What is 'Fiscal Deficit'

Fiscal Deficit: Definition

A fiscal deficit is defined as the discrepancy

between a government's revenue and its
expenditures over a designated timeframe, usually
a fiscal year. When a government experiences a
fiscal deficit, it signifies that its spending outstrips
its income. This condition emerges when the total
expenditures of the government exceed the
revenue collected from taxes and other financial
sources. It serves as a vital measure of a nation's
economic stability and highlights the disparity
between governmental income and outlays.

A fiscal deficit necessitates that a government

borrows funds to fulfill its financial commitments,
typically sourced from both domestic and
international lenders. The presence of a fiscal
deficit can have profound effects on the overall
economy.

Fiscal Deficit: Key Takeaways

Fiscal deficit refers to the gap between the

government's total expenditure and its total
revenue, excluding money from borrowings. Key
points regarding fiscal deficit include:
1. Impact on economy: High fiscal deficits can
lead to inflation, lower investment, reduced
confidence in the economy, and may necessitate
borrowing, potentially increasing debt levels.

2. Fiscal discipline: Adequate monitoring and

control of government spending is essential to
manage fiscal deficit and maintain a healthy
economy.

3. Economic indicators: Fiscal deficit is a crucial

economic indicator, reflecting the government's
financial health and fiscal policy effectiveness.

4. Structural deficits: Differentiation between

cyclical and structural deficits is necessary to
understand the long-term impact of fiscal policies
on the economy.

5. Fiscal policy: Governments use fiscal deficit as

a tool to stimulate or stabilize the economy,
making it a vital component of macroeconomic
policy.

In conclusion, managing the fiscal deficit is

essential for sustainable economic growth and
stability, requiring prudent fiscal policies and
careful monitoring to ensure a healthy financial
position for the government and the economy as a
whole.

Understanding Fiscal Deficit

A fiscal deficit can be quantified in two ways: as a

specific dollar amount or as a percentage of a
nation's Gross Domestic Product (GDP). For
example, if a government incurs expenditures of
 $1 trillion while generating only $900 billion in
revenue, it results in a fiscal deficit of $100 billion.
This deficit can also be expressed as 1% of GDP,
assuming the GDP is $10 trillion.

Fiscal deficits frequently occur when governments

opt to increase spending to boost economic
activity, particularly during recessions or periods of
economic decline. To address this deficit,
governments may resort to borrowing, which can
contribute to the growth of national debt over time.

Factors Affecting Fiscal Deficits

A variety of elements contribute to the magnitude

and frequency of fiscal deficits:

 Economic Environment: The general condition of

the economy is a significant determinant. Elevated
unemployment levels and diminished business
revenues may compel governments to enhance
expenditures or lower taxes, thereby exacerbating
the deficit.
 Government Strategies: Fiscal strategies related
to taxation and public expenditure have a direct
effect on whether a government experiences a
deficit. For instance, increased allocations for social
initiatives or infrastructure development without a
corresponding rise in tax income is likely to result
in larger deficits.
 External Influences: Global economic factors,
including inflationary trends or shifts in
international trade, can also affect domestic fiscal
 stability and contribute to the emergence of
deficits.
How Does Fiscal Policy Impact the Budget
Deficit?

 Fiscal policy involves how the government uses

taxes and spending to affect the economy, and it
significantly influences the budget deficit. When
the government adopts an expansionary fiscal
policy, which means increasing spending or
lowering taxes, it usually results in a larger budget
deficit. Conversely, a contractionary fiscal policy,
which entails cutting spending or raising taxes, can
help decrease the budget deficit.
 An expansionary approach can lead to a higher
budget deficit because it raises government
spending without a matching rise in tax income.
This creates a gap between what the government
spends and what it earns, resulting in a deficit. In
contrast, a contractionary approach can lower the
deficit by reducing spending or increasing tax
income, aligning expenditures with revenues more
closely.
 Additionally, the effect of fiscal policy on the
budget deficit can change based on various
factors, including the economic climate, the
success of the policies, and unexpected events. For
instance, during a recession, governments might
use expansionary fiscal policies to boost growth,
 which can temporarily increase budget deficits.
However, these deficits are often seen as
necessary to support the economy during tough
times.
 Fiscal policy is vital in shaping the budget deficit.
By managing spending and tax strategies wisely,
policymakers can either raise or lower the deficit to
meet economic goals like fostering growth,
controlling inflation, or managing public debt. It is
important for governments to find a balance
between the immediate effects on the budget
deficit and long-term economic aims to maintain
sustainable fiscal practices.
Keynesian Macroeconomics and Fiscal Deficit

Keynesian Macroeconomics highlights the

importance of government action in stabilizing the
economy, especially through fiscal policy. A central
idea in this theory is that during economic
downturns, the government should increase
spending or lower taxes to boost overall demand
and stimulate economic activity. This approach is
based on the belief that market forces alone may
not ensure full employment and economic stability.

In Keynesian economics, a fiscal deficit occurs

when government spending surpasses its income,
leading to a negative balance. From this viewpoint,
having a fiscal deficit can be a necessary step
during economic recessions or slowdowns. The
rationale is that increased government spending,
financed by borrowing, can inject money into the
economy, create jobs, and encourage consumer
spending, which can ultimately drive economic
growth and recovery.

However, Keynesian economists stress the need

for careful management of fiscal deficits. Excessive
deficit spending can result in inflation, reduce
private investment, and raise interest rates. Thus,
Keynesian policy suggests using fiscal deficits
strategically, focusing on specific sectors or
investments that can significantly impact the
economy.

Thus, Keynesian Macroeconomics sees fiscal

deficits as a useful tool to combat economic
downturns and foster growth. By effectively
balancing government spending with revenue,
policymakers can leverage fiscal deficits to meet
macroeconomic goals while avoiding the risks of
unsustainable debt.

Criticism of Deficit Spending

Many conservative economists, particularly from

the Chicago School, oppose Keynesian ideas,
arguing that deficit spending leads to temporary
effects and ultimately higher taxes and interest
rates. This view, rooted in 19th-century economist
David Ricardo's theory, suggests that people will
save rather than spend in anticipation of future tax
increases, limiting the intended economic boost.
Additionally, critics warn that excessive deficit
spending could hinder economic growth, forcing
governments to raise taxes or default, and
potentially disrupting capital markets by limiting
opportunities for private entities.

What Are Twin Deficits?

The twin deficits describe a situation where a
country has both a fiscal deficit and a current
account deficit at the same time. A fiscal deficit
happens when a government's spending is greater
than its income, forcing it to borrow money to
cover the gap. Meanwhile, a current account deficit
occurs when a country buys more goods and
services from other countries than it sells to them,
leading to a need for foreign borrowing to cover
the difference.

These two deficits are linked. A high fiscal deficit

can increase government borrowing, which may
raise interest rates and attract foreign investment,
causing the currency to strengthen and worsening
the current account deficit. On the flip side, a
significant current account deficit can make a
country rely more on foreign funds for its spending
and investments, which might increase the fiscal
deficit.

To manage these twin deficits, a careful approach

to fiscal and monetary policies is needed.
Governments can work to lower the fiscal deficit by
cutting expenses or raising taxes to stabilize the
economy and lessen the need for borrowing. At the
same time, strategies to boost exports, improve
competitiveness, and draw in foreign investment
can help reduce the current account deficit and
ease the pressure from external financing.

Big Economies & Twin Deficit

Economies with both a fiscal deficit and a current

account deficit are referred to as having "twin
deficits." This indicates that the government's
income is less than its spending, and the cost of
imports exceeds the earnings from exports. The
United States has faced twin deficits since the
1980s.

Japan had the largest public debt, reaching 216.2%

of its GDP in 2022, based on World Bank data.
Many countries have outdated or missing data.
India's trade deficit narrowed to $21.94 bn in
December from November's revised $32.84 billion,
as exports grew while overseas shipments went
down on sequenial basis. India's trade deficit will
be a key topic in the coming months as Donald
Trump, the US President-elect, starts his term on
January 20. He intends to establish a new agency
named the External Revenue Service to gather
tariffs, duties, and all income from foreign sources.

World Bank data indicates that Equatorial Guinea

had the highest trade deficit as of 1996. The
country's account balance showed a deficit of -
148% of the country's GDP.

