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Chapter 3 Classical Full-Employment Model Economy in the Long Run : The Classical Full-Employment Model Before explaining the Keynesian macro-theory of income and employment, it will be in the fitness of things...

Chapter 3 Classical Full-Employment Model Economy in the Long Run : The Classical Full-Employment Model Before explaining the Keynesian macro-theory of income and employment, it will be in the fitness of things to explain classical theory regarding income and employment determination. The study of classical theory of income and employment is essential because some of the aspects of classical theory are more relevant to the conditions prevailing in the developing countries and this theory highlights those factors which govern income and employment in these countries. While the Keynesian theory emphasises the role of effective demand in the determination of income and employment, classical economists believed that in a free-market economy there was always a tendency towards the establishment of full employment of labour and there was sufficient demand for the output produced. Note that Keynes called all economists who preceded him (including Marshall and Pigou) as classical economists. CLASSICAL THEORY OF INCOME AND EMPLOYMENT : AN INTRODUCTORY ANALYSIS Classical theory of employment and output is based on the following two basic notions: 1. Say’s Law 2. Wage-price flexibility We explain below these two notions of classical theory. Say’s Law and Classical Theory According to the classical theory propounded by Ricardo and Adam Smith, levels of income and employment are governed by fixed capital stock on the one hand and wage-goods fund on the other. It may be noted in the beginning that the classical theory believes in full employment or near full employment prevailing in the economy. This belief of classical theory regarding the existence of full employment in the economy is based on Say’s Law of Market put forward by a French economist, J.B. Say. According to Say’s Law, “Supply creates its own demand.” This implies that every increase in production made possible by the increase in the productive capacity or the stock of fixed capital will be sold in the market and there will be no problem of lack of demand. Thus, classical economists rule out the possibility of overproduction, there being no problem in selling the output produced. According to Say’s Law, greater production automatically leads to a greater money income which creates the market for the greater flow of goods produced. Thus, deficiency in demand being no problem, the process of capital accumulation and expansion of productive capacity will continue till all people are employed and there is no reason why the productive capacity created remains unutilized or underutilized. According to this theory, the income which is not spent on consumer goods and thus 53 54 Macroeconomics : Theory and Policy saved will become investment expenditure. Therefore, investment equals saving. Thus, the leakage in the income flow caused by the saving is made up by the investment expenditure. In this way, a given productive capacity continues to be fully utilized and no problem of deficiency of demand arises. Classical economists thought that if price mechanism in a capitalist economy is allowed to work freely without any interference by the Government, there is always a tendency towards full employment in it. Of course, they admitted that in advanced capitalist economies often certain circum- stances arise due to which they are not in full-employment equilibrium. But they firmly believed that there was always a tendency towards full employment in the economy and certain economic forces automatically operate so as to move the economy towards full employment. Therefore, according to the classical economists, whenever there are lapses from full-employment level, these are removed automatically by the working of free price mechanism. The modern economists do not regard this aspect of classical theory of employment as valid and correct description of the real world. J.M. Keynes bitterly criticised the classical theory of automatic establishment for full employment. The classical theory of employment was based upon two basic assumptions. The first assumption is that there is always enough expenditure or aggregate demand to purchase the total production at full-employment level of resources. In other words, in this theory the classical economists disregarded the problem of deficiency of demand for purchasing goods produced at full-employment level of resources. The second assumption is that even when deficiency of aggregate expenditure or demand arises, the prices, wages and interest would adjust quickly so that equilibrium is restored at full- employment level of output. The classical view that there was no problem of deficiency of expenditure and demand was based upon Say’s Law of Markets. J.B. Say has been a famous French economist of the 19th century. Say’s law is based upon the fact that every production of goods also creates incomes equal to the value of goods produced and these incomes are spent on purchasing these goods. In other words, production of goods itself creates its own purchasing power, that is, demand for buying them. Therefore, Say’s law is expressed as “supply creates its own demand”, that is, the supply of goods produced creates demand for it equal to its own value with the result that the problem of general overproduction does not arise. In this way in Say’s law, the possibility of lack of aggregate demand has not been visualised. Say’s law expresses an important fact about the working of