Unit 3: The Classical System

ECOIDC-151: Foundation of Economics - II | 2nd Semester Notes

1. Basic ideas of Classical Macroeconomics

The "Classical" school of thought (led by economists like Adam Smith, David Ricardo, and J.B. Say) dominated economics before the 1930s. Their worldview was based on the power of free markets.

Core Assumptions:

  1. Rational Economic Agents: All individuals and firms act rationally in their own self-interest.
  2. Perfect Competition: All markets (for goods, labor, and capital) are perfectly competitive.
  3. Laissez-Faire: The belief that the government should not interfere in the economy. An "invisible hand" (market forces) guides the economy to its best outcome.
  4. Full Employment: The economy will *always* automatically return to a state of full employment. Any unemployment is temporary and voluntary.
  5. Wage-Price Flexibility: Wages and prices are perfectly flexible and adjust quickly to any shortages or surpluses.

2. Classical theory of income and employment

In the Classical model, the level of **output and employment** is NOT determined by demand (as Keynes later argued). Instead, it is determined by the **supply side** of the economy, specifically in the labor market.

How Output and Employment are Determined:

  1. Production Function: The economy's output (Y) depends on the amount of labor (N) employed, given a fixed stock of capital and technology. Y = f(N).
  2. Labor Market:
    • Demand for Labor (Nd): Firms demand labor up to the point where the Real Wage (W/P) equals the Marginal Product of Labor (MPL). The labor demand curve is downward sloping.
    • Supply of Labor (Ns): Households supply labor based on the real wage. A higher real wage encourages more people to work. The labor supply curve is upward sloping.
  3. Equilibrium: The labor market finds an equilibrium where Nd = Ns. This equilibrium determines the **real wage (W/P)* ** and the **level of full employment (NF)**.
  4. Final Output: This full-employment level of labor (NF) is then plugged into the production function to determine the economy's **full-employment level of output (YF)**.
Key Takeaway: In the Classical model, output is *always* at its full-employment potential (YF). The economy is supply-determined.

3. Say's law market

This is the most famous and important idea of the Classical system, attributed to Jean-Baptiste Say.

Say's Law: "Supply creates its own demand."

What it means:

  • The very act of producing goods (supply) automatically generates an equivalent amount of income (wages, profits, rent) for the factors of production.
  • This income is then used to purchase the goods that were produced (demand).
  • Conclusion: There can never be a general glut or "general overproduction" in the economy. It is impossible for there to be a deficiency of aggregate demand.

What about Savings?

Critics asked: What if people don't spend all their income? What if they save it?

  • The Classical answer was the Loanable Funds Market.
  • Savings (S) is the *supply* of loanable funds. Investment (I) is the *demand* for loanable funds.
  • The **interest rate (r)** is the "price" that adjusts to make savings equal to investment (S=I).
  • If savings increase (a leakage), the interest rate falls. This encourages firms to invest more (an injection), and the full amount of income is still spent.
Say's Law implies there is no *general* unemployment. It doesn't mean there is no unemployment. There can be "frictional" unemployment (people between jobs) or "voluntary" unemployment (people who refuse to work at the market wage), but there cannot be large-scale "involuntary" unemployment due to a lack of demand.

4. Wage - price flexibility and Classical Full Employment Model

Wage-price flexibility is the "engine" that makes the Classical model work and ensures it always returns to full employment.

[Image of the Classical labor market diagram showing Demand and Supply for labor determining the full employment level]

The Full Employment Model:

The model rests on the belief that any deviation from full employment is temporary and will be fixed automatically by flexible wages and prices.

How it Works (The Adjustment Mechanism):

  • Scenario: Imagine a temporary shock (like a recession) that causes unemployment.
  • Step 1: There is now a **surplus of labor** (Ns > Nd).
  • Step 2: Unemployed workers will compete for jobs by offering to work for less.
  • Step 3: This competition forces the **money wage (W) to fall**.
  • Step 4: As wages (a cost of production) fall, firms can lower their **prices (P)**.
  • Step 5: The **Real Wage (W/P)** falls.
  • Step 6: At a lower real wage, firms are now willing to hire more workers (movement down the Nd curve) and households supply less labor (movement down the Ns curve).
  • Step 7: This continues until the surplus is eliminated and the market returns to equilibrium at full employment (NF).
Conclusion: According to the Classical model, the *only* reason for persistent unemployment is that wages are *not* flexible (e.g., due to minimum wage laws or powerful trade unions keeping wages artificially high).

5. Quantity theory of money- Classical approach

This part of the Classical model explains how the **general price level (Inflation)** is determined. It argues that money is *only* used for transactions and does not affect real variables like output or employment.

Fisher's Equation of Exchange (Transaction Version):

MV = PT
  • M = Money Supply (Total amount of money in the economy).
  • V = Velocity of Money (The average number of times a unit of money is spent in a year).
  • P = General Price Level.
  • T = Total number of Transactions.

Classical Assumptions:

The Classical economists turned this equation into a theory by making two key assumptions:

  1. V is Constant: Velocity is fixed in the short run, determined by people's stable habits (e.g., how often they get paid).
  2. T is Constant: The number of transactions is fixed at the full-employment level (determined by Say's Law and the labor market). T is replaced by Y (Real Output/Income).

The Theory (MV = PY):

With V and Y fixed, the equation becomes:

M * (Fixed V) = P * (Fixed Y)

This leads to a direct and proportional relationship between money and prices.

Conclusion: If the government doubles the **Money Supply (M)**, the **Price Level (P)** must also double. This means inflation is *purely* a monetary phenomenon. Increasing the money supply *only* causes inflation; it does not increase output or employment.