HARAMBEE UNIVERSITY

FACULTY OF BUSINESS AND ECONOMICS

DEPARTMENT OF ECONOMICS

GROUP ASSIGNMENT OF HET II

Group member : ID No.

1. Yohannes Tadele. 215807

2. Bekalu Begashaw. 219350

3. Ayinalem Mogess. 218488

4. Marta Anberbir. 218899

5. Meaza Tadese. 216488

6. Hana Tilahun. 216487

Submission date: 5/8/17

 UNIT FIVE: THE POST KEYNESIAN DEVELOPMENT IN ECONOMIC THOUGHT

Emergence of macroeconomics

The earliest macroeconomic thinking started from the days of “mercantilists” when was
concerned with the government policies for the promotion of economic growth of economic
resources. After mercantilists the physiocrates also looked at the economy as a whole and
analyzed the circular flow of wealth Quesnay’s Tableau economique” (1758) represented the
first systematic attempt in national income analysis (Although macroeconomics owed its
systematic origin to Adam Smith). A part of classical literature was a mixture of microeconomic
theories. Smith and his followers assumed full employment and aggregate output as given. They
believed in the invisible hand which managed the whole economic system.

But J.S. Mill among the classical writers and K. Marx among the later writers did not agree with
the classical ideas. Mill refuted the Say’s law of market and questions the reliability of the
invisible hand theory. He can be considered as the father of macro economics. His theory of
“market gluts” based on under consumption/over production/ is the forerunner of Keynes’s
general theory. The neoclassical economists were predominantly interested in microeconomic
thinking (modern macroeconomic analysis originated in 1930’S). At the time of the great
depression the free economy failed to function properly. Keynes published his “General Theory
of Employment Interest and Money” In 1936. The central problem of macroeconomics is the
problem of determining income and employment. Therefore, it is known as the theory of income
and employment or simply income analysis. The credit for the evolution of macroeconomics as a
field of economics goes to Lord J. M. Keynes.

Modern macroeconomic thinking originated from four main sources. Which are:-

The concept of circular flow of payments. It was a leading concept of the physic rates. It was
later developed by Schumpater and Walras.

The concept of national dividend or national income: - it was propounded by Marshall and later
developed by Pigou.
The main approach to the values of money responsible for the development of concepts like
aggregate demand and supply and their components like aggregates cost of saving and
investment.

The Analysis of trade cycles.

The emergence of econometrics as the sister discipline of economics

The ‘second stage’ in the development of numeracy in economics, which start from the founding
in 1883 of the Statistical Section of the British Association for the Advancement of Science and
the Statistical Society of London, focused on data collection and statistics for the purpose of
establishing ‘correct views’ about the moral sciences and their relationship to the physical
sciences. Some thinkers, William Stanley Jevons among them, believed that the science of
Political Economy ‘might gradually be erected into an exact science.’ He became an avid student
of commercial fluctuations in search of laws that governed seasonal and cyclical variations by
linking them to meteorological changes, but his enthusiasms were not widely shared. This was
partly because the construction of a hedonic balance sheet for the guidance of policy makers was
recognized as insoluble, so that British economists disassociated themselves from the notion of
utility as a measurable magnitude. Jevons’ views on the prospective role of inductive research in
economics failed to dominate, because many contemporaries, among them John Elliot Cairnes,
were of the opinion that, as a moral science, economics is inherently deductive. This was, of
course, also Marshall’s view.

By the mid-1920s, the deductive method had long since become the accepted mode of inquiry for
discovering laws relating to the behavior of market phenomena. There was little concern about
reinforcing deductive analysis with empiricism beyond the casual sort that used actual (or
conjectural) data for purposes of example and illustration. Marshall’s Principles and his strong
reservations about the application of mathematical methods to economics influenced most
economists to teach deductive analysis to their students and relied on it for their own work. Thus,
mathematics and statistics existed as disciplines that remained quite separate from economics.

