase the employment level. This mode of increased financing by the state to create employment in excess of its earning capacity is known as deficit financing. Thus Keynesian economics entrenched.

It prevailed to be the popular theory providing the basis of economic policy formulation until    1970-s. But in the early 1970-s following events such as Vietnam war, collapse of Bretton woods system  the economic scenario in USA so turned out that it started developing both high inflation and high employment. The situation paved way for other theories to emerge such as Monetarism, which is again a theory that stood aligned to classical thought in essence. Milton Friedman, the one who propounded Monetarism, argued that an effective monetary policy (Rate of Interest wielding) by a central bank could only be a cure for economic 

crisis.

Thus over the period of time economic theory has evolved taking different forms in response to the spurs of different point of times. Of late economies have started deploying unconventional tools such as Quantitative Easing (QE), modified methods of deploying monetary policy etc... to fight against economic crisis. With the emergence of new complexities the need for a wary conception and implementation of economic theories into the policies stands very imperative.