a free-enterprise economy. The fact is that the source of demand for goods is the incomes earned by the various factors of production employed for their production. All unemployed and idle labourers and other resources when employed for production, create their own demand because the total incomes which they earn create equal market demand for the goods produced by their employment. When a new entrepreneur employs some factors of production and pays them their monetary rewards, he not only increases the supply of goods but also at the same time creates the demand for them. Therefore, it is the production which creates market or demand for goods. Production is the only source of demand. Dillard rightly writes that “Say’s Law of Markets is the denial of the possibility of deficiency of aggregate demand. Therefore, employment of more resources will always be profitable and will take place to the point of full employment, subject to the limitation that the contributors of the resources are willing to accept rewards no greater than their physical productivity justifies. There could be no general unemployment, according to this view, if workers will account what they are worth.”1 We thus see that according to Say’s law aggregate expenditure or demand will always be such that all resources are fully employed. The factors which participate in productive activity and earn incomes from it, they spend a good part of their incomes on consumer goods and some part they save. But, according to classical economists, the savings by the individuals are actually spent on investment or capital goods. Since saving when invested also becomes expenditure or demand, in 1. D. Dillard, Economics of J. M. Keynes.  Classical Full Employment Model 55 classical theory the whole income is spent, partly on consumption and partly on investment. There is thus no reason for any leakage in the income stream and hence supply creates its own demand. Now, a question arises as to how in classical theory saving becomes equal to investment expenditure. According to the classical theory, it is the rate of interest which makes investment equal to saving. When savings of the people increase, the rate of interest declines. As a result of fall in the rate of interest, demand for investment rises and in this way investment becomes equal to the increased savings. Hence, according to the classical economists, it is the interest rate changes that bring about equality between saving and investment and, therefore, Say’s law applies in spite of saving by the people. This guarantees full employment in the economy. In other words, it is changes in the rate of interest due to which the withdrawal of some money from the income stream as a result of savings automatically comes back to it in the form of investment expenditure and therefore income flow continues unchanged and supply goes on creating its own demand. Wage-Price Flexibility and Full Employment The classical economists also proved the validity of the assumption of full employment with an- other fundamental logic. According to them, the amount of production which the business firms can supply does not depend only on aggregate demand or expenditure but also on the prices of products. When aggregate demand for goods and services declines due to fall in investment, the economy will still remain at full-employment level of output. According to them, this happens because product prices fall quickly so that quantity demanded increases to restore equilibrium at full-employment level of output. In this way, they expressed the view that in spite of the decline in aggregate demand caused by the decline in investment, the real output, income and employment will not fall because the fall in prices of products brings about balance between demand and supply at full-employment level of output. Classical economists thought that a free-market capitalist economy is self-correcting. Owing to the intense competition between the sellers of products as a consequence of the fall in demand, the prices will decline. This is because when aggregate expenditure on goods or demand for them declines, the various sellers and producers reduce the prices of their products so as to avoid the excessive accumulation of stocks of goods with them. Hence, according to the classical logic, decline in demand will bring down the prices of products and not the amount of production and employment. But now a question arises as to what extent the sellers or producers will tolerate the decline in prices. However, to make their business profitable they will have to reduce the prices of the factors of production such as labour. When due to the decrease in demand for output, demand for labour declines, this will cause a fall in wages quickly so that labour-demanded increases to restore labour-market equilibrium at full employment. Thus, a fall in wages of labour ensures that all workers will get employment. If some workers do not want to work at reduced wages, they will not get any job or employment and therefore will remain unemployed. But, according to classical economists, those workers who do not want to work at lower wages and thus remain unemployed are only voluntarily unemployed. This voluntary unemployment is not real unemployment. According to the classical thought, it is involuntary unemployment which is not possible in a free-market capitalist economy. All those workers who want to work at the going wage rate determined by market forces will get employment. That is, full employment of labour continues to prevail due to quick adjustment of wages. During the period 1929-33 when there was a great depression in capitalist economies, a renowned