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Useful Notes / Economic Theories

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As discussed in the Economics article, economic systems exist to allow a society to economize, i.e. allocate their supply of means towards various different ends. The supply of means is scarce because it cannot achieve all these ends. Thus, an economic system is something that provides a method by which these ends are prioritized and means are directed to fulfilling them.


Economic systems, whether ad hoc or intentionally designed, accumulate theories about how they function and how best to optimize them — and, in particular, to respond to adverse events. For purposes of this discussion, we'll talk about economic theories that are based on scarcity models (post-scarcity is an entirely different, and hypothetical, beast).

    Classical theory 

In 1776, Adam Smith published his magnum opus, An Inquiry into the Nature and Causes of the Wealth of Nations, launching the era of economic theory that is now labeled "classical". The Industrial Revolution was just starting and Smith's theories were seminal in the transition from agricultural economies to industrial economies throughout the Western world. The Wealth of Nations defined the terms that we use today, such as division of labor, productivity, and free markets. Smith opposed mercantilism: the use of government policy to restrict trade among nations in favor of their own industries.

A full study of classical theory is beyond the scope of this document, but its core tenets may be summarized:

  • Humans specialize not out of inherent differences in ability but because of advantages gained in barter, where a person finds that they are better able to trade when they produce a large quantity of a specific product rather than attempting to produce small quantities of many products.
  • The inherent value of products is based on the labor used to produce them.
  • Prices are set based on the sum total of labor value, rent paid on land, and profit to the capitalist for risking his resources.
  • When demand exceeds supply, prices rise.
  • When supply exceeds demand, prices fall.
  • Labor follows similar rules: when the supply of labor exceeds the demand for labor, either on a national scale or within specific specializations, wages fall. When the demand for labor exceeds its supply, wages rise.
  • As a stable currency is needed to accurately set prices, currency should be based on precious metals and stamped to prevent debasement, which is the natural inclination of governments.

The Role of Government

Smith advocated a government that interfered to the minimum degree possible in the operation of markets. He believed that government should provide those common services that markets were not inherently suited for, such as public education, judicial systems, and the military. When governments interfere, such as by granting monopolies or regulating labor, it creates distortions that interfere with the markets' ability to set prices and wages.

In this model, recessions are a natural consequence of distortions in the prices of products, labor, or capital, which are settled when those prices adjust to their proper values in the marketplace.

    Marxist theory 
In the mid-1800s, various economic theories arose to propose alternatives to the capitalist system — in particular, the flagrant abuses of labor and the stark inequality of wealth and opportunity seen in capitalist societies. The most significant of these was penned by Karl Marx, in The Communist Manifesto (1848) and Das Kapital (1867-1894). Marx called for the establishment of a socialism, or economy run for the benefit of laborers rather than the capitalist society he saw as existing for the benefit of producers.

Marx held that capitalist societies are inherently oppressive and that there is no way to fully redress this situation short of a complete reform/overhaul of the system. According to him, left unchecked, capitalism will always seek to exploit labor and enshrine inequality in systems of class, and will inevitably self-destruct as a result. Marx saw it as the axiomatic outcome of such an event for the proletariat, or the working classes, to rise up and overthrow the bourgeoisie, or capitalist classes, seizing control of the means of production and distributing the goods produced by society fairly and evenly to all members of that society.

The ultimate outcome of this socialist revolution would be Communism, a classless society wherein the means of production would be collectively owned by all workers, and the products distributed according to each individual's need. "To each according to his need, from each according to his ability." In such a system, there would be no need for money except as a metric for determining the relative value of any given good.

Marx's ideas were inherently revolutionary, advocating overthrow of existing systems rather than attempting to reform them. He therefore inspired many revolutionary movements, all of which were opposed to the authoritarian, hierarchical systems of government and business that dominated most societies.

