Classical Theory of Income and Employment

The study of macroeconomics commences with the theory of national income determination and was
propounded by JM Keynes
Q = f (K, L)
Before preceding to the Keynesian model of output and income determination let us now proceed with the
classical theory of output, income and employment
The classical theory of employment was developed by the combined contribution of classical economist
such as Adam Smith, J. S. Mill, A. C Pigou, Ricardo etc.
The classical Postulates: / Assumptions
There is always full employment

 According to the Classical economist there is always full employment.

 They leads to the conclusion that market forces operate in the economic system which lead to
maintain full employment.
 If there is unemployment at any time then there is always tendency towards full employment,
provided that there is no any government or external interference with functioning of the
economy.
 There might be frictional or voluntary unemployment in the economy.

The wage rate is equal to the marginal productivity of labor

 Classical economist believe that in case of full employment wage rate is equal to the marginal
productivity of labor.
 Marginal productivity is measures by the addition to the production by employment of one
additional labor.

The economy is always in the state of Equilibrium

 The classical postulated that the economy is always in the state of equilibrium.
 They believed that full employment of the resources generates income on the one hand and goods
and services on the other
 The value of goods and services is always equal to the income generated through the process of
production
 The income earners spend their income on the goods and services is equal to the total social
expenditure.
 There is no general over production or underproduction over a period of production.
The classical postulates of the full employment economy are based on the assumption that the conomy
works on the principle of laissez-faire system has the following features:

i. There is no government control on the regulation of the private enterprise, of there is any
government intervention then the main aim is to ensure competition
ii. There is no monopolies and restrictive practices- if there is any it is eliminated by the law
iii. There is complete freedom for the choice for both consumer and the producers
iv. Market forces of the demand and the supply are fully free to take the their own course depending
on the demand and the supply function.

Money does not matter

 The classical economist treated money as a medium of exchange.

 In their opinion, money is only to facilitate transaction
 It does not play a significant role in determining the output and employment
 The output and employment are determined by the availability of the resource i.e. labor and
capital.

SAY’S Law of Market

Foundation of classical economics

 Say’s law is generally stated as supply creates its own demand or supply call forth its own
demand
 The logic behind this law is that the supply of goods and services itself generates sufficient
income to generate a demand equal to the supply of goods
 This is how supply creates its own demand
 In a barter economy people tend to specialize their production of goods and services which
they can produce relatively more efficiently though they consume many other goods and
services.
 They acquire other goods and services they consume in exchange for their own produce
 When they offer their produce in barter they create demand for other goods

For example

A farmer offers his surplus produce (say wheat) to the weaver in exchange for cloth. Thus the farmer
creates demand for cloth. The weaver who is need for wheat produce surplus cloth which created
demand for wheat. Thus supply of wheat created demand for wheat.
 (supply )Wheat – cloth (weaver) --- wheat (demand)

Implications of Say’s Law

1. Self-Adjusting Economy
 According to Say there is an automatic adjustment of each of the factor in the working of
the economy
 For example if supply increase demand also increase and the adjustment takes place
between them
 Hence government should not interfere in the working of the economy.
2. No general overproduction
 The general overproduction is impossible
 When there is increase in the production the income of the factors of the production
increase
 Consequently new demand is created and the increased stock of the goods is sold in the
market
Over production More Factor of Production income of the factor of Production
increases Increase in Demand  So market is clear (Demand = Supply)
3. No general unemployment
 Since general overproduction is impossible there is no general unemployment
 Even if there is unemployment it is temporary and disappears after some time
4. Flexibility in the wage rate:
 Wage cut creates the situation of full employment
 Hence the government should not adopt the policy of wage rigidity in the economy
 If there is wage rigidity the government should play active role to remove it
5. Policy implication
 Important for policy implication
 Economy is automatically adjustable and it works without external stimulus
 Therefore there is no need of the government interference in the economy.

Classical Theory of output and Employment

Assumptions
1. Individual are rational human beings and are motivated by the self interest
2. Perfect competition exists both in the product market and the factor market
 3. Individual does not suffer from money illusion
4. Laissez-faire condition prevails ( there is no government intervention)
5. There is closed economy which do not have international trade relations
6. Technology remains constant or techniques of production and business do not change
7. Money is only medium of exchange
8. Wages and price are flexible both upward and down ward
9. The labors are homogeneous
10. There is full employment in the economy

