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Introduction

  • The classical economists believed in the existence of full employment in the economy. To them, full employment was a normal situation and any deviation from this regarded as something abnormal.
  • According to Pigou, the tendency of the economic system is to automatically provide full employment in the labour market when the demand and supply of labour are equal. Unemployment results from the rigidity in the wage structure and interference in the working of free market system in the form of trade union legislation, minimum wage legislation etc. Full employment exists “when everybody who at the running rate of wages wishes to be employed.”
  • Those who are not prepared to work at the existing wage rate are not unemployed because they are voluntarily unemployed. Thus full employment is a situation where there is no possibility of involuntary unemployment in the sense that people are prepared to work at the current wage rate but they do not find work.
  • The basis of the classical theory is Say’s Law of Markets which was carried forward by classical economists like Marshall and Pigou. They explained the determination of output and employment divided into individual markets for labour, goods and money. Each market involves a built-in equilibrium mechanism to ensure full employment in the economy.

Assumptions

  1. There is the existence of full employment without inflation.
  2. There is a laissez-faire capitalist economy without government interference.
  3. It is a closed economy without foreign trade.
  4. There is perfect competition in labour and product markets.
  5. Labour is homogeneous.
  6. Total output of the economy is divided between consumption and investment expenditures.
  7. The quantity of money is given and money is only the medium of exchange.
  8. Wages and prices are perfectly flexible.
  9. There is perfect information on the part of all market participants.
  10. Money wages and real wages are directly related and proportional.
  11. Savings are automatically invested and equality between the two is brought about by the rate of interest
  12. Capital stock and technical knowledge are given.
  13. The law of diminishing returns operates in production.
  14. It assumes long run.
  • If there is general overproduction in the economy, then some labourers may be asked to leave their jobs. The problem of unemployment arises in the economy in the short run. In the long run, the economy will automatically tend toward full employment when the demand and supply of goods become equal.
  • When a producer produces goods and pays wages to workers, the workers, in turn, buy those goods in the market. Thus the very act of supplying (producing) goods implies a demand for them. It is in this way that supply creates its own demand.

Determination of Output and Employment

According to classical thinkers, the level of employment and level of output belong to real sector and calculated following equations:

  • Y = f(N)

Where, Y = Real output

              N= Labour and employment

  • Nd = f(w/p)

Where, w/p = Real Wage

              Nd = Demand for labour

  • Ns = f(w/p)

            Ns = Supply of labour

  • M = kPY

             K = Reciprocals of velocity of circulation of money

M = Money

Above equation is known as Cambridge Equation of Exchange. This is also classical theory of aggregate demand on which The Quantity Theory of Money is based.

  • S = I

Where, S = Saving

          I= Investment

Above equations is Saving-Investment equality, by which an equilibrium point is established in the stock market.

Aggregate Production Function (Figure 1)

Aggregate production function occupies central place in the concept of the classical approach: During short run- exogenous factors like capital stock, technology, resources also supply of labour are considered as remaining constant.

Equation, Y = f(N)

Where, Y = Real output

N = Labour and Employment

Considered short run production function which indicates that total output is a function of variable input like labour as shown in the above figure 1 employment level is determined only in the factor market. Labour supply is increasing functional of real wage rate. This concept is belonging to the classical doctrine of increasing disutility of work.

On Contrary, demand for labour is decreasing function of real wage rate. As we know that wage rate should be equal to VMP (Value of marginal Productivity) of labour in a perfectly competitive factor market, labour demand curve is same as marginal product curve of labour. Above explanation can be illustrated by following manner-

Conditions for short run profit maximisation

P = MC= W/MPL                                (1)

Where, P = Price of Product

MC = Marginal Cost

W = =Money wage Rate

MPL = Marginal Physical Product of Labour

MC = W/MPL                                        (2)

Since, P = MC in a perfectly competitive market, above two equations, i.e., (1) and (2) can be expressed as

P = W/MPL

Or W/p = MPL

Therefore, in a perfectly competitive factor market, with wage-price flexibility

Real wage rate = Marginal Product of Labour

Thus, demand for Labour curve is similar with Marginal Physical Product (MPP) curve for labour.

Labour Market

While capital stock and production function is given employment level is determined only in the factor market. Aggregate demand level is of no consequences in this case. Figure shows the labour market.

Ns = Labour Supply

Nd = Labour Demand

W/P = Real Wage Rate

In the Classical approach, concept of quantity theory of money is applied for determing the level of aggregate demand. Thus, any distortions or departure in aggregate demand it will certainly affect the nominal values like money wages as well as price level. But there is no doubt that employment and even output level will remain as it is i.e., no changes will occur. It will remain same. Thus, the spirit of classical economist in this regard is explained by J.S.Mill in his words that certainly there should be no confusion regarding the demand for output.

Classical Aggregate Demand Function

The Classical approach of aggregate demand is derived from quantity theory of money. In the Cambridge version, it is expressed as

Md = kPy                    (3)

Md = Money Demand

k = Reciprocal of velocity of circulation of money

Py = Nominal income

P = Price

Y = Quantity of real output

During Equilibrium stage:

Given stock of money = demand for money

Which is according to equation 3 = kPy

Thus,   Ms = kPy

In Fisher’s equation

Mv = Py

Where, V= Velocity of circulation of money, which is reciprocal of Cambridge k.

Therefore, in the Fisher’s version,

Demand for money = 1/V.Py

Quantity theory may be transformed to a classical theory of aggregate demand for output.

Classical Aggregate Supply Function

Concept of Classical aggregate supply function is identical to the microeconomics concept of a firm’s supply curve. In case of a firm only difference which is noticed that money wage rate is assumed to be fixed. But for making aggregate supply curve money- Wage rate should accordingly just to maintain equilibrium in the factor market.

Aggregate supply curve establish the relationship between commodity prices and supplied level of output. According to classical approach, employment and output level are finalised in factor market with reference to equilibrium real wage rate. Thus, product price makes no impact on equilibrium real wage rate. Thus, product price makes no impact on equilibrium level of output and employment-as are assumed to be fixed in product market. Classical supply curve will be a vertical straight times shown in figure (Classical Aggregate Supply Curve).

Any distortions or departure in the level of prices will shift relevant supply curves and also demand for labour accordingly so that equilibrium will be re-established so far as real wage rate is concerned. In case of full employment output level, there will be no effect even if any change in aggregate demand occurs.

Explanations regarding when any change in aggregate demand has no impact on the output level as the aggregate supply curve is vertical at the full employment level (in classical system).

In words of Aschheim, assumptions of full employment equilibrium rendered classical and Neo classical theories of interest real theories.

Classical theory of interest shows by equations

S = f(i)

Where, S = Saving,

i = rate of interest

I = f(i)

Where, I = Investment

S = I

Sates causes why changes in components of aggregate demand like government spending, investment etc. Do not affect aggregate level of aggregate demand.

Saving is an increasing and investment is a decreasing function of rate of interest. Equation S= I indicates capital market equilibrium as shown in Figure.

In case of Full employment, both investment as well as consumption are mutually exclusive alternatives, i.e., an increase in one brings reduction in other. Rate of interest acts as equilibrating instrument to bring saving investment equality. Thus additional investment does not result inflation as full employment. Thus, according to classical thinkers, any change in consumption or investment does not affect level of aggregate demand for output.

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