Classical Economics

1. Classical Economics

2. Defined • A body of economic thought originating with the work of Adam Smith based on the idea that the operation of unrestricted markets generates aggregate or national production that fully utilizes the economy's resources and maintains full employment. • Classical economists believed that the government should not intervene to try to correct any disequilibrium as it would only make things worse, and so, the only way to encourage growth was to allow free trade and free markets. This approach is known as a 'laissez-faire' approach.

3. Assumptions • Classical economics, especially as directed toward macroeconomics, relies on three key assumptions--flexible prices, Say's law, and saving-investment equality. Although of questionable realism, these three assumptions imply that the economy would operate at full employment.

4. Flexible wages • The Classical economists assumed that if the economy was left to itself, then it would tend to full employment equilibrium. This would happen if the labour market worked properly. If there was any unemployment, then the following would happen:

5. Flexible Prices • The proposition that prices adjust in the long run in response to market shortages or surpluses. This condition is most important for long-run macroeconomic activity and long-run aggregate market analysis. In particular, flexible prices are the key reason for the vertical slope of the long-run aggregate supply curve. This proposition is also central to original classical theory of macroeconomics and to modern variations, including rational expectations, new classical theory, and supply-side economics. • Flexible prices ensure that markets adjust to equilibrium and eliminate shortages and surpluses.

6. unemployment Wage rate a b Q1 Q2 Quantity of labour Wages are initially too high and there is unemployment of ab. This causes wage rates to fall and employment increases as a result from Q1 to Q2. Any unemployment left in the economy would be purely voluntary unemployment - people who have chosen not to work at the going wage rate.

7. Flexible interest rates • The same would also be true in the 'market for loanable funds'. If there was any discrepancy between savings and investment the equilibrium would change in the market. This would again require a free market and flexible prices. In this market the price is the rate of interest. Say, for example, investment increased, then the following process would occur to restore equilibrium: • Increase in investment increased demand for money increased rate of interest increased savings as borrowers are attracted by higher interest rates equilibrium restored

8. Rate of interest S - Supply of loanable funds S 1 R R1 D - Demand for loanable funds 0 Q Q1 Quantity of loanable funds • The demand for loanable funds comes from firms wanting to invest, households wanting to purchase on credit and the government engaging in deficit financing. Of the three govt's demand is the least sensitive to interest rate changes. • A rise in the r.o.i. will lower firms' and households' demand - hence the slope of the curve downward from left to right. • The supply of loanable funds comes from savings. A higher r.o.i. will increase the return from savings hence the supply curve slopes upwards. • An increase in the supply of savings will lower the r.o.i and cause an extension in demand.

9. Price determination (Quantity Theory) • A theory that changes in the money supply have a direct influence on prices and nothing else. • The theory is derived from the identity MV = PT (the Fisher Equation) where M is the stock of money, V is the velocity with which the money circulates, P is the average price level and T is the number of transactions or output.

10. Price determination (Quantity Theory) • Classical economists suggested that V would be relatively stable and T would always tend to full employment. Friedman developed this and tested it further, concluding that V and T were both independently determined in the long-run - that: Increases in the Money Supply will lead to increases in Price • If the MS grew faster than the underlying growth rate of output there would be inflation. Inflation would be bad for the economy because of the uncertainty it created. This uncertainty could limit spending and also limit the level of investment. Higher inflation may also damage a country’s international competitiveness.

11. Say’s Law • any increase in output of goods and services (supply) will lead to an increase in expenditure to buy those goods and services (demand). There will not be any shortage of demand and there will always be jobs for all workers - full employment. If there was any unemployment it would simply be temporary as the pattern of demand shifted. However, equilibrium would soon be restored by the same process as shown above.

12. Saving-investment equality • The saving-investment equality ensures that any income leaked from consumption into saving is replaced by an equal amount of investment.

13. Full Employment • Full employment is achieved in principle when all available resources (labor, capital, land, and entrepreneurship) are used to produce goods and services. This is commonly indicated by the employment of labor resources (the unemployment rate). However, all resources in the economy--labor, capital, land, and entrepreneurship--are important to this goal. • An economy is considered to be at full employment when the unemployment rate is around 5 - 5 1/2 percent and the capacity utilization rate of capital is about 85 percent. • The economy benefits from full employment because resources produce the goods that satisfy the wants and needs that lessen the scarcity problem. If the resources are not employed, then they are not producing and satisfaction is not achieved.

14. Full employment is indicated by the boundary of the production possibilities frontier. The production possibilities frontier is constructed under the assumption that all available resources are engaged in production of two goods. As such being on the frontier is, by definition, tantamount to full employment. Flash drives A 1000 Y 700 500 Tomatoes Full Employment (graphically) 0

15. Full employment is indicated by the position of the long-run aggregate supply curve. The long-run aggregate supply curve is constructed based on the assumption that flexible prices have adjusted to achieve equilibrium in all markets. Most important, resource markets are in equilibrium, with quantities demanded equal to quantities supplied. In other words, for the labor market, the number of jobs available matches the number of workers available. LRAS Price Level Real Output Full Employment (graphically) 0

16. Classical unemployment • An extreme view on unemployment is that there is none. The classical view of labour markets is that the labour market is like any other market. If the quantity demanded for labour is too low, then the price (wages) must fall until the market clears. • Thus anyone without a job is unemployed because they want to be, apart from a small few who are in the transition period between one job and the next.