India's Fiscal Deficit Situation

India's fiscal deficit for FY25 may be affected as the

economy is expected to grow by 9.6% in nominal
terms, which is less than the 10.5% growth
predicted in the budget, according to economists.
If the fiscal deficit remains at Rs 16.1 lakh crore as
planned, the lower nominal GDP, which is not
adjusted for inflation, could raise the fiscal deficit
ratio to 4.98% of GDP instead of the targeted
4.94%. The government had estimated nominal
GDP at Rs 326.4 lakh crore in the FY25 budget, but
early estimates show it at Rs 324.1 lakh crore.
India's fiscal deficit situation is a topic of significant
concern, particularly in the context of its impact on
the country's economy and financial stability.
Fiscal deficit refers to the difference between the
government's total revenue and its total
expenditure. In India, the fiscal deficit has been a
longstanding challenge, exacerbated by various
factors such as rising expenditure, structural
inefficiencies, and economic shocks.

Aditi Nayar, chief economist at ICRA, says that due

to expected shortfalls in capital expenditure, the
fiscal deficit is likely to fall short of the revised
budget estimates for 2024-25, which will largely
balance out the lower nominal GDP figures. She
mentioned that the fiscal deficit to GDP ratio will
only slightly miss the budget estimate.

Sakshi Gupta, the principal economist at HDFC

Bank, mentioned that the government is expected
to reach a fiscal deficit of 4.65% of GDP. This is due
to tax collections being higher than planned and
capital spending being lower than expected.

Data from December indicated that India's capital

expenditure dropped by 12.3% year-on-year from
April to November, largely due to general elections
in the first quarter and heavy rainfall afterward.
During this period, expenditure reached 46.2% of
the annual target of Rs 11.1 lakh crore, compared
to 58.5% in the same timeframe last year.
What is 'Crowding Out
Effect'
Definition: A situation when increased interest
rates lead to a reduction in private investment
spending such that it dampens the initial increase
of total investment spending is called crowding out
effect.

Description: Sometimes, government adopts an

expansionary fiscal policy stance and increases its
spending to boost the economic activity. This leads
to an increase in interest rates. Increased interest
rates affect private investment decisions. A high
magnitude of the crowding out effect may even
lead to lesser income in the economy.

With higher interest rates, the cost for funds to be

invested increases and affects their accessibility to
debt financing mechanisms. This leads to lesser
investment ultimately and crowds out the impact
of the initial rise in the total investment spending.
Usually the initial increase in government spending
is funded using higher taxes or borrowing on part
of the government.

FREE MARKET: The History of an Idea, by Jacob Soll

The most vivid character is Jean-Baptiste Colbert, King Louis XIV’s
first minister of state, from 1661 to 1683, who used subsidies, tariff
barriers and the king’s authoritarian powers to propel his
backward country part of the way to economic modernity. Colbert
believed that France should participate in global markets but not
be ruled by them, and variants of his model have been followed
ever since by nations making the leap to riches and power, from
the United States to Germany to Japan to China.

Colbert doesn’t get a lot of credit for this, instead often being
tagged by free-marketers as a misguided mercantilist obsessed
with having France run trade surpluses and hoard precious metals,
an erroneous approach supposedly swept aside by Adam Smith’s
1776 blockbuster, “An Inquiry Into the Nature and Causes of the
Wealth of Nations.”

Soll argues that Colbert saw trade policy as a way to stimulate

development, not an end in itself, and that Smith’s main criticism of
what he called Colbert’s “mercantile system” was that it was too
solicitous of merchants.

That I’ll buy. Less convincing is Soll’s claim that what Smith meant
by an “invisible hand” that leads self-interested merchants to
serve the public good was “society” (the surrounding text in
“Wealth of Nations” doesn’t really back this up). But he’s right that
Smith’s work is leavened with more skepticism of capitalists and
respect for government than the “cherry-picked” caricatures of it
that gained currency in the 19th and 20th centuries.

Milton Friedman was among the cherry-pickers, and his work

certainly invites scrutiny and critique. But while I wholeheartedly
endorse Soll’s conclusion that “faith in the market alone will not
save us,” he hasn’t really delivered the book for those who want to
learn what will.

CAPITALISM AND ITS CRITICS: A History: From the Industrial

Revolution to AI, by John Cassidy

But then capitalism has always been a protean force. In the 18th
century, merchant capitalism yielded to industrial capitalism; in the
postwar era, Keynesianism yielded to neoliberalism.

Despite the obvious differences among the people in this book, they
share some complaints. “Over the centuries,” Cassidy writes, “the
central indictment of capitalism has remained remarkably
consistent: that it is soulless, exploitative, inequitable, unstable and
destructive, yet also all-conquering and overwhelming.”
The result is an expansive history of capitalism that places less
emphasis on economic abstractions like perfectly competitive
markets and draws attention instead to how often capitalist
systems have fallen short. “It is barely hyperbole to say that
capitalism is always in crisis, recovering from crisis or heading
toward the next crisis,” Cassidy remarks. In 1857, a financial panic
on Wall Street prompted Marx and Engels to believe that a collapse
was imminent. “The American crisis,” Marx wrote, “is
BEAUTIFUL.” Engels replied, “The AMERICAN CRASH is superb.”

But the state stepped in, as it usually does — averting wholesale

disintegration by saving the capitalist system from blowing itself
up. This habit of state intervention, of course, runs counter to
laissez-faire orthodoxy, with its insistence that markets should be
left to their own devices. Cassidy devotes a chapter to Karl Polanyi
(1886-1964), the Austro-Hungarian economic anthropologist who
argued that free markets were such a “stark utopia” that they
required a strong state to lay the ground rules. They were also so
disruptive that societies spontaneously tried to reassert some order
in response: Writing during World War II, Polanyi described
socialism (which he supported) and fascism (which he abhorred) as
two disparate reactions to the same capitalist upheaval. As Polanyi
put it, “Laissez-faire was planned; planning was not.”

Polanyi was underappreciated in his day, when laissez-faire

economics had been discredited by the Great Depression; he was
rediscovered in the 1980s, when neoliberalism was ascendant and
his grim view of unfettered capitalism served as a stinging rebuke.
Cassidy shows how belated recognition was often the fate of
capitalism’s critics. The Cambridge economist Joan Robinson
(1903-83) was a colleague of John Maynard Keynes, who
maintained that the state could get an economy out of a slump by
spending money to stimulate demand. Robinson was a Keynesian
who nevertheless recognized the limits of Keynesianism. Writing in
the 1930s, she theorized about the possibility of unemployment
getting so low that bargaining between employers and workers
could lead to what was later called a “wage-price spiral.”

At the time, deflation was the biggest threat; it was only four
decades later, when stagflation proved resistant to the Keynesian
tool kit, that Robinson’s analysis got its proper due. By then she
was already frustrated by the state of the economics profession,
including the “bastard Keynesians” she accused of simplifying and
deforming some of Keynes’s “acid” insights. Toward the end of her
life, when asked by an economics student at Oxford if she would
have done anything differently, she said she would have studied
something more useful, like biology.
Those who have predicted capitalism’s imminent collapse
underestimate its ability to shape-shift into yet another
configuration. But stability has always been tenuous: Resolving
capitalism’s many contradictions has also meant creating new ones.

FIREFIGHTING
The Financial Crisis and Its Lessons
By Ben S. Bernanke, Timothy F. Geithner and Henry M. Paulson Jr.

For a few months in 2008 and 2009 many people feared that the
world economy was on the verge of collapse. They had good reason
to be afraid. Financial markets were virtually frozen, with credit
almost unavailable to anyone except the safest of borrowers. The
real economy was in free fall: Over the winter America was
losing 700,000 jobs a month, while world trade and industrial
output were falling as fast as they did in the first year of the Great
Depression.

In the end, however, the worst didn’t happen. The financial crisis
caused huge, lasting damage. But the bottom didn’t fall out
completely.

What saved us? There were multiple factors. But one element was
that key public officials didn’t stand aside while the world burned.
Instead, they acted — not always soon enough, not always
forcefully enough, not always wisely, but pretty effectively all the
same.

Fundamentally, they argue, what happened in 2008 was a “classic

financial panic,” of the kind that has happened again and again
ever since the dawn of modern banking. (Even Adam Smith called
for financial regulation, having seen a banking crisis firsthand.)

So why didn’t people see it coming? Part of it was hubris: “Serious

economists were arguing that financial innovations like derivatives
… had made crises a thing of the past.” (How serious were these
economists, actually?) And the reality was that financial innovation
made things worse, not better: Most of “the leverage in U.S.
finance” — debt that was vulnerable to panic — had moved to
“shadow banks” that, unlike conventional banks, were largely
unregulated and lacked a financial safety net.