neoclassical economist, A.C. Pigou, suggested a cut in wage rates in order to remove huge and widespread unemployment prevailing at that time. According to him, the cause of depression or unemployment was that the Government and trade unions of workers were preventing the free working of the capitalist economies and were artificially keeping the wage rates at high levels. He expressed the view that if the wage rates were cut down, demand for labour would increase so that all would get employment. It is important to mention here what has been called Pigou effect or real 56 Macroeconomics : Theory and Policy balance effect.Pigou pointed out that all-round cut in wages will cause price level to fall. The fall in price level will lead to the increase in real value of money assets such as stock of money, deposits in banks, bonds of government or private companies held by them. This implies that due to fall in price level, the purchasing power of their money assets will increase. As a result, they would feel better off or richer which will lead to their consumption demand for goods and services which will prevent the fall in any aggregate demand due to all-round cut in wages. Later Parkinson supported Pigou’s view about favourable effect of reduction in wages on fall in price level which according to him will lead to what he calls increase in real money balances. This increase in real money balances, as pointed out above, will have a favourable effect on demand for goods. However, critics have pointed out that the effect of increase in real money balance on consumer’s demand for goods and services is quantitatively insignificant and therefore one cannot rely on this to create enough demand to counteract the fall in demand for goods and services as a result of all-round cut in wages. J.M. Keynes challenged the classical theory and put forward a new theory of income and employment. He brought about a fundamental change in economic thought regarding the determination of income and employment in a free-market capitalist economy. Therefore, it is often said that Keynes brought about a revolution in our economic theory and laid the foundation of macroeconomic theory. THE CLASSICAL THEORY OF EMPLOYMENT AND OUTPUT (INCOME) : A FORMAL FULL-EMPLOYMENT MODEL Classical economists such as Adam Smith and Ricardo maintained that the growth of income and employment depends on the growth of the stock of fixed capital and inventories of wage goods. But, in the short run, the stock of fixed capital and wage goods inventories are given and constant. According to them, even in the short run full employment of labour force would tend to prevail as the economy would not experience any problem of deficiency of demand. On the basis of their theory they denied the possibility of the existence of involuntary unemployment in the economy. The short- run classical theory of income and employment can be explained through the following three stages: 1. Determination of income and employment when there is no saving and investment; 2. Determination of income and employment in an economy with saving and investment; and 3. Determination of income and employment : Role of money and prices. Determination of Income and Employment in the Short Run without Saving and Investment According to the classical theory, the magnitude of national income and employment depends on the aggregate production function and the supply and demand for labour. To show this let us assume that the economy produces one homogeneous and divisible good, say corn. Let symbol Y stand for output of this good. To produce this good we require two factors of production : (1) labour which we denote by N and (2) capital which we denote by K. Thus we have the following aggregate production function Y = F(N, K, T)…(i) In the short run the stock of capital (i.e., plant and equipment) is assumed to be fixed. The state of technology is also assumed to be constant in the short run. Thus, rewritting the aggregate production function we have Y = F ( N , K , T ) …(ii) The bar over the symbols K and T for capital and technology indicates that stock of capital and technology is fixed. It is worth noting that changes in capital stock and technology will cause a shift in the production function. Therefore, with a fixed capital stock and a given and constant technology, the output Y (or what is also the real income) would increase only when employment of labour N  Classical Full Employment Model 57 increases. That is, employment of labour Y and output (income) rise or fall together. N S Now, according to classical theory, with a Unemployment fixed capital stock and given technology as employment of labour increases, marginal W  A B Real Wage Rate product of labour would diminish. This is P  1 the famous law of diminishing returns of W  P the classical economics.  