Timeline
Pre Keynesian (till 1929)
Classical
Great Depression (1929 - 1933)
Keynesian
Stagflation & Supply Shocks
Post-Keynesian
Monetarists
Classical Macro Economists
Adam Smith, David Ricardo, John Stuart Mill, Robert Malthus, Alfred Marshall, Pigou
The Classical Theory of Employment
John Maynard K eynes in his book General Theory of employment interest and money published in 1936, made a frontal attack on the classical postulate. He developed new economics which bought about a revolution in economic thought and policy. The general theory was written against the background of classical thought. By the “classicists” Keynes meant “the follower of Ricardo, those, that is to say, who adopted and perfected the theory of Ricardian economics” they included, in particular, J. S. Mill., Marshall and Pigou. Keynes rejected traditional and orthodox economics which has been built up over a century and which dominated economic thought and policy before and during the Great depression. Science Keynesian Economics is based on the criticism of classical economics, it is necessary to know the latter as embodied in the theory of employment.
Classical Theory of Employment
The classical theory assumes the existence of full employment without inflation. Given wage-price flexibility, there are automatic forces in the economic system that tend to maintain full employment and produce output at that level. Thus, full employment is regarded as a normal situation; any deviation from this level is abnormal and automatically tends towards full employment. The classical theory of output and employment is based on the following assumptions:
1. There is the existence of full employment without inflation.
2. There is a closed laissez-faire capitalist economy without foreign trade.
3. There is perfect competition in the labour and product market.
4. Labour is homogeneous.
5. The economy’s total output is divided between consumption and investment expenditures.
6. The quantity of money is given.
7. Wages and prices are flexible.
8. Money wages and real wages are directly related and proportional.
9. Capital stock and technological knowledge are given in the short run.
The classical theory of employment is based on the assumption of the flexibility of wages, interest, and prices. This means that wage rate, interest rate, and price level change in their respective markets according to the forces of demand and supply.
Say's Law of Markets:
Say's Law of Markets is the core of the classical theory of employment. Jean Baptiste Say, an early 19th-century French economist, enunciated the proposition that "supply creates its own demand." This is known as Say's Law. In Say's words, "It is the production which creates markets for goods. A product is no sooner created than it, from that instant, affords a market for other products to the full extent of its own value. Nothing is more favourable to the demand of one product than the supply of another." In its original form, the law is applicable to a barter economy where goods are ultimately sold for goods. Every good brought to the market is a demand for some other goods. According to Say, work is unpleasant no person will work to make a product unless he wants to exchange it for some other product which he desires. Therefore, the very act of supplying goods implies a demand for them. In such a situation there cannot be general overproduction because the supply of goods will not exceed demand as a whole. But a particular good may be overproduced because the producer incorrectly estimates the quantity of the product which others want. But this is a temporary phenomenon for the excess production of a particular product can be corrected in time by reducing its production. James Mill supported Say's Law in these words, " Consumption is coextensive with production and production is the cause and the sole cause of demand. It never furnished supply without furnishing demand, both at the same time and both to an equal extent... whatever the amount of annual produce, it can never exceed the amount of annual demand." Thus, supply creates its own demand and there cannot be general overproduction and hence general unemployment.
The existence of money does not alter the basic law. "Say's law, in a very broad way is.” as Professor Hansen has said, " a description of a free-exchange economy. So conceived, it illuminates the truth that the main source of demand is the flow of factor income generated from the process of production itself." When producers obtain the various inputs (land, labour and capital) to be used in the production process, they generate necessary income accruing to the factor owners in the form of rent, wages and interest. This, in turn, causes demand for the goods produced. In this way, supply creates its own demand. This reasoning is based on the assumption that all income earned by factor-owners is spent on buying commodities which they help to produce.
What is not spent is saved which is automatically invested. Thus, saving must equal investment. If there is any divergence between the two, the equality is maintained through the mechanism of the rate of interest. To the classicists, interest is a reward for saving. The higher the rate of interest, the higher the saving, and vice versa. On the contrary, the lower the rate of interest, the higher the demand for investment funds and vice versa. If at any given period, investment exceeds saving, the rate of interest will rise saving will increase and investment will decline the two are equal at the full employment level. This is because saving is regarded as an increasing, function of the interest rate and investment as a decreasing function of the rate of interest.
The mechanism of the equality between saving and investment is shown in Fig 1.1 where SS is the saving curve and II is the investment curve. The two curves intersect at E where the rate of interest is Or and both saving and investment are equal to OA. If there is an increase in investment, the investment curve shifts to the right as I'I' curve and at the interest rate Or investment OC is greater than OA saving. According to classical economists, the saving curve SS remains at its original level when there is any increase in investment. To maintain the equality between saving and investment, the rate of Interest will rise. This is shown to rise to Or' in the figure. At this interest rate, the saving curve SS intersects the investment equal to OB.
