There are different schools of economic thought that came during different time periods in the past and tried to explain economic phenomena
The classical economic theories first came in eighteenth and nineteenth century. It came in being through Adam Smith’s “Wealth of Nations” in 1776. It mainly dealt with the economic growth and gave birth to the laisse- faire and free competition. As per the classical economics theory, the prices are determined from the market equilibrium which itself is determined by the demand-supply of the particular product in the market. It means, prices are flexible here which changes based on the equilibrium condition.
The factor of unemployment in macroeconomics is the main topic that led to Keynesian Theory. The theory gained huge popular during the great depression of 1929. It was Keynes who brought in the concept where equilibrium is maintained by increasing the job offers and reducing the wages paid for the job.
The theory helps us to maintain economic stability in a mixed economy. John Maynard Keynes explains this through his book “The General Theory of Employment, Interest and Money” that was published in 1936. Keynes said that government intervention is necessary to maintain the stable economy and Government has to work based on the situation to tackle the economic crisis if any. It was Keynesian theory which gave birth of modern macro-economics.
Keynes said that aggregate demand during an economic crisis would be less and hence will lead to unemployment. He said that government should intervene during these times by spending more in different projects and introducing various policies so that unemployment and deflation would reduce. The main target will be to increase the money flow inside the economy. He suggested decreasing the interest rate and government to invest in developing the country’s infrastructure which would create more employment.
According to Keynes, people will refuse to accept a reduction in the nominal wages unless they see a decrease in the price of goods. Keyes pointed out that excessive saving would lead to depression or recession; which has happened in Japan after the 1991 crisis time.
Monetarism was introduced during the 1950s when the price of oil was increasing continuously which has led to very high inflation. Milton Friedman is the founding father for Monetarism who said that the cause for inflation in the 1970s was due to the increase in money supply in the financial system. According to monetarism there should be less government intervention and the market should be free. The theory says that fiscal policies are useless and monetary policies are what we actually need to follow. As per him, High money supply in the financial system leads increase in aggregate demand, which is the main reason behind high inflation. Milton Friedman and Anna Schwartz in their book “A monetary history of United States, 1867-1960” said that the reduction of money supply caused the 1929 great depression and excessive money supply caused the post war inflation.
New Classical Economics
In the mid of 1970s, a new theory is put forward on the basis of rational expectations hypothesis, popularly known as New Classical Economics theory. John Muth’s assumption of dynamic rationality and the oil shock of 1970s were the source for new classical economics. The Real business cycle model is an example for new classical economics which was developed by Nobel Prize winner Robert Lucas Jr. As per him, the unique stability in the business has been achieved by adjusting price and wages and at any one time, the economy is assumed to have a unique equilibrium.
New Keynesian economics was developed based on the criticisms of new classical economics. But Like the New Classical approach, New Keynesian macroeconomic analysis assumes that households and firms have rational expectations. It says that unemployment exist seven when we have rational expectation.
According to New Keynesian economists, by lowering the wages of employees would reduce their productivity and hence the profit of the firm would go down. By increasing the wages of the worker there is less number of people quitting the job. Also it talks about the effectiveness of proper monetary supply to drive the economic growth and control inflation.