Progress in Economics As elusive as soap in the bath?
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Transcript of Progress in Economics As elusive as soap in the bath?
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Progress in Economics
As elusive as soap in the bath?
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The issue of social science
• Pure science includes subjects such as Physics and Chemistry
• They have the ability to use laboratory experiments to test theories and examine the world
• Social sciences have no laboratory, there can be no experiments, just observation.
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No lab, so what do you do?
• There are two ways to approach a problem when you can’t experiment
• 1. Observe the world and see if you can see a pattern
• 2. Think about the world and form a theory which you then test against reality
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No lab, so what do you do?
• The first is called Induction or the inductive method
• The second Deduction or the deductive method
• The problem is the first is logical nonsense and the second may never work!
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Induction
• The process of induction
• Observe the data – an empirical study
• Form a theory (hypothesis) from those observations
• Usually works in the hard sciences. Repeat experiments, get the same results time and time again and you are probably on safe ground
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Induction
• Social sciences have a problem
• No matter how many observations are made there is no inevitability that future observations will support the same theory.
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Induction
• I observe only white swans
• I induce that all swans are white
• But a black one might be out there
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Deduction
• Start with axioms which are taken to be true
• Apply deductive logic and form a theory
• Then test against reality (the data)
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Deduction
• Axiom: Consumers try to maximise their satisfaction through rational decisions
• Logic: Consumers will try to get the best value for money from their income when deciding what to buy
• Theory: If the price of a good rises Consumers will buy less of it
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Deduction
• Problems for Economics
• Consumers may not be rational
• More than just price may change at the same time
• So price may rise and people buy more of a good – maybe incomes changed, people judge quality by price, a good consumed with it got cheaper
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Deduction
• So economics must make the assumption of Ceteris Paribus – All other things stay the same – for the theory to make sense
• Also the assumptions may be wrong.
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Hypothetico-Deductive Method
• Science requires a theory to produce a set of predictions which have the potential to be falsified by the evidence.
• So Economists favour the hypothetico-deductive method of reasoning as induction and deduction seem inadequate
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Hypothetico-Deductive Method
Hypothesis
Deduction
Proposition
Empirical testing
Induction
Revised hypothesis
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Hypothetico-Deductive Method
HypothesisThere is a relationship between theLevel of unemployment and wage rises
DeductionWhen unemployment is low Unions can ask for higher wages
PropositionInflation is caused by ‘wage-push’ factors
Empirical testing
Induction
Revised hypothesis
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The Phillips Curve
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Hypothetico-Deductive Method
Hypothesis
Deduction
Proposition
Empirical testing
InductionThere is a trade-off between Unemployment and inflation
Revised hypothesisInflation is caused by cost factors and highest duringlow unemployment
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Phillips curve
It turned out to be wrong!
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The Reality
• Economists debate – argue with each other to make progress
• The problem is that when forming the hypothesis they will rely on selecting axioms
• And the economists core belief will guide that choice
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Progress through debate
• Since the start of Economics as a distinct subject (1776) economists have argued their point
• One of the oldest debates in economics is the one about the cause of recessions.
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Progress through debate
• There are two fundamental schools of thought:
• Those who believe that the economy is essentially self regulating
• Those who believe that the economy can fail to employ everyone and growth is not assured
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What causes recessions?
• This debate has been an active one since the 18th Century
• We will concentrate on its latest incarnation the Keynesian – Monetarist debate
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How debates proceed
• One side lays out their theory. They state their assumptions and put forward their predictions
• They appeal to the data to support their theory
• The other side put forward their objections and may state a theory of their own
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Keynesian thinking• Keynes reignited this old debate in his
‘General Theory’ in 1936. His aim was to explain the ‘Great Depression’ of 1930 to 33.
• His axiom is that the economy is not self-regulating
• His hypothesis is that it is possible for expenditure in the economy to be less than the total level of output
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Keynesian thinking
HypothesisIt is possible for effective demand to beless than total output
DeductionThis will lead to a ‘surplus’ level ofoutput and so workers will bereleased by firms
PropositionWithout government actionto boost demand the situationpersists
Empirical testing
Induction
Revised hypothesis
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Keynesian thinking
Hypothesis
Deduction
Proposition
Empirical testingThe Great Depression 1930To 1933
InductionIf effective demand risesthe recession will end
Revised HypothesisGovernments shouldManage the economy
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Keynesian thinking• The Keynesian view was very
persuasive in the wake of the experience of the 1930s
• Governments after 1945 followed a policy of managing the level of economic activity by manipulating the level of demand.
• They did this by varying their own spending and taxation levels
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Monetarist thinking• Monetarists represent the type of
thinking that dominated economics prior to the Great Depression
• There axiom was that the economy is essentially self-regulating, but cyclical
• Their hypothesis was that prolonged recessions must be caused by some sort of intervention in the normal process
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Monetarist thinking• For the Monetarists, led by Milton
Friedman and the Chicago School the problem was the quantity of money in circulation
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Monetarist thinking
HypothesisEffective demand is determined by thequantity of money in circulation
DeductionA fall in the money supply will leadto a fall in demand and so output
PropositionThe Central Bank shouldmaintain a stable money supply
Empirical testing
Induction
Revised hypothesis
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Monetarist thinking
Hypothesis
Deduction
Proposition
Empirical testingDuring Great Depression the FederalReserve allowed the US money supplyto fall by a third
InductionThe Great Depressionwas caused by theFederal Reserve Bank
Revised HypothesisCentral Banks should adopt a ‘Money Supply Rule’
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Monetarist thinking• After the failure of Keynesian policy in
the 1970s the Monetarist view became the norm
• This developed into the ‘New Classical’ approach as Monetarism is essentially a ‘one problem’ theory.
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The debate• In the 1970s Keynesians and
Monetarists debated how the economy worked with passion
• The debate was often difficult as each side talked at cross-purposes
• This was because their axioms – which were based on their core beliefs - conflicted
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The debate• But as time wore on progress was
made.
• Keynesians (now called Post-Keynesians and New-Keynesians) accepted that ‘money does matter’
• Milton Friedman discussed the Monetarist case in the format of the Keynesian IS/LM model
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The debate• By the 1990s a consensus was
reached.
• Inflation stability was prioritised but not by manipulating the money supply. Instead interest rates were used
• Aggregate demand was monitored to smooth out the business cycle while not threatening the inflation target
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The latest• The Global Financial Crisis was met by
a massive Keynesian style stimulus to boost demand in the economy
• No serious objections to this was raised by market economists recognising this was a major and unusual demand side shock
• Monetary policy was changed to support an economic recovery
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The latest• Sadly the debate now reignites
• There is still disagreement on
• 1. What caused the GFC
• 2. How to design policy to recover from it after the initial shock
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The latest
• But that’s why economics is so interesting – it’s always changing