What is Classical Economics?
While macroeconomics as a discipline may have started with Keynes, he was not the first to think about issues involving the economy as a whole. Economics usually labels those thinkers classical (or neoclassical) economists. These included Alfred Marshall, William Stanley Jevons, Arthur Cecil Pigou, John Bates Clark, Irving Fisher, and Knut Wicksell. The Classical economists believed in free market efficiency given a series of assumptions known as the First Welfare Theorem. The conditions of this theorem are that there is perfect information in the market, zero transaction costs, a large number of buyers and sellers, no externalities, and all transactions of voluntary. According to the classical school of thought, free markets functioned better than regulated markets as long as the conditions of the First Welfare Theorem held.
Macro is aggregated Micro
The classical economists did not differentiate between macroeconomic and microeconomic theory. They used their understanding of (micro)economic theory to analyze both micro and macroeconomic phenomena. Classical economists conceived of the macroeconomy as no more than aggregated microeconomics. Thus, what we now conceive of as aggregate supply was simply the sum of each firm’s production decision. Similarly, aggregate demand was the sum of all individual demand curves.
Gerard Debreu, in his 1957 book, Theory of Value proved the existence of a general competitive equilibrium. That is, if all markets are perfectly competitive, all firms maximize profits, and all individuals maximize utility, there is a set of prices at which all markets will be in equilibrium. This is the macroeconomic model of the Classical economists, and for this, Debreu won the 1984 Nobel Prize.
One topic that the classicals did recognize as being economy-wide was business cycles. However, classical tools to analyze business cycles were rather primitive by modern standards. Another topic was inflation, or the rate of change of the aggregate level of prices.
Focus on the Supply Side
Classical economics focused on the supply side of the economy. Specifically, Jean Baptiste Say’s Law dominated classical economic thought: Supply creates its own demand. Say meant that production creates income that provides enough purchasing power to purchase all the goods being produced, no more and no less. One hundred dollars worth of goods produced creates one hundred dollars worth of income. The critical assumption in this theory is that there is no hoarding. All income is either spent or saved. All saving is invested so that all income stays in circulation. In this model, excess supply in one market must be balanced with excess demand in another; there can be no such thing as economy-wide excess supply. This conclusion is known as Walras’ law. A shift in relative demand will result in changes in relative prices; if one good is more desirable it will rise in price, while less desirable goods will fall in price. The aggregate price level will not change.
Analysis starts with the Labor Market
The classical view of the economy begins with the labor market. Profit maximizing firms hire labor up to the point where the marginal revenue product, or the additional revenue gained from one extra unit of labor, equals the wage rate. (In real terms, the real demand for labor is its marginal productivity. The real demand equals the real wage, that is, the nominal wage divided by the price level.)
Given the supply of labor, the wage rate will adjust to insure full employment.
Analysis proceeds to the Product Market
Equilibrium employment thus served as the source of aggregate supply. Given the equilibrium level of employment, the aggregate production function determines the equilibrium left of output.
Thrift & Enterprise determine the Composition of GDP
There are two key parameters or behavioral coefficients in the Classical model: thrift and enterprise. Thrift can be thought of as economic agents’ propensity to save, and is based on their willingness to defer present for future consumption. Enterprise can be thought of as their propensity to invest, which is dependent on the availability of investment opportunities or the rate of return on capital. Thrift and enterprise are fixed in the short run; changes in either and have no effect on the level of GDP, only on its composition.
[ Insert graph of Loanable Funds model? Attributed to D.H. Robertson ]
For example, if there was an autonomous increase in saving (an increase in “thrift”), the real interest rate would decrease as the supply of loanable funds increased. The lower interest rates would induce entrepreneurs to borrow the “extra” saving. Thus, if GDP is the sum of consumption (C) and Investment (I), and C decreases (as saving increases), I increases by the same amount, and GDP stays exactly the same. As another example, suppose there is some technological improvement that causes an increase in the rate of return on investment (an increase in “enterprise”). The desired increase in investment translates to an increase in demand for loanable funds, leading to a higher real interest rate. The higher interest rate induces an increase in saving to finance the investment. As a result, consumption decreases and investment increases, while overall output stays the same.
The Classical Dichotomy Segments the Economy into Real & Financial Sides
The Classical analysis of the macro-economy led to what is now known as the classical dichotomy. The economy has two sides, real and financial. The real side includes the real variables in the economy, including output and employment, while the financial side includes all nominal factors of the economy, such as the aggregate price level and nominal interest rates. The notion of a dichotomy means that nominal factors only influence financial side of the economy, never the real side. As we noted above, real variables are determined entirely on the supply side of the economy: employment is determined in the labor market, and output is determined by the aggregate production function.
