Economics is a social science that studies how individuals, businesses, and governments make decisions about the allocation of resources. At its core, economics seeks to explain how people interact with one another in the production, distribution, and consumption of goods and services.

Over time, economists have developed various theories to understand these interactions and predict economic behavior. This article will explore some of the main economic theories that form the foundation of modern economics, providing insights and examples to illustrate each theory's significance.

1. Classical Economics

Classical economics, often considered the first school of economic thought, emerged in the late 18th and early 19th centuries. The theory is grounded in the belief that free markets are self-regulating and that individuals acting in their self-interest would lead to an efficient allocation of resources. Classical economists advocate for minimal government intervention in the economy.

Laissez-Faire: The idea that government should not interfere in the functioning of markets.

Invisible Hand: A metaphor introduced by Adam Smith, suggesting that individuals seeking their self-interest unintentionally benefit society by creating wealth and opportunities.

Say's Law: The principle that "supply creates its own demand," meaning that production generates an equal amount of demand in the economy.

2. Keynesian Economics

Developed by John Maynard Keynes in the early 20th century, Keynesian economics challenges the classical view that markets are always self-correcting. Keynes argued that aggregate demand (the total demand for goods and services in an economy) is the primary driver of economic growth and employment. He believed that government intervention could stabilize the economy, particularly during recessions.

Aggregate Demand: The total spending in an economy, including consumption, investment, government spending, and net exports.

Multiplier Effect: The concept that an initial increase in spending leads to a more than proportional increase in overall economic activity.

Fiscal Policy: The use of government spending and taxation to influence the economy.

The Great Depression of the 1930s exemplifies the application of Keynesian economics. During this period, Keynes advocated for increased government spending to boost aggregate demand and pull the economy out of depression. The U.S. government's New Deal programs, which included public works projects and social welfare, are examples of Keynesian fiscal policies aimed at stimulating economic activity and reducing unemployment.

3. Monetarism

Monetarism is an economic theory that emphasizes the role of governments in controlling the amount of money in circulation. Milton Friedman, a leading proponent of monetarism, argued that changes in the money supply have a significant impact on economic activity and inflation. Monetarists advocate for a steady, predictable increase in the money supply, rather than active fiscal or monetary intervention.

Quantity Theory of Money: The theory that the general price level of goods and services is directly proportional to the amount of money in circulation.

Monetary Policy: The process by which a central bank controls the money supply and interest rates to influence economic activity.

Natural Rate of Unemployment: The level of unemployment that exists when the economy is at full capacity, not influenced by monetary policy.

The U.S. Federal Reserve's response to the stagflation of the 1970s is an example of monetarism in practice. Stagflation, characterized by high inflation and high unemployment, challenged Keynesian economics. The Fed, influenced by monetarist thought, adopted a policy of controlling the money supply to curb inflation. This policy shift eventually led to lower inflation rates, though it initially resulted in a recession and high unemployment.

4. Supply-Side Economics

Supply-side economics focuses on boosting economic growth by increasing the supply of goods and services. It argues that lower taxes, reduced regulation, and a more flexible labor market create incentives for businesses to invest and expand, leading to greater economic output. Supply-side economics gained prominence in the 1980s, particularly during the Reagan administration in the United States.

Laffer Curve: A theory that suggests there is an optimal tax rate that maximizes government revenue without discouraging productivity and economic activity.

Trickle-Down Economics: The idea that benefits provided to the wealthy and businesses will eventually "trickle down" to the rest of the economy, leading to overall economic growth.

Deregulation: The reduction or elimination of government rules and regulations that restrict business activity.

The Reagan administration's economic policies, known as "Reaganomics," are a classic example of supply-side economics. The policies included significant tax cuts for individuals and businesses, deregulation, and reductions in government spending on social programs. Proponents argue that these policies led to economic growth and job creation, while critics contend that they increased income inequality and national debt.

5. Austrian Economics

Austrian economics, originating in the late 19th century, emphasizes the importance of individual choice and the limitations of central planning. Austrian economists argue that the complexity of human behavior and market processes cannot be fully captured by mathematical models or central planning. They advocate for free markets and minimal government intervention.

Subjective Value: The idea that the value of goods and services is determined by individual preferences and circumstances, rather than intrinsic qualities.

Entrepreneurship: The role of entrepreneurs in discovering and exploiting opportunities in the market, driving innovation and economic growth.

Business Cycle Theory: The Austrian perspective on business cycles emphasizes the role of credit expansion and monetary policy in causing economic booms and busts.

