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jet aircraft, have all been introduced within living memory. So also have the products that have eliminated much of the drudgery formerly associated with housework. Dishwashers, detergents, disposable diapers, washing machines, refrigerators, and their complement, the supermarket, were not there to help your great grandparents when they first set up house.

Another aspect of the constant change that occurs in the evolving market economies is the globalization that has been occurring at any accelerating rate over the last two decades. At the heart of globalization lie the rapid reduction of transportation costs and the revolution in information and telecommunications technologies. The cost of moving products around the world has fallen greatly in recent decades. Moreover, our ability to transmit and to analyze data has been increasing, while the costs of doing so have been decreasing equally.

Many markets are globalizing; for example, as some tastes become universal to young people, we can see the same designer jeans leather jackets in virtually all big cities. Many corporations are globalizing, as they increasingly become what are called trans-nationals. These are massive firms with a physical presence in many countries and an increasingly decentralized management structure. Many labor markets are globalizing, as the revolutions in communications and transportation allow the various components of any one product to be produced all over the world. A typical compact disc player, TV set, or automobile will contain components made in literally dozens of different countries. We still know where a product is assembled, but it is becoming increasingly difficult to say where it is made.

One result of this globalization of production is that components that can be produced by unskilled labor can now be produced in any low-wage country around the world, where previously they were usually produced in the country that did the assembly. This has proven valuable for developing countries. They have a better chance of becoming competitive in a small range of components than in the integrated production of all commodities. However, unskilled labor in developed countries is losing, as their labor becomes less scarce relative to the need for it. In short, the market for unskilled labor is globalizing, throwing unskilled labor in advanced countries into direct competition with unskilled labor in poorer countries.

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The globalization of the world economy has had profound effects on all economies of the world. Exports and imports are dramatically increasing and constitute nowadays a big part of the economic activity. On the investment side, the most important result of globalization is that large firms are seeking a physical presence in many major countries. Today most developed countries see major flows of investment in both directions, inward as foreign firms invest in their markets, and outward as their own firms invest abroad. As well as the well-known developed economies, the emerging economies, like the China, Latin American countries and some East-European countries, become highly integrated countries in the international economic flows of goods and services and in the technological change process. Then, these economies attract main parts of all foreign investment. The world is truly globalizing in both its trade and investment flows. Today no country can take an isolationist economic stance and hope to take part in the global economy where an increasing share of jobs and incomes is created.

The economics is an evolutionary and non uniform science. It includes social, technical, psychological and political concerns that affect the quantitative relations of production and consumption. Various theories and schools have tried to understand and to explain the economic evolution of human societies but also to cope with numerous issues that economic relations among people, institutions and objectives generate.

Theories and observations are in continuous interaction. Starting with the assumptions of a theory and the definitions of relevant terms, the economist deduces by logical analysis everything that is implied by the assumptions. These implications are the predictions of the theory. The theory is then tested by confronting its predictions with evidence. If the theory is in conflict with facts, it will usually be amended to make it consistent with those facts. This does not mean that the observed facts are without any error or judgment interferences. Although the possibility of error cannot be eliminated when testing theories against observations, it can be controlled. When action must be taken, some rule of thumb is necessary, but it is important to understand that no one can ever be certain about being right in rejecting any hypothesis and there is nothing magical about arbitrary cutoff points. Some cutoff point must be used whenever decisions have to be made. Although distinguishing positive from normative questions and seeking

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to answer positive questions are important aspects of science, it does not follow that economic inquiry can be totally value free. Although values intrude at almost all stages of scientific inquiry, the rule that theories should be judged against evidence wherever possible tends to produce advances knowledge over time.

A theory’s predictions are the propositions that can be deduced from that theory. They are called hypotheses. When the predictions of a theory have been confirmed in a large number of specific cases, they are referred to as laws. In this vein, economists deal with many relations among variables. A function, also known as a functional relation, is a formal expression of a relationship between two or more variables. When two variables are related in such a way that an increase in one is associated with an increase in the other, they are said to be positively related. When two variables are related in such a way that an increase in one is associated with a decrease in the other, they are said to be negatively related. On the basis of detailed factual studies, economists often have a relevant idea of by how much the quantity demanded will change as a result of specified changes in price; that is, they can predict magnitude as well as direction.

