NATIONAL UNIVERSITY OF STUDY

AND RESEARCH IN LAW,

RANCHI

ECONOMICS PROJECT
Traditional Approach of Macroeconomics

SUBMITTED TO: SUBMITTED BY:

DR. SHWETA MOHAN NAME: AAPIR AKSHANSH
ASSISTANT PROFESSOR GAURAV
SEMESTER: I
SECTION: B
ROLL NO:1273

1|Page
 CONTENTS
1. DECLARATION………………………………………………………3
2. ACKNOWLEDGEMENT…………………………………………….4
3. INTRODUCTION……………………………………………………..5
4. CLASSICAL APPROACH OF MACROECONOMICS……………6
5. NEO-CLASSICAL APPROACH OF MACROECONOMICS……..11
6. CONCLUSION…………………………………………………………15

2|Page
 DECLARATION
I, Aapir Akshansh Gaurav, a first semester BBA LLB Student of National University Of Study
And Research in Law, Ranchi, at this moment declare that the project titled “Traditional
Approach of Macroeconomics” under the guidance of, Dr. Shweta Mohan Mam, faculty of
economics is an original work. I have made great efforts to complete this project and have not
misrepresented facts or data.

I assert the statements and conclusions are drawn are an outcome of my research work. I further
assert that, to the best of my knowledge and belief, proper references have been given and do not
contain any work that has been submitted to other universities.

3|Page
 ACKNOWLEDGEMENT
Thanking I would like to express my deep gratitude of thanks to my teacher Dr. Shweta Mohan
mam, who showed faith in me by providing me with this project. Her patient guidance, enthusiastic
and useful advices also played a very vital role in completion of the project. Due to this I was able
to complete the project without facing much difficulties. I would like to extend my gratitude to
each and every staff members of NUSRL, Ranchi for providing such a good library, I.T.
Department and infrastructure due to which I have been able to complete the project.

Finally, I would like to express my heartfelt gratitude to everyone who helped me in completing
the project without any problems.

Thanking you

NAME: AAPIR AKSHANSH GAURAV

SEMESTER: I

SECTION: B

ROLL NO.: 1273

4|Page
 INTRODUCTION
Macroeconomics is the study of an economy’s aggregate behaviour. Because what hold true for
the individual unit may not hold true for the aggregate, a special branch of macroeconomics is
required. For example, a company may be able to increase output in the short run to meet increased
demand for its product. However, if all firms want to increase their output level, it will be
impossible in the short run due to limited availability of resources, such as labour, unless there are
unemployed resources in the economy. As a result, an increase in demand may result in a price
increase without an increase in output.

We get aggregate output and aggregate price level for the economy by intersecting aggregate
demand and aggregate supply. Changes in aggregate demand or aggregate supply would have an
impact on input and price levels Different economists disagree on the mechanism and speed with
which such change occurs in the economy. In this project, we will discuss traditional approaches
to macroeconomics, specifically the Classical and Neo-Classical approaches.

5|Page
 CLASSICAL APPROACH OF
MACROECONOMICS

• INTRODUCTION TO CLASSICAL ECONOMICS

.Classical economics is a school of thaught in economics that emerged in the late 18th
Century and 19th Century, particularly in Britain. It emphasized economic growth and
freedom, promoting laissez-faire ideas and belief in free competition. The classical
macroeconomic structure is based on the works of well-known classic economists such as
Adam Smith, A.C. Pigou, Irving Fisher, and others. When their disparate writings are
combined, they produce a systematic and coherent macroeconomic framework. Classical
economic theory encouraged countries to transition from monarchy to capitalist democracy
with self-regulation. Classical economists believed in free trade and minimal government
intervention in economic activities. They advocated for a “leave us alone” economy in
which the government’s role should be limited to law, defence and governance. Market
forces will determine real variables such as output, employment, and prices in such an
economy. This is enabled by price and wage level flexibility.

FULL EMPLOYMENT
Classical economists believed that the economy would always be at or near full
employment. Full employment of not only labour but also other major resources such as
land, capital, and other factors of production. In the case of labour, for example, they
believed that in a free enterprise capitalist economy with a ‘flexible labour market’, all
labour would normally find employment. However, such full employment does not rule
out the possibility of temporary unemployment (i.e., unemployment for a limited time).
Classical economists, on the other hand, completely rule out long- term unemployment.
For example, temporary unemployment may occur as a result of a misalignment between
demand and supply of resources in a capitalist economy or economic frictions, such as
workers changing jobs or locations.
in the development of capitalist economy while full employment being a normal
phenomenon. Lapses in full employment, according to classical economists may be

6|Page
 addressed by appropriate wage cuts if the wage structure is flexible enough. As a result,
traditional economists saw unemployment as a transitory phase.1
.

