Economic Policy Theories: Simply Explained |

This article is about the topic of economic policy theories. Here you can find out what the basic economic policy theories are and how they differ.

Economic theories simply explained

With their measures, politicians try to come close to an ideal image of the economy. This ideal image is purely rational and ignores emotional aspects. In this way, the economic goals should be achieved as best as possible. Economic policy theories are used for orientation.

With the passage of time, various economic policy theories, too economic theories called, used to explain the processes in an economy. They are intended to provide the theoretical basis for a state’s economic decisions.

On the basis of economic policy theories, a state can decide which basic economic policy positions it adopts. Based on this, he can decide which economic policy instruments and measures need to be taken. You can find out what the individual terms mean in the following paragraphs.

Basic economic positions

Basic economic policy positions represent the goals of an economy. These can be derived from the magic hexagon. Possible goals can be:

Illustration 1: Magic hexagon Source: bpb.de

economic policy instruments

Economic policy instruments represent the overarching means that can have an impact on the economy. These can be:

economic policy measures

Economic policy measures are the direct means used to achieve economic policy goals. The economic policy instruments are concretized directly into specific measures. Examples of these are:

  • tax cuts
  • Government Investments
  • subsidies
  • change in money circulation

Economic policy theories – historical development

Until the time of absolutism in the 16/17. For centuries there has been no scientific study of economic activity. But even in antiquity (e.g. with Plato and Aristotle) ​​and in the time of the Enlightenment (Thomas Hobbes and John Locke) there were some philosophers and scientists who dealt with economic processes. However, these theories were never really taken into account in economic policy decisions.

Illustration 2: Adam Smith Source: www.faz.net

At the time of absolutism, the first economic findings were then taken into account. With the help of the theory of mercantilism, the states intervened directly in economic activity.

With mercantilism, as many goods as possible should be exported. The individual countries specialized in individual goods and thereby improved their quality and were able to outperform other countries. Market power should also reflect the other strengths of states.

For example, England rose to become the largest wool producer in Europe. This led to a complete decline in wool production in other countries. Nevertheless, there were also disadvantages, such as some vital economic sectors, such as agriculture, were completely neglected.

However, since the complete state control of the economy had led to an inefficient and one-sided economy, many states turned away from mercantilism. Many states carried out their economic policies on the basis of classical economics.

One of the main founders of this theory is the Scotsman Adam Smith. State intervention was reduced and the economy was made more liberal. The so-called invisible hand of the market was a keyword of this theory. This means that without government intervention, market players find the most efficient solution. This leads to an optimization for everyone involved. Classical economics was later developed into neoclassical economics. The national economy was expanded to include microeconomic principles such as dynamic supply and demand curves. This theory prevails in economics to this day.

With the beginning of industrialization, classical national economy and the associated free market freedoms reached their limits. Great social inequalities developed as a result of the national economy. On the one hand there were rich factory owners and on the other hand a working class living in poverty. This led to the emergence of socialism or Marxism.

Illustration 3: Karl Marx Source: www.fes.de

One of the main founders of this theory was Karl Marx. Marx again called for greater intervention in economic processes. This was intended to protect workers and distribute wealth more evenly. Large landowners were to be expropriated. Many goods should belong to everyone. The theory continued to evolve until it culminated in communism. His theory was one of the cornerstones of the planned economy.

On the other hand, there were also nationalistic economists at the same time, who also called for more state intervention, but not to protect the workers, but to protect the domestic economy and to make progress over others. On the basis of the new currents, the old practices were loosened up and more interventions took place again. For example, social security was introduced in Germany in the 1880s.

More recently, the neoclassical model has been further split and expanded to include macroeconomic theories. This is how supply-oriented monetarism developed on the one hand and demand-oriented Keynesianism on the other. Nowadays, politics takes several economic policy theories into account. In Germany, after the Second World War, the social market economy was formed, which allows state intervention, but still allows the economy to develop naturally.

Central economic theories

neoclassic

Neoclassical economic theory was developed independently by various economists in the 1870s. A well-known representative in the German-speaking world was Carl Menger from Austria. Because of the different currents, there is no unified neoclassical theory today, but there are some basic assumptions.

The theory sees itself as a further development of classical economics. The model was extended to include microeconomic theory. This means an extension to the marginal principle with marginal costs and marginal revenues. This allows supply and demand curves to be derived. The optimum is always formed where supply and demand are equal. In this theory, money is completely independent of the goods market. Furthermore, the assumptions of the invisible hand of the market and an individual and rational thinking behavior of the market participants apply. This theory is still the most commonly used today.

Monetarism (supply politics)

Monetarism, also known as supply-side politics, was primarily developed by Milton Friedman in the 1930s in response to the Great Depression. Monetarism primarily assumes that jobs and new investments are created by companies (as providers). The investments are made on the basis of profit expectations.The state should not be big in this conception economic policy operate, but should be handed over to private hands as much as possible. The main task of the state is to promote companies through tax breaks and the removal of bureaucratic obstacles. Overall, this theory assumes that state intervention only brings about change in the very long term.

Keynesianism (demand politics)

Keynesianism, also known as demand politics, was also developed in the 1930s. Namesake and one of the main people responsible was John Maynard Keynes. Keynes believed that the Great Depression could have been mitigated with more government intervention.

Illustration 4: John Maynard Keynes Source: www.manager-magazin.de

Keynesianism, also known as demand politics, was also developed in the 1930s. Namesake and one of the main people responsible was John Maynard Keynes. Keynes believed that the Great Depression could have been mitigated with more government intervention.Keynesianism is again turning away from the neoclassical ideas that the state should not interfere in economic activity. The market is not always able to stabilize itself again. According to this theory, the state should actively influence the economic cycle again in order to mitigate economic fluctuations.

For example, the state should increase its public spending during a recession and cut spending during a boom phase. In this way, the economy should always be boosted by the state at the right moments. The state should therefore actively control demand.

The Stability and Growth Act of 1967 has ensured that economic policy in the Federal Republic of Germany has been controlled on the basis of the rules laid down by Keynes ever since. This can be seen, for example, in the measures to rescue companies and government purchases during economic crises.

Central economic policy theories – comparison

The three central theories are compared on the basis of four different points:

Differences in viewsNeoclassicismMonetarism (supply politics)Keynesianism (demand politics)viewmicroeconomic viewmacroeconomic viewmacroeconomic viewIncomeIndividuals optimize their utility with their income. Depending on what increases the benefit, the savings rate or the benefit rate is increased. The income is stable and the savings rate therefore always remains the same. As income increases, consumption increases, but the savings rate stays the same. When income increases, consumption and the savings rate both increase. EconomyThe state should hardly intervene in the economy at all. The invisible hand of the market always ensures the best possible result. Government interventions in the economy must always be planned for the long term, since government investments take effect very late and lead to changes. The state can also intervene in the short term and stimulate the economy again.MoneyMoney is neutral and the economy has no influence on moneyMoney is directly related to the economy. With the help of an expansion of the money supply, economic fluctuations can be improved in the short term. This means that economic growth can be improved. Money is not directly related to the economy, but interest is. By regulating interest rates, investments can be stimulated and the economy starts to grow again.

Economic policy theories – the most important

  • Economic policy theories should break down economic reality and economic policy decisions should be made with this model.
  • Over time, there have always been…