Economic Schools of Thought

Why This Matters

Understanding economic schools of thought isn't just about memorizing names and dates—it's about grasping the fundamental debates that shape economic policy today. Every time you hear arguments about government stimulus, inflation control, or market regulation, you're witnessing these theoretical frameworks in action. On the AP exam, you're being tested on your ability to recognize why economists disagree, what assumptions drive different policy recommendations, and how historical context shaped economic thinking.

These schools of thought represent different answers to core questions: Does the economy self-correct? What causes recessions? Should governments intervene, and if so, how? Don't just memorize that Keynes favored government spending—understand why he believed aggregate demand drives the economy and how that contrasts with classical faith in market self-correction. When you can connect a policy recommendation to its underlying theoretical framework, you're thinking like an economist.

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Market-Centered Approaches

These schools share a fundamental belief that markets, when left relatively free, produce efficient outcomes. The key mechanism is price signals coordinating decentralized decisions among buyers and sellers.

Classical Economics

• Self-regulating markets—the economy naturally moves toward equilibrium through the "invisible hand" of supply and demand without government direction
• Say's Law holds that supply creates its own demand, meaning production generates enough income to purchase all output
• Long-run focus on economic growth driven by capital accumulation and productivity, with limited government intervention as the policy prescription

Neoclassical Economics

• Marginal analysis—decisions are made at the margin, where consumers maximize utility and firms maximize profit by equating marginal benefit to marginal cost
• Rational actors make optimal choices given constraints, leading to market equilibrium where $Q_s = Q_d$
• Mathematical modeling formalizes economic relationships, making this the foundation of most modern microeconomics courses

Austrian School

• Subjective value theory—value isn't inherent in goods but determined by individual preferences and circumstances
• Entrepreneurship drives market processes through discovery and innovation, not just equilibrium conditions
• Critique of central planning argues that no planner can replicate the information conveyed through market prices (Hayek's "knowledge problem")

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Demand-Side and Interventionist Frameworks

These schools emphasize that markets can fail and government action may be necessary to stabilize the economy. The core insight is that aggregate demand can be insufficient, causing prolonged recessions.

Keynesian Economics

• Aggregate demand drives output—recessions occur when total spending ($AD = C + I + G + NX$) falls short, leaving resources unemployed
• Sticky wages and prices prevent rapid market clearing, so the economy can remain stuck below full employment
• Fiscal policy activism—government spending and tax cuts can fill demand gaps during recessions, with the multiplier effect amplifying initial spending

New Keynesian Economics

• Microfoundations for stickiness—explains why prices and wages don't adjust instantly through menu costs, contracts, and coordination failures
• Rational expectations incorporated, meaning people anticipate policy effects, but market imperfections still justify intervention
• Monetary policy emphasis—central banks can stabilize output through interest rate adjustments, making this the dominant framework at institutions like the Federal Reserve

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Money and Monetary Policy Focus

These approaches center on the money supply as the key variable determining economic outcomes. The mechanism is the quantity theory of money: changes in money supply directly affect price levels and nominal GDP.

Monetarism

• "Inflation is always and everywhere a monetary phenomenon"—Milton Friedman's core claim that excessive money growth causes rising prices
• Natural rate of unemployment exists regardless of policy; attempts to push unemployment below this rate only cause inflation
• Rules over discretion—stable, predictable money supply growth beats activist policy, which often destabilizes the economy through lags and errors

Chicago School

• Market efficiency is the baseline assumption; government failures typically exceed market failures
• Deregulation advocacy—regulations often protect incumbents rather than consumers, reducing competition and efficiency
• Empirical rigor—emphasizes data-driven research to test economic theories, influencing fields from finance to law

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Institutional and Behavioral Critiques

These schools challenge the assumptions of traditional models, emphasizing that context, psychology, and social structures shape economic outcomes. The insight is that "rational economic man" is an incomplete model of human behavior.

Behavioral Economics

• Bounded rationality—people use mental shortcuts (heuristics) that lead to systematic biases like loss aversion and present bias
• Nudges can improve decisions without restricting choice—default options, framing, and social norms influence behavior predictably
• Market anomalies like bubbles and panics become explainable when we account for how people actually think rather than how models assume they think

New Institutional Economics

• Transaction costs explain why firms exist and how contracts are structured—it's often cheaper to organize activity within a firm than through markets
• Property rights and their enforcement determine whether markets can function efficiently; weak institutions undermine economic development
• Path dependence—historical choices constrain current options, explaining why inefficient institutions can persist

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Radical and Heterodox Perspectives

These schools fundamentally challenge mainstream economics, questioning not just policy recommendations but the entire framework of analysis. They emphasize power, conflict, and historical change over equilibrium and optimization.

Marxian Economics

• Labor theory of value—the value of goods derives from the labor required to produce them; capitalists extract surplus value from workers
• Class conflict between capital owners and workers drives historical change, with capitalism containing internal contradictions
• Critique of markets as systems that perpetuate inequality and exploitation rather than neutral mechanisms for efficient allocation

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Quick Reference Table

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Self-Check Questions

1. Which two schools both favor limited government intervention but disagree about whether mathematical models are appropriate tools for economic analysis?

2. A policymaker argues that the government should increase spending during a recession because consumers and businesses aren't spending enough. Which school of thought is this most consistent with, and what key concept explains why such spending might have amplified effects?

3. Compare and contrast Monetarism and Keynesian economics: What do they identify as the primary cause of economic instability, and what policy tools does each recommend?

4. If an economist argues that people consistently save too little for retirement because they overweight immediate gratification, which school of thought provides the best framework for understanding this behavior? What policy solution might this school suggest?

5. An FRQ asks you to explain why some countries remain poor despite having natural resources. Which school of thought would emphasize the role of property rights, legal systems, and transaction costs in your answer?