• WAGE – PRICE FLEXIBILITY

Wages and prices, according to classical economics, are flexible and not inflexible under a
capitalist society. This means that these rates can move up and down in response to typical
supply and demand forces in their individual marketplaces. In other words, demand and
supply are price elastic.
In the case of wage rate flexibility, it is stated that it is always in the best interests of both
employers and employees. Employers benefit from pay rate reductions since it lowers their
wage costs and so enhances their profit margin. As a result, they will be motivated to hire
additional people and therefore enhance output. Workers will benefit from increasing
labor-force employment. Wage increases work in the opposite direction as well. It could
be further understand with the help of graph given below:

1
AVAILABLE In https://www.egyankosh.ac.in/handle/123456789/22633

7|Page
 P AS

P1
P2
AD1
AD2
O Q1 Q
Figure: Classical Approach to Output and Price Determination

• CLASSICAL THEORY OF SAVING AND INVESTMENT

Assume that there is a downward change in aggregate demand from AD1 to AD2 as a result
of lower household consumption expenditure. As a result, there will be an excess supply at
the current price P1. As a result, prices will fall to P2, while output will fall, and the market
will be cleared. Wage rates in the factor market will fall in order to maintain full
employment. According to classical economists, the economies market clearing model is
supported by a “self-correcting mechanism.” This process of changing pay rate occurs
instantly. Classical economists also believe in a distinction between real variables like
money supply and prices. Thus, changes in the money supply have no effect on output or
employment. When the money supply is reduced, price levels and wage rates fall.
Investment refers to the creation and acquisition of any real capital asset, such as factories,
raw materials, machinery, finished and semi-finished goods, inventories and so on. It is the
rate of increase of capital asset over time. To begin, keep in mind that the theory of saving
and investment describes how interest rates are determined, which is a genuine phenomena
in the sense that interest rates are affected by real causes While the capital productivity is
the primary driver of savings behaviour, both of these characteristics are genuine and are
unaffected by monetary factors.
Classical economists now believe that such investment occurs in the economy primarily
because capital is more productive. Now the purchase of new capital asset, such as new
machine, entails a cost in the form of interest on funds borrowed from savers. However, as

8|Page
 more capital is invested, the marginal productivity of capital falls, just as the marginal
productivity of labour or any other factors falls with increasing volume. As a result, any
rational entrepreneur would be interested in acquiring more capital assets as long as the
marginal productivity of additional capital exceeds the interest cost. As a result investment
is higher at lower interest rates. On the other hand, as interest rates rise, so does the volume
of savings.

R1 A B
R E
R2 C D

O SI S1I1
Fig: Saving and Investment Relation
The graph above depicts the two curves, the first rising with the rate of interest on savings
(S) and investment (I). The first is an upward rising curve with an interest rate, and the
second is a downward falling curve with an interest rate. At point E the equilibrium rate of
interest is established when the total volume of savings equals the total volume of
investment SI at the corresponding rate of interest R. At R1 interest rate, the volume of
savings exceeds the volume of investment by the amount AB. Similarly, at R2 rate of
interest, the amount of savings is less than the amount of investment. The disequilibrium
point, on the other hand will automatically restore equilibrium through appropriate changes

9|Page
 in interest rates. As a result, in equilibrium S=I. As a result, we conclude that classical
macroeconomics provides a consistent set of theories, namely an employment theory, a
monetary theory, and a saving-investment theory, each of which despite appearing
separate, is linked to and supports each other.

10 | P a g e
 NEO-CLASSICAL APPROACH OF
MACROECONOMICS

• INTRODUCTION TO NEO-CLASSICAL ECONOMICS

The theory of supply and demand as the driving forces behind the production, pricing
and consumption of goods and services is known as neoclassical economics. It was
developed in the late 19th century based on books by William Stanley Jevons, Carl
Menger and Leon Walras to compete with classical economics. According to
neoclassical economists, a consumer’s primary concern is to maximise personal
satisfaction. As a result, they base their purchasing decisions on their assessments of
the utility of a product or service. This theory is compatible with rational behaviour
theory, which holds that people make rational economic decisions.
Furthermore, neoclassical economists states that a product or service frequently has
value in excess of its production cost, While classical economic theory holds that a
product’s value is determined by the adding the cost of materials and the cost of
labour. And lastly according to this economic theory, competition leads to the efficient
allocation of resources within an economy. Market equilibrium is created by supply
and demand forces.

