SEBI Gr A 2020

Economics
Phase
1&2
Classical approach to determination of
output and employment
Who were Classical Economists?
• Classical economics or classical political economy is a school of thought in
economics that flourished, primarily in Britain, in the late 18th and early-
to-mid 19th century.
• Its main thinkers are held to be Adam Smith, Jean-Baptiste Say, David
Ricardo, Thomas Robert Malthus, and John Stuart Mill.

• Classical Economists believed that in a free-market economy there was

always a tendency towards the establishment of full employment of
labour and there was a sufficient demand for the output produced.
• They justified that ‘frictional unemployment’ could be there due to
people switching jobs, but involuntary unemployment could not be
sustained for long.
 Concept check

Q. According to Classical economists, which kind of

unemployment may exist in the economy?

(a)Structural unemployment
(b)Involuntary unemployment
(c)Frictional unemployment
(d)Cyclical unemployment

Answer: (c) Frictional unemployment

 Assumptions of Classical Economists
1. Full Employment 2. Closed Economy

All people willing to work at

prevailing wage rate are employed
Foreign
in an economy.
Sector
I deserve better
wages. I will wait
for better job.
3. Laissez Faire
Is this person
unemployed? Government
No Govt.
Interference

Why?
Demand Supply
Because he is voluntary
unemployed.
 Assumptions of Classical Economists

4. Perfect Competition in Labour and 5. Total output of the economy is

Product Markets divided between consumption and
investment expenditures

Y = C + S
Or
Y = C + I

Where, Y = Total Output/ Income

C = Consumption Expenditure
S = Savings
I = Investment Expenditure
• Also, the Labour is Homogenous.
 Assumptions of Classical Economists

6. Quantity of money is given and money is only used for transaction purposes (only as
a medium of exchange).

7. There is perfect information on the part of all market participants.

8. Money wages and real wages are directly related and proportional.

9. Savings are automatically invested and equality between the two is brought about
by the rate of interest.

When Savings > Investment = Rate of Interest

When Investment > Savings = Rate of Interest

10. Capital stock and technical knowledge are given.

11. It assumes long run.

 Assumptions of Classical Economists

12. ‘Law of diminishing returns’ operates in production

The law of diminishing marginal returns states that, at some point, adding an additional
factor of production results in smaller increases in output.
Assumptions of Classical Economists
 Assumptions of Classical Economists

13. Wage- Price Flexibility

The classical economists assumed that there was always full employment in the financial
system. In case of redundancy, a usual slash in remuneration will achieve the full employment
level.

Due to reduction
When
Cost of It will lead to in Prices,
Remuneration or
Manufacturing lesser price of Demand of
wages are
will reduce commodities Products will
slashed
increase.

This is also
called ‘Pigou Enhanced sales
effect’ or ‘Real Full Employment Due to high
will require the
balance will be demand, Sales will
employment of
effect’. accomplished go up.
more labour
 Basic Pillars of Classical Theory

Classical theory of output and Employment is based on two basic notions:

1. Say’s Law of Market
2. Quantity Theory of Money

Say’s Law of Market

Say’s law of markets is the core of the classical theory of employment.

“Supply creates its own demand”

• Therefore, there cannot be general overproduction and the problem of unemployment

in the economy.
• Thus, Classical economists rules out the possibility of overproduction, there being no
problem in selling the output produced.
• Acc. to say’s law, greater production automatically leads to a greater money income
which creates the market for the greater flow of goods produced.
 Basic Pillars of Classical Theory

• According to this theory, the income which is not spent on consumer goods and
thus saved will become investment expenditure.
• Therefore, Investment Expenditure = Savings
• In this way, a given productive capacity continues to be fully utilized and no
problem of deficiency of demand arises.
 Classical theory of Employment and Output (Income)

The short run classical theory of Income and Employment can be explained through
the following three stages:
1. Determination of Income and Employment, when there is no saving and investment.
2. Determination of Income and Employment in an economy with saving and
investment
3. Determination of income and Employment: Role of money and prices

Determination of Income and Employment, when there is no saving and investment

• According to the classical theory, the magnitude of national income and employment
depends on the aggregate production function and the supply and demand for labour.
• To show this let us assume that the economy produces one homogeneous and
divisible good, say corn.

To produce this good we require two factors of production: Y = Output of this good (corn)

N K
(Labour) (Capital)
 Classical theory of Employment and Output (Income)
• Thus we have the following aggregate production function
Y = F (K, N)
• In the short run the stock of capital (i.e. plant and equipment) is assumed to be
fixed. The state of technology and the population are also assumed to be constant in
the short ran.

• So, the output Y (or what is also the real income) would increase only when
employment of labour N increases. That is, employment of labour and output
(income) rise or fall together.