The creative spasm of theoretical innovation known as ‘high theory,’ which dates from the mid-
1920s, also encouraged new methods for studying the behavior of the economy, although these
were not primarily mathematical or statistical. Concern about cyclical phenomena and the
usefulness of the ex ante-ex post construct of the Stockholm School are among the intellectual
breakthroughs of the period. Unlike the neoclassical concept of equilibrium, which focused on
the requisites for an economy’s return to stability, the ex ante-ex post construct offered a way of
conceiving of an economy in the process of changing from one phase of the business cycle to
another. Once suggested, this idea implied the need to invent a method to evaluate the relative
merits of one plausible cycle theory as opposed to another equally plausible theory. The
challenge was taken up by the League of Nations, which commissioned Jan Tinbergen, a Dutch
scholar, to evaluate their relative merits empirically. Jointly, with the Norwegian Ragnar Frisch,
he became the 1969 recipient of the Nobel Prize in economics. Tinbergen’s 1939 statistical
verification of alternative business cycle theories, which pioneered the method of least squares
and regression analysis, marks the beginning of econometrics as the sister discipline of
economics. It also marks the beginning of the third and present stage of numeracy, in which
economics has emerged as a predictive rather than as a moral science.

Econometrics is the branch of economics that is concerned with establishing empirical content
into economic relations. The term, which is a combination of the words economics and metrics
(from the Greek metron, which means ‘measurement’) was apparently coined by Ragnar Frisch,
one of the founders of the Econometrics Society in 1930. More precisely, econometrics is
concerned with ‘the quantitative analysis of actual economic phenomena based on the concurrent
development of theory and observation, related by appropriate methods of inference.’

Keynesians, and Monetarists

Keynesians: The Keynesian system of ideas is one of the most significant schools of economic
thought. The school began with the publication of Keynes’s The General Theory of
Employment, Interest and Money in 1936 and remains a major presence in orthodox economics
today. It arose out of the neoclassical school, Keynes himself being steeped in the Marshallian
tradition. Although Keynes sharply criticized certain aspects of neoclassical economics, which
he lumped together with Ricardian doctrines under the heading of “classical economics,” he used
many of its postulates and methods. His system was based on a subjective psychological
approach, and it was permeated with marginalist concepts, including static equilibrium
economics. Keynes disassociated himself from attacks on the neoclassical theory of value and
distribution.
Monetarism: Monetarism is view of the aggregate economy that stresses the primacy of changes
in the money supply. Monetarism developed in 1960s and 1970s as an alternative to the
Keynesian analysis that had come to dominate macroeconomics following the publication of
Keynes's general theory in 1936. The origin of monetarism may be traced in the writings of a
long life of university of Chicago's distinguished students and the teachers of money who are
best represented by Professor Milton Friedman. The Chicago economists are the vehement
supporters of the free market system. They are wedded to the belief that almost all economic
problems have their solution in the free and unimpeded operation of the free market forces of
supply and demand.

Monetarism is a school of economic thought that emphasizes the role of monetary authority
(Central Bank) in controlling the amount of money in circulation for stability and growth. It is
the view within monetary economics that variation in the money supply has major influences on
national output in the short run and the price level over longer periods and those objectives of
monetary policy are best met by targeting the growth rate of the money. Monetarism today is
mainly associated with the work of Milton Friedman, who was among the generation of
economists to accept Keynesian economics and then criticize Keynes' theory of gluts based on a
policy of government intervention. Thus, Monetarism is an economic theory which focuses on
the macroeconomic effects of the supply of money and central banking. It argues that excessive
expansion of the money supply is inherently inflationary, and that monetary authorities should
focus solely on maintaining price stability. Friedman and Anna Schwartz wrote an influential
book, A Monetary History of the United States, 1867- 1960, and argued that "inflation is always
and everywhere a monetary phenomenon." It attributed deflationary spirals to the reverse effect
of a failure of a central bank to support the money supply during a liquidity crunch. Friedman
advocated, a central bank policy aimed at keeping the supply and demand for money at
equilibrium, as measured by growth in productivity and demand. Friedman focused on price
stability, which is the equilibrium between supply and demand for money.

The rise of monetarism accelerated from Milton Friedman's 1956 restatement of the quantity
theory of money. Friedman argued that the money could be described as depending on a small
number of economic variables. Thus, where the money supply expanded, people would not
simply wish to hold the extra money in idle money balances; i.e., if they were in equilibrium
before the increase, they were already holding money balances to suit their requirements, and
thus after the increase they would have money balances surplus to their requirements. These
excess money balances would therefore be spent and hence aggregate demand would rise.
Similarly, if the money supply were reduced people would want to replenish their holdings of
money by reducing their spending. In this, Friedman challenged a simplification attributed to
Keynes suggesting that "money does not matter." Thus the word 'monetarist' was coined. Milton
Friedman and Anna Schwartz in their book A Monetary History of the United States, 1867-1960
argued that the Great Depression of 1930 was caused by a massive contraction of the money
supply and not by the lack of investment Keynes had argued. They also maintained that post-war
inflation was caused by an over-expansion of the money supply. Monetarists of the Milton
Friedman school of thought believed in the 1970s and 1980s that the growth of the money supply
should be based on certain formulations related to economic growth. As such, they can be
regarded as advocates of a monetary policy based on a "quantity of money" target.