This implies a vertical aggregate supply curve based on the available resources, with factor prices adjusting so that all resources are fully employed, and output prices adjusting for all goods and services to be purchased. As a consequence, aggregate demand has no effect on the levels of output or employment. The only way to change output or employment is either an increase in the supply of labor or an increase in labor productivity, which would shift the aggregate supply curve to the right.
This is easy to see in the labor market. Since employment is defined by the intersection between labor demand and labor supply, and both are multiplicatively functions of the price level, an increase in aggregate demand raises both labor supply and labor demand proportionately, so that AD has no effect on the equilibrium level of employment and thus none on real GDP.
Quantity Theory of Money
The Classical view of aggregate demand was the Quantity Theory of Money. The Quantity Theory is, based on the equation of exchange: MV = PQ, where M is the supply of money, V is the velocity of money (the average number of times a dollar is spent in a year), P is the aggregate price level and Q is real GDP. The equation of exchange is an identity, but the classicals reinterpreted it as a behavioral relationship as follows: Let M represent money demand (MD). Then MD=(1/V)PQ or MD=kPQ where k=1/V.
This means that the demand for money, MD is proportional to nominal GDP (PxQ) or income. An increase in real income (Q) means that people spend more, so they need to hold more money, which means the demand for money increases. Also, if the price level increases the demand for money similarly increases, because people must carry more cash to have equivalent purchasing power.
The model is completed by adding the equilibrium condition that MS=MD.
Consider an increase in money supply so that MS>MD. Since velocity was assumed to be constant, and since output (Q) was at potential, the resulting increase in spending can only increase the price level.
Graphically, the increased money supply shifts aggregate demand curve to the right, increasing the price level. But this change only affects nominal factors, not any real factors. Because the classical economists assumed that labor was always at full employment, there are no labor resources that could be devoted increasing output, as indicated by the inelastic aggregate supply curve.
On the other hand, inflation must be caused by increases in the money supply. The solution is simple—the monetary authorities need to rein in money creation.
The Quantity Theory of Money was later reinterpreted by Milton Friedman and the Monetarists. See Chapter #.
Economy-wide Unemployment isn’t likely
In classical thought, the labor market determines employment. At the equilibrium wage rate, everyone who wants a job will have one. Unemployment was believed to be caused by people choosing not to work for low wages. Unemployment occurring in one sector of the economy was the result of a change in consumer demand away from that sector’s products towards another sector’s products. The result should be lower wages in the former sector and rising wages in the latter. Over time, labor should migrate from the former to the latter. Unemployment then is a sectoral problem and exists when people choose not to work for low wages or when they choose not to migrate.
Widespread unemployment simply should not occur, according to classical theory. If it did, the cause must be “sticky” wages—wages that don’t adjust downward, due to market imperfections such as unions. Labor unions interfere with the economy’s movement towards full employment because they push up wages and make workers less willing to relocate for new work. Over time though, unemployment should disappear.
Classical Views on Fiscal Policy
Classical economists conceived of fiscal policy in much more limited terms than it is viewed today. The notion of discretionary policy was not widely accepted, since the only responsible fiscal policy was a balanced budget. Thus, expansionary fiscal policy, for example increasing government spending without increasing taxes to stimulate the economy, was not generally considered by policy makers. Since the economy was assumed to be at potential output, an expansionary policy could only lead to higher prices. (Later, the Monetarists would interpret this as leading to complete “crowding-out.”) Similarly, an increase in net exports would only change the composition of output towards export goods and away from domestically consumed goods (C & I). Again, there is no effect on the level of GDP.
[ The Classical school was the primary school of thought in economics until the 1930’s and the time of the Great Depression. The shortcomings of the Classical school became extremely evident when its practitioners were unable to explain the extraordinary decline in economic activity and increase in unemployment during the 1930s. The Classicals were mostly criticized for being unable to see the importance of the short-run changes that were taking place. Their models which held many variables fixed and focused on the supply side of the economy could not give a viable answer for what was happening. This brought about a great deal of criticism from many analysts and cast the entire economics discipline in a bad light, much like what happened after the Great Recession of 2007-09. Nonetheless, Classical economics is the jumping off point for understanding all modern macroeconomic theories, since in one way or another they change or relax the assumptions first discussed in the Classical school of thought to derive a more realistic model. ]