The classical economist believe that an stable equilibrium at full employment level is a normal situation
If there is no full employment in actual life there is always tendency towards full employment
Less than full employment is an abnormal situation which will disappear in the long run through
automatic adjustment
Flexibility in the wage and prices means that any change in these factors automatically adjusts the
economic system in such a way that ensures full employment
Thus working of the self- regulating mechanism under the classical system can be understood in the three
markets of the economy

Labor market, Product and the Money Market

Aggregate Production function

The aggregate production is central to the classical model as ir determines simultaneously the aggregate
output and the employment.
According to the classical economist the national output of a country at any period of time depends on the
capital and the labour employed.
As, it is the aggregate production used in reconstructed classical model can be expressed as
Y= f ( K, N)
Where Y is the aggeragate output, K = capital and N = Labour required to produce Y
The classical production function is constructed in the short run framework
The national output in the short run is therefore the function of the employment of the labour drawn from
the constant population
The model assumes also that the use of successive units of labour is subject to the law of diminishing
returns
In other words marginal productivity of the labour decreases with the increase in employment
According to the classical view, the level of output at which MPPL= 0 is the maximum possible level of
employment and national output.
Labour Market equilibrium:
According to the classical economist other things remaining the same wage rate flexibility assumes that in
a competitive market full employment is provided and full employment output is produced.
Real wage rate is determined by the demand and supply of labour in the labour market
Demand for labour is a negative function of the real wage rate and the supply of labour is a positive
function of the real wage rate
The real wage rate is determined at the point where demand for labour is equal to its suppl, and this level
also represent the full employment equilibrium level
If there exists some unemployment level then the labour compete for jobs and the real wage rate fall a fall
in the real wage rate will lead to the increase in the demand for labour and decrease in the supply of
labour
This will reduce the unemployment
According to the classical, unemployment is the result of the rigidity of the wage rate structure and the
interference in the automatic working of the economy of the labour market
In the classical system, full employment is achieved automatically due to wage-price flex ibility. For
instance, at a real wage (W/P) 1 there exists a situation of unemployment. Now, this excess supply of
labour (AB) will reduce the real wage rate until labour supply is equal to the labour demand. Ultimately,
real wage rate will decline to (W/P) F where aggregate labour demand is exactly matched by aggregate
labour supply.
It may be added here that the volume of output and employment in the classical system are determined by
only supply side of the market for output. Since the classical model is a supply-determined one, it says
that equiproportionate increases (or decreases) in both money wage and the price level will not change
labour supply.

Product Market Equilibrium

According to the classical economist full employment is maintained only when whole income generated
at full employment level is spent on the purchase of output
Total output comprise of the consumer goods and the investment goods
Again total income is partly spent on the consumer goods and partly saved
Hence part of the income is not consumed and must be spent on the investment goods
Total income = Total Output
C+S=C+I
S= I
Thus saving equals to investment is the market clearing equilibrium in the product market at full
employment level
According to the classical economist, equality between savings and investment is bought about through
the interest rate flexibility
Saving is the positive function of the rate of interest and investment is the negative function of the rate of
interest

The goods market equilibrium is achieved when saving is equal to investment, i.e. S = I
Figure shows how equilibrium rate of interest is determined in the classical model, independent of the
monetary sector. Saving curve (S) and investment curve (I) are equal to each other at point E where the
equilibrium volume of saving (SE) is equal to the equilibrium value of investment (I E). Interest rate is
flexible and it adjusts to maintain the equality between saving and investment.
If the interest rate is above the above the equilibrium rate, there will be excess savings which cause
interest rate to fall and the interest rate is below the equilibrium rate then then there will be increase in the
investment which will cause interest rate to rise at the original level.
Money Market Equilibrium
The classical economist believe in the quantity theory of money
According to the quantity theory of money the supply of money determines the price level in the economy
Irving Fisher equation of exchange states that the total expenditure on the final goods and services (MV)
is equal to the total value of goods and services (PY)
MV = PY
MV
Or P =
Y
Where M = quantity of money
Y = level of aggregate output
V= Velocity of money/ circulation of money
According to the classical economist level of aggregate output (Y) remains constant at full employment
level
They also assumed that the velocity of circulation of money V remains constant and stable
Thus Y and V along being constant the level of price is determined by the quantity of Money M and there
is direct relation between M and P
It means changes in the money supply lead to the proportional changes in the price level
At the full employment level of output OY, corresponding level is OP. when the supply of money
increases from MV to M1V there will be proportional increase in the price level form OP to OP1
Panel B of the figure represent the determination of the money wage rate (W/P) is the given real wage
rate line
When the price level increases the real wage rate also increases. The price-wage combination OW1 =
OP1 is consistent with the full employment real wage level (W/P) determined in the labor market.