Comparison of the Keynesian and Monetarists approach

For the purpose of vivid comparison, it will be useful to characterize Keynesianism and
Monetarism in their polar forms. In reality the lines between many contemporary Keynesians and
Monetarist are not so neatly drawn. But at the extreme, Keynesians Monetarists have
substantially different views as the inherent stability of capitalistic economics. They have
important ideological differences, particularly with the role of government.

Keynesians

Instability intervention: They believe that capitalism, more particularly the free market system
suffer from inherent shortcomings. The Keynesian contention is that capitalism contains no
mechanism to guarantee macroeconomic stability. Imbalances of planned investment and savings
do occur and the result is business fluctuations- periodic episodes of inflation or unemployment.
To Keynesian, the instability of private investment causes the economy to be unstable.
Government plays a positive role by applying stabilization medicine.
 Aggregate spending: Keynesian economics focuses upon the aggregate spending and its
component. Hence their basic equation is Co + In + Xn + G = NNP; Where:- Co- Consumption,
In- Investment, Xn- Net export, G- Government expenditure, and NNP- Net National Product.
This theory says that the aggregate amount spent by buyer is equal to the total volume of goods
and services sold. In equilibrium, Co + In + Xn + G (aggregate expenditure) is equal to NNP
(National output)

The Keynesian monetary transmission mechanism emphasize on the roles of interest rates and
investment spending in explaining how changes in the money supply affect nominal NNP.

Keynesian believes that fiscal policy is much more powerful and reliable stabilization device.
This is implied by the equation of Keynesianism. Government spending, after all is direct
component of aggregate expenditure and tax changes have direct and dependable effects upon
consumption and investment. Keynesian conception of monetary policy is that the demand for
money curve is relatively flat and investment demand relatively steep causing monetary policy to
be a comparatively weak stabilization tool. They argue that monetary policy entails a lengthy
transmission mechanism involving monetary policy decision, bank reserves, and interest rate.
Uncertainties at each step in the mechanism limit the effectiveness and dependability of
monetary policy. The Keynesian view is that it would be foolish to replace discretionary
monetary policy with a monetary rule. They contend that a constant annual rate of increase in
the money supply could contribute to substantial in aggregate expenditure and promote economic
instability.

Monetarist

The monetarists view with regard to stability and Laisezz Faire is that markets were competitive
and that a competitive market system provides the economy with a high degree of
macroeconomic stability. Thus, market system would provide substantial macroeconomic
stability. Monetarists favor a more Laissez Faire policy or free market orientation. Government
decision-making is held to be bureaucratic, inefficient, and harmful; to individual incentives,
frequently characterizes by policy mistakes, which destabilize the economy. Furthermore,
centralized decision making by government inevitably erodes individual freedoms
To monetarist, government has harmful effects upon the economy. It creates rigidities.
Monetarism focuses on money. The fundamental equation of monetarism is the equation of
exchange. MV=PQ where; M supply of money, V is the income or circuit of velocity of money
i.e. the member of times per year the average dollar is spent on final goods & services, P the
price level, Q physical volume of goods produced, and MV represents the total amount received
by the seller of that output Monetarist's money Transmission mechanism does not include
interest rate.

The contend that changes in the money supply cause direct changes in aggregate demand and
thereby change in nominal NNP.

Monetarists believe that the relative stability of velocity of money indicate a rather dependable
link between money supply and nominal NNP. However, they think that because of variable time
lags on becoming effective and incorrect use of interest rate as a guide to policy, the economic is
likely to fail. Monetarists therefore recommend a monetary rule whereby the money supply in
increased in accordance with the long-term growth of real NNP. The monetary authorities should
stabilize, not the interest rate, but the rate of growth of money the money supply. Friedman
advocates legislating the monetary rule that the money supply be expanded each year at the same
annual rate as the potential growth of our real GNP.

Post-Keynesian Economics

Post-Keynesian economics is a diverse group and consists of different ideas and policies. The
major developments in economics after Keynes are briefly summarized below. They include
New Classical Economics consisting of monetarism, rational expectations school, supply side
economics and new- Keynesian economics.