0 Labour Market Equilibrium W  P C D  2 d The demand for labour is derived from Excess Demand N MP this short-run production function, that is, diminishing marginal product of labour. The classical theory assumes perfect competition in both the factor and product markets. Further, assuming that the firms which O NF X Labour Employment undertake the task of production attempt to maximise profits, they will employ labour Fig. 3.1. Labour Market Equilibrium : Determination of Employment and Wages until the marginal product of labour is equal to the given real wage rate. It may be noted that real wage rate is given by nominal wage rate divided W by the general price level, that is, real wage rate = where W is the nominal or money wage rate P and P is the average price level. Thus, a firm will employ so much labour at which W = MPN P where MPN stands for marginal product of labour. At a lower real wage rate, more labour will be demanded or employed by the firms and vice versa. Thus, the demand curve for labour is derived from the marginal product curve of labour. In fact, the former coincides with the latter. Thus demand function for labour can be written as Nd = f (WP )  …(iii) This shows that demand for labour (N d) is a function of real wage rate (WP ). Consider Fig. 3.1 where MP curve depicts the diminishing marginal product of labour with a given stock of fixed capital and a given state of technology. As explained just above, marginal product (MP) curve of labour also represents the demand curve of labour (Nd ). On the other hand, the supply of labour by the households in the economy depends on their pattern of preference between income and leisure. The classical theory assumes that in the short run when population does not vary, supply curve of labour slopes upward. Now, what is the rationale behind the upward-sloping supply curve of labour? This is based on the assumption that households or individual workers maximise their utility or satisfaction in their choice of work (which yields them income) and leisure. When real wage rate rises, two effects work in opposite direction. It may be noted that real wage is the opportunity cost or relative price of leisure. When real wage rate rises leisure becomes relatively more expensive, that is, opportunity cost or price of leisure in terms of income forgone by not working goes up. This induces the individual to work more (i.e., supply more labour hours) and thereby substitutes income for leisure. This is the substitution effect. On the other hand, with a rise in real wage rate individuals become relatively richer than before, and this induces them to consume 58 Macroeconomics : Theory and Policy more of all commodities (including leisure which is regarded as a normal commodity). This is income effect of the rise in real wage rate which tends to increase leisure and reduce labour-hours supplied. The classical economists believed that substitution effect is larger than income effect of the rise in real wage rate and as a result supply of labour increases with the rise in wage rate. Thus the supply function of labour can be written as Ns = g W ( ) P …(iv) This implies that at a higher wage rate, more labour would be supplied and vice versa. It will be seen from Fig. 3.1 that supply and demand for labour are in equilibrium at the real wage rate ( ) W P 0. Hence, given the supply and demand curves, the wage rate ( )W P 0 is determined. It will be seen that ONF labour is employed in this equilibrium situation. Thus, in classical theory level of employment is determined by labour market equilibrium. This equilibrium between supply and demand for labour at the real wage rate ( ) W P 0 implies that all those who offer their labour services at this wage rate are in fact employed. There is neither excess supply of labour, nor excess demand for labour. In other words, there is no involuntary unemployment of labour in this equilibrium situation and full employment of labour prevails. If somehow real wage rate in the labour market is higher than this equilibrium wage rate ( ) W P 0 , say it is equal to( ) W P 1 , then it will be observed from Fig. 3.1 that excess supply of labour equal to AB would emerge. In other words, at real wage rate ( )W P 1 , AB workers will be unemployed. But given the competition among workers, the excess supply of labour at wage rate ( ) W P 1 would cause the wage rate to fall to the equilibrium level ( ) W P 0 at which the labour market is cleared. On the contrary, if somehow real wage rate in the labour market is ( ) W P 2 , the firms would demand more labour than is offered at this real wage rate. As a result of the competition among the firms to hire labour desired by them, the wage rate would go up to the equilibrium level ( ) W P 0. At( ) W P 0 to repeat, all those who offer their labour services are in fact demanded and employed. It therefore follows that at the real wage ( ) W P 0 , there is no involuntary unemployment, or, in other words, full employment of labour prevails. Further, it is the wage flexibility (i.e., quick adjustment in wage rate) which brings about this full-employment situation. Self-Correction by a Free-Market Economy To clarify further the restoration of full employment of labour due to quick adjustment of real wage rate, let us consider the decrease in demand for labour following the fall in aggregate demand for output as it happens when depression or recession occurs in the economy. Consider Fig. 3.1(A) where following the decrease in aggregate demand for output labour demand curve shifts to the left W so that at the initial wage rate 0 fewer workers will be demanded than the number of workers who P0 are willing to supply their labour at this wage rate. As a result (as is seen from Fig. 3.1A) the excess W supply of labour equal to KE0 will emerge at this initial real wage rate 0. However, in the classical P0  Classical Full Employment Model 59 full-employment model this excess supply of labour (i.e., unemployment of workers) will cause real wage rate W to fall to 1 (where W1< W0) at P0 which new equilibrium between demand for and supply of labour is again established at point E1. Note that even in this new labour-market equilibrium at lower real wage rate W1 full employment of labour P0 prevails as all those who are willing to work at this real wage rate find employment. Of course, N 0 N 1 workers have voluntarily withdrawn themselves from labour force and Fig. 3.1A. Adjustment of real wage rate when therefore no one remains depression occurs. involuntarily