• Further, assuming that the firms which undertake the task of production attempt to
maximise profits, they will employ labour until the marginal product of labour is
equal to the given real wage rate.
• It may be noted that real wage rate is given by nominal wage rate divided by the
general price level
Real wage rate = W/P
where W is the nominal or money wage rate
P is the average price level.
 Classical theory of Employment and Output (Income)
Thus, a firm will employ so much labour at which
W/P = MPN
where MPN stands for marginal product of labour.
Classical theory of Employment and Output (Income)
 Concept check

Q. If the real wage is above the equilibrium level in the labour

market:

(a) The quantity demanded of labour is higher than the quantity supplied
(b) The quantity demanded of labour equals the quantity supplied
(c) The quantity demanded of labour is lower than the quantity supplied
(d) None of these

Answer: (c) The quantity demanded of labour is lower than the

quantity supplied
 Classical theory of Employment and Output (Income)
Determination of Income and Employment, when there is saving and investment
In applying Say’s law that supply creates its own demand an invalid assumption was
made above that entire income earned by the households will be actually spent.
What happens when part of income is saved?
• Saving represents a withdrawal of some income from the expenditure flow.
• This will result in deficiency of demand or expenditure on output of goods
produced.
• Thus, if a part of income is saved (that is, not spent), supply of output produced
would not create sufficient demand for itself.
• This will cause deficiency of aggregate demand which will cause fall in output and
employment and the emergence of involuntary unemployment.
• However, classical economists denied the possibility of deficiency of aggregate
demand even when a part of income is saved by the households.
• They showed that Say’s law that supply creates its own demand holds good even in
the presence of saving.
• They argued that every rupee saved by households will be invested by businessmen,
that is, investment expenditure will be equal to savings done by households.
 Classical theory of Employment and Output (Income)

How in Classical theory savings become equal to

Investment Expenditure?

• Acc. to the classical theory, it is the rate of Interest

which makes Investment equal to saving.
• When savings of the people increase, the rate of
interest declines.
• As a result of the fall in the rate of interest, demand
for investment rises and in this way investment
becomes equal to the increased savings.
• In other words, it is changes in the rate of interest
due to which the withdrawal of some money from
the income stream as a result of savings
automatically comes back to it in the form of
investment expenditure.
• Therefore income flow continues unchanged and
supply goes on creating its own demand.
 Classical theory of Employment and Output (Income)
Determination of income and Employment: Role of money and prices

• Now, we shall examine how full employment of labour is assured in the classical theory
even when money is introduced in the system.
• The introduction of money does not affect the result of the classical theory that problem
of deficiency of aggregate demand would not be experienced by the free-market system
and therefore full employment of labour is guaranteed.

Quantity theory of Money

• Acc. to this theory, supply of money determines price level in an economy.

• It is generally expressed by Fisher’s equation of exchange:
MV = PY
Where, M = Quantity of Money
V = Velocity of Money
P = Price level of goods and service
Y = Level of aggregate output ( or real income)
• Velocity of money is defined as the number of times a unit of money is used for
purchase of final goods and services in a period, say during a year. In classical
theory velocity is assumed to be constant.

• Further, due to operation of Say’s law and wage-price flexibility, full employment of
resources occur in the economy. Hence, the aggregate output (Y) is held constant at
full-employment level of output in the short run.
• Therefore, we have shown aggregate supply curve as a vertical straight line which
shows that whatever the price level, aggregate output remains constant.

• Now, with V and Y remaining constant, increase in

money supply will cause proportionate increase in the
price level.

MV = PY

MV = Aggregate Expenditure

Aggregate Expenditure = C + I + G + NX
= Aggregate Demand
 Classical theory of Employment and Output (Income)

Classical Aggregate Supply curve

• Aggregate supply curve describe the relationship

between aggregate supply of output with price
level.
• Classical theory regards aggregate supply curve
to be perfectly inelastic.

Why in classical model, aggregate supply curve

is perfectly inelastic ?

• Because this model holds that the economy is at

its full employment level.
• That means that even if demand increases, firms
can't hire new workers and expand because
everyone is already working.
• So in case of increase of demand, Price increases
 Classical theory of Employment and Output (Income)

How with changes in price level, which in the classical theory depends on the
quantity of money, leave level of employment and output unaffected?

• The reason for this is that changes in price level causes equal proportionate changes
in money wage rate with the result that the equilibrium real wage rate which is given
by W/P remains constant and therefore equilibrium level of employment does not get
affected.

• If due to the increase in supply of money price level rises, with a given money wage
rate (W), real wage rate, which is equal to W/P, will fall.
• At a real wage rate lower than the equilibrium real wage rate, the quantity demanded
of labour will exceed the supply of labour.

• This disequilibrium between labour demand and supply will cause money wage
rate to rise to the level so that original real wage rate determined by labour
market equilibrium is restored.
Classical model of Employment and Output (Income)
 Concept check

Q. Suppose there is full employment and vertical aggregate supply

schedule. An increase in the nominal money supply-

(a) reduces the rate of interest and changes the composition of output
(b) causes a proportional increase in real output
(c) has no effect on the real money supply or the composition of output
(d) causes the real money supply to increase, which changes
composition of output

Answer: (c) has no effect on the real money supply or the

composition of output
 Concept check

Q. According to the basic classical model, an increase in the

money supply will cause

(a) the price level to increase

(b) output to increase
(c) employment to increase
(d) investment to increase

Answer: (a) the price level to increase

 Classical Dichotomy

• The classical theory of output and employment is that changes in the quantity of
money affect only nominal variables (i.e. money wages, nominal GNP, money
balances).
• It 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) etc.
• This independence of real variables from changes in money supply and
nominal variables is called classical dichotomy.
Happy Learning!