Classical Economics Explained

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Classical Economics ExplainedClassical economics is considered to be the first school of economic thought.

Let us start with a general overview of what this school of thoughtpropagates. By the way, I am an out-and-out Classical economist, so forgive

any biases that might creep in. Also understand, that even if it may seem so

in this particular article at times, one cannot conclude that Keynesianeconomics is flawed or classical economics is flawed (there's no absolute

right and wrong in economics, different theories are applicable underdifferent economic assumptions).

Classical Economics Definition and Groundwork for the ClassicalEconomics Model

"By pursuing his own interest, he (man) frequently promotes that (good) ofthe society more effectually than when he really intends to promote it. I

(Adam Smith) have never known much good done by those who affected to

trade for the public good."- Adam Smith (1776), An excerpt from 'AnInquiry into The Nature and Causes of The Wealth of Nations'.

Adam Smith is the great economist, who is known as the founder of the

classical economics school of thought. Though many others (David Ricardo,Thomas Malthus, John Stuart Mill, William Petty, Johann Heinrich Von

Thunen, etc.) have come and gone, and added a few things here and there,

to the classical theories, we will only be stressing on Adam Smith's versionin this article.

The Classical economics theory is based on the premise that free markets

can regulate themselves if left alone, free of any human intervention. AdamSmith's book, 'The Wealth of Nations', that started a worldwide Classicalwave, stresses on there being an invisible hand (an automatic mechanism)

that moves markets towards a natural equilibrium, without the requirementof any intervention at all. In better economic words, the division of labor and

the free market will automatically tend toward an equilibrium that advances

public interests. Sounds fascinating? Let us see how.

Classical Economics AssumptionsBefore working our way towards the workings of the Classical economics

model, let us first know and understand the classical economicsassumptions. The idea, is that like any theory, if the founding assumptionsdo not hold, the theory based on them is bound to fail. There are three basic

assumptions of Classical Economics theories. They are:

Flexible Prices: The prices of everything, the commodities,

labor (wages), land (rent), etc. must be both upwardly anddownwardly mobile. Unfortunately, in reality, it has been

observed that these prices are not as readily flexible


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downwards as they are upwards, due a variety of marketimperfections, like laws, unions, etc.

Say's Law: 'Supply creates its own demand'. The Say's law

suggests that the aggregate production in an economy must

generate an income enough to purchase all the economy's

output. In other words, if a good is produced, it has to bebought. Unfortunately, this assumption also does not hold good

today, as most economies today are demand driven(production is based on demand. Demand is not based on

production or supply).

Savings - Investment Equality: This assumption requires

the household savings to equal the capital investmentexpenditures. Now it takes no genius to know, that this is

rarely the case. Yet, should the savings not equal the

investment, the 'flexible' interest rates should be able to

restore the equilibrium.

Classical Economics - The Workings of An Economy"Civil government, so far it is instituted for the security of property, is in

reality instituted for the defense of the rich against the poor, or of those who

have some property against those who have none at all."- Adam Smith from'The Wealth of Nations', 1776.

All the normal principles of economics apply to classical economics as well. Ifall the assumptions hold, classical economics works as follows.

Wage MarketsClassical economics negates the fact that there can be some unemployment

(especially involuntary) in an economy, because classical economists believein the self-correcting mechanism of an economy. Their contention is based

on the following:

Whenever there is unemployment in an economy, it is usually a

temporary disequilibrium because it is an equilibrium caused by

excess labor available at the current wage rate.

Whenever wages are high, there are always more people willing to

work at that ongoing rate and this is termed as unemployment.

In an unregulated, classical economy, where wages are perfectlyflexible, the wage rates fall, eliminating the excess labor availableand reducing the unemployment back to equilibrium levels.

How exactly does this happen? This happens because all hirers

favor their self-interest motives. When laborers are still available

when he pays them a lower wage, why should he pay more. He
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thus adjusts his wage rates downwards, acting in the overallwelfare of society, without knowing it.

Commodity Markets

The Say's law that equates the demand and supply in an economy actually

applies to aggregates and not single goods and commodities. Classicaleconomists believe that the commodities markets will also always be inequilibrium, due to flexible prices. If the supply is high and there is

inadequate demand for it, it is a temporary situation. The prices for the

commodity in question, decrease, to equate the demand and supply andbring the situation back to equilibrium. How does this work? Well, what

would you do if you had a commodity that you needed to sell but weren'table to secure a buyer. You'd obviously reduce the prices step by step, in a

trial and error manner and finally reach a price that might tempt a buyer tobuy. It is a similar case with the aggregate demand and supply, say the

classical theorists.

