Classical macroeconomics is the theory and the classical model of the economistsAdam Smith, David Ricardo, John Mills and Jean Baptiste Say. Below theassumptions of the classical macroeconomics are described. 1. Assumptions:? Competitive markets: Classical theories all make many assumptions aboutthe markets and their competitiveness.these assumptions are that all the marketsare easy to enter and exit. No monopoly elements are present in the market toprevent newcomers from entering the market or stopping the present ones fromquiting the market. Pricess and wages are flexible in both upward and downwarddirections according to the demand and supply forces.
No single seller or buyerof a product has sufficient market power to influence the industry price, nordoes any supplier or purchaser of labor services have sufficient market power toinfluence the market wage rate. Thus all economic agents are price-takers andnot price-setters. Because the markets are competitive, a disequilibrium canonly exist for a short period of time which economists call the short run. Thefirm can not change some of its aspects of operation.
So every firm has somefixed inputs while the pricess and the wages are changing and flexible. So, iffor some reason the product market were experiencing excess demand in someindustry, with quantity demanded greater than quantity supplied, prices wouldrise until quantity demanded once again equaled quantity supplied. The rise inprice returns the market to equilibrium. On the factor side, if there were anexcess supply of workers, wages would decline until equilibrium in the labormarket was restored and everyone who wanted to work can find a jobwhich iscalled the full employment. ? Perfect information: In classical theoryall economic decision-makers are assumed to be operating by having all theinformation they needed to make the best decisions. The cost of acquiringinformation, transactions costs are so low that they can be assumed to benegligible. So, consumers, producers and workers know the prices and wagesexisting among traders in the markets and aware of their options and newproducts which recently entered the market. No one would be privy to somespecial information providing them with an advantage for long. ? Fullemployment: As a result of the above assumptions, a prediction of the classicalsystem is that is essentially operates at full employment on a long-runequilibrium path over time. While in the short run unemployment can result, itcant exist permanently because wage rates fall when there is excess supply oflabor. As workers compete for jobs,then by the law of demand wage rates fall andthe quantity of labor services hired by firms increases. Alternately, if therewere a labor shortage, the wage rate would rise as firms compete for workers.
The classical model incorporates the notion that the economy is on a long-runmoving equilibrium path, and any deviations from long run equilibrium are norpermanent because wage and price flexibility can remove excess demands or excesssupplies. Let us summarise the assumptions we made above: 2. SAYs Law : Theequilibrium real wage defines full employment of the labor force, and fullemployment of the labor force ( with a given production function ) defines thefull employment level of output. Classical theory found no obstacle to theattainment of these positions as long as the money wage was flexible – that is,as long as it would fall in the face of unemployment. The possibility that thislevel of output once produced wouldn’t find a market was dismissed; Say’s Lawruled out any deficiency of aggregate demand. Say’s Law, simply states that” supply creates its own demand. ” More precisely it states thatwhatever the level of output, the income created in the course of producing thatoutput will necessarily lead to an equal amount of spending and thus an amountof spending sufficient to purchase the goods and services produced. Thus, ifoutput is below that which can be produced with a fully employed labor force,inadequate demand can not stand in the way of an expansion of output. As long asthere are idle resources that can be put to work, the very expansion of outputresulting from the utilization of such resources will create a proportionaterise in income that will be used to purchase the expanded output. In this way,this law, denied that involuntary unemployment could be caused by a deficiencyof aggregate demand. 3. Markets The equilibrium levels of output and employmentare determined in the classical system as soon as we are given (a) the economy’sproduction function, from which is derived the demand curve for labor, and (b)the supply curve of labor. ? Goods market: P S P1 Pe A D D S,D First,let us show the supply of a good and demand for a good on the horizontal axis,and the price of that good on the vertical axis. Demand for a certain gooddepends on its price.Demand is an inverse function of the price, whereas thereis a positive relation between supply and price. Pe is the equilibrium price,that is at point A, quantity supplied is equal to quantity demanded. With theeconomy already operating at capacity, a rise in the aggregate demand from D toD’ will have zero effect on output and 100% effect on prices. The price levelwill increase from Pe to a new equilibrium level P1. Classical economists alsoregarded this apparatus as reversible. A fall in the demand would lower theprices, with no effect ( or at most a temporary effect ) on output. Labor market: W SN A DN SN,DN As we can see from the graph above the labor supply ( SN ) isa direct function of the wage, whereas the amount of labor hired or demanded (DN ) is an