Economic theories help explain how economies function, what determines output and employment, and how governments can influence economic performance. Three major schools of thought—Classical, Keynesian, and Monetarist—offer different perspectives on how economies behave and what role government policy should play.
1. Classical Theory
The classical theory of economics, prominent from the 18th to early 20th century, is based on the belief that markets are self-regulating and naturally move toward full employment equilibrium. Classical economists argued that:
- Prices, wages, and interest rates freely adjust to balance supply and demand.
- Any unemployment is temporary because labour markets correct themselves.
- Competitive markets promote efficiency and long-term stability.
- Government intervention is unnecessary—and may even disrupt the natural functioning of the economy.
Classical theory is closely linked to Say’s Law, which claims that “supply creates its own demand.” This suggests that producing goods and services generates sufficient income to purchase them, ensuring that markets clear in the long run.
2. Keynesian Theory (Demand-Side View)
The Keynesian view, developed by John Maynard Keynes during the Great Depression, challenges the classical assumption that markets always self-correct. Keynes argued that economies can experience prolonged recessions because:
- Aggregate demand—total spending in the economy—is the main driver of output and employment.
- If demand is too low, businesses cut production and lay off workers.
- Prices and wages may be slow to adjust (“sticky”), preventing markets from quickly returning to equilibrium.
To restore full employment, Keynes advocated for active government intervention, particularly through fiscal policy. By increasing government spending, cutting taxes, or both, national authorities can stimulate demand, encourage consumption and investment, and help the economy recover. This demand-side approach is especially influential during recessions or periods of economic stagnation.
3. Monetarist Theory (Supply-Side View)
The monetarist theory, most associated with Milton Friedman, emphasises the critical role of the money supply in influencing economic activity. Monetarists argue that:
- Changes in the money supply significantly affect inflation, output, and employment.
- Stable, predictable growth in the money supply supports stable economic performance.
- Excessive increases in the money supply cause inflation, while reductions can trigger recession.
Monetarists believe that monetary policy, rather than fiscal policy, is the most effective tool for managing the economy. They argue that governments should limit discretionary interventions and allow central banks to follow clear, rule-based approaches.
Monetarism is often linked to supply-side principles, such as reducing regulation, lowering taxes, and encouraging investment and production to support long-term economic growth.
How the Three Views Differ
Classical economists trust free markets and price flexibility, believing the economy naturally returns to full employment without government intervention.
Keynesians argue that demand drives economic performance and that government spending is sometimes essential to restore stability.
Monetarists focus on the money supply and the importance of controlling inflation through predictable monetary policy.
In practice, modern economic policy uses elements of all three approaches, depending on the economic challenges faced.
