Classical Theory of Income

and Employment
 Classical Theory of Income and Employment

“The General Theory of Employment, Interest and Money” by Keynes.

Some Basic Assumptions related to the Classical Theory.

1. Full employment will present.

2. Free Market Price System.

3. Perfect competition in labor and goods market.

4. Laissez Faire policy.

5. Wages and Prices are flexible.

6. Closed capitalist economy.

7. Close coordination between money and real wages.

8. Supply creates its own demand.

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9. Total output divided into consumption and investment.

10. Capital tock and technology is given.

Say’s Law of market:

“Supply creates its Own Demand”

Involuntary Unemployment : No

Voluntary Unemployment : Yes

Frictional Unemployment : Yes

Involuntary unemployment is due to interference with free market

economy.
 Full Classical Model
Labor Market Equilibrium:

 Demand for Labor : Depends upon marginal product (MPL)

In order to maximize profit firms employ labor until the MP L is equal

to real wage rates (W/P)

Demand for Labor (Nd) = f (W/P) {Negative}

 Supply of Labor : Depends on pattern of preference between income
and leisure.
As Real Wage Rate Increases two effects take place simultaneously:
Substitution Effect and Income Effect
Substitution Effect is more powerful than income effect.
Supply of Labor (Ns) = f (W/P) {Positive}
 Goods Market: Determination of Output

Short-run production function shows that as more labor are employed,

output increases but at the diminishing rate, that is there are
diminishing returns to labor.

The level of output OYf is referred as full-employment level of output

of potential GDP or Aggregate Supply (AS).

Say’s Law of Market:

Value of Output = Income generated by the process of production

 Capital Market Equilibrium
• It is the change in the rate of interest that brings about equality between
saving and investment.

Investment is a decreasing function of rate of interest (r);

I = f - (r)
Saving is an increasing function of rate of interest (r)
S = f + (r)
• National Income Relationship and Saving and Investment
Equilibrium.
Aggregate Demand = C + I
Income can either consumed or saved, then
Y=C+S
S=Y–C
At full level of employment Saving (S) = Investment (I)
So, S = I = Y – C s
 Money Market Equilibrium
• Quantity Theory of Money:

MV=PY, P = MV/Y

Increase in money supply brings about rise in [price levl at same

proportion.

Function of money according to the classical are only medium of

exchange.

Supply of money os fixed by Monetary authority of India

 Neutrality of Money

• In the classical theory of output and employment, changes in the

quantity of money affect only nominal variables (i.e. money wages,
nominal interest rate, nominal GNP, money balances), and no
influence on the real variables of the economy such as real GNP (i.e.
Output of goods and services produced),level of employment(i.e. no.
of labour-hours) real wage rate.
• Nominal Variables move in proportion to changes in the quantity of
money. This is called Neutrality of Money.
 Classical Dichotomy

• In the classical theory real variables such as levels of output and

employment, real wages, real rate of interest, depends on the stock of
capital (K), supply of labour (N) and state of technology(T).
• The independence of real variables from changes in money supply
and nominal variables is called classical dichotomy.
 Aggregate Supply Curve (ASC)
• Establish relation between aggregate supply of output with price level.

LONG-RUN AGGREGATE SUPPLY CURVE (LRASC)

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• LRASC is determined by supply-side factors i.e. preference of

households or individuals regarding work and leisure, the stock of
capital (and other factor endowment), the state of technology.
 Aggregate Demand Curve in classical model

• Quantity theory of money is an implicit theory of the aggregate

demand for output in the classical model.
AD = MV
 Criticism of Classical Theory of employment
• Criticism No. 01: Economic system is not working automatically and
not self-correcting.

• Criticism No. 02: Unemployment would not disappear if the workers

were accept a voluntary cut in wages.
• Classical’s argument : -

Wage Low
Low cost
Cuts price

Textile High AD,

Industry Emply.
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• Keynes argument regarding general wage cut :- ‘General wage cut
would lessen the purchasing power in the hand of workers which would
result in cutting down their effective demand for the products of
industry.’
• Pigou state that employment depended upon the money wages but
Keynes state that employment depends upon effective demand.
• Dual nature of wage: cost (Pigou) for industrialist but income (Keynes)
for workers.
• Criticism No. 03 : - Money wage cut is undesirable on two grounds.

• Worker will resist.

• Do not reduce money wages but the real wages.

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• Criticism No. 04:- Government intervention is must for continuity in
the economic system,
• Criticism No. 05:- Saving would not be equal to the investment at the
level of full employment.

Saving ≠ Investment
• Saving and investment are two different phenomenon.

Saving in the function of personal disposable income while investment

is the function of interest rate and marginal efficiency of capital.
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• The main points of criticism of classical theories are as follows:
States that supply creates its own demand that is not possible if
certain part of income is saved and aggregate revenue is not always
equal to aggregate cost.

Considers that the employment can be increased by decreasing the

wage rate, which is not true in the real world.

Assumes that rate of interest helps in maintaining equilibrium

between savings and investments, which is not true in practical
applications.

Infers that the economy can be adjusted on its own and it does not
require any government intervention, which is not possible.
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Considers that the wages and prices are very much flexible, which is
not true in the real world economy

Regards money as a medium of exchange only; however, money

plays an important role in the economy

Fails to explain the occurrence of trade cycles.