What is Classical Economic theory?

September 6, 2015
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While macroeconomics as a discipline may have started with Keynes, he was not the first to think about issues involving the economy as a whole. Economics usually labels those thinkers classical (or neoclassical) economists. These included Alfred Marshall, William Stanley Jevons, Arthur Cecil Pigou, John Bates Clark, Irving Fisher, and Knut Wicksell. The Classical economists believed in free market efficiency given a series of assumptions known as the First Welfare Theorem. The conditions of this theorem are that there is perfect information in the market, zero transaction costs, a large number of buyers and sellers, no externalities, and all transactions of voluntary. According to the classical school of thought, free markets functioned better than regulated markets as long as the conditions of the First Welfare Theorem held.

Macro is aggregated Micro

The classical economists did not differentiate between macroeconomic and microeconomic theory. They used their understanding of (micro)economic theory to analyze both micro and macroeconomic phenomena. Classical economists conceived of the macroeconomy as no more than aggregated microeconomics. Thus, what we now conceive of as aggregate supply was simply the sum of each firm’s production decision. Similarly, aggregate demand was the sum of all individual demand curves.

Gerard Debreu, in his 1957 book, Theory of Value proved the existence of a general competitive equilibrium. That is, if all markets are perfectly competitive, all firms maximize profits, and all individuals maximize utility, there is a set of prices at which all markets will be in equilibrium. This is the macroeconomic model of the Classical economists, and for this, Debreu won the 1984 Nobel Prize.

One topic that the classicals did recognize as being economy-wide was business cycles. However, classical tools to analyze business cycles were rather primitive by modern standards. Another topic was inflation, or the rate of change of the aggregate level of prices.

Focus on the Supply Side

Classical economics focused on the supply side of the economy. Specifically, Jean Baptiste Say’s Law dominated classical economic thought: Supply creates its own demand. Say meant that production creates income that provides enough purchasing power to purchase all the goods being produced, no more and no less. One hundred dollars worth of goods produced creates one hundred dollars worth of income. The critical assumption in this theory is that there is no hoarding. All income is either spent or saved. All saving is invested so that all income stays in circulation. In this model, excess supply in one market must be balanced with excess demand in another; there can be no such thing as economy-wide excess supply. This conclusion is known as Walras’ law. A shift in relative demand will result in changes in relative prices; if one good is more desirable it will rise in price, while less desirable goods will fall in price. The aggregate price level will not change.

Analysis starts with the Labor Market

The classical view of the economy begins with the labor market. Profit maximizing firms hire labor up to the point where the marginal revenue product, or the additional revenue gained from one extra unit of labor, equals the wage rate. (In real terms, the real demand for labor is its marginal productivity. The real demand equals the real wage, that is, the nominal wage divided by the price level.)

Given the supply of labor, the wage rate will adjust to insure full employment.

Analysis proceeds to the Product Market

Equilibrium employment thus served as the source of aggregate supply. Given the equilibrium level of employment, the aggregate production function determines the equilibrium left of output.

Thrift & Enterprise determine the Composition of GDP

There are two key parameters or behavioral coefficients in the Classical model: thrift and enterprise. Thrift can be thought of as economic agents’ propensity to save, and is based on their willingness to defer present for future consumption. Enterprise can be thought of as their propensity to invest, which is dependent on the availability of investment opportunities or the rate of return on capital. Thrift and enterprise are fixed in the short run; changes in either and have no effect on the level of GDP, only on its composition.

[ Insert graph of Loanable Funds model? Attributed to D.H. Robertson ]

For example, if there was an autonomous increase in saving (an increase in “thrift”), the real interest rate would decrease as the supply of loanable funds increased. The lower interest rates would induce entrepreneurs to borrow the “extra” saving. Thus, if GDP is the sum of consumption (C) and Investment (I), and C decreases (as saving increases), I increases by the same amount, and GDP stays exactly the same. As another example, suppose there is some technological improvement that causes an increase in the rate of return on investment (an increase in “enterprise”). The desired increase in investment translates to an increase in demand for loanable funds, leading to a higher real interest rate. The higher interest rate induces an increase in saving to finance the investment. As a result, consumption decreases and investment increases, while overall output stays the same.

The Classical Dichotomy Segments the Economy into Real & Financial Sides

The Classical analysis of the macro-economy led to what is now known as the classical dichotomy. The economy has two sides, real and financial. The real side includes the real variables in the economy, including output and employment, while the financial side includes all nominal factors of the economy, such as the aggregate price level and nominal interest rates. The notion of a dichotomy means that nominal factors only influence financial side of the economy, never the real side. As we noted above, real variables are determined entirely on the supply side of the economy: employment is determined in the labor market, and output is determined by the aggregate production function.

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