Dynamic Economics: Optimization by the Lagrange Method

By Gregory C. Chow | Go to book overview

CHAPTER FIVE Business Cycles

5.1 Keynes and the Classics

The title of this section is borrowed from a well-known article of Hicks ( 1937), which attempted to give an exposition of Keynes' General Theory ( 1936). Observing the Great Depression in the United States in the early 1930s, Keynes thought that full-employment equilibrium could sometimes fail to be attained by the institutions of a market economy. His influential book has guided research in economic fluctuations since the 1940s. The classical ideas in economics, as taught at the University of Chicago since at least the time of Henry Simon and Frank Knight in the early 1930s, consist of two key words: competitive equilibrium. By competitive, one can mean perfectly competitive or monopolistically (or imperfectly) competitive. In a class on the history of economic thought given in the academic year 1951-1952, Knight said that when Chamberlin ( 1933) had first appeared, he had thought that the contribution was important, but with more deliberation, he later thought Chamberlin's book on monopolistic competition was merely a footnote to Marshall ( 1920). When Milton Friedman, a student of Frank Knight, taught price theory in the autumn quarter of 1951, Marshall Principles of Economics was still the main text. Friedman remarked in class, "Marshall is still the best text even though some newer expositions have appeared." There is no question that the word competitive means mainly "perfectly competitive" rather than "monopolistically competitive" to the classical economists in Chicago.

The second difference between the classics and the Keynesians, or between Chicago and Cambridge, Mass., is that the word "equilibrium" is more relevant than "disequilibrium." Keynes' idea of wage rigidity suggests that the market consisting of demand for and supply of labor might not be in equilibrium, with wage frequently adjusting to guarantee full employment. The observation of mass unemployment in the early 1930s in the United States has led Keynes and others following him to believe that perhaps the labor market is not always near its equilibrium point. Furthermore, the rate of interest is

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