New Classical Macroeconomics

New classical economics introduced a set of macroeconomic theories that were based on
optimizing microeconomic behavior. These models have been developed into the Real Business
Cycle Theory, which argues that business cycle fluctuations can to a large extent be accounted
for by real (in contrast to nominal) shocks. Beginning in the late 1950s new classical
macroeconomists began to disagree with the methodology employed by Keynes and his
successors. New classical theorists demanded that macroeconomics be grounded on the same
foundations as microeconomic theory, profit-maximizing firms and rational, utility-maximizing
consumers.

Keynesian-Monetarist Debate

There was debate between Monetarists and Keynesians in the 1960s over the role of government
in stabilizing the economy. Both Monetarists and Keynesians are in agreement over the fact that
issues such as business cycles, unemployment, inflation are caused by inadequate demand, and
need to be addressed, but they had fundamentally different perspectives on the capacity of the
economy to find its own equilibrium and as a consequence the degree of government
intervention that is required to create equilibrium. Keynesians emphasized the use of
discretionary fiscal policy and monetary policy, while monetarists argued the primacy of
monetary policy, and that it should be rules based. The debate was largely resolved in the 1980s.
Since then, economists have largely agreed that central banks should bear the primary
responsibility for stabilizing the economy, and that monetary policy should largely follow the
Taylor rule – which many economists credit with the Great Moderation. The Global Financial
Crisis, however, has convinced many economists and governments of the need for fiscal
interventions and highlighted the difficulty in stimulating economies through monetary policy
alone during a liquidity trap.

The Monetarist - Keynesian debate is not yet dead, but it is certainly quieter than before. There
are new theoretical issues to be resolved which have little if any relation to the Monetarist -
Keynesian debate. Currently, the monetarist-Keynesian debate seems little concerned with
theoretical issues. Somewhat concerned with the empirical magnitudes of such parameters as the
interest elasticity of real investment and real money demand and most basically involved with
the stability of private sector of the economy.

Generally, monetarist argues that stability of private sectors is accurate descriptions of the macro
economy, while Keynesians believe that they are less accurate. That is the typical monetarist
would say that the economy: Is characterized by negligible business fluctuations in the absence
of monetary and fiscal policy, and ameliorates the disturbance of the policy, which does occur.
Keynesian would typically think of the economy as randomly fluctuating and slow to self-correct
except for the wise intervention of monetary and fiscal policy. The near conclusion of
Monetarist-Keynesian debate and emerge theoretical synthesis has opened up many new topics
for research - topics, which had been, pushed aside in the excitement of the earlier debate. Topics
such as expectation formation, international economic linkages and optimal labor contracts
provide a rich menu for research, which will substantially extend our knowledge of the macro
economy.

Neo-WalrasiansTheory

The Neo-Walrasian theory is an extension of the ideas originally put forth by Léon Walras, a French
economist known for his contributions to general equilibrium theory. The Neo-Walrasian approach
builds upon Walras's foundational ideas but incorporates more modern developments in economic
theory, particularly in the areas of microeconomics and game theory.

Key Features of Neo-Walrasian Theory:

1. General Equilibrium: Like Walrasian theory, the Neo-Walrasian framework focuses on general
equilibrium, where all markets in an economy are in balance simultaneously. It analyzes how supply
and demand interact across multiple markets to determine prices and quantities.

2. Rational Expectations: Neo-Walrasian models often incorporate the concept of rational

expectations, where economic agents form their expectations about the future based on all available
information. This contrasts with earlier models that might assume adaptive expectations.

3. Dynamic Models: The Neo-Walrasian theory often employs dynamic models to analyze how
economies evolve over time. This includes considerations of how agents adjust their behaviors in
response to changing economic conditions.

4. Incorporation of Incomplete Markets: While traditional Walrasian models often assume complete
markets (where every conceivable risk can be traded), Neo-Walrasian theory acknowledges that many
real-world markets are incomplete. This leads to different implications for resource allocation and
welfare.

5. Role of Institutions: The Neo-Walrasian framework may also consider the role of institutions and
market frictions, acknowledging that real-world markets are not perfectly competitive and that
various institutional factors can influence market outcomes.
6. Computational Models: With advancements in technology, Neo-Walrasian theorists have utilized
computational methods to simulate complex economic systems and analyze equilibrium conditions,
allowing for a more nuanced understanding of how economies function.

Applications:

Neo-Walrasian theory is applied in various fields of economics, including macroeconomic modeling,

financial economics, and public policy analysis. It provides a rigorous framework for understanding
how economies operate under different conditions and helps economists evaluate the impacts of
policy changes or external shocks.

