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Classical Theory of Output and Employment
Propounded by Adam Smith in his classic entitled ‘An Inquiry into the Nature and causes of the Wealth of Nations’.
Other architects of the theory were Ricardo,John Stuart Mill and J.B Say.
Assumption of Full Employment(there could be only Frictional or Voluntary Unemployment).
Wage-Price flexibility is all that is required.
Assumption of perfect competition in the factor and product markets and profit maximization.
There are basically three markets to study-the Labour market,the Product market,and the Money market.
The first two markets deal with the equilibrium of of the real sector of the economy while the money market is concerned with the equilibrium of the monetary sector of the economy.
There is dichotomy-separation- between these two sectors.This dichotomy arises from the argument of the Classicists that ‘money is a veil’.
Money does not matter and its function in the economy is merely to facilitate the real transactions by serving as a medium of exchange.
Two basic pillars on which the elegant edifice of the classical macroeconomic theory stands are the Say’s Law of Markets and the Quantity Theory of Money.
Say’s Law states that supply creates its own demand.Consequently,whatever be the level of aggregate output in the economy,it will always be demanded for consumption and investment.Here saving was not precluded.
However a rational saver would never hoard money and it would eventually be put back in the system through investment.
The other basic tenet is the Quantity Theory of Money according to which the general price level(P) is a function of the total money supply(M).The identity equation was MV=PQ.The possibility of hoarding having been ruled out changes in money supply would cause proportionate changes in in the price level assuming the velocity of money(V) and the aggregate real output(Q) to be constant.
1.The Great Depression of the 1930s gave a severe blow.