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What Are the Different Theories of Economic Growth?

A monument honoring Adam Smith, an extremely important economist.
20th Century economist Milton Friedman provided criticism on Keynes' theories.
John Maynard Keynes.
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  • Written By: Mark Wollacott
  • Edited By: A. Joseph
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  • Last Modified Date: 07 August 2014
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Different theories of economic growth center on the question of what circumstances lead to sustained economic development within an economy. These tend to look at the interactions of the state and free enterprise. They also look at other factors that affect economic performance. Each theory tends to grow out of one person’s attempted to understand economics and then create a model to maximize growth from it. Among the different economic growth theories are the mercantilist, classical and neoclassical theories, Spontaneous Order and Monetarism.

Early economic theories developed as Europe moved away from feudalism and toward capitalism. Two early and opposing schools of thought were the physiocratic and mercantilist theories of economic growth. The former, an 18th century French theory, believed that economic growth came only from land ownership and agriculture. The latter, on the other hand, believed that trade was the sole producer of economic growth.

Adam Smith, in his 1776 work Inquiry into the Nature and Causes of the Wealth of Nations, developed the classical theories of economic growth as a critique of both the physiocrats and the mercantilists. According to Smith, economic growth depends on the specialization and division of labor and the accumulation of wealth. For this to work, he believed, the government had to be small and non-interventionalist, which would lead to a large free-enterprise sector. Robert Solow helped develop the classical theory by insisting that savings creates growth and consumption should be postponed to allow savings to be built up.

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Solow, along with Paul Romer and Paul Omerod, helped develop the neoclassical or new economic growth theory. This theory developed Smith’s theories further. The theory states that the growth of labor will cause a corresponding economic growth. This is also said of rises in labor quality through education and training, the growth of entrepreneurship and a growth in investment.

Joseph Schumpeter took this one step further with his theories of economic growth that took into account the effects of technology and innovation. According to Schumpeter, the development of new technology leads to growth. Innovation and new products and services also lead to the creation of new markets and the destruction of old ones — a theory known as creative destruction. Edward J. Neil took this one step further with his transformational growth theory that showed how new products create new business models.

Not all theories of economic growth are born at times of economic growth and stability. Some, such as the theories of John Maynard Keynes, are born during times of economic depression. Keynes believed that during a recession, the wealth creators or wealth holders will hold onto their money and not invest it in the free market. As a result, Keynes' theories on economic growth state that the government must invest in the labor market to boost consumption and trigger economic growth.

The main sources of criticism against Keynes have come from Friedrich Hayek and Milton Friedman. Hayek believed that many elements of economic growth could not be predicted. His theories on economic growth, one of which is called Spontaneous Order, realizes that there is an "invisible hand" at play in the economy. This hand is manmade but is accidental rather than by human creation.

Friedman, on the other hand, believed that the supply of money created growth. His theory, called Monetarism, stated that governments should control the amount of money in supply, but this money should be spent by individuals and individual companies and not by the government. The policy worked by finding an equilibrium between supply and demand, thus reducing inflation to zero and maintaining a minimal level of unemployment.

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Discuss this Article

Vincenzo
Post 3

@Logicfest -- One can only wonder how well stimulus spending and trying to grow the labor market when the trend to outsource jobs took hold in the 1970s and has increased over the years. Will the jobs we are losing be replaced by something else and how are those jobs to come into being?

Logicfest
Post 2

Like it or not, we are all pretty much in the Keynes camp now. Whenever we see a recession and the government engages in stimulus spending, the main reason that policy is put in place is to create more jobs and grow the labor market.

That strategy makes a certain kind of sense. If people are not working or are worried about losing their jobs, then they are not likely to expand the economy by going out and buying things.

There is an ongoing debate about whether the government should spend money in hopes of growing jobs, but that argument has lasted for decades and won't be resolved anytime soon.

Anyway, the people wondering why stimulus spending takes place need look no further than Keynes. His theories are alive, well and defining what role the government should have in the economy.

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