Classical dichotomy

Classical Economics Assumptions

(supply side economics)
Classical theory of output and employment is
based on the following 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.
 [Link] is perfect information on the part of all market
participants
 [Link] 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.
 Say's Law of Markets
 Say's law of markets is the core of the classical theory of employment.
 J.B. Say, pronounced that "supply creates its own demand.“
 Therefore, there cannot be general overproduction and the problem of
unemployment in the economy.
 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.
 Determination of
output and
Employment
 In the classical theory, output and employment are determined by the
production function and the demand for labour and the supply of
labour in the economy.
 Given the capital stock, technical knowledge and other factors, a
precise relation exists between total output and amount of
employment, i.e., number of workers. This is shown in the form of the
following production function:
 Q = f (K,T,N)
 where total output (Q) is a function (f) of capital stock (K), technical
knowledge (T), and the number of workers (N).
 Given K and T, the production function becomes Q = f (N)
which shows that output is a function of the number of workers.
 Output is an increasing function of the number of workers.
 But after a point when more workers are employed, diminishing
marginal returns to labour start.
 This is shown in Fig. 1 where the curve Q=f(N) is the
production function and the total output OQ1 corresponds to the
full employment level NF.
 But when more workers NF N2 are employed beyond the full
employment level of output OQ1, the increase in output Q1Q2 is
less than the increase in employment NFN2.
 Labour Market
determineEquilibrium
 In the labour market, the demand for labour and the supply of labour
the level of output and employment.
 The classical economists regard the demand for labour as the function of
the real wage rate: DN = f(W/P)
 where DN = demand for labour, W = wage rate and P = price level.
 Dividing wage rate (W) by price level (P), we get the real wage rate
(W/P).
 The demand for labour is a decreasing function of the real wage rate, as
shown by the downward sloping DN curve in Fig. 2.
 It is by reducing the real wage rate that more workers can be employed.
 The supply of labour also depends on the real wage rate :
 SN = f (W/P), where SN is the supply of labour. But it is an increasing
function of the real wage rate, as shown by the upward sloping SN curve in
Fig. 2.
 It is by increasing the real wage rate that more workers can be employed.
 When the DN and SN curves intersect at point E, the full employment
level NF is determined at the equilibrium real wage rate W/P0.
 If the wage rate rises from WP0 to WP1, the supply of labour will be more than its
demand by ds.
 Now at W/P1 wage rate, ds workers will be involuntary unemployed because the
demand for labour (W/P1-d) is less than their supply (W/P1-s).
 With competition among workers for work, they will be willing to accept a lower
wage rate. Consequently, the wage rate will fall from W/P1 to W/P0
 Wage Price
 Flexibility
The classical economists believed that there was always full
employment in the economy.
 In case of unemployment, a general cut in money wages would take the
economy to the full employment level. This argument is based on the
assumption that there is a direct and proportional relation
between money wages and real wages.
 When money wages are reduced, they lead to reduction in cost of
production and consequently to the lower prices of products.
 When prices fall, demand for products will increase and sales will be
pushed up. Increased sales will necessitate the employment of more
labour and ultimately full employment will be attained.
 Pigou explains the entire proposition in the equation : N = qY/W.
 In this equation, N is the number of workers employed, q is the fraction of
income earned as wages, Y is the national income and W is the money wage
rate.
 N can be increased by a reduction in W. Thus, the key to full employment is a
reduction in money wage. When prices fall with the reduction of money wage,
real wage is also reduced in the same proportion.
 Goods Market
Equilibrium
 In the classical analysis, the goods market is in equilibrium
when saving and investment are in equilibrium (S=I).
 This equality is brought about by the mechanism of interest rate
at the full employment level of output so that the quantity of
goods demanded is equal to the quantity of goods supplied.
 This is shown in Panel (A) of the figure where S=I at point E
when the interest rate is Or.
 Money Market Equilibrium

