Classical Theory

of
Employment & Income
“Say’s Law of Market”
Classical Theory:
 Classical Economists: Adam smith, Ricardo, J.B Say and Marshal, etc
 There is existence of full Employment without inflation in the Economy
 No overproduction in the economy (Goods Market Equilibrium)
 Full employment (Labour Market Equilibrium)
 Full employment is Permanent & Unemployment is temporary
 If there is unemployment, it will be for short period only
 In the long-run it will be automatically corrected/self adjusted to the full
employment level.
 Classical economist believes in the long run
In the long-run there is always existence of full
employment in the economy.
Full Employment (Meaning)
 Full employment is a situation in which all those who are able to
and want to work at the existing rate of wage get work without any
undue difficulty
 All those workers who are not ready to work at the existing Wage
rate come under category of Voluntary unemployment.
 “ Full employment implies absence of involuntary unemployment.”
 Involuntary unemployment means people are ready and willing to
work at prevailing wage rate but do not get any work.
 Full Employment is a situation where:
Demand for Labour = Supply of Labour
Assumptions:
1. Full employment
2. Laissez Faire Economy (Capitalist Economy without any Govt.
Interference)
3. Closed Economy without foreign Trade
4. Wage, Price & Interest Rate are flexible(it changes/adjusted based on
demand and supply)
5. Self Adjustment Mechanism (Economy will be corrected automatically to
the equilibrium level without Govt. intervention)
6. Perfect Competition (Price changes based on Demand & Supply)
7. Total output of the economy is divided into Consumer Goods and Capital
Goods which are used for investment purpose.
8. Long-Run
Wage-Price Flexibility & Full employment
 Classical Economist believed in Full Employment
 In case of Unemployment, a general wage cut would take the
economy to the full employment situation.
 The classical theory proposes that all markets re equilibrate
because of adjustments in prices and wages which are flexible.
For instance, if an excess in the labor force or products exist,
the wage or price of these will decreases to absorb the excess.
If prices and wages are flexible, markets re equilibrate.
Wage Cut
Cost of production
Price decrease
Demand increase
Investment increase
Employment increase
Say’s Law of Market: “Supply Creates it’s own Demand”
 Classical theory of Full Employment is explained with the help of Say’s
Law of Market. J B Say Proposed this theory.
 Proposition : “Supply Creates it’s own Demand”
 For an example, when an economy is producing Rs. 100 value of output
at the same time equal amount of income (Rs. 100) is generated in form
of factor payments (Rent+Wages+Interest+Profit) which can be used for
consumption of all those goods produced. Total Income (100) = Total
Expenditure (100). In this sense supply creates its own demand.
 Total supply (Total Income) = Total Demand (Total Expenditure)
 Supply is the source of demand
 Start producing, automatically the demand will be created.
 Each supply has an equal amount of demand
Say’s Law of Market Cont….
 Say’s Law which rules out the possibilities of general-overproduction
& general unemployment in the economy.
 Supply creates its own demand leads to Goods Market equilibrium
 Aggregate Supply (Total Income) = Aggregate demand(Total
Expenditure)
 When the goods market is equilibrium (Supply =Demand) at that
time no possibility of overproduction in the economy.
 Overproduction leads to unemployment problem. Producers will cut
the production and employment.
 No overproduction means no general unemployment in the
economy.
 Goods Market Equilibrium (S=I)
 When Total Supply (Income)=Total Demand (Expenditure)
 Total Income (Y) = Consumption(C) + Savings (S)
 One part of Income (Y) is consumed (C) and one part is saved (S)
 For Savings (S), Whatever is produced not demanded
 Total Expenditure is less than Total Income (Y) due to savings
 Due to Savings (S), there is deficiency in demand (Demand < Supply)
 Classical Economists believe that Savings (S) is automatically invested (I) in the
market. Savings (S) = Investment(I) exp.
 Total Expenditure = Consumption exp. (C) + Investment Exp. (I)
 When Savings(S) = Investment(I), Total Income = Total Expenditure
Total Income (Y) = C+S, Total Expenditure (Y) = C+I
C+S = C+I
S = I (Condition for Goods Market Equilibrium)
Total Income= 100 (Supply)
Y = C+S=100
C= 70
S=30
Total Expenditure (Demand)= 70
Savings is automatically invested
S=I=30
Total Exp. = C+I= 70+30= 100(Total Demand)
Condition for goods mkt equilibrium
S=I
 Savings & Investment Equality (S = I)
Classical believes that Savings (S) is automatically invested (I). Goods market is
always equilibrium (S=I), in case there is temporary disequilibrium (S>I), The
equality (S=I) will be automatically adjusted through rate of interest (r).