inverse function of the wage. In this system, both workers and thefirms that employ them, are maximizing their units. Firms will not hire morelabor at a lower wage rate if the prices at which they can sell their outputfalls proportionately with the money wage rate. Of relevance to the firm is thecost of a unit of labor relative to the price at which the firm’s ouput sells-itis the real wage that counts in the same way, workers will not supply more laborat a higher money wage rate if the prices of the goods purchased with theirwages rise proportionately with the money wage rate. Of relevance to the workeris the money wage received per unit of labor supplied relative to the prices ofthe goods that can be purchased with that money wage-it is the real wage thatcounts. The intersection of the supply and demand curve for labor determines thelevel of employment and the real wage. At point A, there is equilibrium betweenthe supply and demand for labor. In the classical scheme of things, any wagerate other than the equilibrium wage rate, in a system of competitive marketswill generate forces causing the wage rise or fall by the amount necessary toestablish equilibrium in the labor market. The equilibrium level of employmentso determined is also the full employment level; that is, at this level allthose who are able, willing and seeking to work at prevailing wage rates areemployed. Since any other level of employment is a disequilibrium level, afamiliar proposition of classical theory is that the equilibrium position in themarket for labor is necessarily one of full employment. Whatever unemployment,apart from frictional unemployment, persists in the face of this equilibriummust be voluntary unemployment. ? Capital market: i S A I S,I Classicalmodel fails to break aggregate demand down into demand for consumption goods anddemand for capital goods. We must recognize that not every dollar of incomeearned in the course of production is spent for consumption goods; some part ofthis income is withheld from consumption, or saved. A part of classical theoryprovides the mechanism that assures that presumably planned saving will notexceed planned investment. This mechanism is the rate of interest. Classicaltheory treated saving as a direct function of the rate of interest andinvestment as an inverse function. Competition between savers and investors willmove the rate of interest to the level that equated saving ( S ) and investment( I ). If the rate were above the equilibrium rate, there would be more fundssupplied by savers than demanded by investors, and the competition among saversto find investors would force the rate down. If the rate were below theequilibrium rate, competition would force the rate up. 4. Money: Traditionallyin economics money has been defined as any generally accepted medium ofexchange. A medium of exchange is anything that will be accepted by virtuallyeveryone in a society in exchange for goods and services. Money has severalfunctions. It acts as a medium of exchange, as a store of value and as a unit ofaccount. ? A Medium of Exchange If there were no money, goods would haveto be exchanged by barter, one good being swapped directly for another. He majordifficulty with barter is that each transaction requires a double coincidence ofwants. For an exchange to occur between A and B, not only must A have what Bwants, but also B must have what A wants. If all exchange were restricted tobarter, anyone who specialized in producing one commodity would have to spend agreat deal of time searching for satisfactory transactions. The use of money asa medium of exchange removes these problems. People can sell their output formoney and subsequently use the money to buy what they wish from others. Thedouble coincidence of wants is unnecessary when a medium of exchange is used. Toserve as an efficient medium of exchange, money must have a number ofcharacteristics. It must be readily acceptable. It must have a high valuerelative to its weight. It must be divisible, because money that come only inlarge denominations is useless for transactions having only a small value. 5.
The Quantity Theory Of Money In the early classical tradition, all intermediatetransactions involving money were accounted for in the equation of exchange. Butmost people are concerned about the level of income that an economy generates,because it is income that determines the standard of living that people enjoy.
Therefore, the relation between money and income should be emphasised. Theequation of exchange is; MV=PY where, M is the money supply, V is the velocityof money, P is the general price level and Y is the physical output. M is thestock of money. It is the supply of money at a given time. Velocity of the moneymeans the number of times the money supply is used to purchase goods. Theclassical economists assumed that the velocity of the money was constant. Theybelieved the institutional, structural and customary conditions determined thevelocity. P is the general price level. It is an average of prices of all thosefinal goods and services provided and exchanged in the economy over the timeperiod chosen for observation. The classical macroeconomists assumed that,because of full employment and flexibility of price, wage and interest, physicaloutput would be constant. As a result, a change in the amount of money supplywill cause a proportional change in the general price level. This is called”The Quantity Theory of Money “.
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PURVIS, Douglas D. 4. Principles Of Economics; SCOTT, Robert Haney NIGRO.
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