Also, as they say, “it’s hard to fix something before it breaks.” As

long as the housing bubble was still inflating, defaults were few
and everything seemed sound. A few Cassandras warned about the
risks, but like the original Cassandra, they went unheeded. And
BGP, to their credit, acknowledge their own failures to recognize
the danger, including Bernanke’s notorious declaration that
problems in subprime lending were “contained.”

There is, however, a unifying theme to all that complexity:

Containing this crisis was so hard precisely because of all that
financial innovation. Conventional banks are both overseen and
guaranteed by the Federal Deposit Insurance Corporation, which
has the power “to wind down insolvent banks in an orderly fashion
while standing behind their obligations.” But “the federal
government had no orderly resolution regime for nonbanks.”

So BGP and company had to engage in frantic innovation. For

example, the Fed funneled money through conventional banks into
the hands of nonbanks, in effect lending to institutions they weren’t
really supposed to support. This exposed the Fed to new risks;
Paulson effectively indemnified the Fed against those risks,
apparently without real legal authority to do so. At another point,
when a run on money-market funds — which would have been a
complete catastrophe — seemed imminent, Paulson guaranteed
those funds using money legally earmarked for a completely
different purpose, defending the dollar’s foreign exchange value.

Banking, they argue, is actually less risky than it was, thanks to

financial reforms that, while far short of what should have been
done, have nonetheless led to safer practices. But crises will still
happen, and when they do, the firefighting abilities of policymakers
will have been gravely compromised. Interest rates are too low for
cutting them further to do much good. Fiscal stimulus, which BGP
agree was crucial, will be much harder to sell given high levels of
debt. And Congress has taken away much of the authority that
made extraordinary measures possible in the crisis. In other words,
it’s hard to imagine BGP’s modern successors carrying out the kind
of rescue operation the authors managed a decade ago.

Financial Romanticism
October 9, 2011 6:27 pm October 9, 2011 6:27 pm 167

One line I’ve been seeing in various places,

including comments here, is the claim that the
real way to deal with Wall Street is laissez-faire
economics: no more bailouts! On this view,
policy makers should raise their right hand in
the air, place their left hand on a copy of Atlas
Shrugged, and swear in the name of A is A that
they will never again step in to rescue failing
banks. And all will be well with the world.

Sorry, but that’s a fantasy.

First of all, bank regulation is important even in

the absence of bailouts. Don’t trust me, trust
Adam Smith. Scotland invented modern
banking; it also invented modern banking
crises; and Smith, having witnessed such a
crisis, favored bank regulations, declaring that

Such regulations may, no doubt, be

considered as in some respect a
violation of natural liberty. But
those exertions of the natural
liberty of a few individuals, which
might endanger the security of the
whole society, are, and ought to be,
restrained by the laws of all
governments; of the most free, as
well as or the most despotical. The
obligation of building party walls, in
order to prevent the communication
of fire, is a violation of natural
liberty, exactly of the same kind
with the regulations of the banking
trade which are here proposed.

Second, there are in fact very good reasons to

intervene to support banks during a financial
crisis. Bagehot knew it; Diamond and
Dybvig showed it theoretically; and it remains
true. Letting a financial crisis spread is very
dangerous.

Finally, even if you persuade yourself that the

moral hazard created by financial firefighting
outweighs the benefits of avoiding a 1931-style
cascading crisis, the fact is that policy
makers will intervene. Hank Paulson set out to
make Lehman an example; two days later he
was staring into the abyss.

So the only feasible strategy is guarantees and

a financial safety net plus regulation to limit the
abuse of those guarantees. It’s imperfect; it
faces the constant threat of regulatory capture;
but it has worked in the past, and it’s the only
game in town.
 FIRST CHAPTER

‘On “The Wealth of Nations”’

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By P. J. O’Rourke
 Jan. 7, 2007
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Adam Smith's Simple Principles . Smith illuminated the mystery

of economics in one flash: "Consumption is the sole end and
purpose of all production." There is no mystery. Smith took
the meta out of the physics. Economics is our livelihood and just
that.

The Wealth of Nations argues three basic principles and, by plain

thinking and plentiful examples, proves them. Even intellectuals
should have no trouble understanding Smith's ideas. Economic
progress depends upon a trinity of individual prerogatives: pursuit
of self-interest, division of labor, and freedom of trade.

division of labor
specialization
One person makes a thing, and another
person makes another thing, and
everyone wants everything.
Hence trade.
Trade is a fact.
Adam Smith saw that all trades, when
freely conducted, are mutually
beneficial by definition.
The whole business of authority is to
interfere in other people's business.
Princes and priests can never resist
imposing restrictions on the pursuit of
self-interest, division of labor, and
freedom of trade. Successful pursuits
mean a challenge to authority. Let
people take the jobs they want and
they'll seek other liberties. As for trade,
nab it.
A restriction is hardly a restriction
unless coercion is involved.
Coercion destroys the mutually
beneficial nature of trade, which
destroys the trading, which destroys the
division of labor, which destroys our
self-interest.
It is clear from Adam Smith's other writings that he was a moral
advocate of freedom. But the arguments for freedom in The Wealth
of Nations are almost uncomfortably pragmatic. Smith opposed
most economic constraints: tariffs, bounties, quotas, price controls,
workers in league to raise wages, employers conniving to fix pay,
monopolies, cartels, royal charters, guilds, apprenticeships,
indentures, and of course slavery. Smith even opposed licensing
doctors, believing that licenses were more likely to legitimize
quacks than the marketplace was. But Smith favored many
restraints on persons, lest brute force become the coin of a lawless
realm.

In words more sad and honest than

we're used to hearing from an
economist, Smith declared, "The peace
and order of society is more important
than even the relief of the miserable."
Without economic freedom the number
of the miserable increases, requiring
further constraints to keep the peace
among them, with a consequent greater
loss of freedom.
Smith was also aware that economic
freedom has its discontents. He was
particularly worried about the results of
excess in the division of labor: "The man
whose whole life is spent in performing
a few simple operations ... generally
becomes as stupid and ignorant as it is
possible for a human creature to
become." We've seen this in countless
politicians as they handshake and rote-
speak their way through campaigns. But
it's worth it. Productivity of every kind
can be increased by specialization. And
the specialization of politics at least
keeps politicians from running
businesses where their stupidity and
ignorance could do even greater harm
to economic growth.
Smith's logical demonstration of how
productivity is increased through self-
interest, division of labor, and trade
disproved the thesis (still dearly held by
leftists and everyone's little brother)
that bettering the condition of one
person necessarily worsens the
condition of another. Wealth is not a
pizza. If I have too many slices, you
don't have to eat the Domino's box.
By proving that there was no fixed
amount of wealth in a nation, Smith also
proved that a nation cannot be said to
have a certain horde of treasure. Wealth
must be measured by the volume of
trades in goods and services-what goes
on in the castle's kitchens and stables,
not what's locked in strongboxes in the
castle's tower. Smith specifies this
measurement in the first sentence of his
introduction to The Wealth of Nations:
"The annual labour of every nation is the
fund which originally supplies it with all
the necessaries and conveniences of life
which it annually consumes." Smith
thereby, in a stroke, created the concept
of gross domestic product. Without GDP
modern economists would be left with
nothing much to say, standing around
mute in ugly neckties, waiting for
MSNBC to ask them to be silent on the
air.
If wealth is all ebb and flow, then so is
its measure, money. Money has no
intrinsic value. Any baby who's eaten a
nickel could tell you so. And those of us
old enough to have heard about the
Weimar Republic and to have lived
through the Carter administration are
not pained by the information. But
eighteenth-century money was still
mostly made of precious metals. Smith's
observations on money must have been
slightly disheartening to his readers,
although they had the example of bling-
deluged but impoverished Spain to
confirm what he said. Gold is, well,
worth its weight in gold, certainly, but
not so certainly worth anything else. It
was almost as though Smith, having
proved that we can all have more
money, then proved that money doesn't
buy happiness. And it doesn't. It rents it.
Okay, yes, I admit that total removal of
every market restraint would be "good
for the economy." But money isn't
everything. Think of the danger and
damage to society. Without government
regulation the big shots who run
companies like Enron, WorldCom, and
Tyco could have cheated investors and
embezzled millions. Without restrictions
on the sale of hazardous substances
young people might smoke, drink, and
even use drugs. Without the licensing of
medical practitioners the way would be
clear for chiropractors, osteopaths, and
purveyors of aromatherapy. If we didn't
have labor unions, thirty thousand
people would still be wage slaves at
General Motors, their daily lives filled
with mindless drudgery. And if there
weren't various forms of retail collusion
in the petroleum industry, filling
stations could charge as little as they
liked. I'd have to drive all over town to
find the best price. That would waste
gas.
Also consider the harm to the
developing world. Cheap pop music
[[Link].3] downloads imported from
the United States will put every nose-
flute band in Peru out of business. Plus
some jobs require protection, to ensure
they are performed locally in their own
communities. My job is to make quips,
jests, and waggish comments.
Somewhere in Mumbai there is a
younger, funnier person who is willing
to work for less. My job could be
outsourced to him. But he could make
any joke he wanted. Who would my wife
scold? Who would my in-laws be
offended by? Who would my friends
shun? . . .