Another key element of any theory is a set of assumptions about the behavior of the variables in which we are interested. These state how the behavior of two or more variables relate to each other. For example, economists make two basic assumptions about consumers. The first concerns how each consumer’s satisfaction (utility) is related to the quantities of all the goods and services that they consume. The second is that in making their choices on how much to consume, people seek to maximize the satisfaction they gain from that consumption. For example, we often use the assumption that the sole motive of individuals is to maximize their satisfaction (utility for the consumers and profits for the owners of firms). This assumption allows us to make predictions about the behavior of individuals on the markets. The matter is not to criticize a theory because its assumptions seem realistic or unrealistic. All theory is an abstraction from reality in order to put the main characteristics of the economic behaviors.

This course aims at presenting fundamental economic approaches2 in order to give students tools of analysis of modern economic dynamics.

2 For a presentation of institutionalist and evolutionist approaches, see the second part of this course, Concepts of Economic Analysis (F21).

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Chapter I. Pre-classical and classical economics3

1. Mercantilism, the 18th–century predecessors and Physiocracy

The term ‘mercantilism’ first acquired significance at the hands of Adam

Smith. ‘The different progress of opulence in different ages and nations has given occasion to two different systems of political economy, with regard to enriching people ‘, he noted: ‘the system of commerce or mercantile system’ and ‘the system of agriculture’.

1. 1. The balance-of-trade doctrine and the specie-flow mechanism

The leading features of the mercantilist outlook are well known: gold bullion and treasure of every kind as the essence of wealth; regulation of foreign trade to produce an inflow of gold and silver; promotion of industry by encouragement of cheap row-material imports; protective duties on imported manufactured goods; encouragements of exports, particularly finished goods; and an emphasis on population growth, keeping wages low.

The core of mercantilism, of course, is the doctrine that a favourable balance of trade is desirable because it is somehow productive of national prosperity. The question that immediately arises is how such a notion ever came to be held. Adam Smith gave the first and still the simplest answer: mercantilism is nothing but a tissue of protectionist fallacies foisted upon a venal Parliament by

‘our merchants and manufacturers ‘, grounded upon ‘the popular notion that wealth consists in money’. Like an individual, a country must spend less than its income if its wealth is to increase. What tangible form does this surplus over consumption take? The mercantilist authors identified it with the acquisition of hard money or ‘treasure’. Money was falsely equated with capital and the favourable balance of trade with the annual balance of income over consumption. This was the gist of Adam Smith’s critique of mercantilism. It is also true that almost all mercantilist writers entertained the idea that money is ‘the life of commerce’, ‘the vital spirit of trade’. Such animistic imagery was epitomised in the eighteenthcentury doctrine that ‘money stimulates trade’, but it was current for centuries without any apparent theoretical justification. In the final analysis, it is pointless to argue the question because the absence of a technical vocabulary in the literature

3 See Blaug (1997) and Screpanti and Zamagni (1995).

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of the day makes it almost impossible to distinguish between the axiomatic identification of money with wealth and the broad suggestion that an increase of one will always cause an increase of the other. The idea that an export surplus is the index of economic welfare may be described as the basic fallacy that runs through the whole of the mercantilist literature. The title of Thomas Mun’s book puts it nicely: England’s Treasure by Foreign Trade or the Balance of our Foreign Trade is the Rule of our Treasure (1664).

The balance of payments must always be balanced, for it is merely a bookkeeping identity of debits and credits (we do talk about ‘deficits’ and ‘surpluses’ in international payments but only by excluding certain debits and credits from a set of accounts which must always be in balance when taken as a whole). But the balance of trade need not be in balance.

A country earns foreign exchange by either

1.Visible commodity exports,

2.Invisible export of services,

3.Export of precious metals or

4.Imports of capital, either in the form of foreign investment at home, profits on its own foreign investment abroad, or loans granted by foreigners.

A country spends foreign exchange by

1.Visible imports,

2.Invisible imports,

3.Import of precious metals and

4.Exports of capital in general form of acquiring claims on foreigners.

The four items always balance because if the first three do not, the difference appears as a capital export or import. When mercantilist authors speak of a surplus in the balance of trade, however, they mean an excess of exports, both visible and invisible, over imports, calling either for an inflow of gold or for the granting of credit to foreign countries, that is, capital exports. In other words, they were roughly thinking of what we could now call ‘the current account’ as distinct from ‘the capital account’ in the balance of payments.

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The classical economists never doubted the arguments of their predecessor in favour of a chronic export surplus were based from start to finish on an intellectual confusion: whatever the mercantilist hoped to achieve with a favourable balance of trade was bound to be short lived.

Thomas Mun, writing as early as 1630, had realised that an inflow of bullion raises domestic prices and that ‘selling dear and buying cheap’ tends to turn the balance of trade against a country.

