Classical school of thought rose after the mercantilist doctrine and were famous for attacking and successfully refuting it.
Classical economics is really the start of economics as we know it.
They did not have a macroeconomic theory as such, but their ideas could be interpreted in a macroeconomic framework. In fact, it should be noted that, there was and is no unified Classical macroeconomic theory because macroeconomics as such did not exist before Keynes
Influential classical economists included:
▪ David Hume (1711-76) ▪ Adam Smith (1723-90) ▪ Thomas Malthus (1766- 1834) ▪ David Ricardo (1772- 1823) ▪ John Stuart Mill (1806- 1873) ▪ Karl Marx (1818-1883) ▪ Alfred Marshall (1842- 1924) ▪ Arthur Pigou (1877-1959) ▪ Jean-Baptiste Say (1767- 1832)
Classical economists focused on real assets, rather than financial assets, as being important because they determined the productive capacity of an economy.
They also argued that markets would act to co-ordinate peoples plans (i.e. the “invisible hand” of Adam Smith).
They believed that government intervention was not necessary in the economy. This is because given flexible prices and wages economy will return fairly rapidly to the neighborhood of long-run equilibrium at the natural rate of unemployment in case of any shock.
We will look at the different strands of thought and attempt to present them in a unified fashion using our AS-AD framework.
Aggregate Supply
Workers and firms in the labor market were thought to learn reasonably quickly about their economic environment. Prices and wages were also thought to adjust quickly and fully to economic changes. Firms also acted to maximize the profits of their owners
If the price level increases, then both workers and firms learn about this reasonably quickly. Firms increase the quantity of labor they demand and workers decrease the quantity of labor they supply at the initial nominal wage. The nominal wage is bid up to the point where the new real wage is exactly equal to the old real wage. The aggregate supply curve is thus vertical. The only things that were thought by the Classical economists to change the position of the AS curve were changes in:
▪ The capital stocks.
▪ Technology.
▪ The skills of the workers.
Aggregate Demand
The Classical theory of aggregate demand centers around the quantity theory of money. The basis for this theory is the equation of exchange: MV = PT
where,
M = the quantity of money in circulation.
V = the transaction velocity of money.
P = the price level.
T = the volume of transactions.
The equation of exchange is an identity, in that it must hold always. Classical economists argued that there were three factors that affected the equation of exchange.
- Constant Short-Run Transactions Velocity of Money
The transactions velocity of money was assumed to be fixed in the short-run and determined by institutional factors involved with the payment habits and the payment technology of society such as:
✓ The average length of the pay period (e.g. shorter pay periods implied a smaller average holding of money for any income level and hence the velocity would increase).
✓ The prevalence of trade credit among businesses. (high ⇒ low V
✓ The practice of using credit cards. (a lot ⇒ low V)
2.Volume of Transactions Proportional to Real Output
The volume of transactions was assumed to be equivalent to the level of real output produced in an economy and was regarded as determined by factors controlling the labor market and production technology. This meant that we can replace T by Y, where Y is output, and that output is fixed given the preferences of workers and firms, the level of technology, and the amount of capital available.
3.Exogenous Money Stock.
The money stock was determined by factors such as the government and taken as given.
The three assumptions imply the quantity theory of money, MV = PY
A change in the money stock feeds through into the price level, but has no impact on output. This can be modelled as assuming a downward sloping AD curve which depends only on the stock of money.
Equilibrium Output and The Price Level
If the money stock increases, then AD (as the quantity theory is only an implicit theory of aggregate demand) increases but the only thing that happens is that the price level increases. It is a story of “too much money chasing too few goods”, so that prices increase to restore equilibrium.
Equilibrium Interest Rate
The Classical theory predicts that the price level and output level are determined independently of the interest rate.
The role of the interest rate is to stabilize aggregate demand. The interest rate was considered to be determined in what they called the market for loanable funds, the market in which bonds are sold and bought, which today we would call the credit market.
Net Suppliers of Bonds (Net Borrowers)
Firms routinely undertake investment projects. The firms look at the expected profitability of the projects which depend (positively) on future expected demand, and (negatively) on interest costs. Investment is thus expected to depend negatively on the interest rate.
Government need to fund their deficits through borrowing. It is assumed that this depends on government expenditure and taxation, both of which are not affected by other economic variables, that is they are exogenous and were affected by such things as wars and natural disasters.
Net Purchasers of Bonds (Net Lenders)
Households save for the future. Since saving is forgoing consumption today some payment is required to induce people to do this with positive interest rates reward people for saving. It was assumed that a higher interest rate will induce people to save more today (and thus consume less today).
Market for Loanable Funds
The equilibrium interest rate ensures that the amount of bonds supplied by borrowers equaled the amount of bonds demanded by the lenders.
Say that firms believe that future demand would be higher and thus believe that more investment projects are profitable than currently is the case. The demand for loanable funds would shift to the right
The increase in the demand for loanable funds leads to the following series of changes in behavior. First, an increase in the interest rate. Then the higher interest rate leads to a smaller number of extra projects going ahead compared to the increase in demand at the initial interest rate (although some new projects do still get undertaken).
The higher interest rate also leads to an increase in the supply of loanable funds because the higher interest rate increases savings by the lenders. The increased saving by households is achieved by reducing the amount of consumption undertaken. • Overall, the increase in the demand for investment goods exactly matches the decrease in the demand for consumption goods and so AD is unaffected. This shows how the interest rate acts as a stabilizing mechanism in the Classical model.
Main views of classical macroeconomics
- Money supply changes have no effect on current output, and only affect the price level.
- Changes in government expenditure have no effect on current output and only affect the interest rate, and the amount of investment and consumption undertaken.
- Changes in the overall level of taxation do not affect current output.
- Changes in marginal tax rates can cause current output to change.
Implications of classical macroeconomics
- Traditional government policy tools will not affect output or employment.
- Traditional government policy tools will in fact add instability or decrease future output.
- Markets quickly adapt to economic changes.
- There is a basic stability about the economic system when left to itself.
- Given 1-4, if the economy does work this way, then letting markets work properly is the best thing that governments can do (i.e. get rid of taxes, subsidies, price controls like minimum wages etc.).
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