Economics 576
Macroeconomic Theory and
Policy
CLASSICAL/NEOCLASSICAL
ECONOMICS
VERY BRIEF GENERAL
SUMMARY
WHO WERE THE
CLASSICAL ECONOMISTS? Keynes used
the term “classical” to
refer to virtually all orthodox (non-Marxian) economists
who had written on macroeconomics prior to 1936
(the year of his General Theory). More conventional modern
terminology distinguishes between
two periods in the development of economic theory before 1930.
The first, termed classical, is the period dominated by the
work of Adam Smith (Wealth of Nations, 1776), David Ricardo (Principles of
Political Economy, 1817), and John
Stuart Mill (Principles of
Political Economy, 1848). The
second, termed the
neoclassical period, is represented by such economists as Alfred Marshall and A. C. Pigou.
THEORY BASE:
Microeconomic + logical extensions
POLICY PHILOSOPHY: Laissez faire - Government should protect competition and the market,
otherwise hands off. Confidence that
markets would self-
correct - eliminate temporary
problems.
SOME SPECIFICS: Classical economics assumed that the
normal (or equilibrium) level
of income at any point in time
was the full employment level.
Why? Classical economists generally accepted
Say's
Law (Supply creates its
own demand-named for the French economist, J.B. Say, who wrote in the
early nineteenth century).
IMPLICATIONS OF SAY’S
LAW: There would not be general or
aggregate over-production. Since
any level of production would call forth a level of spending sufficient (in the
aggregate) to take that production/output off the market, then overproduction
would not be a cause for concern. Insufficient aggregate demand thus could not be the cause of significant unemployment and recession. Finally, wage flexibility would eliminate any minor,
temporary unemployment; price flexibility would clear product markets.
Classical economists emphasized the importance
of real factors. Money played a role only
in facilitating
transactions as a
medium of exchange. Money was seen to be held only
for the sake of the goods that it could purchase. The quantity of money was
seen to affect the price level, but
not relative prices or real output.
A general functional
representation of this theoretical system would be as follows:
(1) y =
y(N)
dy > 0, but declining a N increases
dN
(2)
dy = W
dN P
(3) N = n æWö
èPø
dN >
o
d W
P
(4) M = lPy
where
N =
employment
W =
money wage rate
P =
price level
M =
quantity of money
l = fraction of income that needs to be
held in cash
balances to satisfy the
transactions
demand for money.
d = small change in
Equation (1) is the
aggregate production function of the economy. We must specify as to its shape only that
output increases less than in proportion to labor input. Equation (2) expresses the profit
maximization condition -- that
the real wage equals the marginal
product of labor. Equation (3) represents the supply curve of labor, and equation (4) is
the quantity theory.
Keep in mind that the Classical economists
tended to focus
primarily on microeconomics. And microeconomics concerns itself with relative prices as
opposed to absolute prices (or the price
level). Thus under the quantity
theory, money--which was seen not to
affect relative prices, but only the price level--was of no great
consequence.
Generally, the
Classical economists recognized
only a "transactions demand" for money. Money was viewed simply as
a medium of exchange. So does this
preclude saving? A theory that
holds that all money which is received
automatically gets spent does not square with the fact that many people
save who do not themselves invest.
(Keep in mind that the acts of saving
and investing are totally distinct phenomena.) Thus can it be that the act of saving (ie., of not spending) might
invalidate Say's Law--meaning that
there could be
insufficient aggregate demand =
too little spending = too much saving = overproduction??
The
answer to that question is no. Why not?
(5)
S = s(i) a
positive relationship
(6)
I = f(i)
an inverse relationship
(7)
S = I equilibrium