Savings (S) > Investment (I)
• Savings(S) & Investment (I) both are the function interest rate
(r ). S= f(r) & I = f (r)
• Higher rate of interest (r ) encourages more savings (S)
• Lower rate of interest (r ) encourages more investment (I).
• When S > I, Excess supply of capital in the economy
• Due to excess availability of loan fund, the interest rate (r) will
decrease automatically to the equilibrium level (S=I)
Saving & Investment Equality (S =I)
 Wage price Flexibility & full employment
• Classical economist believes in full
employment
• In case unemployment, a cut in
money wages would take the
economy into full employment
• Employment depends on Real Wage
• Money wage & real wage are directly
proportional
• A cut in money wage leads to cut in
real wage Employment
• Decrease in real wage leads to full
employment
 Money Market Equilibrium
• Classical economist believes that all the
markets are equilibrium at full employment
level.
• Money market is equilibrium when
Supply of Money=Demand for Money
MV=PT
M=Quantity of Money
V=Velocity of Money
Velocity: It is the number of times the same
currency is used to purchase goods and
services
P=Price
T= total output or Quantity
• Total
  output (T) is fixed at full employment level.
• Velocity of Money (V) also fixed
• Only Q & P are variable
MV=PT
P= ( where T & V are fixed)
P= f(M)
Price (P) is the function of Quantity of Money (M)
At full employment level, Price rises with quantity of money
• According to classical theory Money is neutral
• Money has no impact on real variables like Investment, interest rate output,
employment
• Money supply only affects price not real variables.
MV curve is rectangular Hyperbola
This is because the equation MV=PT holds at all the points
MV=PT
Quantity of Money (M)=100
Velocity of Money (V)=10
Supply of Money =MV= 1000
Price (P)=10
Total Quantity (T) at full employment =100
Total Demand for Money (PT) = 1000
V & T both are fixed
If quantity of Money (M) increased to 200
Price also will increase to 20
 Keynes Theory
of
Employment & Income
 Background of the Keynes Theory:
Great Depression: 1930’s
• Depression means recession continue for a longer period of time
• Global GDP decline: -26% (1929-33)
• Global Unemployment Rate: 25% (1933)
• Classical theory believes that full employment is permanent &
unemployment is temporary.
• The full employment level will be re-established automatically without
any govt. intervention in the economy.
• Classical theory failed to explain the great depression.
• Keynes rejected the notion of full employment and instead suggested full
employment as a special case and not a general case.
Up to 11th March
Keynes Criticism
on
Classical theory
 Classical View
Full Employment
Supply Creates Demand
Long-Run Analysis
(In long-run always Full Employment)
Wage-Price Flexible
S = f(r) & I = f (r)
Self-Adjustment
Keynes View
Under Employment
Demand Creates Supply
Short-Run Analysis
(In long-run we all are dead)
Wage-Price Rigidity
(Rigidity due to labour union)
S = f (Y) & I = f(Y, r)
Govt. Intervention
Keynes Criticism on Classical theory:
Demand creates supply not supply creates demand: When demand in
the economy increases automatically the supply increases.
Underemployment Situation: Many workers are ready to work at the
existing wage rate but unable to find any kind of work. Keynes believes
that unemployment is permanent & full employment is a special
situation.
Self-Adjustment not possible: Keynes believes that economy wont be
corrected to the equilibrium level automatically.
Govt. / State Intervention Essential: Govt. need to invest directly to
raise the level of employment, output in the economy.
Long-Run Analysis is unrealistic : Classical economists believe that in the
long-run the economy will be automatically adjusted to the full
employment level. In the “long run we all are dead”. Keynes believes in
the short-run.
Criticism…….
Wage-Price Rigidity (Sticky Wage): Keynes argued that prices and wages are
not flexible as the classical theory asserts. Wages tend to be rigid on the
down side because workers will not accept wages which do not permit them
to live adequately; this is reinforced by the actions of unions. In the short-run
wages are sticky.
Saving & Investment Equality: Classical economists believe savings &
Investment equality (S=I) adjusted automatically through changes in rate of
interest (r ).
Keynes believes that Self adjustment is not possible as Savings & investment
depends on different variables. S = f(Y) & I= (Y & r).
Savings depends on level of Income (Y)
Investment Depends on level of Income (Y) & Rate of interest (r ).
