What is Economics

The Federal Reserve Bank of California

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Economics
Introduction
The word "economics" is derived from oikonomikos, which means skilled in household
management. Although the word is very old, the discipline of economics as we understand it
today is a relatively recent development. Modern economic thought emerged in the 17th and
18th centuries as the western world egan its transformation from an agrarian to an industrial
society.
!espite the enormous differences etween then and now, the economic prolems with which
society struggles remain the same"
#ow do we decide what to produce with our limited resources$
#ow do we ensure stale prices and full employment of our resources$
#ow do we provide a rising standard of living oth for ourselves and for future
generations$
%rogress in economic thought toward answers to these &uestions tends to take discrete steps
rather than to evolve smoothly over time. A new school of ideas suddenly emerges as changes
in the economy yield fresh insights and make e'isting doctrines osolete. The new school
eventually ecomes the consensus view, to e pushed aside y the ne't wave of new ideas.
This process continues today and its motivating force remains the same as that three centuries
ago" to understand the economy so that we may use it wisely to achieve society(s goals.
Mercantilists
Mercantilism was the economic philosophy adopted y merchants and statesmen during the
1)th and 17th centuries. Mercantilists elieved that a nation(s wealth came primarily from the
accumulation of gold and silver. *ations without mines could otain gold and silver only y
selling more goods than they ought from aroad. Accordingly, the leaders of those nations
intervened e'tensively in the market, imposing tariffs on foreign goods to restrict import trade,
and granting susidies to improve e'port prospects for domestic goods. Mercantilism
represented the elevation of commercial interests to the level of national policy.
Physiocrats
%hysiocrats, a group of 18th century +rench philosophers, developed the idea of the economy
as a circular flow of income and output. They opposed the Mercantilist policy of promoting trade
at the e'pense of agriculture ecause they elieved that agriculture was the sole source of
wealth in an economy. As a reaction against the Mercantilists( copious trade regulations, the
%hysiocrats advocated a policy of laisse,-faire, which called for minimal government
interference in the economy.
Classical School
The .lassical /chool of economic theory egan with the pulication in 177) of Adam /mith(s
monumental work, The Wealth of Nations. The ook identified land, laor, and capital as the
three factors of production and the ma0or contriutors to a nation(s wealth. 1n /mith(s view, the
ideal economy is a self-regulating market system that automatically satisfies the economic
needs of the populace. #e descried the market mechanism as an "invisile hand"
that leads all individuals, in pursuit of their own self-interests, to produce the greatest
enefit for society as a whole. /mith incorporated some of the %hysiocrats( ideas, including
laisse,-faire, into his own economic theories, ut re0ected the idea that only agriculture was
productive.
2hile Adam /mith emphasi,ed the production of income, !avid 3icardo focused on the
distriution of income among landowners, workers, and capitalists. 3icardo saw a conflict
etween landowners on the one hand and laour and capital on the other. #e posited that the
growth of population and capital, pressing against a fi'ed supply of land, pushes up rents and
holds down wages and profits.
Thomas 3oert Malthus used the idea of diminishing returns to e'plain low living standards.
%opulation, he argued, tended to increase geometrically, outstripping the production of food,
which increased arithmetically. The force of a rapidly growing population against a limited
amount of land meant diminishing returns to laor. The result, he claimed, was chronically low
wages, which prevented the standard of living for most of the population from rising aove the
susistence level.
Malthus also &uestioned the automatic tendency of a market economy to produce full
employment. #e lamed unemployment upon the economy(s tendency to limit its spending y
saving too much, a theme that lay forgotten until 4ohn Maynard 5eynes revived it in the 1678s.
.oming at the end of the .lassical tradition, 4ohn /tuart Mill parted company with the earlier
classical economists on the inevitaility of the distriution of income produced y the market
system.
Mill pointed to a distinct difference etween the market(s two roles" allocation of resources and
distriution of income. The market might e efficient in allocating resources ut not in
distriuting income, he wrote, making it necessary for society to intervene.
Marginalist School
.lassical economists theori,ed that prices are determined y the costs of production.
Marginalist economists emphasi,ed that prices also depend upon the level of demand, which in
turn depends upon the amount of consumer satisfaction provided y individual goods and
services.
Marginalists provided modern macroeconomics with the asic analytic tools of demand and
supply, consumer utility, and a mathematical framework for using those tools. Marginalists also
showed that in a free market economy, the factors of production -- land, laor, and capital --
receive returns e&ual to their contriutions to production. This principle was sometimes used to
0ustify the e'isting distriution of income" that people earned e'actly what they or their property
contriuted to production.
Marxist School
The Mar'ist /chool challenged the foundations of .lassical theory. 2riting during the mid-16th
century, 5arl Mar' saw capitalism as an evolutionary phase in economic development. #e
elieved that capitalism would ultimately destroy itself and e succeeded y a world without
private property.
An advocate of a laour theory of value, Mar' elieved that all production elongs to laour
ecause workers produce all value within society. #e elieved that the market system allows
capitalists, the owners of machinery and factories, to e'ploit workers y denying them a fair
share of what they produce. Mar' predicted that capitalism would produce growing misery for
workers as competition for profit led capitalists to adopt laour-saving machinery, creating a
