Classical Theory of Employment Quiz

Study Notes

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.

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 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.

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.

Podcast