The Austrian School's critique of central banking and fiat currency is a notable aspect of their economic thought. Austrian economists argue that artificially low interest rates and excessive money creation by central banks can lead to unsustainable economic booms, followed by severe downturns. They advocate for a return to a gold standard or other forms of sound money to prevent such cycles.

6. Behavioral Economics

Behavioral economics integrates insights from psychology and economics to understand how people make economic decisions. It challenges the traditional economic assumption that individuals are rational actors who always make decisions to maximize their utility.

Instead, behavioral economics explores how cognitive biases, emotions, and social factors influence economic behavior.

Bounded Rationality: The idea that individuals have limited cognitive resources and information, leading to satisficing (settling for a satisfactory solution rather than the optimal one).

Prospect Theory: A theory that describes how people perceive gains and losses differently, often valuing losses more heavily than equivalent gains.

Nudging: A concept that involves subtly guiding individuals' choices without restricting their freedom, often through changes in the way choices are presented.

The concept of "nudging" has been widely applied in public policy to encourage healthier or more socially beneficial behaviors. For example, automatically enrolling employees in retirement savings plans but allowing them to opt out has been shown to significantly increase participation rates. This application of behavioral economics recognizes that individuals may not always take action in their best long-term interest without some form of guidance.

7. New Classical Economics

New classical economics emerged in the 1970s as a response to the perceived limitations of Keynesian economics. It is based on the assumption that markets are efficient, and individuals have rational expectations. New classical economists argue that government intervention is often ineffective or counterproductive because people anticipate and counteract policy changes.

Rational Expectations: The hypothesis that individuals and firms use all available information to make forecasts about the future and adjust their behavior accordingly.

Market Efficiency: The idea that asset prices reflect all available information, making it impossible to consistently achieve higher returns without taking on additional risk.

Real Business Cycle Theory: A theory that attributes business cycle fluctuations to real (rather than monetary) shocks, such as changes in technology or resource availability.

The efficient market hypothesis (EMH) is a key tenet of new classical economics. According to EMH, stock prices reflect all available information, making it impossible to consistently outperform the market through stock picking or market timing. This theory has significant implications for investment strategies, suggesting that passive index investing may be more effective than active management.

8. New Keynesian Economics

New Keynesian economics builds on the foundations of Keynesian economics, incorporating microeconomic foundations to explain market failures and the role of government intervention. New Keynesians acknowledge that markets can fail to clear, leading to unemployment and other inefficiencies. They also emphasize the importance of sticky prices and wages, which can prevent markets from adjusting quickly to changes in supply and demand.

Sticky Prices and Wages: The concept that prices and wages do not adjust immediately to changes in economic conditions, leading to short-term imbalances in the market.

Menu Costs: The costs associated with changing prices, which can discourage firms from adjusting prices frequently.

Aggregate Supply and Demand: The framework used to analyze fluctuations in output and prices, incorporating the effects of aggregate demand shocks and supply shocks.

The global financial crisis of 2008-2009 highlighted the relevance of new Keynesian economics. The crisis led to a significant drop in aggregate demand, resulting in high unemployment and economic stagnation. New Keynesian economists advocated for aggressive fiscal and monetary policies to boost demand and restore economic growth. These policies included government stimulus packages and unconventional monetary policy measures such as quantitative easing.

Marxism, an economic and sociopolitical worldview, is based on the works of Karl Marx and Friedrich Engels. It critiques the effects of capitalism and advocates for a classless society. Here's a detailed explanation of Marxist economic theory:

9. Marxism Economics

1. Historical Materialism:

Historical materialism is the methodology that looks at the development of human societies through their modes of production and relations of production. According to Marx, societal change occurs through the dialectical process of contradictions and resolutions between classes.

2. Base and Superstructure:

The base (or substructure) consists of the forces and relations of production (e.g., employer-employee relations, the technical division of labor, and property relations). The superstructure includes culture, institutions, political power structures, roles, rituals, and state. The base determines the superstructure, but there is a reciprocal relationship where the superstructure also influences the base.

3. Class Struggle:

Marxism posits that history is characterized by the struggle between classes, primarily between the bourgeoisie (capitalists who own the means of production) and the proletariat (workers who sell their labor). This conflict is the driving force behind social and economic changes.

4. Surplus Value:

Surplus value is a central concept in Marx's critique of political economy. It refers to the value generated by labor over and above the cost of labor (wages). The capitalist extracts surplus value from workers, leading to profit. This extraction is seen as exploitative.