"reserve army of the unemployed" who would eventually rise up and sei,e the means of
production.
Institutionalist School
1nstitutionalist economists regard individual economic ehaviour as part of a larger social
pattern influenced y current ways of living and modes of thought. They re0ected the narrow
.lassical view that people are primarily motivated y economic self-interest. 9pposing the
laisse,-faire attitude towards government(s role in the economy, the 1nstitutionalists called for
government controls and social reform to ring aout a more e&ual distriution of income.
Keynesian School
3eacting to the severity of the worldwide depression, 4ohn Maynard 5eynes in 167) roke from
the .lassical tradition with the pulication of the General Theory of Employment, Interest, and
Money. The .lassical view assumed that in a recession, wages and prices would decline to
restore full employment. 5eynes held that the opposite was true. +alling prices and wages, y
depressing people(s incomes, would prevent a revival of spending. #e insisted that direct
government intervention was necessary to increase total spending.
5eynes( arguments proved the modern rationale for the use of government spending and ta'ing
to staili,e the economy. :overnment would spend and decrease ta'es when private spending
was insufficient and threatened a recession; it would reduce spending and increase ta'es when
private spending was too great and threatened inflation. #is analytic framework, focusing on the
factors that determine total spending, remains the core of modern macroeconomic analysis.
Summary
<conomic theories are constantly changing. 5eynesian theory, with its emphasis on activist
government policies to promote high employment, dominated economic policymaking in the
early post-war period. =ut, starting in the late 16)8s, trouling inflation and lagging productivity
prodded economists to look for new solutions. +rom this search, new theories emerged"
Monetarism updates the >uantity Theory, the asis for macroeconomic analysis efore 5eynes.
1t reemphasi,es the critical role of monetary growth in determining inflation.
3ational <'pectations Theory provides a contemporary rationale for the pre-5eynesian tradition
of limited government involvement in the economy. 1t argues that the market(s aility to
anticipate government policy actions limits their effectiveness.
/upply-side <conomics recalls the .lassical /chool(s concern with economic growth as a
fundamental prere&uisite for improving society(s material well-eing. 1t emphasi,es the need for
incentives to save and invest if the nation(s economy is to grow.
These theories and others will e deated and tested. /ome will e accepted, some modified,
and others re0ected as we search to answer these asic economic &uestions" #ow do we
decide what to produce with our limited resources$ #ow do we ensure stale prices and full
employment of resources$ #ow do we provide a rising standard of living oth for now and the
future$
hat are the three fundamental !uestions that Economics endeavours to answer
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#ut the main ideas into the time line
1730
$ecade opens with #eace in Europe
Ben%amin Franklin begins #oor Richard&s 'lmanack in #hiladelphia( #enns)lvania
*ohn +a) patents fl)ing shuttle( a ma%or landmark in te,tile mass production( leading to te,tile mills in England
-oltaire writes .ettres sur les 'nglais championing democratic government
$avid /ume creates empiricist philosoph) in his Treatise on /uman 0ature
ar of *enkins& Ear begins when England declares war on 1pain
1740
ar of the 'ustrian 1uccession breaks out among ma%or European powers
ar of *enkins& Ear spreads to Florida and 2eorgia
*ohann 1ebastian Bach issues second volume of The ell3Tempered Clavier
The Treat) of 'i,3la3Chapelle ends ar of the 'ustrian 1uccession. 4a%or powers again at peace in Europe
$avid /artle) writes 5bservations on 4an( arguing that one&s moral sense is derived from an association of ideas
1750
6nterest on Britain&s national debt falls from 789 to :9
$enis $iderot and *ean d&'lembert begin publishing Enc)clopedia
Ben Franklin flies kite with ke) proving that lightning is like an electric spark
1amuel *ohnson publishes $ictionar) of the English .anguage.
Economist Francois ;uesna) founds the #h)siocrats( who advocate laisse<3faire economic policies
Claude3'drien /elvetius publishes $e&l&esprit arguing that self3interest is the primar) motive of human conduct
1760
1even =ears& ar ends with the Treat) of #aris and the Treat) of /ubertusberg
*. *. Rousseau published The 1ocial Contract arguing that government must rest on the consent of the governed
*oseph #riestle) issues an Essa) on First #rinciples of 2overnment anticipating *erem) Bentham&s ideal of
>greatest happiness for the greatest number>
Bo)cott of imports begins in Boston to oppose ta, on lead( paint( paper and tea
1770
Boston Tea #art) protests tea ta, in 'merica after its repeal in England
First Continental Congress meets in #hiladelphia and writes a $eclaration of Rights and 2rievances
Revolutionar) ar begins in Concord( 4assachusetts
Continental Congress on *ul) ?( 7@@A adopts the $eclaration of 6ndependence
'dam 1mith writes 6n!uir) 6nto the 0ature and Causes of the ealth of 0ations
1780
Revolutionar) troops defeat British at =orktown( -irginia to gain independence
6mmanuel +ant publishes Criti!ue of #ure Reason
Britain( B1'( France and 1pain sign the Treat) of -ersailles recogni<ing the independence of the Bnited 1tates of
'merica
First paddle wheel steamboat sails on the 1aone River( France
B.1. Constitution signed in #hiladelphia( #enns)lvania and ratified within a )ear
French Revolution begins in 7@CD with the storming of the Bastille #rison
1790
$ollar becomes the currenc) unit of B1'
Eli hitne) invents the cotton gin
Thomas #aine writes The 'ge of Reason
0apoleonic ars rage throughout Europe following the end of the French Revolution
British 2overnment introduces income ta,
Thomas 4althus completes Essa) on the #rinciple of #opulation
1800
0apoleonic Code( a s)stem of laws( is introduced in France
B1' bu)s .ouisiana Territor) from France
*ean3Baptiste 1a) writes Treatise on #olitical Econom)
.ewis and Clark e,pedition e,plores and maps western continental B1'
.udwig von Beethoven publishes Eth and Ath 1)mphonies
1810