Smith’s thesis, which still resonates today, is that setting people

free to pursue their own self-interest produces a collective result
far superior to what you get if you try to impose political or
religious diktats. Free people allowed to make free choices in free
markets will satisfy their needs (and society’s) far better than any
government can. Finally, Smith believed passionately in free trade,
both within countries and between them. He felt that allowing
people and countries to specialize and to trade freely would
produce enormous wealth, because freeing people and nations to
do what they do best will produce vastly more wealth than if
everyone strives for self-sufficiency.

Now, let’s reduce this theory to microeconomic reality. I can go to

my local hardware store, and for $1.79 (plus sales tax), I can
purchase a pound of eight-penny nails manufactured in China,
thousands of miles from my home. It would take me forever and a
day to manufacture my own nails. Instead, I get paid to write
articles, which is my specialty, and I can buy a pound of nails for
the economic equivalent of a small amount of my time. The store
owner, who specializes in helping people like me who’d rather get
cheerfulness and good service than go to Home Depot, can use her
profit to buy a copy of The New York Times, which helps give the
paper the money to pay me for writing about O’Rourke writing
about Smith writing about what makes nations wealthy. See? Isn’t
that simple?

Maybe as a society, the United States saves money by exporting

manufacturing jobs and importing so many manufactured goods —
but I still have trouble believing that it’s good for us in the long
run.

Revaluations II: Keynes’s General Theory

Robert Lekachman
April 8, 1965 issue

Like many economic classics,

the General Theory of Employment,
Interest and Money, published in early
1936, is an ill-organized, repetitious, and
quarrelsome book. Save for occasional
bravura passages on Egyptian pyramids,
medieval masses for the dead, and the
behavior of stock market speculators,
the graceful English stylist of
the Economic Consequences of the
Peace and the Essays in Biography is
little in evidence. On key issues Keynes
was frequently either obscure or
mistaken. Later theoretical discussion
disproved the conception, in the General
Theory, of the multiplier, the savings-
investment identity, and the
determination of the rate of interest.
Even good Keynesians have completely
discarded such novelties of the master
as user cost and wage units. Shortly
after it was published, gifted and orderly
theorists like Oskar Lange and J. E.
Meade constructed systematic
mathematical models of Keynes’s
theory, far superior in analytic rigor to
the original. Later, Roy Harrod in
England and Evsey Domar in this country
shifted the interest of the profession
from Keynes’s central problem, the
determination of national income under
static short-run conditions, to the new
issue of economic growth. The
econometric fraternity has enjoyed the
game of creating formidable systems of
economic equations, suitable for the
moderately accurate forecasting of what
happened a year or two earlier. The
version of Keynesian doctrine to be
found in Samuelson’s Economics or
Ackley’s more advanced Macroeconomic
Theory has about the same relation to
the General Theory as the Department of
Commerce’s national income estimates
bear to the Physiocrats’ Tableau
Economique. In short, noneconomists
don’t read the General Theory because
they can’t and economists don’t read it
because it is hopelessly behind the
times, all but pre-Keynesian.

But not a word of this judgment detracts

in the least from the book’s immediate
importance and continuing influence. It
is given to few intellectuals to invent an
important new branch of their specialty.
This is precisely what Keynes achieved.
Although he some-what exaggerated his
own iconoclasm, although he was
undeniably guilty of what Myrdal
pleasantly termed unnecessary
originality, Keynes and no one else
forced economists to supplement their
traditional emphasis upon individual
prices and markets with the study of the
social aggregates—savings, investment,
consumption, and national income.
Today the study of macroeconomics is
considered to be as important as
microeconomics, the study of individual
prices and markets. Indeed if the
survivor of an elementary economics
course knows little else, he is at least
aware that aggregate demand and total
employment are determined by the level
of total spending, and that private
investment and public deficits are the
strategic influences upon total spending.

The last sentence implies Keynes’s

second lasting contribution, the
transformation of public policy toward
the treatment of unemployment. The
conventional wisdom of the 1930s
argued that the only certain cure for
depression was wage and price
reductions. Governments for their part
could do nothing more wholesome than
set everybody a good example by
balancing their own budgets. Eminent
Cambridge colleagues of Keynes
testified before the Macmillan
Commission in 1930 that unemployment
was high because wages were
excessive. Just as the French nineteenth-
century follower of Adam Smith, J.-B.
Say, had declared, general glut would be
impossible if only free competition were
allowed to work itself out in the form of
reduced wages and prices.

Keynes offered public officials a sensible

alternative to this frustrating counsel. He
told politicians that the very policies
which their instinct for political survival
urged them into—larger relief
allocations, public works programs, and
huge deficits—were also excellent
economics. In this country the
Employment Act of 1946, a national
commitment to public support of high
employment, was one testimonial to the
persuasive force of this message.
Possibly the most impressive testimonial
of all is the 1964 Tax Act enacted in a
year of economic expansion and existing
budget deficit. It is the ultimate triumph
that the rational segment of the business
community accepted the measure as
sound public policy.
As one distinguished conservative
remarked in my hearing, we are all
Keynesians nowadays. The judgment
contains its ironies, for Keynesian
teaching has suffered the fate of other
powerful messages—simplification,
selection, and vulgarization. In the
United States popular and political
Keynesianism means little more than
confidence in the stimulating impact of
tax reductions. But when we go back to
the General Theory we encounter three
different conceptions of sound public
policy. There is the conservative Keynes
who thinks that if central banks increase
the supply of money, interest rates will
drop and business investment will rise. A
beneficent multiplier process will gently
waft the economy to full employment.
There is also the liberal Keynes,
skeptical of the efficacy of monetary
policy, but certain that increases in
public spending (tax cuts are scarcely
mentioned) can supplement lagging
private investment and restore the roses
to capitalism’s pale cheeks. Finally,
there is the radical Keynes so
despondent about capitalism’s
recuperative powers as to envisage the
necessity of a “somewhat
comprehensive socialization of
investment.”

The Keynes whom we have selected

from this cast of characters is a friendly,
gentle sort who simply wants us to pay
less taxes and spend more money on the
good things that business enterprise
abundantly produces. It is this bland and
winning Keynes who is supposed to have
answers to the new problems of
automation, urban blight, depressed
regions, and persistent poverty. They
show few signs of responding. Perhaps
the best comment on the belated
application of a soothing version of
Keynes to the wrong problems is
Keynes’s own restatement, at the very
end of the General Theory, of his
confidence in the power of human
reason:

…the ideas of economists and

political philosophers, both when
they are right and when they are
wrong, are more powerful than is
commonly understood. Indeed the
 world is ruled by little else. Practical
men, who believe themselves to be
quite exempt from any intellectual
influences, are usually the slaves of
some defunct economist.

Today’s practical men are Keynesians.

Just possibly there is a moral here that
Keynes for one would have relished

classical economics
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Encyclopaedia Britannica

classical economics, English school of economic thought that originated during the
late 18th century with Adam Smith and that reached maturity in the works of David
Ricardo and John Stuart Mill. The theories of the classical school, which dominated
economic thinking in Great Britain until about 1870, focused on economic growth and
economic freedom, stressing laissez-faire ideas and free competition.

