Classical macroeconomics is the theory and the classical model of the economists Adam Smith, David Ricardo, John Mills and Jean Baptiste Say. Below the assumptions of the classical macroeconomics are described.
? Competitive markets: Classical theories all make many assumptions about the markets and their competitiveness.these assumptions are that all the markets are easy to enter and exit. No monopoly elements are present in the market to prevent newcomers from entering the market or stopping the present ones from quiting the market. Pricess and wages are flexible in both upward and downward directions according to the demand and supply forces. No single seller or buyer of a product has sufficient market power to influence the industry price, nor does any supplier or purchaser of labor services have sufficient market power to influence the market wage rate. Thus all economic agents are price-takers and not price-setters. Because the markets are competitive, a disequilibrium can only exist for a short period of time which economists call the short run. The firm can not change some of its aspects of operation. So every firm has some fixed inputs while the pricess and the wages are changing and flexible. So, if for some reason the product market were experiencing excess demand in some industry, with quantity demanded greater than quantity supplied, prices would rise until quantity demanded once again equaled quantity supplied. The rise in price returns the market to equilibrium. On the factor side, if there were an excess supply of workers, wages would decline until equilibrium in the labor market was restored and everyone who wanted to work can find a jobwhich is called the full employment.
? Perfect information: In classical theory all economic decision-makers are assumed to be operating by having all the information they needed to make the best decisions. The cost of acquiring information, transactions costs are so low that they can be assumed to be negligible. So, consumers, producers and workers know the prices and wages existing among traders in the markets and aware of their options and new products which recently entered the market. No one would be privy to some special information providing them with an advantage for long.
? Full employment: As a result of the above assumptions, a prediction of the classical system is that is essentially operates at full employment on a long-run equilibrium path over time. While in the short run unemployment can result, it cant exist permanently because wage rates fall when there is excess supply of labor. As workers compete for jobs,then by the law of demand wage rates fall and the quantity of labor services hired by firms increases. Alternately, if there were 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-run moving equilibrium path, and any deviations from long run equilibrium are nor permanent because wage and price flexibility can remove excess demands or excess supplies.
Let us summarise the assumptions we made above:
The equilibrium real wage defines full employment of the labor force, and full employment of the labor force ( with a given production function ) defines the full employment level of output. Classical theory found no obstacle to the attainment 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 this level of output once produced wouldn’t find a market was dismissed; Say’s Law ruled out any deficiency of aggregate demand.
Say’s Law, simply states that ” supply creates its own demand. ” More precisely it states that whatever the level of output, the income created in the course of producing that output will necessarily lead to an equal amount of spending and thus an amount of spending sufficient to purchase the goods and services produced. Thus, if output 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 as there are idle resources that can be put to work, the very expansion of output resulting from the utilization of such resources will create a proportionate rise 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 deficiency of aggregate demand.
The equilibrium levels of output and employment are determined in the classical system as soon as we are given (a) the economy’s production function, from which is derived the demand curve for labor, and (b) the supply curve of labor.
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 good depends on its price.Demand is an inverse function of the price, whereas there is 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 the economy already operating at capacity, a rise in the aggregate demand from D to D’ will have zero effect on output and 100% effect on prices. The price level will increase from Pe to a new equilibrium level P1. Classical economists also regarded this apparatus as reversible. A fall in the demand would lower the prices, with no effect ( or at most a temporary effect ) on output.
As we can see from the graph above the labor supply ( SN ) is a 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 the firms that employ them, are maximizing their units. Firms will not hire more labor at a lower wage rate if the prices at which they can sell their output falls proportionately with the money wage rate. Of relevance to the firm is the cost of a unit of labor relative to the price at which the firm’s ouput sells-it is the real wage that counts in the same way, workers will not supply more labor at a higher money wage rate if the prices of the goods purchased with their wages rise proportionately with the money wage rate. Of relevance to the worker is the money wage received per unit of labor supplied relative to the prices of the goods that can be purchased with that money wage-it is the real wage that counts.
The intersection of the supply and demand curve for labor determines the level of employment and the real wage. At point A, there is equilibrium between the supply and demand for labor.
In the classical scheme of things, any wage rate other than the equilibrium wage rate, in a system of competitive markets will generate forces causing the wage rise or fall by the amount necessary to establish equilibrium in the labor market. The equilibrium level of employment so determined is also the full employment level; that is, at this level all those who are able, willing and seeking to work at prevailing wage rates are employed. Since any other level of employment is a disequilibrium level, a familiar proposition of classical theory is that the equilibrium position in the market for labor is necessarily one of full employment. Whatever unemployment, apart from frictional unemployment, persists in the face of this equilibrium must be voluntary unemployment.
Classical model fails to break aggregate demand down into demand for consumption goods and demand for capital goods.
We must recognize that not every dollar of income earned in the course of production is spent for consumption goods; some part of this income is withheld from consumption, or saved. A part of classical theory provides the mechanism that assures that presumably planned saving will not exceed planned investment. This mechanism is the rate of interest. Classical theory treated saving as a direct function of the rate of interest and investment as an inverse function.
Competition between savers and investors will move 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 funds supplied by savers than demanded by investors, and the competition among savers to find investors would force the rate down. If the rate were below the equilibrium rate, competition would force the rate up.
Traditionally in economics money has been defined as any generally accepted medium of exchange. A medium of exchange is anything that will be accepted by virtually everyone in a society in exchange for goods and services.
Money has several functions. It acts as a medium of exchange, as a store of value and as a unit of account.
If there were no money, goods would have to be exchanged by barter, one good being swapped directly for another. He major difficulty with barter is that each transaction requires a double coincidence of wants. For an exchange to occur between A and B, not only must A have what B wants, but also B must have what A wants. If all exchange were restricted to barter, anyone who specialized in producing one commodity would have to spend a great deal of time searching for satisfactory transactions.
The use of money as a medium of exchange removes these problems. People can sell their output for money and subsequently use the money to buy what they wish from others. The double coincidence of wants is unnecessary when a medium of exchange is used.
To serve as an efficient medium of exchange, money must have a number of characteristics. It must be readily acceptable. It must have a high value relative to its weight. It must be divisible, because money that come only in large denominations is useless for transactions having only a small value.
In the early classical tradition, all intermediate transactions involving money were accounted for in the equation of exchange. But most 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.
M is the money supply, V is the velocity of money, P is the general price level and Y is the physical output.
M is the stock of money. It is the supply of money at a given time.
Velocity of the money means the number of times the money supply is used to purchase goods. The classical economists assumed that the velocity of the money was constant. They believed the institutional, structural and customary conditions determined the velocity.
P is the general price level. It is an average of prices of all those final goods and services provided and exchanged in the economy over the time period chosen for observation. The classical macroeconomists assumed that, because of full employment and flexibility of price, wage and interest, physical output would be constant.
As a result, a change in the amount of money supply will cause a proportional change in the general price level.This is called “The Quantity Theory of Money “.
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