1pain&s 1outh 'merican colonies struggle to gain independence
alter 1cott publishes averle) beginning popularit) of historical romance novel
British invade B1' and burn ashington $C in ar of 7C7F. Treat) of 2hent ends war
ellington defeats 0apoleon at aterloo. 0apoleonic ars end with the Congress of -ienna deciding the future
map of Europe
David Ricardo publishes rinciples o! olitical Econom" and #a$ation

18%0
#homas Robert &althus publishes rinciples o! olitical Econom"
4ichael Farada) develops primitive electric motor
The 4onroe $octrine e,presses B1'&s opposition to e,tension of European influence in the estern hemisphere
Erie Canal is opened for shipping
ebster publishes 'merican $ictionar) of the English .anguage
estern 'ustralia coloni<ed b) British
The orkingman&s #art) formed in 0ew =ork
1830
The Baltimore and 5hio becomes first railroad in B1'
.ouis *ac!ues $aguerre invents the first practical photographic process
C)rus 4cCormick patents a mechanical reaper
1amuel Colt patents his revolver
1amuel 4orse develops telegraph and 4orse Code for sending/receiving messages
6saac #itman develops a s)stem of shorthand writing
-ictoria becomes ;ueen of England
1840
*ohn 1tuart 4ill publishes #rinciples of #olitical Econom)
#otato crop failure in Europe causes an estimated F.E million to starve
2old is discovered in California
Factor) 'ct in Britain limits the working da) of women and children to 78 hours
1eries of republican revolutions in Europe end in failure and repression
+arl 4ar, and Friedrich Engels publish Communist 4anifesto
*ohn $eere invents plow with a steel mold3board

1850
5ld3'ge insurance introduced in France
Elisha 5tis demonstrates safet) elevator at 0ew =ork Fair of 7CE?
/enr) Bessemer revolutioni<es steel industr) with new converter process
Charles $arwin publishes 5n the 5rigin of the 1pecies b) means of 0atural 1election
First oil well in B1' is drilled in Titusville( #enns)lvania

1860
Civil ar begins at Fort 1umter( 1outh Carolina
6ssue of 2reenbacks to help finance the Civil ar marks the beginning of modern currenc) in B1'
Etienne .enoir invents internal combustion engine in France
0ational Banking 'ct establishes a s)stem of federall)3chartered banks in the B1'
Civil ar ends when 1outh surrenders at 'ppomatto, Courthouse( -irginia
+arl 4ar, begins writing $as +apital
'lfred 0obel invents d)namite
Bnion #acific and Central #acific railroads meet in Btah
1870
The 1tandard 5il Compan) is founded b) *ohn $. Rockefeller
Cit) of Chicago destro)ed b) fire
2erman) adopts the mark as its currenc)
Financial panic in Europe spreads to B1'( causing withdrawal of foreign capital
'le,ander 2raham Bell invents telephone
Thomas 'lva Edison invents the phonograph and electric light bulb
1880
/einrich /ert< identifies radio waves
2ottlieb $aimler builds first automobile
1890
.abor unrest erupts in B1' when workers strike the Carnegie 1teel Compan)
'lfred 4arshall publishes #rinciples of Economics
B.1. Congress enacts 6ncome Ta, 'ct( but 1upreme Court declares it unconstitutional
/enr) Ford produces his first automobile