unemployed. Similarly, when due to depression demand for output declines, in the product market demand curve for output will shift to the left and given the supply curve of output, price of output will fall, W say from P0 to P1 (P1 < P0), the real wage rate will rise to 1 which in equilibrium will become P1 W0  W1 W0  equal to that is, = and thereby equilibrium is established at the initial equilibrium P0  P1 P0  point E0 and thus full employment is restored. Thus it is evident that in the classical model when depression or recession occurs then through quick adjustment of wages and prices the economy corrects itself to attain full-employment equilibrium again. Determination of Aggregate Output (GDP) How much output will be produced in this full-employment situation can be readily known from the short-run aggregate production function. OY which is drawn in the lower part of Fig. 3.2, shows the relationship between employment of labour (N) and total output (Y), given the stock Fig. 3.2. Classical Theory : Determination of Employment and Output 60 Macroeconomics : Theory and Policy of fixed capital (i.e., a set of machines, equipment and buildings) and given the technology. This short-run production function OY shows that as more workers are employed, output increases but at a diminishing rate, that is, there are diminishing returns to labour. It will be seen from the lower panel of Fig. 3.2 that, given the stock of fixed capital and the state of technology, full employment of labour ONF produces OYF output. This output OYF of output will constitute the income of the society and will be distributed between wages and profits. Thus sum of wages as reward for labour and total profits as reward for capital would constitute the total income of the society and would be equal to the national output OYF produced. It follows from above that the quick changes in the real wage rate upward or downward ensures that neither excess supply of labour, nor excess demand for labour will persist and thus equilibrium will be reached with full employment of labour in the economy. Further, given the stock of capital and the state of technology with this full employment of labour, total output or income of the economy equal to OYF is determined. The level of output OYF is referred to as full-employment level of output or potential GDP of the economy. This is also often called aggregate supply. The potential GDP or full-employment level of output is the amount of goods and services that producers are willing to produce, given their stock of fixed capital (machines, equipment and buildings) and the given technology, when labour market is in equilibrium and all workers who want the work at the going wage rate find employment. It will be seen from Fig. 3.2 that full employment of labour as determined by labour-market equilibrium is NF and given the short-run production function OY, potential GDP or full employment output is YF (See lower part of Fig. 3.2). To conclude, potential GDP or full-employment output is the level of output when with adjustment of wages labour market is in equilibrium and all workers who want to work at the going wage rate find employment and firms are using their plant and equipment at normal rates of their utilisation. Now, an important question to enquire is what guarantees that output produced by the full- employment level of labour and capital (assumed as fixed in the short run) will be actually demanded. If this does not happen, then the problem of insufficient demand for the output will emerge which will ultimately lead to reduction in output and employment and hence to the emergence of involuntary unemployment. Say’s Law and the Absence of Deficiency of Demand. In the absence of saving and investment which we are assuming here, classical economists ruled out the possibility of deficiency of aggregate demand on the basis of Say’s law. Say’s law, as mentioned above, states that supply creates its own demand, that is, acts of production of goods create demand equal to the value of output of goods produced. Factors of production earn their incomes during the process of production. If no part of income is saved, as is being assumed here, the entire income will be spent on consumer goods produced. Value of output produced will therefore be equal to the income generated in the process of production. Thus, quantity demanded will be equal to the supply of output produced. In Fig. 3.2, wages earned by ONF quantity of labour employed and profits earned by the entrepreneurs will be spent on OYF output. Expenditure so made will be equal to the value of output produced. Aggregate demand being equal to aggregate supply, there is no problem of deficiency of demand. Say’s law that “supply creates its own demand” holds good and full employment of labour is guaranteed. In this way classical theory denies the possibility of involuntary unemployment. It needs to be emphasised that under such conditions, two things ensure full employment. First, it is because saving and investment are excluded from the system so that entire income is spent on consumer goods. Second, real wage rate changes quickly to bring about equilibrium between demand for and supply of labour. Classical Full-Employment Model: Determination of Income (Output) and Employment with Saving and Investment In applying Say’s law that supply creates its own demand an invalid assumption was made that entire income earned by the households will be actually spent. Although it is correct that production  Classical Full Employment Model 61 of output generates an equal amount of income but what is the guarantee that all income earned by factors/households will be actually