In summary, Neo-Walrasian theory is a modern interpretation and extension of Walras's original ideas
on general equilibrium, incorporating contemporary insights from various branches of economics to
provide a more comprehensive understanding of economic systems.

Rational Expectations Theory

Rational expectations is a hypothesis in economics which states that agents' predictions of the
future value of economically relevant variables are not systematically wrong in that all errors are
random. Equivalently, this is to say that agents' expectations equal true statistical expected
values. An alternative formulation is that rational expectations are model-consistent expectations,
in that the agents inside the model assume the model's predictions are valid. The rational
expectations assumption is used in many contemporary macroeconomic models, game theory
and applications of rational choice theory. Since most macroeconomic models today study
decisions over many periods, the expectations of workers, consumers and firms about future
economic conditions are an essential part of the model. How to model these expectations has
long been controversial, and it is well known that the macroeconomic predictions of the model
may differ depending on the assumptions made about expectations To assume rational
expectations is to assume that agents' expectations may be individually wrong, but are correct on
average. In other words, although the future is not fully predictable, agents' expectations are
assumed not to be systematically biased and use all relevant information in forming expectations
of economic variables.
This way of modeling expectations was originally proposed by John F. Muth and later became
influential when it was used by Robert Lucas, Jr. and others. Modeling expectations is crucial in
all models which study how a large number of individuals, firms and organizations make choices
under uncertainty. For example, negotiations between workers and firms will be influenced by
the expected level of inflation, and the value of a share of stock is dependent on the expected
future income from that stock.

Rational expectations theory defines this kind of expectations as being identical to the best guess
of the future (the optimal forecast) that uses all available information. Thus, it is assumed that
outcomes that are being forecast do not differ systematically from the market equilibrium results.
As a result, rational expectations do not differ systematically or predictably from equilibrium
results. That is, it assumes that people do not make systematic errors when predicting the future,
and deviations from perfect foresight are only random. In an economic model, this is typically
modeled by assuming that the expected value of a variable is equal to the expected value
predicted by the model. For example, suppose that P is the equilibrium price in a simple market,
determined by supply and demand. The theory of rational expectations says that the actual price
will only deviate from the expectation if there is an 'information shock' caused by information
unforeseeable at the time expectations were formed.

Rational expectations theories were developed in response to perceived flaws in theories based
on adaptive expectations. Under adaptive expectations, expectations of the future value of an
economic variable are based on past values. For example, people would be assumed to predict
inflation by looking at inflation last year and in previous years. Under adaptive expectations, if
the economy suffers from constantly rising inflation rates (perhaps due to government policies),
people would be assumed to always underestimate inflation. This may be regarded as unrealistic
- surely rational individuals would sooner or later realize the trend and take it into account in
forming their expectations.

The hypothesis of rational expectations addresses this criticism by assuming that individuals take
all available information into account in forming expectations. Though expectations may turn out
incorrect, they will not deviate systematically from the expected values. The rational
expectations hypothesis has been used to support some radical conclusions about economic
policymaking. An example is the Proposition developed by Thomas Sargent and Neil Wallace. If
the Federal Reserve attempts to lower unemployment through expansionary monetary policy
economic agents will anticipate the effects of the change of policy and raise their expectations of
future inflation accordingly. This in turn will counteract the expansionary effect of the increased
money supply. All that the government can do is raise the inflation rate, not employment. This is
a distinctly New Classical outcome. During the 1970s rational expectations appeared to have
made previous macroeconomic theory largely obsolete, which culminated with the Lucas
critique. However, rational expectations theory has been widely adopted throughout modern
macroeconomics as a modeling assumption thanks to the work of New Keynesians such as
Stanley Fischer.

Rational expectations theory is the basis for the efficient market hypothesis (efficient market
theory). If a security's price does not reflect all the information about it, then there exist
"unexploited profit opportunities": someone can buy (or sell) the security to make a profit, thus
driving the price toward equilibrium. In the strongest versions of these theories, where all profit
opportunities have been exploited, all prices in financial markets are correct and reflect market
fundamentals (such as future streams of profits and dividends). Each financial investment is as
good as any other, while a security's price reflects all information about its intrinsic value.

Criticisms of Rational Expectations School

The models of Muth and Lucas (and the strongest version of the efficient-market hypothesis)
assume that at any specific time, a market or the economy has only one equilibrium (which was
determined ahead of time), so that people from their expectations around this unique equilibrium.