1900
2uglielmo 4arconi transmits messages across 'tlantic with wireless telegraph
5rville and ilbur right make first heavier3than3air machine flight
'lbert Einstein publishes Theor) of Relativit)
Earth!uake and fire destro) much of 1an Francisco
Financial panic in 7D8@ begins with the fall of the 1tock 4arket and causes man) banks to close
2old 1tandard 'ct enacted in B1'
#a)ne3'ldrich Tariff 'ct raises tariffs on imports into B1'

1910
4arie Curie discovers radium
Federal Reserve 'ct creates central bank for the B1'
'ssassination of 'ustria&s 'rchduke Francis Ferdinand brings about orld ar 6
2ilbert .ewis develops electron theor) of valenc) e,plaining structure of atoms
Revolution overthrows monarch) in Russia
#aris #eace Conference redraws map of Europe after orld ar 6 and establishes the .eague of 0ations
19%0
omen in B1' receive the right to vote
#rohibition begins in the B1' as sale of all alcoholic beverages becomes illegal
2erman) suffers financial collapse as h)perinflation destro)s value of the 4ark
B.1. 1teel Compan) abolishes twelve hour work da) and seven da) work week
'le,ander Fleming discovers penicillin
Charles .indbergh makes first solo airplane flight across the 'tlantic
Collapse of 1tock 4arket ushers in decade of economic hardship

1930

orldwide $epression worsens( fostering the rise of political e,tremists
/awle)31moot Tariff Bill sets highest duties in B1 histor)( hurting world trade
*ames Chadwick discovers the neutron( Carl 'nderson discovers the positron
B.1. repeals #rohibition 'mendment
#resident Franklin Roosevelt begins 0ew $eal government spending programs
'dolf /itler becomes Chancellor of 2erman)
allace Carothers produces #ol)mer AA( or n)lon
2erman) invades #oland starting orld ar 66

1940
*apanese bomb #earl /arbor and B1' enters war against *apan( 2erman) and 6tal)
B) 7D?? war rages throughout the world
>$ $a)> offensive b) B1'( Britain and allies begins end of war in Europe
2erman) surrenders in 'pril 7D?E
B1' drops atomic bombs on /iroshima and 0agasaki. *apanese surrender
The Bnited 0ations is formed
*ohn Bardeen( alter Brattain( and illiam 1hockle) invent the transistor
Communist forces sei<e power in China
1950
Cold ar between B1' and Russia develops as Russia builds an atomic bomb
+orean ar breaks out as 0orth +orea invades south +orea. ar ends in 7DE:
Electricit) produced b) atomic power in B1'
*ames atson and Francis /. C. Crick describe the >double heli,> structure of $0'
B06-'C is first mass produced computer
*onas 1alk develops anti3polio vaccine
Russia launches 1putnik 6( the Earth&s first spacecraft
B.1. 1upreme Court orders desegregation of public schools
1960
Russia launches first man into space
#resident +enned) establishes #eace Corps to assist underdeveloped countries
Rachel Carson writes 1ilent 1pring marking concern with environmental pollution
4artin .uther +ing leads massive Civil Rights demonstration in ashington( $.C.
#resident +enned) is assassinated in $allas( Te,as
-ietnam ar intensifies as B1' begins massive militar) buildup. 'nti3war movement begins on college
campuses
6srael defeats 'rab forces in 1i,3$a) ar
B1' lands astronauts on the moon

1970
E!ual Rights 'mendment to B1 Constitution passes Congress but fails to be ratified b) the necessar) number of
states
#resident 0i,on resigns in the wake of the atergate scandal
Following 6sraeli3'rab ar in 7D@:( oil3producing countries double oil prices causing energ) crisis and economic
hardship
-ietnam ar ends as 1outh -ietnam surrenders and B1' evacuates troops
Eg)pt and 6srael sign historic peace accord
1980
#ersonal computers change the wa) businesses do busines
Environmental issues become a ma%or concern for most 'mericans
'6$1( a disease destro)ing the human immune s)stem( becomes pandemic
B.1. sees rise of the largest federal budget deficit in histor)
Free market emphasi<edG deregulation of airlines and 1H.&sG stock market boom

1990
4onetar) Economics
1uppl) 1ide Economics
Economic Rationalism supreme