Fig 1.1
The validity of Say's Law in a money economy also depends on the classical quantity theory of money which states that price level is a function of the supply of money. Algebraically, MV = PT where M, V, P, and T are the supply of money, the velocity of money, price level and the volume of transactions (or total output). The equation tells that the total money supply MV equals the total value of output PT in the economy. Assuming V (the velocity of money) and T (the total output) to be constant, a change in the supply of money (M) causes a proportional change in the price level (P). This is based on the assumption that money acts as a medium of exchange.
The relation between the quantity of money, total output and price level is depicted in fig 1.2 where the price level is taken on the horizontal axis and the total output on the vertical axis. MV is the money supply curve which is a rectangular hyperbola. This is because the equation MV=PT holds on all points of this curve. Given the output level OQ, there would be only one price level OP consistent with the quantity of money as shown by point m on the MV curve. If the number of money increases, the MV curve will shift to the right as M, V curve. As a result, the price level would rise from OP to OP₁, given the same level of output OQ. This rise in the price level is exactly proportional to the rise in the quantity of money, i.e., PP, = mm,.
Fig 1.2
Having determined the price level with the help of the total quantity of money MV and the total output OQ, it is possible to determine the money wage consistent with a given real wage. This is explained in fig. 1.2(B), where W/P is the real wage line or wage-price line. When the price level is OP, the money wage is OW. When the price level rises to OP, the money wage also rises to OW,. The wage-price combination OW, = OP, is consistent with the full employment real wage level W/P of fig 1.3 (A).
Pigou’s Version:
The classical theory of employment received its final version at the hands of Pigou who formulated Say's Law in terms of labour market. According to Pigou under free competition the tendency of the economic system is to automatically provide full employment in the labour market. Unemployment results from rigidity in the wage structure and interferences in the working of the free market economy. When the state intervenes by recognizing trade unions, passing minimum wage laws, etc., and labour adopts monopolistic behaviour, wages are pushed up and unemployment ensues. If all government interferences are removed and forces of competition are allowed to work freely, the manipulation of wage rates will lead to full employment. As pointed out by there will always be at work a strong Pigou, "With perfectly free competition. There will always be at work a strong tendency for wage rates to be so related to demand that everybody is employed." The Pigouvian equation explains the entire proposition. In this equation N is the number of workers employed, q is the fraction of income earned as wages and salaries, Y is the national income and W is money wage rate. N can be increased by a reduction in W. Thus the key to full employment is a reduction in money wage. This is explained in the adjoining fig 1.3. In panel (A), S is the supply curve of labour and D is the demand curve for labour. The intersection of the two curves at E shows the point of full employment N, and the real wage W/P at which full employment is secured. If the real wage is maintained at a higher-level W/P₁, supply exceeds the demand for labour by say N N labour is unemployed. It is only when the wage is reduced to W/P that unemployment disappears and the level of full employment is attained. This is shown in panel(B), where MPL is the marginal product labour curve which slopes downward as more labour is employed. Since every worker is paid wages equal to his marginal product, therefore the full employment level N, is reached when the wage rate falls from W/P₁ to W/P.
In the classical model of employment, changes in money wages and real wages are directly related and are proportional. When there is a cut in the money wage, the real wage is also reduced to the same extent which reduces unemployment and ultimately brings full employment in the economy. This relationship is based on the assumption that prices are proportional to the quantity of money. It is argued that in a competitive economy a reduction in the money wage reduces the cost of production and prices of products thereby raising their demand. In order to meet the increased demand for the products, more workers are employed to produce them.
As employment increases, total output also increases till full employment is reached, but when the economy is at the full employment level, total output becomes stable. Thus, given the stock of capital, technological knowledge and resources, a precise relation exists between total output and the amount of employment. Total output is an increasing function of the number of workers. This is shown in Fig 1.4 where Q=f(K,T,N), that is, total output Q is a function of 'f of the capital stock K, of technological knowledge T, and the number of workers, M. This production function shows that in the short run the total output is an increasing function of the number of workers given the capital stock and technological knowledge. In the figure, the total output OQ, corresponds to the full employment level N, (of fig 1.3).
The classicists believed that under normal competitive conditions full employment will be maintained without inflation. Even competition among employers to hire more workers will no bid wages above the full employment level, and there will be no possibility of cost push inflation in the economy. Further, due to the operation of Say's law, the full employment level of output will create demand equal to that level. It is the increase in aggregate demand which causes inflation. But the mechanism of the rate of interest prevents aggregate demand to increase more that the total output. Again, inflation is caused by the increase in the quantity of money by more than what can be absorbed by the expanding output. But this is also not possible because an increase in the quantity of money increases only the absolute price level and not relative prices. Hence, there is full employment without inflation in the classical system.