Capital Markets

In the beautiful free world of classical economics, no human intervention isrequired to lead the capital markets to equilibrium as well. If the economy

does not follow the last assumption and shows a mismatch in savings and

investments, the classical economists provide the evergreen solution - donothing, it is temporary and will correct itself. If savings exceed investment,

the interest rates fall and the market achieves equilibrium again. On theother hand, if savings fall short of investments, the interest rates rise and

once again, the economy reaches its own equilibrium. Let us now see how all

the markets come together in the classical economics model.

One potential problem with the classical theories is that Say's law may notbe true. This may happen because not all the income earned goes towards

consumption expenditures. The total savings thus saved, translate into the

missing potential demand, which is the cause of the disequilibrium. Whensupply falls short of effective demand like this, several things spiral

downwards: producers reduce their production, workers are laid off, wagesfall resulting in lower disposable incomes, consumption declines reducing

demand by further more and starting a self-sustaining vicious cycle.

However, classical economists argue that what happens to the savings thatstarted to the whole chain is the key solution here. If all of these savings go

in as investments, the interest rates adjust to bring the economy back toequilibrium once again, with absolutely no problems at all. The only glitch,

are all savings actually invested in reality? By investment, classicaleconomists mean capital generation, so I doubt it! But as one can see,

according to classical theories, there is really no need for any government

intervention. No wonder then, that they are against it, for they can provide


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good backing to all the arguments that state, that government interventioncannot help, but can actually harm the economy in the long run.

We will contemplate this later, in the comparison of Classical economics vs

Keynesian economics section. For now, we will move on to the next

economic theory, Keynesian economics.

Keynesian Economics Theory ExplainedKeynesian economics is the brain child of the great economist, John Maynard

Keynes. The Keynesian school of economics considers his book, 'The General

Theory of Employment, Interest and Money' (1936) as its holy Bible. Let ushave an overview of this theory, which contradicts and confronts the

classical theory on almost all counts.

Keynesian Economics Definition and Groundwork for the Keynesian

Economics Model"Long run is a misleading guide to current affairs. In the long run we are all

dead."- John Keynes's most famous quote, to stop the Classical economistsfrom rapping about the 'long run'.

Keynesian economics is wholly based on a simple logic, that there is no

divine entity, nor some invisible hand, that can tide us over economic

difficulties, and we must all do so ourselves. Keynesian economic modelsstress on the fact that Government intervention is absolutely necessary to

ensure growth and economic stability. While classical economists believethat the best monetary policy is no monetary policy, Keynesian economists

(Alvin Hansen, R. Frisch, Tinbergen, Paul Samuelson etc.) believe otherwise.In the Keynesian economic model, the government has the very importantjob of smoothening out the business cycle bumps. They stress on the

importance of measures like government spending, tax breaks and hikes,etc. for the best functioning of the economy.

Keynesian Economics AssumptionsLike all economic theories, the Keynesian Economics school of thought is

based on a few key assumptions. Let us have a look at them first, before weprogress on to the application of Keynesian economics in the actual

economy. Rigid or Inflexible Prices: Mostly we see that while a wage

hike is easier to take, wage falls hit some resistance. Likewise,

while for a producer, commodity prices are easily upwardlymobile, he is extremely reluctant for any reductions. For all such

prices, it is easily notable that they are not actually as flexible aswe'd like, due to several reasons, like long-term wage

agreements, long-term supplier contracts, etc.


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Effective Demand: Contrary to Say's law, which is based on

supply, Keynesian economics stresses the importance of

effective demand. Effective demand is derived from the actualhousehold disposable incomes and not from the disposable

income that could be gained at full employment, as the classical

theories state. Keynesian economics also recognizes that only afraction of the household income will be used for consumption

expenditure purposes.

Savings and Investment Determinants: Keynesian

economics directly contradicts the savings-investment proponentof Classical economics, because of what it believes to be the

savings and investment determinants. While classical economistsbelieve that savings and investment is triggered by the

prevailing interest rates, Keynesian economists believe

otherwise. They believe that household savings and investments

are based on disposable incomes and the desire to save for thefuture and commercial capital investments are solely based onthe expected profitability of the endeavor.

Keynesian Economics - The Workings of an Economy

"The biggest problem is not to let people accept new ideas, but to let themforget the old ones."- John Maynard Keynes.