Money is not neutral: When money supply changes it affects interest rate,
investment, employment and output. Money affects real variables like
interest, investment, employment & Output.
The Revolutionary Idea by Keynes:
• Keynes argued that inadequate overall demand could lead to
prolonged periods of high unemployment during great depression.
• Total Demand or expenditure is the sum of four components: consumption (C)
expenditure, investment (I) expenditure, government expenditure (GE), and net
export (X-M) expenditure.
Aggregate Demand = C + I + GE + (X-M)
• Demand has to come from one of these four components.
• During great depression both consumer sentiment & investment sentiment was
down due to high unemployment & overproduction.
• Consumption (C) & Investment (I) expenditure was less. No investor wants to
take risk of investing more.
• Net foreign Demand (X-M) also down due to world wide depression.
• One component left that is Govt. Expenditure (GE)
The Revolutionary Idea……
• Keynes suggested for state/govt. intervention in the economy.
• Govt. needs to invest directly to raise the level of employment, output &
income in the economy.
• Before Great depression, the role of Govt. was limited.
• Most of the economies followed Keynes & started spending more on the
economy.
• Due to more govt. expenditure the Aggregate Demand started increasing.
• As a result employment, output & income increased.
• Slowly slowly the consumer & producer sentiment improved.
• Most of the economies came out from the great depression.
• The Govt. Spending of USA has increased to 4985 Million in 1940 from
2047 million in 1927.
• USA GDP growth rate has increased to 8.8% in 1940, 17.7% in 1941,
18.9% in 1942.
Keynes theory of Employment:
• Starting point of the theory is “Effective Demand”
• Effective demand is a situation where the Aggregate
Demand(AD) = Aggregate (AS) in the economy.
• Unemployment is a problem of deficiency of effective
demand.
• Level of employment can be raised by increasing the level of
effective demand
• When AD increases, Effective Demand increases &
Employment, output & income in the economy also
increases.
Aggregate Demand & Aggregate
Supply
 Aggregate Demand (AD)
• The aggregate-demand is the total demand for final goods & services
at various price levels.
• Aggregate demand refers to total spending on domestic goods
and services in an economy.
Components of Aggregate Demand
AD = C+I+GE+(X-M)
1. Consumption expenditure (C)
2. Investment Expenditure (I)
3. Govt. Expenditure (GE)
4. Net Export (X-M)
Aggregate demand of an economy increases when anyone of the
four component increases.
Aggregate Demand (AD) Curve

Price Level
• “Y” axis represents Price Level (P) Aggregate Demand
• “X” axis represents the real (AD) Curve
quantity of all goods and services
purchased as measured by “Real
GDP”
• AD curve slopes downward
• As price increases the demand for
goods and services decreases.

Real GDP
 Why Does Aggregate Demand Curve Slopes
downward?
1. Wealth Effect/ Real Income Effect : A decrease in the price level raises
the real value of money, makes consumer wealthier, there by encouraging
to spend more. AD increases due to Consumption (C ) demand increases.
2. Interest Rate Effect: When price decreases, households do not need to
hold more money to buy goods and services. They might deposit the excess
money in Banks. When savings (S) increases, Availability of loan also
increases as a result rate of interest(r) decreases & Investment (I) demand
increases. AD also increases for higher investment.
3. Trade Effect : When domestic price decreases, the demand for exports
(X) increases & the demand for imports (M) decreases. Net Export rises &
AD increases.
M/p= 100/10=10
=100/5=20
 Factors Determining Aggregate Demand
& Shifts in AD Curve
Aggregate demand curve shifts to the right when anyone of the 4 components (C, I,
GE & X-M) rises due to non-price factors (Ex: Tax, interest rate, Exchange rate etc).
Due to other factors not price.
Tax: Lowering taxes raises disposable income & consumption expenditure (C). AD
curve shifts to the right. When the tax increases, consumption expenditure (C)
decreases & AD shifts to the left
Money Supply: When RBI increases the money supply (M) in the economy,
interest rate (r ) falls & private investment (I) and private consumption (C) increases
. AD curve shifts to the right for higher (C) & (I ). In opposite case AD curve shifts to
left.
Tax on Corporate: When there is a cut in tax, Investment rises & AD curve
shifts to the right.
Exchange Rate: When the rupee value depreciates (Ex: exchange rate
73 to 80), it encourages more export and less import. As a result Net export
(X-M) rises & AD curve shifts to the right. If rupee value appreciates(Ex:
exchange rate 73 to 65), it discourages export and encourages import. As a
result Net export falls & AD curve shifts to the left.