5. Labor Theory of Value:

According to Marx, the value of a commodity is determined by the socially necessary labor time required to produce it. This theory is used to critique the capitalist mode of production, where workers receive wages less than the value of what they produce, leading to surplus value.

6. Alienation:

Marx describes several forms of alienation that workers experience under capitalism: from the product of their labor, from the labor process, from their own human potential, and from other workers. This alienation is a result of the capitalist mode of production.

Dynamics of Capitalism

1. Capital Accumulation:

Capitalists reinvest profits into production to generate more profit. This process leads to the concentration of wealth and capital in fewer hands, increasing inequality.

2. Commodity Fetishism:

This concept refers to the perception of social relationships involved in production, not as relationships among people, but as economic relationships among the money and commodities exchanged in market trade.

3. Crisis of Capitalism:

Marx theorized that capitalism is inherently unstable and prone to crises due to overproduction, underconsumption, and the falling rate of profit. These crises lead to economic recessions and depressions, which further exacerbate class struggle.

Transition to Socialism and Communism

1. Revolution:

Marx believed that the proletariat would eventually become conscious of their exploitation and overthrow the bourgeoisie through a revolution, leading to the establishment of a dictatorship of the proletariat.

2. Socialism:

In the socialist phase, the means of production would be owned collectively, and the state would wither away as class distinctions disappear. Production would be planned to meet human needs rather than for profit.

3. Communism:

The final stage of human development, according to Marx, is a classless, stateless, and moneyless society where the principle "from each according to his ability, to each according to his needs" prevails. In this stage, true human freedom and fulfillment would be achieved.

Influence and Criticism

Marxism has had a profound influence on various political movements and ideologies around the world. It has been the foundation for communist regimes in countries such as the Soviet Union, China, and Cuba. However, it has also faced criticism for its determinism, its view on human nature, and the outcomes of its practical implementations, which have often diverged significantly from Marx's original vision.

Marxist economic theory remains a critical framework for analyzing capitalism and advocating for social change. It provides tools to understand the dynamics of power, exploitation, and inequality in capitalist societies.

Macroeconomics

macroeconomics, study of the behaviour of a national or regional economy as a whole. It is concerned with understanding economy-wide events such as the total amount of goods and services produced, the level of unemployment, and the general behaviour of prices.

Unlike microeconomics—which studies how individual economic actors, such as consumers and firms, make decisions—macroeconomics concerns itself with the aggregate outcomes of those decisions. For that reason, in addition to using the tools of microeconomics, such as supply-and-demand analysis, macroeconomists also utilize aggregate measures such as gross domestic product (GDP), unemployment rates, and the consumer price index (CPI) to study the large-scale repercussions of micro-level decisions.

Early history and the classical school

Although complex macroeconomic structures have been characteristic of human societies since ancient times, the discipline of macroeconomics is relatively new. Until the 1930s most economic analysis was focused on microeconomic phenomena and concentrated primarily on the study of individual consumers, firms and industries.

The classical school of economic thought, which derived its main principles from Scottish economist Adam Smith’s theory of self-regulating markets, was the dominant philosophy.

Accordingly, such economists believed that economy-wide events such as rising unemployment and recessions are like natural phenomena and cannot be avoided. 

If left undisturbed, market forces would eventually correct such problems; moreover, any intervention by the government in the operation of free markets would be ineffective at best and destructive at worst.

The classical view of macroeconomics, which was popularized in the 19th century as laissez-faire, was shattered by the Great Depression, which began in the United States in 1929 and soon spread to the rest of the industrialized Western world.

The sheer scale of the catastrophe, which lasted almost a decade and left a quarter of the U.S. workforce without jobs, threatening the economic and political stability of many countries, was sufficient to cause a paradigm shift in mainstream macroeconomic thinking, including a reevaluation of the belief that markets are self-correcting. The theoretical foundations for that change were laid in 1935–36, when the British economist John Maynard Keynes published his monumental work The General Theory of Employment, Interest, and Money. Keynes argued that most of the adverse effects of the Great Depression could have been avoided had governments acted to counter the depression by boosting spending through fiscal policy. Keynes thus ushered in a new era of macroeconomic thought that viewed the economy as something that the government should actively manage.

Economists such as Paul Samuelson, Franco Modigliani, James Tobin, Robert Solow, and many others adopted and expanded upon Keynes’s ideas, and as a result the Keynesian school of economics was born.