Many of the fundamental concepts and

principles of classical economics were set
forth in Smith’s An Inquiry into the Nature
and Causes of the Wealth of Nations (1776).
Strongly opposed to the mercantilist theory
and policy that had prevailed in Britain since
the 16th century, Smith argued that
free competition and free trade, neither
hampered nor coddled by government,
would best promote a nation’s economic
growth. As he saw it, the entire community
benefits most when each of its members
follows his or her own self-interest. In a free-
enterprise system, individuals make a profit
by producing goods that other people are
willing to buy. By the same token,
individuals spend money for goods that they
want or need most. Smith demonstrated how
the apparent chaos of competitive buying
and selling is transmuted into an orderly
system of economic cooperation that can
meet individuals’ needs and increase their
wealth. He also observed that this
cooperative system occurs through the
process of individual choice as opposed to
central direction.

In analyzing the workings of free enterprise, Smith introduced the rudiments of

a labour theory of value and a theory of distribution. Ricardo expanded upon both
ideas in Principles of Political Economy and Taxation (1817). In his labour theory of
value, Ricardo emphasized that the value (i.e., price) of goods produced and sold
under competitive conditions tends to be proportionate to the labour costs incurred in
producing them. Ricardo fully recognized, however, that over short periods price
depends on supply and demand. This notion became central to classical economics, as
did Ricardo’s theory of distribution, which divided national product between three
social classes: wages for labourers, profits for owners of capital, and rents for
landlords. Taking the limited growth potential of any national economy as a given,
Ricardo concluded that a particular social class could gain a larger share of the total
product only at the expense of another.

These and other Ricardian theories were restated by Mill in Principles of Political
Economy (1848), a treatise that marked the culmination of classical economics. Mill’s
work related abstract economic principles to real-world social conditions and thereby
lent new authority to economic concepts.

The teachings of the classical economists attracted much attention during the mid-
19th century. The labour theory of value, for example, was adopted by Karl Marx,
who worked out all of its logical implications and combined it with the theory
of surplus value, which was founded on the assumption that human labour alone
creates all value and thus constitutes the sole source of profits.
More significant were the effects of classical economic thought on free-trade doctrine.
The most influential was Ricardo’s principle of comparative advantage, which states
that every nation should specialize in the production of those commodities it can
produce most efficiently; everything else should be imported. This idea implies that if
all nations were to take full advantage of the territorial division of labour, total world
output would invariably be larger than it would be if nations tried to be self-sufficient.
Ricardo’s comparative-advantage principle became the cornerstone of 19th-
century international-trade theory.

capitalism
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Also known as: free enterprise economy, free market economy,
private enterprise economy
Written byRobert L. Heilbroner,
Peter J. Boettke
Fact-checked byThe Editors of Encyclopaedia
Britannica
Updated: Apr. 08, 2025•Article History

What is capitalism?
Capitalism is a widely adopted economic system in which there is
private ownership of the means of production. Modern capitalist
systems usually include a market-oriented economy, in which the
production and pricing of goods, as well as the income of
individuals, are dictated to a greater extent by market forces
resulting from interactions between private businesses and
individuals than by central planning undertaken by a government or
local institution. Capitalism is built on the concepts of private
property, profit motive, and market competition.
Who invented capitalism?
Modern capitalist theory is traditionally traced to the 18th-century
treatise An Inquiry into the Nature and Causes of the Wealth of
Nations by Scottish political economist Adam Smith, and the origins
of capitalism as an economic system can be placed in the 16th
century. From the 16th to the 18th century in England,
the industrialization of mass enterprises, such as the cloth industry,
gave rise to a system in which accumulated capital was invested to
increase productivity—capitalism, in other words. No one person can
be said to have invented capitalism, however, and antecedent
capitalist systems existed as far back as ancient times.
What are some criticisms of capitalism?
Capitalism has been criticized for a number of reasons throughout
history. Among them are the unreliability and instability of capitalist
growth, production of social harms, such as pollution and inhumane
treatment of workers, and forms of inequality attributed to
capitalism, such as mass income disparity. Many capitalist critiques
stem from the theories of Karl Marx, the 19th-century economist
and philosopher whose work gave rise to Marxism. Some historians
connect profit-driven economic models, such as capitalism
and mercantilism, to the rise of oppressive institutions such
as slavery, colonialism, and imperialism.
Which countries are capitalist?
Capitalism is the dominant economic system in Western countries.
In comparison, fewer countries use socialist economic systems. As
of 2020, only Laos, China, Cuba, and Vietnam claimed to follow the
principles of socialism as dictated by Marxist and Leninist theories.
More often, however, it is difficult to label countries as solely
capitalist or socialist. Many have mixed economies that operate
under both capitalist and socialist principles.
Is neoliberalism capitalist?
Neoliberalism is an economic model based on free
market and laissez-faire capitalist principles. The policies of British
Prime Minister Margaret Thatcher and U.S. President Ronald
Reagan are often cited as embodying neoliberalism. Neoliberalism
prioritizes economic growth and minimal government intervention,
because its core principle is a belief in the productivity of market
competition and free trade. Although usually categorized under the
broad spectrum of capitalist models, neoliberalism stands in
contrast to capitalist schools of thought that emphasize government
regulation, such as Keynesian economics and monetarism.

capitalism, economic system, dominant in the Western world since the breakup
of feudalism, in which most means of production are privately owned and production
is guided and income distributed largely through the operation of markets.

History of capitalism
Although the continuous development of capitalism as a system dates only from the
16th century, antecedents of capitalist institutions existed in the ancient world, and
flourishing pockets of capitalism were present in Europe during the later Middle
Ages. The development of capitalism was spearheaded by the growth of the English
cloth industry during the 16th, 17th, and 18th centuries. The feature of this
development that distinguished capitalism from previous systems was the use of
accumulated capital to enlarge productive capacity rather than to invest in
economically unproductive enterprises, such as pyramids and cathedrals. This
characteristic was encouraged by several historical events.
In the ethic fostered by the Protestant Reformation of the 16th century, traditional
disdain for acquisitive effort was diminished while hard work and frugality were
given a stronger religious sanction. Economic inequality was justified on the grounds
that the wealthy were more virtuous than the poor.

Another contributing factor was the increase in Europe’s supply of precious metals
and the resulting inflation in prices. Wages did not rise as fast as prices in this period,
and the main beneficiaries of the inflation were the capitalists. The early capitalists
(1500–1750) also enjoyed the benefits of the rise of strong national states during
the mercantilist era. The policies of national power followed by these states succeeded
in providing the basic social conditions, such as uniform monetary systems and legal
codes, necessary for economic development and eventually made possible the shift
from public to private initiative.

Beginning in the 18th century in England, the focus of capitalist development shifted
from commerce to industry. The steady capital accumulation of the preceding
centuries was invested in the practical application of technical knowledge during
the Industrial Revolution. The ideology of classical capitalism was expressed in An
Inquiry into the Nature and Causes of the Wealth of Nations (1776), by the Scottish
economist and philosopher Adam Smith, which recommended leaving economic
decisions to the free play of self-regulating market forces. After the French
Revolution and the Napoleonic Wars had swept the remnants of feudalism into
oblivion, Smith’s policies were increasingly put into practice. The policies of 19th-
century political liberalism included free trade, sound money (the gold standard),
balanced budgets, and minimum levels of poor relief. The growth of industrial
capitalism and the development of the factory system in the 19th century also created
a vast new class of industrial workers whose generally miserable working and living
conditions inspired the revolutionary philosophy of Karl Marx (see also Marxism).
Marx’s prediction of the inevitable overthrow of capitalism in a proletarian-
led class war proved shortsighted, however.
 Adam Smith, paste medallion by James
Tassie, 1787; in the Scottish National
Portrait Gallery, Edinburgh.

Courtesy of the Scottish National Portrait

Gallery, Edinburgh
World War I marked a turning point in the development of capitalism. After the war,
international markets shrank, the gold standard was abandoned in favour of managed
national currencies, banking hegemony passed from Europe to the United States, and
trade barriers multiplied. The Great Depression of the 1930s brought the policy
of laissez-faire (noninterference by the state in economic matters) to an end in most
countries and for a time created sympathy for socialism among many intellectuals,
writers, artists, and, especially in western Europe, workers and middle-class
professionals.
 Detail of a sculpture by George Segal
depicting unemployed men in a breadline
during the Great Depression; part of the
Franklin Delano Roosevelt Memorial,
Washington, D.C.