 The money market equilibrium in the classical theory is based on the

Quantity Theory of Money which states that the general price level (P)
in the economy depends on the supply of money (M).
 The equation is MV =PT, where M = supply of money, V = velocity of
circulation of M, P =Price level, and T = volume of transaction or total
output.
 The equation tells that the total money supply MV equals the total
value of output PT in the economy.
 Assuming V and T to be constant, a change in the supply of money
(M) causes a proportional change in the price level (P).
 Thus, the price level is a function of the money supply : P = f (M).
 The relation between quantity of money, total output and price level is
depicted in Figure 5 where the price level is taken on the horizontal axis
and the total output on the vertical axis.
 MV is the money supply curve which is a rectangular hyperbola. This is
because the equation MV = PT holds on all points of this curve.
 Given the output level OQ, there would be only one price level OP
consistent with the quantity of money, as shown by point M on the MV
curve. If the quantity of money increases, the MV curve will shift to the
right as M1V curve.
 As a result, the price level would rise from OP to OP1, given the same
level of output OQ. This rise in the price level is exactly proportional to
the rise in the quantity of money, i.e., PP1 = MM1 when the full
employment level of output remains OQ.
 Classical
dichotomy
 An important conclusion which follows from the
classical theory of output and employment is that
changes in the quantity of money affect only
nominal variables (i.e., money wages, nominal
interest rate, nominal GNP, money balances), and
have no influence whatsoever on the real variables
of the economy such as real GNP (i.e. output of
goods and services produced), level of employment
(i.e. number of labour-hours or number of workers
employed), real wage rate (i.e. wage rate in terms
of its purchasing power).
 Actually, as seen above in Fig. 3.7 according to classical full-
employment model, the nominal variables move in proportion to
changes in the quantity of money, while real variables such as GNP,
employment, real wage rate, real rate of interest remain unaffected.
 Classical economists explained that real variables such as GNP,
employment, real wage rate are determined by real factors such as
stock of capital, the state of technology, marginal physical product
of labour, households’ preferences regarding work and leisure.
 In the classical model based on flexibility of prices and
wages, changes in money supply affect only the price
level and nominal magnitudes (i.e., money wages, nominal
interest rate), while the real variables such as levels of
labour employment and output, saving and investment,
real wages, real rate of interest remain unaffected.
 That is, money is neutral in its effect on the real variables
of the economy.
 In the classical theory real variables such as levels
of output and employment, real wages, real rate of
interest, as mentioned above, depend on the stock
of capital (K), supply of labour (N) and the state of
technology (T) and are not affected by changes in
money supply.
 Thus, the nominal variables and the real variables are
determined by two different sets of factors. The
independence of real variables from changes in money
supply and nominal variables is called classical dichotomy.
KEYNES'S CRITICISM
OF CLASSICAL THEORY
 (1) Underemployment Equilibrium. Keynes rejected the
fundamental classical assumption of full employment equilibrium in the
economy.
 He considered it as unrealistic.
 The general situation in a capitalist economy is one of underemployment.
 This is because the capitalist society does not function according to Say's law,
and supply always exceeds its demand.
 We find millions of workers are prepared to work at the current wage rate, and
even below it, but they do not find work.
 Thus, the existence of involuntary unemployment in capitalist economies proves
that underemployment equilibrium is a normal situation and full employment
equilibrium is abnormal and accidental.
 (2) Refutation of Say's Law. Keynes disproved Say's
Law of markets that supply always created its own demand.
 He maintained that all income earned by the factor owners
would not be spent in buying products which they helped to
produce.
 A part of the earned income is saved and is not automatically
invested because saving and investment are distinct functions.
 So, when all earned income is not spent on consumption goods
and a portion of it is saved, there results in a deficiency of
aggregate demand. This leads to general overproduction and
general unemployment.
 (3) Self-adjustment not Possible. Keynes did not agree
with the classical view that the laissez-faire policy was essential for
an automatic and self adjusting process of full employment equilibrium.
 He pointed out that the capitalist system was not automatic and self-
adjusting because of the nonegalitarian structure of its society.
 There are two principal classes, the rich and the poor.
 The rich possess much wealth but they do not spend the whole of it on
consumption.
 The poor lack money to purchase consumption goods.
 Thus, there is general deficiency of aggregate demand in relation to
aggregate supply which leads to overproduction and unemployment in
the economy.
 Keynes, therefore, advocated state intervention for adjusting supply and
demand within the economy through fiscal and monetary measures.
 4. Investment is Equated to Saving by Changes in
Income:
 The classicists believed that saving and investment were
equal at the full employment level
 Keynes held that the level of saving depended upon the
level of income and not on the rate of interest.
 Similarly, investment is determined not so much by rate
of interest as by the marginal efficiency of capital
 5. Attack on Money Wage Cut Policy
 Keynes objected the Pigou’s notion that unemployment
will disappear if the workers will just accept sufficiently
low wage rates (i.e., a voluntary cut in money wage).
 He rejected Pigou s plea for wage flexibility as a means of
promoting employment at a time of depression
 Keynes pointed out that trade unions are an integral part
of the modern industrial system and they could certainly
resist a wage-cut policy.
 Strikes and labour unrest are the bad consequences of
such a policy
Keynesian Economics
 Keynesian economics is a macroeconomic theory of total spending in the
economy and its effects on output, employment, and inflation.
 It was developed by British economist John Maynard Keynes during the 1930s in
an attempt to deal with the effects of the Great Depression.
 The central belief of Keynesian is that government intervention can stabilize the
economy.
 Based on his theory, Keynes advocated for increased government expenditures
and lower taxes to stimulate demand and pull the global economy out of the
Depression.
 Subsequently, Keynesian economics was used to refer to the concept that
optimal economic performance could be achieved—and economic slumps could
be prevented—by influencing aggregate demand through economic intervention
by the government.
 Keynesian economists believe that such intervention can result in full
employment and price stability.
Keynesian Economics
and the Great
Depression

Keynesian economics is sometimes referred to as
“depression economics,” as Keynes’ “General
Theory” was written during a time of deep
depression—not only in his native United Kingdom,
but worldwide.
Keynes’ Growing Belief in
Government Intervention
 During Great Depression, the country output was low, and unemployment
remained high.
 The Great Depression inspired Keynes to think differently about the nature of the
economy.
 From these theories, he established real-world applications that could have
implications for a society in economic crisis.
 Keynes rejected the idea that the economy would return to a natural state of
equilibrium. Instead, he argued that, once an economic downturn sets in, for
whatever reason, the fear and gloom that it engenders among businesses and
investors will tend to become self-fulfilling and can lead to a sustained period of
depressed economic activity and unemployment.
 In response to this, Keynes advocated a countercyclical fiscal policy by which,
during periods of economic woe, the government should undertake
deficit spending to make up for the decline in investment and boost consumer
spending to stabilize aggregate demand.