  • Marxism-Leninism, practiced in the USSR and spearheaded by the Bolsheviks, envisioned a revolutionary Party that would run the apparatus of production and of state until such time as it was able to hand power over to the masses.
  • Maoism, practiced in the People's Republic of China, considered the USSR "Revisionist" because it seemed too accepting of the possibility of permanent and centralised party control of the state and economy. However, Maoism never articulated a ideologically 'pure' and coherent "Marxist-Leninist" alternative. Maoism de facto neutered its Soviet-style institutions by devolving power to the district and local level, effectively splitting the country up into hundreds of competing political-economic units.

The key contributions of Marxism to modern Western economic thought include:

  • Labor solidarity (unionization) as a counteragent to the domination of wage setting by business interests.
  • The need for income support programs (social democracy) for the poor to prevent them from reaching a state of revolutionary discontent.


The core criticism of Marxism is that it goes against human self-interest to equally distribute the products of labor without regard for personal ownership. Since your needs will be provided for no matter what you do, and you cannot strive to gain extra products above your needs, there is no incentive to work, or to excel at work. The productivity of such a society is much lower than a society in which individual effort can better one's economic status.

A key example of the truth of this criticism occurred in the collective farms of the U.S.S.R. When workers were granted private plots of land that they could grow food on and sell in markets rather than having all their food seized and redistributed, the productivity of the collective farms increased dramatically.

Another criticism of Marxism is that it offers no coherent path from the socialist worker's revolution to the final Communist worker's paradise. In practice, no system of government based on Marx's theories has ever transitioned to that final stage; they always become mired in authoritarian systems that centralize control of the means of production and refuse to let go. The inherent inefficiencies of the command economy become so great that the system either collapses in a counter-revolution or is forced to adopt capitalist reforms, slowly transitioning towards freer markets.

    Keynesian theory 
Around the time of The Great Depression, John Maynard Keynes (1883-1946) proposed revisions to classical theory based on a model of demand as independent from supply, with significantly different rules for how governments should manage monetary and fiscal policy during recessions than during normal times. Keynes' work inspired the New Deal (and similar reforms in Europe) and went on to become the predominant economic theory employed by Western governments through the mid-20th century, until neoclassical theory emerged in the 1970s. Keynes borrowed many concepts from Marx, but insisted that properly regulated markets were superior to fully socialized or state-controlled markets.

Keynes' work also coincided with the global movement away from hard currencies (the gold standard) to fiat currencies, in which governments found themselves needing new economic theories to handle the increased variables in managing a currency not backed by precious metals.

Keynes' core insight was that, rather than being driven by supply as was assumed in classical theory (in particular Say's Law), demand is an independent variable that can trigger recessions if insufficient, even if there is no loss of productive capacity. Thus, governments wishing to mitigate the effects of this type of recession should, contrary to the wisdom of the time, increase public spending to support private incomes until such time as the private sector recovers sufficiently.

It should be stressed that Keynesianism is a macroeconomic theory. It concerns itself with aggregates, not with individual behaviour. Neoclassical theory in particular takes issue with this as it insists that all economic behaviour should be built up from microeconomic principles.

Core principles

Keynesian theory offers a number of axioms about macroeconomic activity.

  • Supply and demand are independent variables in an economy, controlled by different mechanisms.
  • Accordingly, there are two types of recessions: supply-side and demand-side.
    • A supply-side recession occurs when there is a shortage of production capacity, either because of significant disruption due to war or catastrophe or because of the sudden reduction in availability of a particular, important commodity.
    • A demand-side recession occurs when there is a shortage of purchasing power among consumers. Historically, this occurs when there is a sudden shift from spending to saving, characterized by a run-up of private debt which suddenly has to be paid back.
  • The government's proper role is to act as a cushion: to smooth the curves that would naturally occur within an unregulated economy. The government's primary mechanism for doing this is to affect demand.
    • When demand is slack, the government should run deficits in order to make up the difference, until the private economy picks itself back up.
    • When demand is excessive, the government should run surpluses in order to reduce consumption so that dangerous price bubbles do not form.