Muth's math (sketched above) assumed that P* was unique. Lucas assumed that equilibrium
corresponded to a unique "full employment" level (potential output) -- corresponding to a unique
NAIRU or natural rate of unemployment. If there is more than one possible equilibrium at any
time then the more interesting implications of the theory of rational expectations do not apply. In
fact, expectations would determine the nature of the equilibrium attained, reversing the line of
causation posited by rational expectations theorists. A further problem relates to the application
of the rational expectations hypothesis to aggregate behavior. It is well known that assumptions
about individual behavior do not carry over to aggregate behavior. The same holds true for
rationality assumptions: Even if all individuals have rational expectations, the representative
household describing these behaviors may exhibit behavior that does not satisfy rationality
assumptions (Janssen 1993). Hence the rational expectations hypothesis, as applied to the
representative household, is unrelated to the presence or absence of rational expectations on the
micro level and lacks, in this sense, a microeconomic foundation. It can be argued that it is
difficult to apply the standard efficient market hypothesis (efficient market theory) to understand
the stock market bubble that ended in 2000 and collapsed thereafter; however, advocates of
rational expectations say that the problem of ascertaining all the pertinent effects of the stock-
market crash is a great challenge. Those studying financial markets similarly apply the efficient
markets hypothesis but keep the existence of exceptions in mind.

New Keynesian Economics

Most modern Keynesians reject the neo-Ricardian value theory of the post- Keynesians. They
also reject the post-Keynesians’ call for incomes policies, citing the resource misallocations
resulting from these policies and the poor historical success of wage and price controls in
reducing inflation. New Keynesian Economics is a school of contemporary macroeconomics that
strives to provide microeconomic foundations for Keynesian economics. It developed partly as a
response to criticisms of Keynesian macroeconomics by adherents of New Classical
macroeconomics. Two main assumptions define the New Keynesian approach to
macroeconomics. Like the New Classical approach, New Keynesian macroeconomic analysis
usually assumes that households and firms have rational expectations. But the two schools differ
in that New Keynesian analysis usually assumes a variety of market failures. In particular, New
Keynesians assume that there is imperfect competition in price and wage setting to help explain
why prices and wages can become "sticky", which means they do not adjust instantaneously to
changes in economic conditions. Wage and price stickiness, and the other market failures present
in New Keynesian models, imply that the economy may fail to attain full employment.
Therefore, New Keynesians argue that macroeconomic stabilization by the government (using
fiscal policy) or by the central bank (using monetary policy) can lead to a more efficient
macroeconomic outcome than a laissez faire policy would.

The Radical View

Joseph A. Schumpeter, in his most popular book, Capitalism, Socialism, and Democracy,
published in 1942, deals with many of the themes that are of interest to us. Can capitalism
survive? asked Schumpeter. “No,” was his reply. He believed capitalistic society had for some
time been in a state of decay. But he disagreed with most economists about the precise nature of
that decay. He rejected the Ricardian emphasis on the role of diminishing returns and the
Malthusian population principle, both of which were supposed to thwart progress. He also denied
Marx’s contention that economic contradictions would produce successively more severe crises.
He rejected the Keynesian stagnation thesis on several counts. First, opportunities for great
innovation have not been exhausted; second, the tendency of innovations to become capital
saving has not been demonstrated convincingly— although the process of opening up new
countries has been completed, other opportunities may well replace these; and finally, the falling
birthrate may become economically significant in the future, but it cannot explain the events of
the 1930s.

Schumpeter wrote that if the capitalist system were to follow the pattern of growth it established
in the sixty years preceding 1928, we could achieve the objectives of social reformers without
significant interference with the capitalist process. But he thought this was unlikely. The
economic and social foundations of capitalism are beginning to crumble, said Schumpeter,
because of (1) the obsolescence of the entrepreneurial function, (2) the destruction of protective
political strata, and (3) the destruction of the institutional framework of capitalist society.

Generally, in Schumpeter’s analysis of capitalism, he predicted the ultimate transition from

capitalism to socialism because of the successes of capitalism. He believed that the
entrepreneurial spirit is eliminated by the prudent managers of large, successful firms and that as
the intellectuals supported by this highly productive capitalistic system turn against the system
that makes their unproductive lives possible, the dynamic of capitalism will fade and ever-
increasing governmental intervention and ownership will become the norm. Ironically, socialism
then replaces capitalism not because of capitalism’s failures, as Marx had envisioned, but
because of its successes. And as capitalism dies, so will the dynamic that brought about high
rates of economic growth.