As classical economics and the Great Depression did not go so well together,

with the latter exposing several flaws in the former, but Keynesian

economics came up with a solution. Keynesian economics and the Greatdepression worked well together, with the former giving ways to avoid and

escape the latter. Keynesian economics is equipped to teach everyone abouthow to survive an economic depression. Let us have a look at how the

Keynesian theory works.

Keynesian economists believe that the macroeconomic economy is more

than just an aggregate of markets. Also, these individual commodity andresource markets are not capable of achieving an automatic equilibrium and

it is quite possible that such disequilibriums last for very long. As full

employment is not guaranteed automatically, Keynesian economics

advocates the use of beneficial government policies in order to give theeconomy a helping hand.

Commodity MarketsThe Keynesians start with a graph showing a 45 degree line starting at the

intersection of both the axis. This line depicts all the points where the

aggregate expenditure equals the aggregate production. In other words, the
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economy is at a full employment equilibrium. They then chart a realaggregate expenditures line, an aggregated amount of all the

macroeconomic sector expenditures (Household Consumption, Investment,Government Spending, etc.) and capture the effective demand. When the

economy is below or above the intersection between these two lines, there is

an obvious disequilibrium or imbalance.

If aggregate production is more than the aggregate expenditures, there isexcess supply. Inventories increase and businesses reduce their production

to stop these. On the other hand, when the demand is more than the supply

(aggregate expenditure supersedes aggregate production) the accumulatedinventories of businesses decrease and there is an incentive to increase

production. Through this mechanism of inventories, the commodity marketsfind their equilibrium.

Employment MarketsWhen there is a recessionary gap, that is when the actual aggregate

production in an economy is less than the aggregate production that shouldhave come off full employment and there is rampant unemployment in the

economy. On the other hand, under an inflationary gap, the actualaggregate production exceeds the aggregate production that should have

come off full employment. Both the situations cannot be solved

automatically, contrary to the classical economics fundamentals.

The solution to all the economic problems lies in the manipulation of somekey indicators, say the Keynesian economists. These indicators include

interest rates (increase in interest rates, decrease in aggregateexpenditures), confidence or expectations (pessimistic economic outlook, fallin aggregate expenditures) and Government Policies and Federal Deficit

(Increase in taxes or fall in Government spending, fall in aggregateexpenditures). The government can manipulate these variables (and even

many others) through the two market intervention tools that it has at its

disposal, namely the fiscal policy and the monetary policy. I will not go intothe details of these policies and leave them for another article. Hope you

have understood the basic foundation of Keynesian economics and thereasons why Government intervention is necessary.

Classical Economics vs Keynesian Economics: Comparison andContrast

The following are some of the basic comparisons for a Keynesian economicsvs Classical economics study.

Keynes refuted Classical economics' claim that the Say's law

holds. The strong form of the Say's law stated that the "costs of

output are always covered in the aggregate by the sale-proceeds


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resulting from demand". Keynes argues that this can only holdtrue if the individual savings exactly equal the aggregate

investment.

While Classical economics believes in the theory of the invisible

hand, where any imperfections in the economy get corrected

automatically, Keynesian economics rubbishes the idea.Keynesian economics does not believe that price adjustments

are possible easily and so the self-correcting market mechanismbased on flexible prices also obviously doesn't. The Keynesian

economists actually explain the determinants of saving,

consumption, investment and production differently than theclassical economists.

Classical economists believe that the best monetary policy during

a crisis is no monetary policy. The Keynesian theorists on the

other hand, believe that Government intervention in the form of

monetary and fiscal policies is an absolute must to keep theeconomy running smoothly.

Classical economists believed in the long run and aimed to

provide long run solutions at short run losses. Keynes wascompletely opposed to this, and believed that it is the short run

that should be targeted first.

Keynes thought of savings beyond planned investments as a

problem, but Classicalists didn't think so because they believedthat interest rate changes would sort this surplus of loanable

funds and bring the economy back to an equilibrium. Keynesargued that interest rates do not usually fall or rise perfectly in

proportion to the demand and supply of loanable funds. They areknown to overshoot or undershoot at times as well.

Both Keynes and the Classical theorists however, believed as

fact, that the future economic expectations affect the economy.

But while, Keynes argued for corrective Governmentintervention, Classical theorists relied on people's selfish motives

to sort the system out.

There are many, many more Classical economics vs Keynesian economicscomparison pointers, but I will leave you with the above mentioned basic

ones. If I get a good response from all of you readers, maybe I will write

another individual article on whatever it is that you require. Till then, I hopeI have provided you with some reading material for your term papers.

Classical Economics Explained

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