In contrast to the hands-off approach of classical economists, the Keynesians argued that governments have a duty to combat recessions. Although the ups and downs of the business cycle cannot be completely avoided, they can be tamed by timely intervention. At times of economic crisis, the economy is crippled because there is almost no demand for anything.

As businesses’ sales decline, they begin laying off more workers, which causes a further reduction in income and demand, resulting in a prolonged recessionary cycle. Keynesians argued that, because it controls tax revenues, the government has the means to generate demand simply by increasing spending on goods and services during such times of hardship.

Monetarism

In the 1950s the first challenge to the Keynesian school of thought came from the monetarists, who were led by the influential University of Chicagoeconomist Milton Friedman. Friedman proposed an alternative explanation of the Great Depression: he argued that what had started as a recession was turned into a prolonged depression because of the disastrous monetary policies followed by the Federal Reserve System (the central bank of the United States). If the Federal Reserve had started to increase the money supply early on, instead of doing just the opposite, the recession could have been effectively tamed before it got out of control.

Over time, Friedman’s ideas were refined and came to be known as monetarism. In contrast to the Keynesian strategy of boosting demand through fiscal policy, monetarists favoured controlled increases in the money supply as a means of fighting off recesssions. Beyond that, the government should avoid intervening in free markets and the rest of the economy, according to monetarists.

Later developments

A second challenge to the Keynesian school arose in the 1970s, when the American economist Robert E. Lucas, Jr., laid the foundations of what came to be known as the New Classical school of thought in economics. Lucas’s key introduced the rational-expectations hypothesis.

As opposed to the ideas in earlier Keynesian and monetarist models that viewed the individual decision makers in the economy as shortsighted and backward-looking, Lucas argued that decision makers, insofar as they are rational, do not base their decisions solely on current and past data; they also form expectations about the future on the basis of a vast array of information available to them. That fact implies that a change in monetary policy, if it has been predicted by rational agents, will have no effect on real variables such as output and the unemployment rate, because the agents will have acted upon the implications of such a policy even before it is implemented. As a result, predictable changes in monetary policy will result in changes in nominal variables such as prices and wages but will not have any real effects.

Following Lucas’s pioneering work, economists including Finn E. Kydlandand Edward C. Prescott developed rigorous macroeconomic models to explain the fluctuations of the business cycle, which came to be known in the macroeconomic literature as real-business-cycle (RBC) models. RBC models were based on strong mathematical foundations and utilized Lucas’s idea of rational expectations. An important outcome of the RBC models was that they were able to explain macroeconomic fluctuations as the product of a myriad of external and internal shocks (unpredictable events that hit the economy).

Primarily, they argued that shocks that result from changes in technology can account for the majority of the fluctuations in the business cycle.

The tendency of RBC models to overemphasize technology-driven fluctuations as the primary cause of business cycles and to underemphasize the role of monetary and fiscal policy led to the development of a new Keynesian response in the 1980s. New Keynesians, including John B. Taylor and Stanley Fischer, adopted the rigorous modeling approach introduced by Kydland and Prescott in the RBC literature but expanded it by altering some key underlying assumptions.

Previous models had relied on the fact that nominal variables such as prices and wages are flexible and respond very quickly to changes in supply and demand. However, in the real world, most wages and many prices are locked in by contractual agreements. That fact introduces “stickiness,” or resistance to change, in those economic variables. Because wages and prices tend to be sticky, economic decision makers may react to macroeconomic events by altering other variables. For example, if wages are sticky, businesses will find themselves laying off more workers than they would in an unrealistic environment in which every employee’s salary could be cut in half.

Introducing market imperfections such as wage and price stickiness helped Taylor and Fischer to build macroeconomic models that represented the business cycle more accurately. In particular, they were able to show that in a world of market imperfections such as stickiness, monetary policy will have a direct impact on output and on employment in the short run, until enough time has passed for wages and prices to adjust. Therefore, central banks that control the supply of money can very well influence the business cycle in the short run. In the long run, however, the imperfections become less binding, as contracts can be renegotiated, and monetary policy can influence only prices.

Following the new Keynesian revolution, macroeconomists seemed to reach a consensus that monetary policy is effective in the short run and can be used as a tool to tame business cycles. Many other macroeconomic models were developed to measure the extent to which monetary policy can influence output. More recently, the impact of the financial crisis of 2007–08 and the Great Recession that followed it, coupled with the fact that many governments adopted a very Keynesian response to those events, brought about a revival of interest in the new Keynesian approach to macroeconomics, which seemed likely to lead to improved theories and better macroeconomic models in the future.