© Zack Frank/[Link]
In the decades immediately following World War II, the economies of the major
capitalist countries, all of which had adopted some version of the welfare state,
performed well, restoring some of the confidence in the capitalist system that had
been lost in the 1930s. Beginning in the 1970s, however, rapid increases in economic
inequality (see income inequality; distribution of wealth and income), both
internationally and within individual countries, revived doubts among some people
about the long-term viability of the system. Following the financial crisis of 2007–09
and the Great Recession that accompanied it, there was renewed interest in socialism
among many people in the United States, especially millennials (persons born in the
1980s or ’90s), a group that had been particularly hard-hit by the recession. Polls
conducted during 2010–18 found that a slight majority of millennials held a positive
view of socialism and that support for socialism had increased in every age group
except those aged 65 or older. It should be noted, however, that the policies actually
favoured by such groups differed little in their scope and purpose from the New
Deal regulatory and social-welfare programs of the 1930s and hardly amounted to
orthodox socialism.
 A protester holding a placard at a
demonstration against economic inequality
in Toronto, Canada, on October 17, 2011.

© arindambanerjee/[Link]
For fuller discussion of the history and characteristics of capitalism, see Economic
system: The evolution of capitalism.

The Editors of Encyclopaedia Britannica

Criticisms of capitalism
Advocates and critics of capitalism agree that its distinctive contribution to history has
been the encouragement of economic growth. Capitalist growth is not, however,
regarded as an unalloyed benefit by its critics. Its negative side derives from three
dysfunctions that reflect its market origins.

The unreliability of growth

Many critics have alleged that capitalism suffers from an inherent instability that has
characterized and plagued the system since the advent of industrialization. Because
capitalist growth is driven by profit expectations, it fluctuates with the changes in
technological or social opportunities for capital accumulation. As opportunities
appear, capital rushes in to take advantage of them, bringing as a consequence the
familiar attributes of an economic boom. Sooner or later, however, the rush subsides
as the demand for the new products or services becomes saturated, bringing a halt
to investment, a shakeout in the main industries caught up in the previous boom, and
the advent of recession. Hence, economic growth comes at the price of a succession of
market gluts as booms meet their inevitable end.

This criticism did not receive its full exposition until the publication of the first
volume of Marx’s Das Kapital in 1867. For Marx, the path of growth is not only
unstable for the reasons just mentioned—Marx called such uncoordinated movements
the “anarchy” of the market—but increasingly unstable. Marx believed that the reason
for this is also familiar. It is the result of the industrialization process, which leads to
large-scale enterprises. As each saturation brings growth to a halt, a process of
winnowing takes place in which the more successful firms are able to acquire the
assets of the less successful. Thus, the very dynamics of growth tend to concentrate
capital into ever larger firms. This leads to still more massive disruptions when the
next boom ends, a process that terminates, according to Marx, only when the temper
of the working class snaps and capitalism is replaced by socialism.

Beginning in the 1930s, Marx’s apocalyptic expectations were largely replaced by the
less violent but equally disquieting views of the English economist John Maynard
Keynes, first set forth in his influential The General Theory of Employment, Interest,
and Money (1936). Keynes believed that the basic problem of capitalism is not its
vulnerability to periodic saturations of investment but rather its likely failure to
recover from them. He raised the possibility that a capitalist system could remain
indefinitely in a condition of equilibrium despite high unemployment, a possibility not
only entirely novel (even Marx believed that the system would recover its momentum
after each crisis) but also made plausible by the persistent unemployment of the
1930s. Keynes therefore raised the prospect that growth would end in stagnation, a
condition for which the only remedy he saw was “a somewhat comprehensive
socialization of investment.”

The quality of growth

A second criticism with respect to market-driven growth focuses on the adverse side
effects generated by a system of production that is held accountable only to the test of
profitability. It is in the nature of a complex industrial society that the production
processes of many commodities generate outcomes (called “externalities”) that are
bad as well as those that are good—e.g., toxic waste or unhealthy working conditions
as well as useful products.

The catalog of such market-generated ills is very long. Smith himself warned that
the division of labour, by routinizing work, would render workers “as stupid and
ignorant as it is possible for a human creature to become,” and Marx raised the spectre
of alienation as the social price paid for subordinating production to the imperatives
of profit making. Other economists warned that the introduction
of technology designed to cut labour costs would create permanent unemployment. In
modern times much attention has focused on the power of physical and chemical
processes to surpass the carrying capacity of the environment, a concern made cogent
by various types of environmental damage arising from excessive discharges of
industrial effluents and pollutants—most importantly, global warming and climate
change. Because these social and ecological challenges spring from the extraordinary
powers of technology, they can be viewed as side effects of socialist as well as
capitalist growth. But the argument can be made that market growth, by virtue of its
overriding obedience to profit, is congenitally blind to such externalities.

Equity
A third criticism of capitalist growth concerns the fairness with which capitalism
distributes its expanding wealth or with which it shares its recurrent hardships. This
criticism assumes both specific and general forms.

The specific form focuses on disparities in income among layers of the population. In
the early 21st century in the United States, for example, the lowest quintile (fifth) of
all households received only 3.1 percent of total income, whereas the topmost fifth
received 51.9 percent. Significantly, this disparity results from the concentration of
assets in the upper brackets. Also, the disparity is the consequence of highly skewed
patterns of corporate rewards that give, say, chief executive officers of large U.S.
companies an average of more than 300 times the annual compensation earned by
ordinary office or factory employees.

Moving from specific examples of distribution to a more general level, the criticism
may be broadened to an indictment of the market principle itself as the regulator of
incomes. An advocate of market-determined distribution will declare that in a market-
based society, with certain exceptions, people tend to be paid what they are worth;
that is, their incomes will reflect the value of their contribution to production. Thus,
market-based rewards lead to the efficiency of the productive system and thereby
maximize the total income available for distribution.

This argument is countered at two levels. Marxist critics contend that labourers in a
capitalist economy are systematically paid less than the value of their work by virtue
of the superior bargaining power of employers, so that the claim of efficiency masks
an underlying condition of exploitation. Other critics question the criterion of
efficiency itself, which counts every dollar of input and output but pays no heed to the
moral or social qualities of either and which excludes workers from expressing their
own preferences as to the most appropriate decisions for their firms.

Keynesian economics
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Article History

John Maynard Keynes, detail of a watercolour by Gwen Raverat,

c. 1908; in the National Portrait Gallery, London.

Courtesy of the National Portrait Gallery, London

Keynesian economics, body of ideas set forth by John Maynard

Keynes in his General Theory of Employment, Interest and
Money (1935–36) and other works, intended to provide a
theoretical basis for government full-employment policies. It was
the dominant school of macroeconomics and represented the
prevailing approach to economic policy among most Western
governments until the 1970s.

While some economists argue that full employment can be restored

if wages are allowed to fall to lower levels, Keynesians maintain
that businesses will not employ workers to produce goods that
cannot be sold. Because they believe unemployment results from
an insufficient demand for goods and services, Keynesianism is
considered a “demand-side” theory that focuses on short-run
economic fluctuations.

Keynes argued that investment, which responds to variations in

the interest rate and to expectations about the future, is the
dynamic factor determining the level of economic activity. He also
maintained that deliberate government action could foster full
employment. Keynesian economists claim that the government can
directly influence the demand for goods and services by altering
tax policies and public expenditures.

Starting in the 1970s, Keynesian economics was eclipsed in its

influence by monetarism, a macroeconomic school that advocated
controlled increases in the money supply as a means of
mitigating recessions. Following the global financial crisis of 2007–
08 and the ensuing Great Recession, interest in ongoing theoretical
refinements of Keynesian economics (so-called “new
Keynesianism”) increased, in part because Keynesian-inspired
responses to the crisis, where they were adopted, proved
reasonably successful.

distribution of wealth
and income
economics
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Also known as: wealth, distribution of

Written and fact-checked byThe Editors of

Encyclopaedia Britannica

distribution of wealth and income, the way in which the wealth

and income of a nation are divided among its population, or the
way in which the wealth and income of the world are divided
among nations. Such patterns of distribution are discerned and
studied by various statistical means, all of which are based on data
of varying degrees of reliability.

Wealth is an accumulated store of possessions and financial claims.

It may be given a monetary value if prices can be determined for
each of the possessions; this process can be difficult when the
possessions are such that they are not likely to be offered for
sale. Income is a net total of the flow of payments received in a
given time period. Some countries collect statistics on wealth from
legally required evaluations of the estates of deceased persons,
which may or may not be indicative of what is possessed by the
living. In many countries, annual tax statements that measure
income provide more or less reliable information. Differences in
definitions of income—whether, for example, income should include
payments that are transfers rather than the result of productive
activity, or capital gains or losses that change the value of an
individual’s wealth—make comparisons difficult.