• INVESTMENT FUNCTION
Investment occurs in the economy because it provides certain returns to the investors
and has a profit motive. The marginal product of capital which is also called as the
increase in capital, can be used to calculate the return on investment. When the capital
stock increases by a single unit in output concurrently, business firms or household
must borrow at a certain interest rate in order to operate and make an investment. Even
if a household or business firm does not require borrowings, interest foregone is the
implicit cost of the investment. For example, if I build a new house (investment), I
have an option of obtaining a bank loan on the condition that I repay the loan amount
along with interest on the principal amount. Similarly, business make investments in
order to produce goods and services. In doing so, they consider two factors i.e., return
on investments and the current rate of interest. They undertake the investment project
11 | P a g e
 because the return on investment is greater than the interest rate, otherwise they will
lose money. The optimal level of investment will be achieved when the interest rate
equals the rate of return on investment.
The marginal productivity of capital decreases as the level of capital input increases,
which is a common feature of the production function. As a result, as merit rises, the
return on investment falls. Increased investment, thereby can only be undertaken when
interest rates are relatively low.

R1
R2

MPK

O I1 I2 I

Figure: Investment Function

The investment function is shown as a downward sloping line in the above figure. We plot the
amount of investment(I) on the x-axis and the interest rate on the y-axis. When the interest rate is
R1 the level of investment is I1. If the interest rate falls to R2, the level of investment rises to I2.

Aside from the current interest rate(R), the decision to invert is heavily influenced by
expectations about future price moments, resources availability, government policy, competition
from rival firms and products, and so on. Since the investment involves the creation of capital
stocks that remain in use for a longer period of time, the element of uncertainty is critical in
investment decisions. Economists have found it difficult to explain the pattern of investment
spending. There are several economic models that can be used to explain investment behaviour,
but none of them are perfect.

12 | P a g e
 • Demand and supply of money
In an economy, money serves three important functions i.e., medium of exchange, unit
of account, and store of value. It would be extremely difficult to exchange goods and
services through barter system in a non-monetary economy. Before in invention of
paper money, modern money has greatly simplified the mode. We can go to the
market and buy or sell goods and services in exchange for money. Secondly, money
functions as an accounting unit in the sense that the monetary value of goods and
services is used to determine their worth. Finally, there is a paper despite the fact that
money has no intrinsic value. It is saved because it is a command to amount a certain
purchasing power in the mark.
Demand for money arises as it performs the aforementioned functions so we all want
money. The neo-classical economists emphasized the medium of exchange function of
money and proposed that people demand money because it is required to conduct
market transactions. We are paid on a weekly basis while we make purchases on a
weekly or monthly basis. As a result there is no synchronization between the time we
receive our income and the time we spend it and conduct financial transactions.
Keynes recognized three types of money demand i.e., transction demand,
precautionary demand and speculative demand. People saves money as a
precautionary measure to meet day to day needs which differs from transaction
demand. Precautionary demand for money is determined by individual’s perception.
According to Keynes, speculative demand is primarily used to purchase financial
assets. These assets could be interest-paying bonds or dividend-paying stocks. The
speculative demand of money is determined by the portfolio of assets that we must
maintain. If we maintain , the return on money in the form of cash is zero.
Furthermore, if there is inflation, the economy and purchasing power suffers.
According to neo-classical economists, when there is excess of loanable funds , the
interest rate falls.
The speculative demand for money on the other hand, is affected by the interest rate.
When interest rates are high, people keep a smaller amount in cash because they would

13 | P a g e
 lose interest otherwise. When interest rates are low, people prefer to keep a larger
amount of cash on hand. Thus, speculative demand for money is inversely
proportional to the interest rate.

14 | P a g e
 CONCLUSION
The classical economists assumed price and wage flexibility, thereby ruling out the
possibility of unemployment in the economy. The economy responded to demand
shocks by changing the price level, resulting in no economic fluctuations. There was
no need for government intervention in the classical model because supply was
inelastic at full capacity. The Great Depression on the other hand, demolished the
classical approach as there was widespread unemployment as a result of falling prices
and output.
In neo-classical approach we saw that money is classified into three types: transaction
demand, precautionary demand and speculative demand. Transaction and
precautionary demand for money is determined by income level and the speculative
demand for money is determined by the current interest rate. When the interest rates
are too low, the speculative demand thrives.

15 | P a g e