Supporting principles: Multipliers

Important to Keynes' work is the concept of fiscal multipliers. Put another way, all money is not equal: its value depends on who has it and what they're doing with it. If a person is saving money, that money is not being spent immediately on consumption. Under ordinary circumstances, saved money goes into investment, but under abnormal circumstances, some of that money may instead be held back, in reserve accounts, under mattresses, or what have you. Money not spent is money that does not generate economic activity; therefore it has zero value.

The marginal propensity to consume is the tendency of an individual entity to spend its income. A poor person spends 100% of their income, and this spending goes directly into the consumer economy, where it is used to pay wages, creating more spending, and so on. In fact, poor people spend more than 100%, since they derive some "income" from negative taxation, welfare, subsidies, and similar transfer payments. However, wealthy people do not spend 100% of their income, and the amount they spend decreases the wealthier they become. In this sense, money is less useful in the hands of wealthy people, and if the goal is to maximize economic activity, it should be taxed or borrowed from them and given to less wealthy people.

Supporting principles: The Paradox of Thrift

"Your spending is my income". Over the entirety of an economy, the total amount spent is equal to the total amount paid in wages and other forms of income. Under ordinary circumstances, some people and businesses will be running surpluses (saving more than spending) at any given time, and others will be running deficits (spending more than saving). In abnormal circumstances, such as a credit crisis, the savers will outnumber the spenders — debt-ridden consumers will try to pay off their debts, while consumers who have a positive net worth will withhold spending due to fear.

However, this has a paradoxical effect: if everyone turns to saving at once, everyone's income is reduced. Consumers with debts become less able to pay off their debts, and consumers with money to spend find that they may suddenly have less income. What is prudence for the individual is folly for the economy as a whole.

In supply and demand terms, the demand for money has increased. In this situation, it is necessary for governments to intervene by increasing the supply of money so that debtors can pay off their debts and resume spending, while creditors may feel comfortable spending at their desired levels.

Supporting principles: The Function of Public Debt

Under Keynes, public debt is distinguished from private debt in that public debt, created by a sovereign currency issuer, is a tool of economic policy rather than an evil to be avoided. As stated in the Economics article, public debt is a zero-sum game: the amount owed is exactly balanced by the assets represented by those bonds, such that the net wealth of a nation remains the same no matter how much debt it issues. The myth that we are "borrowing from our future" is simply false; the central bank could, at any time, choose to issue currency to repay its debts and zero out the books. This would, however, be highly inflationary.

The key requirement for this rule is that the debt be issued in the nation's own currency. A nation that does not control its currency, or that owes substantial debts in foreign currencies, is subject to debt crises, as has been observed in the Eurozone from 2008-2015 and counting.

Debt serves several functions:

  • It puts money to use that would not otherwise be used efficiently. For example, a wealthy individual or business with money that it wishes to invest may buy stocks or shares in mutual funds, it may engage in venture capitalism, or it may buy public debt. When it buys public debt, it is funding government programs that seek to utilize that money in ways that are more efficient, in theory, than what the private individual or business might otherwise accomplish. This depends heavily on the principle of multipliers discussed above.
  • It acts as a lever to control the economy. As discussed in the core principles of Keynesianism, when a demand recession is occurring, the government issues debt (taking idle savings that would otherwise go to waste) and puts that money to use stimulating demand. When a boom is occurring, the government instead taxes that income and uses it to pay back debt, reducing the amount of money in circulation and also making private investment more attractive.


It is worth noting that hyperinflation, characterized by frantic currency issuance and rapid devaluation of a nation's currency, is impossible in a sovereign issuer with a functioning economy, for the following reasons:
  • A nation that issues debts in its own currency can always control the value of its currency relative to other currencies.
  • A nation with a functioning production system does not need to borrow from other nations in order to satisfy domestic demand.

Historically, all examples of hyperinflation have occurred when a nation has limited production capacity that requires borrowing in other countries' currencies to fulfil consumer demand. The only way this could occur in the United States would be for a natural disaster or war to devastate vast amounts of industry, requiring extensive borrowing from other countries to keep the citizens supplied with necessities like food.

