Policies, business and government decisions are based on economic theories. Such theories do not only make economists comprehend how the economies operate but also inform policy makers on how to design solutions to the problems encountered among present societies. Gradually, schools of thoughts have been developed which prove to be very different in terms of perspective on changing economic nature, individual decision-making and government influence.
In the current globalized world, it has become apparent that certain economic theories have played pivotal roles in determining the policies used in the financial systems, trade relations, and structures of the society. This paper shall discuss the major economic theories that still dominate and shape the economy of the world and are making economic decision-making processes globally.
Classical Economics: The Pillar of a Free Market
Modern economic thought was founded on the province of Classical economics, which was developed in the 18 th and 19 th centuries by economists such as Adam Smith, David Ricardo and John Stuart Mill. The main tenet of classical economics is that markets self regulate in a manner that the law of supply and demand balance each other out without outside intervention on the part of the government.
Classical theory lays an emphasis on the role of competition, free markets and individual entrepreneurship in propelling prosperity in the economy. Adam Smith is known to have held the even more famous idea of the “invisible hand” that implies that self-benefiting people make a contribution to the benefit of the overall economy without actually knowing it. This theory states that the government should not play much role but the market can self adjust.
Policy Implication of Classical Economics:
- Free Markets: The Classical economics propagates the policies where the government should allow freedom to the markets, free trade and free flowing competition.
- Deregulation: Economists denounce the unnecessary regulations since they feel that once such regulations are done away with businesses are set to prosper bringing economic growth.
- Less Government: The theory proposes limited government, because it states that the natural forces of the market are better in resource allocation compared to decisions made by the government.
Keynesian Economics: The intervention of Government on Economic Cycles
The Keynesian economics is the creation of John Maynard Keynes, and it changed how economists and policy makers look at the economy in the 1930s. To react to the Great Depression, Keynes suggested that free market might not help achieve full employment and that a state should have a role to play in stabilizing economy and moderating the business cycle.
Keynes argues that in times of economic recession, the demand in the private sector declines resulting in increasing cases of unemployment and decreasing level of production. In such situations the government needs to intervene in the form of boosting the public expenditure, lowering taxes, and generating demands. Keynes also thought that the monetary policy, like reducing interest rate, would facilitate in the promotion of economic activity.
Keynesian Economics Implications on Policy:
- Fiscal Stimulus: Keynesian Based on science, Keynesian economics suggests using government spending, especially in cases of recession to stimulate demand and subsequently decrease the unemployment.
- Monetary Easing: Keynesians advise that the central banks reduce interest rates so that it can spur borrowing and investments in cases of economic stagnation.
- Social Programs: Keynesian theory tends to advocate social welfare spending, which stimulates demand both during any bad economic times through raising the amount of disposable income of low-income households.
Monetarism: Vivification by Managing Inflation by Means of Money Supply
Monetarism, which Milton Friedman popularized in the 1970s, focused on the impact of money supply to dictate stability in the economy and inflation. Monetarists further advance the notion that rise in the supply of money is the major causative factor of inflation and management of money supply is the ultimate solution to inflation and the stability of the economy.
Monetarists stand out to differ with Keynesian economics in the sense that Keynesian economics dictates that the government should come into the picture and curb an ongoing economic slump, unlike monetarists who feel that the main purpose of the government is to curb inflation as well as regulate the level of money in the economy. Monetarists believe that fiscal measures (government expenditures, and tax reduction) are less effective over the longer run and can cause inflation.
The Policy implication of Monetarism:
- Money Supply Control: The controlling of growth of the money supply to eliminate inflation is the policy of monetarist. The predictable low money supply growth rates should be pursued by central banks.
- Interest Rate: Monetarists advocate the use of interest rates as one of the prime mechanisms of managing price inflation. Central banks can lower borrowing and control the inflationary pressure by increasing interest rates.
- Limited Government Control: Monetarism believes that the government spending should be cut down and that emphasis should be put on market oriented solutions.
