The rational expectations theory is based on the efficient market hypothesis, which states that markets reflect all available information. The theory assumes that new information is absorbed rapidly by a large number of rational participants and that no participant has significant market power. Similarly, the rational expectations theory assumes that market participants base their expectations of the future, including future policy actions on past, present and projected future information . Government guarantees and support tend to increase moral hazard as market participants expect that the government will help them out.
A possible effect of rational expectations is that it can make government policies ineffective. According to the rational expectations theory, Keynesian theories do not account fully for the changes in people's expectations about the consequences of fiscal and monetary policies . People learn from experience. The consequences of the expansionary monetary policies that started in the 1960's became entrenched in the expectations of people during the 1970's, rendering Keynesian policies ineffective and causing stagflation as people started to anticipate inflation in their decisions.
Another example of how rational expectations work out in practise is the Greenspan Put. When during the tenure of Alan Greenspan a crisis arose and the stock market fell significantly, the Fed lowered the Federal Funds rate and added monetary liquidity to encourage risk taking in the financial markets. This was done to avert further deterioration like in the aftermath of the 1929 stock market crash . The actions of the FED reduced the risks of investing in financial markets but they also increased moral hazard as market participants started to count on FED support in times of crisis.
Supply-side economics argues that economic growth can be improved by lowering barriers for people to produce goods and services, such as lowering income tax and capital gains tax rates, and by allowing greater flexibility by reducing regulation. According to supply-side economics, consumers will then benefit from a greater supply of goods and services at lower prices. Supply-side economics proposes that production or supply is the key to economic prosperity and that consumption or demand is a secondary consequence. This idea is similar to Say's Law .
Supply-siders feel that in a high tax rate environment, lowering tax rates can raise revenue by causing more economic growth. Supply-side economics holds that increased taxation reduces trade between economic participants within a nation and that it discourages investment. Taxes act as a type of trade barrier or tariff that causes economic participants to revert to less efficient means of satisfying their needs, such as doing a job yourself instead of hiring a professional .
It is likely that lower taxes on labour will increase employment. For example, you can hire a contractor for a construction job or do the job yourself. Assume that the contractor can do the job twice as efficient as you can but he charges -- 40 per hour including taxes. If your net income after taxes is -- 15 per hour then it is cheaper to do the job yourself. In countries with high taxes on labour it is often worthwhile to take a leave and do a job yourself, even when a professional works more efficiently, simply because of the tax burden.
Supply-side economics does not advise to improve the quality of education and infrastructure, which are both methods to enhance economic growth by improving supply. If the right investments in education and infrastructure are made, this may greatly improve economic output. A government may not be efficient in estimating future business requirements or may be captured by vested interests, so those policies may not always have the desired results. Many large infrastructure projects that have cost billions of euros have had little impact on the supply side. They may have provided an economic stimulus however.
Austrian School of Economics
The Austrian School bases its analysis on the purposeful actions of individuals. Austrians seek to understand the economy by examining the consequences of individual choices. This approach differs significantly from many other schools of economic thought, which have placed less importance on individual actions and focused instead on aggregate variables, equilibrium analysis, and the consideration of societal groups rather than individuals . The Mises of the Austrian School of Economics branch contends that many economic problems are caused by government actions, which are seen as acts of coercion .
The Mises branch is favoured by libertarians who reject government action to various degrees, most notably in economic issues. A government is a form of monopoly that has a tendency to expand its operations beyond providing an optimal service to its citizens. Governments may become oppressive as government implies authority. The state tends to attract parasites that live off taxpayer money. Some libertarians oppose political freedom because people can collectively decide to restrict economic freedoms, for example the freedom to pollute water in order to make money. Others fear that unproductive people may elect officials that will take money away from hard working people in order to give it to them.
The Austrian business cycle theory views business cycles as the consequence of excessive growth in bank credit, exacerbated by central bank policies which cause interest rates to remain too low for too long, resulting in excessive credit creation, speculative economic bubbles and lowered savings . According to the theory, the boom-bust cycle is generated by credit expansion that is not backed by savings. Fractional reserve banking makes more funds available for lending. This lowers the interest rate and facilitates a boom.
Austrians argue that the monetary boom ends when no further investments can be found which provide adequate returns for speculative borrowers at prevailing interest rates and bank credit expansion stops. They further argue that the longer the artificial monetary boom goes on, the bigger and more speculative the borrowing, and the more wasteful the errors committed, the longer and more severe will be the necessary readjustment consisting of bankruptcies, foreclosures, and depression . The influence of bank credit on the boom-bust cycle is not primarily caused by fractional reserve banking but by positive nominal interest rates.
The Austrian School of Economics rejects many of the findings of mainstream economics. Mainstream economists contend that Austrian School views are often not supported by empirical evidence . Most economists think that financial innovations such as fractional reserve banking improve the efficiency of financial markets. Fractional reserve banking is inflationary as it implies that real money (M1) in current accounts can be used for lending, which expands the amount of real money (M1). If only money in savings accounts can be used for lending, only the amount of money substitutes (M2) would grow, and the effect would be less inflationary as money substitutes (M2) are less liquid than real money (M1).