Introduction of Classical theory of Employement

1. Classical Theory of Employment and Output
 The period from 1976 (Adam Smith’s ‘Wealth of Nation’) to 1890
(Marshall’s ‘Principle of Economics’)- Classical Period
 The main body of classical economics is microeconomics in nature
 The economy working through ‘invisible hands’ of demand and supply,
i.e. no government intervention in the economy
 A full fledged macroeconomics appeared only in 1930s
Assumptions
 Full employment in the economy
 Perfect competition
 Wage price flexibility
Two Basic Pillars of Classical Theory
Say’s Law of Market
Quantity Theory of Money

2. The Say’s Law of Market
‘Market creates its own demand’. This implies any increment of output will
generate an equivalent increment in income and spending. The income and
product can always be at full employment level.
 Supply automatically creates demand, i.e. no overproduction or ‘glut’
 If there are any discrepancies between demand and supply, they are
temporary and the economy ultimately attains equilibrium
 Basis for Laissez Faire policy – no need of govt. intervention
 Applicable in barter as well as money economy
 As money is only a means of exchange, no rational people hold idle
cash and hence the income (output) = expenditure at full employment
level
Criticism
 Malthus – deficient demand creates unemployment (first attack on Say’s
Law)
 Keynes – it is due to the aggregate demand deficiency, the economy is
in underemployment equilibrium (Keynes’ General Theory-1936)

3. Quantity Theory of Money
 The QTM asserts that money is neutral in its effect on output and
employment. No rational people hold idle cash balance for it is used
only as a medium of exchange. Due to imperfect co-incidence
between in-payments and out-payments, people may hold idle cash
but it is a temporary phenomena (neo-classicist argue S = I that
determines rate of interest)
 Money is a barren asset for it generates no return
 Money directly affects the price level as given by Fisher’s equation of
exchange, MV = PT, where V (velocity of money) and T (transaction
volume) are constant (assumption of full employment). This implies
any increment in M directly affects the price level but not output (y)
0
P
M

4. Output and Employment Determination
 Equilibrium level of aggregate output and employment is given by
production function and labor’s demand & supply function respectively
 The aggregate production function shows that with given capital stock
and technology, additional labor employed yields diminishing additional
output, i.e. marginal physical product (MPL) of labor diminishes. A profit
maximization firm hires labor up to the point where the real wage (W/P)
paid equals the MPL
Symbolically, Y = F(N,K) where, Y = aggregate output, N = labor, K= capital
dF/dN = MPL = W/P
The demand for labor, DN = f (W/P), f’<0
The supply of labor, SN = f (W/P), f’>0 (but may be f’<0 at higher real wage)
 The equilibrium in the labor market is determined corresponding to that
real wage rate where the demand for and supply of labor are in
equilibrium. The equilibrium output is determined by the production
function corresponding to the equilibrium level of employment.

5. Output and Employment Determination
y
y
y0
N0
N0
N
DN
SN
(W/P)0
(W/P)1
(W/P)2
Wage/price flexibility eliminates
excess demand/supply
and ensures full employment
y0
(M1V)y
(M2V)
p2p1
Contd.

6. Criticism of Classical Theory
 Assumption of full employment (long-run analysis)
 Assumption of perfect competition
 Wage-price flexibility
 Say’s Law of Market
 Money functions not only as the medium of exchange
 Working of invisible hands (i.e. self-adjustment mechanism)
 The rate of interest is a monetary phenomenon
 Laissez faire policy failed, the need of state intervention emerged
during the Great Depression
 Interest inelastic saving function and level of income as the
equilibrating variable between I and S

7. Discussion
 Meaning of full employment (voluntary, frictional and structural
unemployment)
 Perfect Competition
 Economic implication of Say’s Law of Market
 The Irving Fisher’s equation of exchange, MV = PT (or MV = PY)
 Classical Dichotomy
 What happens to the level of employment if the assumption of wage
price flexibility is dropped?
 Neutrality of money
 Interest rate determination (neo-classical theory) and equality of
saving and investment
 Determination of level of employment and output in classical theory
(diagrammatic explanation)

8. 1. Olivier Blanchard: Macroeconomics (second edition), MIT
2. Edward Shapiro: Macroeconomic Analysis (fifth edition)
3. W. H. Branson: Macroeconomic Theory and policy, (second edition)
4. N. G. Mankiw: Macroeconomics (fourth edition)
5. P.A. Samuelson and W.D. Nordhaus: Macroeconomics (sixteenth edition)
6. R. Dornbusch, S. Fischer and R. Startz: Macroeconomics (9th
edition)