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The liberal theory of economics is the theory of economics developed in the Enlightenment, and believed to be first fully formulated by Adam Smith. It is associated with the political ideology of classical liberalism. The concept of economic liberalism or market liberalism underpinned the move towards a free market capitalist economic system in the late 18th century, and the subsequent demise of the mercantilist system. Today, the liberal theory of economics is strongly associated with some schools of conservatism, particularly liberal conservatism.

Private property and individual contracts form the basis of the liberal theory of economics. The early theory was based on the assumption that the economic actions of individuals are largely based on self-interest, and that allowing them to do so without any restrictions will produce the best results, provided that at least minimum standards of public information and justice exist, e.g., no-one should be allowed to coerce or steal.

Initially, the liberal theory of economics had to contend with the supporters of feudal privileges for the wealthy, aristocratic traditions and the rights of kings to run national economies in their own personal interests. By the end of the 19th century and the beginning of the 20th, these had been largely defeated. However, a new challenge arose from the left, and economic liberalism found itself under attack from progressive and socialist schools of thought that favoured redistribution of wealth, greater economic equality, government programs to help the poor and, in some cases, planned economies. These remain the main opponents of economic liberalism to this day.

Famous proponents of the liberal theory of economics include Adam Smith, Anders Chydenius, François Quesnay, Jean-Baptiste Say, Frédéric Bastiat, Ludwig von Mises, Friedrich Hayek, Milton Friedman and James M. Buchanan.

[edit] Decline and revival

The liberal theory of economics fell partially out of practice in the late 19th and early 20th century, when many countries followed the protectionism of Germany, which wanted to achieve self-sufficiency in order to be able to survive a long war. ^{[citation needed]}

Following World War I and the Great Depression, the theory fell out of favour. ^{[citation needed]} It was largely superseded by Keynesian economics in 1945–70 period, which take into account macro-level phenomena and call for a mixed economy involving significant state intervention.

After Keynesianism failed to explain stagflation in the 1970s, many concepts from the traditional liberal theory were revived by monetarist and new classical economists. Keynesian economics as practiced in the post World War period is generally considered incapable of explaining the behavior of modern economies.^{[citation needed]} There has been a revival in some Keynesian ideas based more rigorously on economics theory in certain universities under the name New Keynesian economics. The dominant discourse in modern macroeconomics in particular and economics in general, is new classical. New classical economics is rigorously based in theory, in contrast to Keynesian models.^{[citation needed]} The majority of central banks as well as international institutions such as World Bank and International Monetary Fund use the new liberal models in their policy making process.