Cantillon and Hume restated this argument in the eighteenth century and for a century or more this ‘specie-flow mechanism’ provided the definitive refutation of mercantilist principles. Purely automatic forces, the argument ran, tend to establish a ‘natural distribution of specie’ between the trading countries of the world and levels of domestic prices in different countries such that each country’s exports come to be equal to its imports. Any additional mining of gold in one country will raise its price level relative to those of other countries; the resulting import surplus must be financed by a specie outflow; this engenders the same reaction in the goldreceiving country; and the process continues until all trading nations have established a new equilibrium between imports and exports corresponding to the higher supply of gold. Since external trade and gold are akin to water in two connected vessels that is constantly seeking a common level, a policy aiming at a favourable balance of trade is simply self-defeating.

All the elements forming such a theory of the self-regulatory mechanism of specie distribution were already at hand in the seventeenth century. Thomas Mun had shown that any net deficit or surplus in the balance on current account, the visible plus invisible items, must be financed by the outflow or inflow of bullion and, hence, that the volume of exports imports depends upon relative price levels in different countries. Writing in the 1690s, John Locke made it perfectly clear that prices vary in a definitive proportion to the quantity of money in circulation.

The stern condemnation visited upon mercantilist errors by classical theory went unchallenged for a hundred years. The relativist interpretation of mercantilism had to wait upon the revival of protectionism in Europe and the rise of the German Historical School. First, Roscher, Schmoller and then their English disciples, Cunningham and Ashley, rose to defend mercantilist policies as perfectly rational in the sense that they were appropriate means to achieve certain desired

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ends, namely, those of national autarky and the expansion of state power, and even these ends were now regarded as reasonable in and for their time. This interpretation came to be widely accepted by economic historians. As Locke expressed it, ‘riches’ means not just more gold and silver but more in proportion to other countries. Indeed, most mercantilist writers subscribed to the view that the economic interests of nations are mutually antagonistic, as if there were a fixed quantity of resources in the world that one country could acquire only at the expense of another, the economic growth of nations was a zero-sum game. This explains why they were not embarrassed to advocate beggar-my-neighbour policies or to deprecate domestic consumptions as an objective of national policy.

The preoccupation of the mercantilist with gold inflows was no ‘puerile obsession’,

Keynes declared, but an intuitive recognition of the connection between plenty of money and low interest rates Moreover, there has always been a ‘chronic tendency throughout human history for the propensity to save to be stronger than the inducement to invest’, and the mercantilist must be praised for recognising that weakness of the inducement to invest is indeed the key to the economic problem. When direct public investment or monetary policy is out of the question, as it was before modern times, the best that can be done is to encourage inflation through a favourable balance of trade: the export surplus serves to keep up prices and the inflow of gold lowers interest rates, thus stimulating investment and employment by boosting the money supply. This, Keynes felt, was ‘the element of scientific truth in mercantilist doctrine’.

No doubt the English economists of the seventeenth and eighteenth centuries often sound like precursors of Keynes. They railed against ‘locking up money’, converting it into ‘dead stock’; they urged spending on luxury goods and proposed public works programmes to relieve ‘supernumeraries’; and the frequency with which statements concerning the desirability of bullion were associated with a belief in its employment-producing effect is indeed striking. We have to remark however that the analogy to the problem of unemployment as it appears in the mercantilist literature is not underemployment in a mature capitalist economy but actual or disguised unemployment in the now overpopulated underdeveloped countries of Asia, Africa and Latin America.

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1. 2. The mercantilist dilemma, the quantity theory of money and Cantillon

The resolution of the dilemma lies in the characteristic mercantilist doctrine that money ‘quickens’ trade by increasing the velocity of circulation of goods.

According to the familiar equation of exchange:

MV PT,

the quantity of money (M) multiplied by the number of times it changes hands in a given time period (V) is identically equal to the total volume of goods traded (T) multiplied by the average prices of these goods (P). The identity becomes a theory by relating the variables in a definite way. The quantity theory of money is a doctrine linking M to P, with P somehow determined by ‘real’ forces and given by the payment habits and financial institutions of the economy. This formulation does not begin to do justice to the complexity of the quantity theory of money in the nineteenth century but it will suffice for present purposes. The point is that the mercantilist emphasised the effect of M on T rather than on P. The quantity theory in the seventeenth and eighteenth centuries had at its centre the proposition that ‘money stimulates trade’: an increase in the supply of money was thought to be followed by a rise in the demand for money, and hence the volume of trade and not prices would be directly affected by a specie inflow. The mercantilist did not take account of Hume’s self-regulating specie-flow mechanism because they did not interpret the quantity theory of money as he did. As first formulated by Locke, the quantity ‘theory’ stated simply that the level of prices is always in proportion to the quantity of money, the quantity of money being understood to include ‘the quickness of its circulation’. Money is peculiar in that, serving only as a means of exchange, it has no ‘intrinsic’ value. The thesis is obviously destructive of mercantilist principles but Locke nevertheless remained a mercantilist because he thought it was to a country’s advantage to have a larger stock of money than any other country.