Supply-Side Economics: Cutting Tax to Increase Growth
The concept behind supply-side economics is that the economy can be jump-started by lowering taxes and government control to entice business to increase production of goods and services. The theory is that with reduced taxes on businesses and individuals, the businesses and individuals have more funds to invest in production hence creating jobs, promoting innovation and boosting the economy.
Supply-side economics has its origin in the classical economics thoughts but its popularity came in the 1980s more so during the Reagan administration in the U.S. Advocates hold that by lowering taxes of businesses and high-income earners, more will be invested hence more jobs and prosperity in the overall society.
Supply-side Economics: Policy Implications:
- Business Tax Cuts: The supply-side aspect of the economy suggests tax cut on the businesses to boost the investment in innovation and growth.
- Tax Cuts to the Pay 100K+: Cutting on income tax rates of the richest persons is expected to trigger an increase on savings and investments, which are beneficial to the economy.
- Deregulation: Economists in supply-side believe that doing away with any redundant regulation will enable business to expand and elevate their output.
Behavioral Economics: Human Decision-Making Revealed
Behavioral economics criticizes the conventional economic logic which states that people are always rational and are always interested in maximizing their utility. Rather, it incorporates the psychological understanding into economic thinking considering that individual economic choices are frequently susceptible to mental biases, emotional and social determinants.
Policy makers have in greater numbers relied on behavioral economics in coming up with more effective policies in the formulation of public policies taking into consideration how individuals will actually behave. This knowledge of decision-making helps the policymakers to direct individuals to choices that promote their well-being without limiting their freedom, a process known as nudge.
Behavioral Economics implications on Policy:
- Nudging: Nudging involves some methods applied by the governments and organizations that promote making better choices. Case in point, automatic enrollment into retirement savings plans have proven to lead to participation increase.
- Consumer Protection: Policies that safeguard an individual against a decision that can harm the outcomes of his/her finances or health are designed by utilizing behavioral economics.
- Public Health and Social Welfare: Behavioral interventions are used to promote more healthy behaviors, e.g. eating healthy or exercising by maneuvering changes in policies and providing incentives.
Neoclassical Economics: Efficiency And Market Equilibrium
The neoclassical economics is based on the principles of classical but it adds marginalism concept. It concerns itself with how people and firms act with the assumption that people behave in a rational manner in order to maximize on their utility and firms maximize on their profits. Neoclassical economics suggests that there should be minimal involvement of the government in the markets since it is believed that markets will automatically arrive to equilibrium point where the supply and demand are equal.
The major policy implication of neoclassical economics is that the governments must not interfere with the work of market forces. With the markets operating freely, the economy will efficiently distribute the available resources thus leading to the best allocation of goods and services.
Policy Implications of the Neoclassical Economics:
- Free Trade: Neoclassical economics supports the opening up of barriers to trade by proposing that goods and services move freely in and out of international borders by supporting free international trade.
- Deregulation: Neoclassical economists believe that the government should lessen its regulation on markets so that the latter could be run more efficiently.
- Private Property Rights: Property rights may be equally important to allow individuals and businesses to invest and preserve their property without the fear that competitors can cheat and take over property at a lower price.
Chapter Conclusion: The Changing Power of Economic Theories
Economic theories still keep on developing which provide new revelations and solutions to the problems confronted by advanced economies. Although classical Keynesian, monetarist, supply-side, and behavioral economics continue to be the backbone in economic policymaking, there is a need to revise the old views in the face of changing issues, like the problem of climate change, use of technology and inequality in income. Other theories that previously dominated in the field of economy are being juggled or overridden to remedy such emerging problems.
Due to the presence of the economic theories that shape today the world, policymakers, business leaders, and individuals having intentions of taking a step forward in the labyrinth of the global economy need to understand what the economic theories of the world are. The theories offer the tools required to handle the prevailing challenges with a view of ensuring that the focus is on sustainable growth, stability and prosperity in the long-run.