Famous Economic Theories and How They Might Affect Your Investments

Economists claim that the study of economics gives us the ability to understand fundamental social issues that range from how your chicken rice is priced to how wealth is distributed the way it is in Singapore.

However, over the history of mankind, there have been many schools of thoughts and very rarely have any been totally right about everything. There is a reason why we call economic theories, “theories”. Let us dive into a few of the major ideas that’ve emerged in economics over the past five hundreds years and how understanding them can help us in our investments.

Classical economics

The idea of classical economics first gained popularity in the 1700’s. It was first introduced by the great economist, Adam Smith, who argued in his book The Wealth of Nations that it will be best to leave the markets to its own, as it will readjust itself and find a point of equilibrium. Government policy will only hinder the process of the market finding its own balancing point and should be avoided at all cost. This theory marked the start of modern economics and there are many aspects of our society that still generally follow Smith’s leanings.

We see this in many companies that sell consumer products, such as Eu Yan Sang (SGX: E02) and Sheng Siong (SGX: OV8). These companeis are free to price their products and the market is free to choose if they are willing to buy their products at that price. If there is an imbalance between demand and supply, the market will readjust itself accordingly. Understanding this will allow us to make decisions by analysing the demand and supply of the products and services of any particular company.

Keynesian economics

This theory first caught on during the great depression in the United States in the early 1930’s. By leaving the market to itself, the economy of the USA fell into a deep depression. At that point, the famous economist, Sir John Maynard Keynes, argued that although a country’s economy can be self-correcting over the long-term, it could be very volatile in the short term. And, governments should help the population weather the downturn by intervening in the economy – to help “jump-start” the growth engine, in other words.

We saw this happening during the great financial crisis of 2007-09 when the US authorities started the largest monetary stimulus package in its history to help prevent a prolonged depression in the US economy.

In Singapore, similar to all free-market economies, the banks – DBS Group Holdings (SGX: D05), Oversea-Chinese Banking Corporation (SGX: O39), and United Overseas Bank (SGX: U11) – will be the sector that has an exposure to almost all industries. Therefore, in an event where our country faces the risk of recession, the government might choose to assist the banks to increase liquidity in the market to restart the economy.

Foolish Summary

There are many other theories on how the economy actually works. But it seems to me that there is no theory that will continue to work in all scenarios all of the time. Investors should take economic theories as more of a guideline rather than as a law when thinking about their investments.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.