Classical Theory of Employment Quiz

Classical Theory of Employment

• According to classical economics, a decline in demand for goods leads to a decrease in prices, not production and employment.
• Businesses reduce factor prices, including wages, to maintain profitability.
• A decrease in demand for labor leads to lower wages, restoring equilibrium at full employment.
• Unemployed workers are considered voluntarily unemployed because they choose not to work at lower wages.
• Classical theory argues that involuntary unemployment is impossible in a free-market capitalist economy.
• A.C. Pigou, a neoclassical economist, advocated for wage cuts during the Great Depression to address widespread unemployment.
• Pigou argued that government interventions and trade unions artificially kept wages high, hindering economic recovery.
• Pigou's theory of the "real balance effect" suggests that a cut in wages lowers the price level and increases the demand for labor, leading to full employment.
• Wage flexibility, quick adjustment of wages, plays a crucial role in achieving full employment.

Self-Correction and Full Employment

• When aggregate demand decreases, the labor demand curve shifts to the left, resulting in an excess supply of labor.
• The short-run production function shows diminishing returns to labor.
• With full employment, total output (OYF) is distributed between wages and profits, representing the total income of the society.
• The economy reaches equilibrium with full employment when there is no excess supply or demand for labor due to flexible wages.
• Given the state of technology and the stock of capital, full employment of labor (NF) determines the potential GDP or full-employment output (YF).
• The potential GDP represents the maximum output achievable with existing resources and technology when the labor market is in equilibrium.

The Quantity Theory of Money and Monetary Equilibrium

• The Quantity Theory of Money states that the general price level is directly proportional to the money supply.
• The equation of exchange (MV = PY) relates the money supply (M), velocity of money (V), price level (P), and real GDP (Y).
• The Cambridge version of the Quantity Theory emphasizes the demand for money (Md) as a proportion (k) of national income (PY).
• Monetary equilibrium occurs when the supply of money (M) equals the demand for money (Md).
• In the classical model, money is neutral in its effect on real variables like output and employment.
• Changes in the money supply only affect nominal variables like prices and wages, not real variables.

Neutrality of Money and Saving-Investment Equilibrium

• Classical theory views money as a medium of exchange, demanded primarily for transaction purposes.
• Money is a neutral factor in the economy, impacting only the price level and not real variables like output and employment.
• The neutrality of money arises from the fact that any change in the money supply is fully reflected in a proportionate adjustment of prices.
• According to the classical model, saving and investment are always equal in equilibrium.
• Any disturbance in this equilibrium is quickly rectified through price adjustments, ensuring a full return to equilibrium.
• The neutrality of money implies that monetary policy cannot be used to stimulate output or employment.
• The classical model maintains that the economy is self-regulating and will always gravitate towards full employment.