Wealth & Income Changes: When wealth rises due to property value
appreciates, Stock market rises, etc people use to consume more & AD
curve shifts to the right. During recession stock market crashes, property
value depreciates, people use to consume less & AD shifts to the left.
Govt. Spending's (GE): AD shifts to the right due to increase in Govt.
spending's & shift to left due to decrease in spending.
Future Expectations about Price: If the consumers are expecting
that price in future will go up, then they will start consuming more, AD
curve shifts to right. In opposite case, AD curve shifts to left.
Shifts in Aggregate Demand (AD) Curve
Aggregate Supply (AS)
Curve
• The aggregate-supply curve tells us
the total value of goods and services

Price Level
that firms produce and sell at any Aggregate
given price level. Supply
• It is the real GDP Curve (AS)
• AS curve slopes upward
• AS slopes up bcz when the price level
increases while the price of inputs
remain fixed, the opportunity for
Real GDP (Y)
additional profit encourages to
produce more.
Keynes View on Aggregate
Supply (AS) Curve
• Keynes believes in the short-run. Short Run

Price Level
• Economy operates below its Aggregate
potential level or full employment

(P)
Supply Curve
level of output in the short-run.
• Short-run AS curve slopes upward.
• It is affected by Demand & Price. It is
price elastic.
• AS increases when demand & price
increases in the economy.
Real GDP (Y)
Classical View on Aggregate
Supply (AS)
• Classical economists believe in the long-run. Full
employment in the economy.
Potential/Full employment GDP:
It is the maximum output that an economy can
produce by fully using all its available resources
labour, capital , technology etc.
• Long-Run AS curve is vertical straight line.
• In Long-Run, AS is not affected by the Demand &
Price. It is not price elastic.
• If demand & price increases in the economy the
output will remain same at full employment level
• Long-run AS curve shifts to the right if there is an
improvement in productivity & efficiency.
Increase in the level of skills, technological
advancements, etc
• Up to 23rd
Aggregate Supply Curve (Short-Run + Long-Run
Combined)
 Factors Determining Aggregate Supply
& Shifts in AS Curve
Factors affecting the short-run supply includes factor
cost, Temporary supply shocks, Govt. policies etc
Oil Price: When oil price rises, the cost increases & supply reduced.
AS curve shifts to left. In opposite AS curve shifts to the right.
Wages & Raw material: When Wage rate rises, the cost
increases & supply reduced. AS curve shifts to left. In opposite case,
supply rises and AS curve shifts to the right.
Tax: When tax increases, the cost increases & AS curve shifts to the
left. In opposite case it shifts to the right.
Temporary Supply shocks: Bad weather, Strikes, Covid etc
reduced the sully in the short-run & AS curve shifts to the left.
Subsides: It decreases cost & supply increases. AS curve shifts to
the right.
Productivity: If the productivity increases, AS curve shifts to the
right.
Shifts in Long-Run AS curve
Long-Run vertical AS curve shifts to the right if the size of labour force,
Size of capital, Productivity: Skills & Education, Technology, Natural
Resources Exploration.
Shifts in Aggregate Supply Curve
 Equilibrium level of Employment,
Output, Income & Price
Aggregate Demand (AD) = Aggregate Supply(AS)
 When Aggregate Demand (AD) increases & shifts to the
right, the equilibrium level of Employment, Output &
Income increases .
 When AD decreases & shifts to left, The equilibrium level of
employment, output & income decreases.
 Equilibrium Level of Income & Price
( Equilibrium Income/GDP =Y, Price=P)
Shifts in AD & Equilibrium Level of Income & Price
Aggregate Demand (AD): Short-Run Impact
 Keynes believes that, the level of employment, output & income can be increased
by increasing the AD in the economy.
 IN the short-run when AD increases & shifts to the right, General Price level
increases (Inflationary situation) in the economy
 When Price increases, Firms produce more and supply more
 As a result, Investment, employment, output & Income increases.
 Output can be increased up to the Maximum full-employment level (YF) by
increasing the aggregate demand in the economy.
Aggregate Demand: Long-Run Impact
 In the long-run economy is operating at its full capacity level of output (YF).
 If AD increases, Only Price (inflation) in the economy increases without output.
 AD creates inflationary situation in the long run.
 In the Long-run if AS increases, then only Output, Employment & income increases.