In order to classify patterns of national wealth and income, a basis

of classification must be determined. One classification system
categorizes wealth and income on the basis of the ownership of
factors of production: labour, land, capital, and, occasionally,
entrepreneurship, whose respective forms of income are labeled
wages, rent, interest, and profit. Personal distribution statistics,
usually developed from tax reports, categorize wealth and income
on a per capita basis.

Gross national income (GNI) per capita provides a rough measure

of annual national income per person in different countries.
Countries that have a sizable modern industrial sector have a much
higher GNI per capita than countries that are less developed. In the
early 21st century, for example, the World Bank estimated that the
per-capita GNI was approximately $10,000 and above for the most-
developed countries but was less than $825 for the least-developed
countries. Income also varies greatly within countries. In a high-
income country such as the United States, there is considerable
variation among industries, regions, rural and urban areas, females
and males, and ethnic groups. While the bulk of the U.S. population
has a middle income that is derived largely from earnings, wages
vary considerably depending on occupation. (See also gross
national product, gross domestic product.)

A significant proportion of an economy’s higher incomes will derive

from investment rather than earnings. It is often the case that the
higher the income, the higher the investment-derived portion tends
to be. Because most fortunes require long periods to accumulate,
the existence of a class of very wealthy persons can result from the
ability of those persons to retain their fortunes and pass them on to
descendants. Earned incomes are influenced by a different kind
of inheritance. Access to well-paid jobs and social status is largely
the product of education and opportunity. Typically, therefore,
well-educated children of wealthier parents tend to retain their
parents’ status and earning power. A dynamic economy, however,
increases the likelihood of attaining wealth and status through
individual effort alone.

supply and demand

economics
PrintCiteShareLinks
Also known as: consumer demand, supply

Written and fact-checked byThe Editors of

Encyclopaedia Britannica

Updated: May 18, 2025•Article History

Illustration of the relationship of price to supply (S) and demand

(D).

Encyclopædia Britannica, Inc.

Key People:

Thomas Malthus

Angus Deaton

J.-B. Say

William Stanley Jevons

Alvin E. Roth
supply and demand, in economics, relationship between the
quantity of a commodity that producers wish to sell at
various prices and the quantity that consumers wish to buy. It is
the main model of price determination used in economic theory.
The price of a commodity is determined by the interaction of supply
and demand in a market. The resulting price is referred to as
the equilibrium price and represents an agreement between
producers and consumers of the good. In equilibrium the quantity
of a good supplied by producers equals the quantity demanded by
consumers.

Demand curve
The quantity of a commodity demanded depends on the price of
that commodity and potentially on many other factors, such as the
prices of other commodities, the incomes and preferences of
consumers, and seasonal effects. In basic economic analysis, all
factors except the price of the commodity are often held constant;
the analysis then involves examining the relationship between
various price levels and the maximum quantity that would
potentially be purchased by consumers at each of those prices. The
price-quantity combinations may be plotted on a curve, known as
a demand curve, with price represented on the vertical axis and
quantity represented on the horizontal axis. A demand curve is
almost always downward-sloping, reflecting the willingness of
consumers to purchase more of the commodity at lower price
levels. Any change in non-price factors would cause a shift in the
demand curve, whereas changes in the price of the commodity can
be traced along a fixed demand curve.
Illustration of an increase in equilibrium price (p) and equilibrium
quantity (q) due to a shift in demand (D).
Encyclopædia Britannica, Inc.

Supply curve
The quantity of a commodity that is supplied in the market depends
not only on the price obtainable for the commodity but also on
potentially many other factors, such as the prices of substitute
products, the production technology, and the availability
and cost of labour and other factors of production. In basic
economic analysis, analyzing supply involves looking at the
relationship between various prices and the quantity potentially
offered by producers at each price, again holding constant all other
factors that could influence the price. Those price-quantity
combinations may be plotted on a curve, known as a supply curve,
with price represented on the vertical axis and quantity
represented on the horizontal axis. A supply curve is usually
upward-sloping, reflecting the willingness of producers to sell more
of the commodity they produce in a market with higher prices. Any
change in non-price factors would cause a shift in the supply curve,
whereas changes in the price of the commodity can be traced along
a fixed supply curve.

Illustration of an increase in equilibrium price (p) and a decrease in

equilibrium quantity (q) due to a shift in supply (S).

Encyclopædia Britannica, Inc.

Market equilibrium, or balance

between supply and demand
Supply and demand are equated in a free market through
the price mechanism. If buyers wish to purchase more of a good
than is available at the prevailing price, they will tend to bid the
price up. If they wish to purchase less than is available at the
prevailing price, suppliers will bid prices down. The price
mechanism thus determines what quantities of goods are to be
produced. The price mechanism also determines which goods are
to be produced, how the goods are to be produced, and who will
get the goods—i.e., how the goods will be distributed. Goods so
produced and distributed may be consumer items, services, labour,
or other salable commodities. In each case, an increase in demand
will lead to the price being bid up, which will induce producers to
supply more; a decrease in demand will lead to the price being bid
down, which will induce producers to supply less. The price
system thus provides a simple scale by which competing demands
may be weighed by every consumer or producer.

The tendency to move toward the equilibrium price is known as

the market mechanism, and the resulting balance between supply
and demand is called a market equilibrium.

As the price of a good rises, the quantity offered usually increases,

and the willingness of consumers to buy the good normally
declines, but those changes are not necessarily proportional. The
measure of the responsiveness of supply and demand to changes in
price is called the price elasticity of supply or demand, calculated
as the ratio of the percentage change in quantity supplied or
demanded to the percentage change in price. Thus, if the price of a
commodity decreases by 10 percent and sales of the commodity
consequently increase by 20 percent, then the price elasticity of
demand for that commodity is said to be 2.

In algebraic form, elasticity (E) is defined as E = %Δy/%Δx; y is

elastic with respect to x if E is greater than 1, inelastic with respect
to x if E is less than 1, and “unit elastic” with respect to x if E is
equal to 1. Several other types of elasticities are frequently used to
describe well-known economic variables. These include, but are not
limited to, the income elasticity of demand, the cross-price
elasticity (the elasticity of the price of a good with respect to the
price of another good), the elasticity of substitution between
different factors of production (for example, between capital and
labour), and the elasticity of intertemporal substitution (for
example, the elasticity of consumption in the future relative to
consumption in the present).

Several other types of elasticities that are frequently used to

describe well-known economic variables have acquired their own
special names over time. These include, but are not limited to, the
income elasticity of demand, the cross-price elasticity (the elasticity
of the price of a good with respect to the price of another good),
the elasticity of substitution between different factors of production
(for example, between capital and labour), and the elasticity of
intertemporal substitution (for example, the elasticity of
consumption in the future relative to consumption in the present).

The demand for products that have readily available substitutes is

likely to be elastic, which means that it will be more responsive to
changes in the price of the product. That is because consumers can
easily replace the good with another if its price rises. The demand
for a product may be inelastic if there are no close substitutes and
if expenditures on the product constitute only a small part of the
consumer’s income. Firms faced with relatively inelastic demands
for their products may increase their total revenue by raising
prices; those facing elastic demands cannot.

Supply-and-demand analysis may be applied to markets for final

goods and services or to markets for labour, capital, and other
factors of production. It can be applied at the level of the firm or
the industry or at the aggregate level for the entire economy.

Chicago school of
economics
economics

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Written byDavid Hess

Fact-checked byThe Editors of Encyclopaedia Britannica

Article History

Date:

c. 1930 - present

Headquarters:

Chicago
 Areas Of Involvement:

economics

free market

monopoly and competition

competition

antitrust law

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Chicago school of economics, an economic school of thought,

originally developed by members of the department
of economics at the University of Chicago, that emphasizes free-
market principles. The Chicago school of economics was founded in
the 1930s, mainly by Frank Hyneman Knight, and subsequently
produced multiple Nobel Prize winners. In addition to Knight, some
of the leading and best-known members of the school were Gary S.
Becker, Ronald Coase, Aaron Director, Milton Friedman, Merton H.
Miller, Richard Posner, and George J. Stigler. The Chicago school is
also associated with the law-and-economics approach to
jurisprudence, which was developed at the University of Chicago
Law School.