Debt panics, or death by interest rates

A key criticism of public debt is that it may make the nation vulnerable to a confidence crisis: in effect, a bank run at the national level. In Keynesian theory, this is impossible because a sovereign currency issuer may always buy its own debt and thereby controls the interest rates on said debt. As long as there are not artificial obstacles enacted, such as legislative limits on debt issuance, this truth holds absolutely.

Supporting principles: Sticky Prices, The Zero Lower Bound and the Liquidity Trap

Another important component of Keynes' theory is a refutation of the classical principle that prices and wages are infinitely flexible, especially downward. Classical (and neoclassical) theory hold that a recession is an attempt by the marketplace to reset distorted prices to their natural, correct place, and that government should allow these crises to occur in order to have a more robust economy in the future.

Sticky prices and wages

What Keynes observed in practice, however, was that in a demand-driven crisis, wages and prices resist falling. The precise mechanisms for this have not been perfectly explained; rather, they are based on empirical data. Even in the deepest of depressions, most people don't see a reduction in their hourly wages or a reduction in the prices of products. What happens instead is that people get laid off, their hours get cut back, and they become less able to afford things. Meanwhile, their debts increase in relative value because they have less income to pay them back with. Rather than reduce prices to sell their existing products, producers instead reduce production, shuttering plants and closing stores.

The liquidity trap

In conditions of persistently depressed demand, everyone is trying to save more than they spend. As noted above under the paradox of thrift, this causes excess savings to accumulate with nothing of value to spend them on. In this condition, increasing the money supply, contrary to common wisdom, does not drive inflation, because no matter how much money is in the economy, it's not making its way to consumers who need it to relieve their debt burdens.

The zero lower bound

The interest rate set by the central bank on short-term lending is a key lever of economic activity. In the U.S., this is known as the "Federal Funds Rate". When interest rates are high, borrowing costs more, and so private entities are less inclined to run deficits. Correspondingly, investment has higher returns, so there is an increased incentive to save and loan funds, driving capital investment. This investment increases supply and relieves pent-up demand. When interest rates are low, borrowing is cheaper and so private entities have incentives to spend more than they earn. This can cause inflationary pressure if too much demand runs up against insufficient supply.

There is a concept in Keynesianism called the Natural Rate of Interest (credited to Knut Wicksell), which is the interest rate set by the central bank that is consistent with full employment in a growing economy. In normal conditions, that rate is positive; that is, the government may stimulate demand by lowering it and reduce demand by increasing it. In a liquidity trap, however, the natural rate of interest may well become negative, meaning that the desire to save is so great that even zero interest rates are insufficient to break an economy out of stagnation and into growth.

In these circumstances, monetary policy becomes ineffective and the only way to increase growth is to conduct fiscal stimulus.


Neo-Keynesianism is a relatively modern attempt to reconcile neoclassical models based in rigorous mathematics with the "back of the napkin" methodology of Keynes. Its basic concept is to demonstrate Keynesian principles through mathematical models. It has seen limited adoption due to two factors: the observation central to Keynes that macroeconomic behaviour is more than the sum of individual behaviours, and the ideological nature of the neoclassical paradigm, which denies as a matter of principle that macroeconomic effects exist.


The main criticism of Keynesian theory is that it prescribes a market capitalism that is adequately regulated by government to restrain its excesses. The historical record, however, shows that in any market system, wealth holders will seek to gain political power to sway regulation in their favor — for example, by using it to prop up monopolies and exclude competition. An active and educated democratic voter base is needed to elect leaders who will resist the temptations of regulatory capture and crony capitalism.

Keynesian theory also requires technically sophisticated fiscal and monetary manipulations, which may be beyond the understanding (or desires) of elected politicians and the voters who choose them. Thus, the theory may be misapplied, resulting in catastrophic failures. Stagflation is a primary example of this.

Marxist theory proposes that all capitalist societies will inevitably collapse due to the pressure of inequality, and that Keynesian theory, by incompletely restraining the excesses that lead to such a collapse, merely postpones it rather than averts it.


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