David Hume, failing to recognise that the quantity ‘theory’ as Locke stated it presupposes a different amount of money, everything else being the same, that is, a once-and-for-all change in the money supply rather than a temporal process of increasing the money supply, introduced the notion of the casual relationship

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between M and P. He laid down this commonly accepted version: T and V being insensitive to monetary changes, M and P will vary proportionately.

Perhaps, the best example of the doctrine “money stimulates trade” is the so-called “paper-money mercantilist” John Law. The argument in his Money and Trade Considered (1705), as in the Jacob Vanderlint’s Money Answers all Things

(1734) and in Bishop Berkeley’s Querist (1737), is based in essence on profit inflation and the premise that ‘an addition to the money will employ the people that are now idle’. He utilises Petty’s needs-of-trade doctrine to show that extra specie or paper money will be taken up by barrowers owing to abundant profit opportunities, while relying on income payments to the previously unemployed to give rise to new consumers’ demand. As money is cheaper to barrow, realised profits and sales increase without leading to a rise in prices; indeed, Law thought that prices might actually fall. It is evident that Law’s argument supposes that the supply of commodities is highly elastic, a small increase in price leading to large increases in the amount of goods offered.

A very different resolution of the mercantilist dilemma is to be found in Cantillon’s Essay on the Nature of Commerce, written in the 1720s but published in 1755. This is the most systematic, the most lucid, and at the same time the most original of all the statements of economic principles before The Wealth of Nations. Cantillon is the first to leave absolutely no doubt that the effect of an increase in V is equivalent to an increase in M alone, and he put monetary analysis on its feet by showing that the effect of an increase in the quantity of money upon prices and incomes depends upon the manner in which cash is injected into the economy.

We see here some interesting links between theories. Actually, Cantillon stressed the fact that an increase in M will not only raise the level of prices but will also alter the structure of prices, depending upon the initial recipients of the new cash and their relative demand for goods. The differential effect of a cash injection, as governed by the nature of the injection, will hereafter be called the Cantillon Effect; it was stated less explicitly by Hume in his essay ‘On Money’ (1752) and it is probably in this version, rather than in Cantillon’s, that it was handed down to the classical economists. It has its modern counterpart in Keynes’s analysis of ‘the diffusion of price levels’ in chapter 7 of the Treatise on Money (1930), namely, ‘the fact that monetary changes do not affect all prices in the same way, in the same

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degree, or at the same time’, and as such it became an essential and even central element in the Austrian theory of business cycles associated in the 1930s with the names of Friedrich Hayek and Lionel Robbins.

Cantillon also gave an excellent account of the specie-flow mechanism and a sound critique of Law’s doctrine that ‘money stimulates trade’ which, he noted, is much more likely to be true when the increase in specie is due to an export surplus than to increased production in gold mines at home; in the latter case, it is likely to raise prices directly without promoting an expansion of output. Still, Cantillon was a mercantilist who did not hesitate to say that ‘the comparative power and wealth of states consists, other things being equal, in the greater or less abundance of money circulating in them’ and that ‘every state which has more money in circulation than its neighbour has an advantage over them so long as it maintains this abundance of money’. A specie inflow will indeed raise domestic prices to some extent, but this is all to the good. Selling dear and buying cheap means not only favourable barter term of trade-a high ratio of export to import prices-but a favourable balance of payments as well, implying that foreign demand for domestic goods and the domestic demand for foreign goods is highly inelastic.

1. 3. Money and the rate of interest

The gradual emergence of real analysis in the eighteenth century and its victory over the monetary analysis of the early mercantilists is nowhere better expressed than in the development of the theory of interest. Following Schumpeter (in History of Economic Analysis) by ‘monetary analysis’ we mean any analysis that introduces the element of money at the outset of the argument and denies that the essential features of economic life can be represented by a barter model. By ‘real analysis’ we mean analysis that explains economic activity solely in term of decisions about goods and services and the relations between them; money is a veil because a well-functioning monetary system permits analysis of trade as if it were barter. With these distinctions in mind, we can make short shrift of the so called ‘monetary theory of interest’ of the mercantilist.

The idea that the rate of interest varies inversely with the quantity of money is found, among others, in Locke, Petty and Law; it rested on the commonsense idea that, since interest is the price paid for the hire of the money, interest is lower where there is more money about, just as a commodity falls in price when it is less

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