At the heart of the Chicago school’s approach is the belief in the

value of free markets (see also laissez-faire). Simply stated, the
Chicago school asserts that markets without government
interference will produce the best outcomes for society (i.e., the
most-efficient outcomes). A primary assumption of the school is the
rational-actor (self-interest-maximizing) model of human behaviour,
according to which people generally act to maximize their self-
interest and will, therefore, respond to appropriately designed
price incentives. At the level of society, free markets populated by
rational actors will cause resources to be distributed on the basis of
their most-valuable uses (allocative efficiency).

The Chicago school’s approach to antitrust law in the area of

regulatory policy provides an excellent demonstration of its general
principles. The traditional approach to antitrust regulatory policy is
to limit concentrations of market power, such as by breaking up a
firm that has become a monopoly. The Chicago school, on the other
hand, argues that consumers are best protected by competition,
even if it is only between a few large firms in an industry. Such
large firms may have gained their dominant market positions
through efficiency advantages that provide greater benefits to
consumers than a market forced by the law to include many smaller
firms. Even if a firm gains monopoly power, the Chicago school
prefers to allow the market to correct the problem rather than to
rely on government intervention, which may cause greater harm to
efficiency.

The Chicago school’s principles have been applied to a wide variety

of areas, including both market- and nonmarket-based activities.
For example, Becker applied the assumption that people make
rational self-interested economic choices to help explain aspects of
human behaviour not traditionally studied by economics,
including crime, racial discrimination, marriage, and family life. In
the realm of law and economics, the Chicago school argued that
legal rules and court decisions should be aimed at promoting
efficiency. The role of the law is simply to alter the incentives of
individuals and organizations to achieve that end. For example, in
the area of tort law, the goal should be not simply to minimize the
cost of accidents but also to minimize the cost of preventing
accidents. If liability rules require individuals to take precautions
against accidents that are more costly than the accidents
themselves, then the outcome is allocatively inefficient.

The Chicago school has been criticized from many points of view.
For example, behavioral economics scholars challenge the
assumption that humans are rational self-interest maximizers.
Instead, they argue that certain decision heuristics and biases
prevent people from being the ideal decision makers the Chicago
school assumes them to be. Others argue that the Chicago school’s
goal of efficiency can be achieved only at the cost of justice and
equality in society.

invisible hand
economics
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Written byF. Eugene Heath

Fact-checked byThe Editors of Encyclopaedia

Britannica
Article History

Key People:

Adam Smith

invisible hand, metaphor, introduced by the 18th-century Scottish

philosopher and economist Adam Smith, that characterizes the
mechanisms through which beneficial social and economic
outcomes may arise from the accumulated self-interested actions of
individuals, none of whom intends to bring about such outcomes.
The notion of the invisible hand has been employed
in economics and other social sciences to explain the division of
labour, the emergence of a medium of exchange, the growth of
wealth, the patterns (such as price levels) manifest
in market competition, and the institutions and rules of society.
More controversially, it has been used to argue that free markets,
made up of economic agents who act in their own self-interest,
deliver the best possible social and economic outcomes.

Smith invokes the phrase on two occasions to illustrate how a

public benefit may arise from the interactions of individuals who
did not intend to bring about such a good. In Part IV, chapter 1,
of The Theory of Moral Sentiments (1759), he explains that, as
wealthy individuals pursue their own interests, employing others
to labour for them, they “are led by an invisible hand” to distribute
the necessities that all would have received had there been an
equal division of the earth. In Book IV, chapter 2, of An Inquiry into
the Nature and Causes of the Wealth of Nations (1776), arguing
against import restrictions and explaining how individuals prefer
domestic over foreign investments, Smith uses the phrase to
summarize how self-interested actions are so coordinated that they
advance the public interest. In those two instances, a complex and
beneficial structure is explained by invoking basic principles
of human nature and economic interaction.

However, on other occasions Smith employs the idea of the

invisible hand without using the phrase itself. In the opening
paragraph of chapter 2 of Book I of The Wealth of Nations, for
example, he describes how the division of labour is not the result of
far-seeing wisdom but a gradual outcome of a natural “propensity
to truck, barter, and exchange one thing for another.” Later in the
same treatise, he delineates how individuals are so guided by
prices that the supply of goods tends to meet demand. More
generally, Smith explains how the patterns of commerce, including
the overall creation of wealth, arise out of individuals responding to
and endeavouring to succeed in their own local circumstances.
Although Smith often refers to economic agents as self-interested,
he does not mean to suggest that their motivations are selfish.
Rather, the agents are motivated by beliefs and intentions that
manifest their local knowledge and particular concerns (including
those relating to their families) rather than some broader
conception of a public good.

gold standard
monetary system
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Written and fact-checked byThe Editors of
Encyclopaedia Britannica

Updated: Apr. 26, 2025•Article History

Block of metallic gold.

© wizdata/[Link]

Key People:

Grover Cleveland

William McKinley

Rutherford B. Hayes

John Sherman
 Justin S. Morrill

Related Facts And Data:

Great Depression - Facts

gold standard, monetary system in which the standard unit

of currency is a fixed quantity of gold or is kept at the value of a
fixed quantity of gold. The currency is freely convertible at home or
abroad into a fixed amount of gold per unit of currency.

(Read Milton Friedman’s Britannica entry on money.)

In an international gold-standard system, gold or a currency that is

convertible into gold at a fixed price is used as a medium
of international payments. Under such a system, exchange
rates between countries are fixed; if exchange rates rise above or
fall below the fixed mint rate by more than the cost of shipping gold
from one country to another, large gold inflows or outflows occur
until the rates return to the official level. These “trigger” prices are
known as gold points.

History
The gold standard was first put into operation in the United
Kingdom in 1821. Prior to this time silver had been the principal
world monetary metal; gold had long been used intermittently
for coinage in one or another country, but never as the single
reference metal, or standard, to which all other forms
of money were coordinated or adjusted. For the next 50 years
a bimetallic regime of gold and silver was used outside the United
Kingdom, but in the 1870s a monometallic gold standard was
adopted by Germany, France, and the United States, with many
other countries following suit. This shift occurred because recent
gold discoveries in western North America had made gold more
plentiful. In the full gold standard that thus prevailed until 1914,
gold could be bought or sold in unlimited quantities at a fixed price
in convertible paper money per unit weight of the metal.

The reign of the full gold standard was short, lasting only from the
1870s to the outbreak of World War I. That war saw recourse to
inconvertible paper money or to restrictions on gold export in
nearly every country. By 1928, however, the gold standard had
been virtually reestablished, although, because of the relative
scarcity of gold, most nations adopted a gold-exchange standard, in
which they supplemented their central-bank gold reserves with
currencies (U.S. dollars and British pounds) that were convertible
into gold at a stable rate of exchange. The gold-exchange standard
collapsed again during the Great Depression of the 1930s,
however, and by 1937 not a single country remained on the full
gold standard.

Gold bars.

Courtesy of the United States Mint

The United States, however, set a new minimum dollar price for
gold to be used for purchases and sales by foreign central banks.
This action, known as “pegging” the price of gold, provided the
basis for the restoration of an international gold standard
after World War II; in this postwar system most exchange rates
were pegged either to the U.S. dollar or to gold. In 1958 a type of
gold standard was reestablished in which the major European
countries provided for the free convertibility of their currencies
into gold and dollars for international payments. But in 1971
dwindling gold reserves and a mounting deficit in its balance of
payments led the United States to suspend the free convertibility of
dollars into gold at fixed rates of exchange for use in international
payments. The international monetary system was henceforth
based on the dollar and other paper currencies, and gold’s official
role in world exchange was at an end.

Advantages and disadvantages

The advantages of the gold standard are that (1) it limits the power
of governments or banks to cause price inflation by excessive issue
of paper currency, although there is evidence that even before
World War I monetary authorities did not contract the supply of
money when the country incurred a gold outflow, and (2) it creates
certainty in international trade by providing a fixed pattern of
exchange rates.

The disadvantages are that (1) it may not provide sufficient

flexibility in the supply of money, because the supply of newly
mined gold is not closely related to the growing needs of the world
economy for a commensurate supply of money, (2) a country may
not be able to isolate its economy from depression or inflation in
the rest of the world, and (3) the process of adjustment for a
country with a payments deficit can be long and painful whenever
an increase in unemployment or a decline in the rate of economic
expansion occurs.