The first major theory of economics is called classical economics. Classical economics originated in the 1860s with writings of Adam Smith and was further developed by later economists. The classical school of thought dominated economic thinking first in Great Britain and later the United States. In his book The Wealth of Nations, Smith asserted that free competition and free trade, unregulated by government, would create wealth for individuals and the nation as a whole. This is also referred to as laissez-faire economics. Smith believed the community benefited most when each of its members followed his or her own self-interest and profits. In the free-enterprise system, individuals create profits by producing products that other people want to purchase. On the flip side, individuals also spend money to obtain goods they need or want. In the apparent chaos of buying and selling, an orderly market would emerge and create growing prosperity for a nation.

CS Question #1: What economist defined the classical theory of economics?

The next major economic theory was developed by John Keynes in the mid-1930s. Keynes wrote a complex book called The General Theory of Employment, Interest and Money, which gave definition to Keynesian or stabilization theory. In his book, Keynes argued that a free market would never provide full employment or stable prices. He also asserted that without government or centralized markets to provide stability, economies have no way to recover from economic downturns. According to Keynes, an economy could grow only if the government supported its growth by using fiscal and monetary policies. Stabilization theory supports the idea of government social spending to help boost a nation's economy. When Keynes first wrote his book, many economists disagreed, but by the 1950s many governments had adopted stabilization policies.

Rational expectations is somewhat contradictory to Keynes' stabilization theory. Rational expectations assumes that individuals, businesses and governments make economic decisions taking into account the future consequence of their decisions. Using all information available, individuals make an effort to avoid repeating past mistakes. This applies to, among other things, using rational expectations when viewing economic indicators and making policy changes. Stabilization theory proposes government spending to smooth over downturns in the business cycle or boost the economy. For example, if the government is buying more goods and services in the market, businesses will recognize a greater profit and in turn will produce more and hire more employees-boosting the economy. However, the wage for the current and new workers does not increase. Workers earn the same wage rate, while the prices have increased. The labor force experiences a decreased real wage. Rational expectations states that workers will learn from the past and not support a similar government spending policy.

CS Question #2: What is the difference between stabilization theory and the theory rational expectations?

Monetarist economics revolves around monetary policy and money supply. Developed by American economist Milton Friedman, monetarism maintains that the money supply is the chief determinant of economic activity. According to the monetarist theory, moderate growth of the money supply could assure a steady rate of economic growth with low inflation. In the 1980s, however, this school of thought became problematic. This was because the diverse forms of bank deposits made it difficult to calculate the amount of currency circulating in the economy. Without a clear picture of the money supply, it became difficult to know how much the money supply should grow.

CS Question #3: What is the monetarist theory of economics?

Supply-side economics has developed only in the last 30 years. Its chief proponent was Arthur Laffer. Laffer believed that lower tax rates would lead to higher tax revenues. Supply-side economics stated that reductions in federal taxes on businesses and individuals would lead to increased economic growth and, eventually, to increased government revenue. In 1981 President Ronald Reagan implemented a dramatic reduction in tax rates, hoping to create eventual higher tax revenues. While the economy grew during most of the 1980s, it never grew fast enough to balance government expenditures. The effects of the Reagan era and supply-side economics are still being observed and debated. While the economy has boomed since the early 1990s, it is unclear if this was a direct result of supply-side economics, emerging world markets, technology, or other numerous variables.

CS Question #4: What is supply-side economics?

Further Thought:

1. Which economic policies are currently being used?
2. How is an economy affected by the theories held by the public and the policy makers?
3. Are supply side-economics effective in generating prosperity? Why or why not?