spent on goods and services produced. In fact, a part of income might be saved. Saving represents a withdrawal or leakage of some income from the expenditure flow. This will result in deficiency of demand or expenditure on output of goods produced. Thus, if a part of income is saved (that is, not spent), supply of output produced would not create sufficient demand for itself. This will cause deficiency of aggregate demand which will cause fall in output and employment and the emergence of involuntary unemployment. However, classical economists denied the possibility of deficiency of aggregate demand even when a part of income is saved by the households. They showed that Say’s law that supply creates its own demand holds good even in the presence of saving. They argued that every rupee saved by households will be invested by businessmen, that is, investment expenditure will be equal to savings done by households. In fact, output produced consists of consumer goods and capital goods. Income earned from production will be partly spent on consumer goods and partly on investment in capital goods. When at full-employment level of output what is not spent on consumer goods is saved and investment expenditure on capital goods made by businessmen equals this saving. Therefore, there is no deficiency of demand or expenditure and circular flow of income goes on undisturbed. Thus, when investment equals saving at full-employment level of output, supply goes on creating its own demand to maintain full employment. Now, in bringing about equality between saving and investment, capital market plays a crucial role. Capital-Market Equilibrium : Determination of Interest Now, the pertinent question is what is the guarantee that investment expenditure will be equal to savings of the households. According to classical economists, it is changes in the rate of interest that bring about equality between saving and investment. Further, according to them, rate of interest is determined in the capital market by supply of savings and demand for investment. The investment demand is stipulated to be decreasing function of the rate of interest. At the lower rate of interest, more would be borrowed for investment. On the other hand, the savings of the people are taken to be the increasing function of the rate of interest, that is,the higher the rate of interest, the larger the savings and vice versa. The capital market will be in equilibrium at the rate of interest at which the demand for investment is equal to the supply of savings. The changes in rate of interest would cause investment and supply of savings to become equal. This is illustrated in Fig. 3.3. It will be seen that intersection of investment demand cuve II and the supply of savings curve SS determines the rate of interest i0. At a higher rate of interest i2, the investment demand is less than the intended supply of savings. Due to the excess supply of savings, rate of interest would fall to i0. On the contrary, at a lower rate of interest, say i1, the demand for investment exceeds the supply of savings. Now, due to the excess demand for investment in the capital market rate of interest would go up. Thus, it is at rate of interest i0 that capital market is in equilibrium, i.e., investment is equal to savings (I = S). Now an important thing to know about classical theory is when due to decline in profit expectations of business firms, investment falls as it happens in times of recession or depression, then how it explains that demand deficiency problem would not arise and equilibrium will continue to remain at full-employment level. This is illustrated in Figure 3.4, where initially saving and investment are in equilibrium at rate of interest i0. Now suppose that due to fall in profit expectations investment by business firms decreases by ∆I or EK causing a shift in the investment curve to the left to the new position I′I′. With this at the initial rate of interest i0, supply of savings exceeds investment by KE. This excess supply of savings will put downward pressure on rate of interest and as a result interest will fall to i1, at which saving and investment are again equal. According to classical theory, the lower interest induces more investment and therefore as a result of fall in interest to i1, investment 62 Macroeconomics : Theory and Policy Y I S I K I E Interest i0 i1 B I I S X O T2 T1 T0 Saving and Investment (b) Fig. 3.3. Capital Market Equilibrium Fig. 3.4. Decrease in investment demand does not disturb full-employment equilibrium. increases from OT2 to OT1. Besides, with the fall in interest rate from i0 to i1, savings decline by T0T1, which implies consumption demand will increase by T0T1. Thus, shift in investment demand curve to the left results in lowering of rate of interest which leads to more investment and consumption demand so that aggregate demand is not affected. It is thus clear that due to adjustment in interest rate even decline in investment does not give rise to demand deficiency problem and full employment continues to prevail. It follows from above that the equality between investment and saving brought about by changes in the rate of interest would guarantee that aggregate demand for output would be equal to aggregate supply of output. Thus, the problem of deficiency of aggregate demand would not be faced and full employment of labour will prevail. Now an important thing to explain is how capital market equilibrium ensures equality between saving and investment at full-employment level of output. It is easy to understand how equilibrium between saving and investment in the capital market ensures equilibrium at full-employment output with the help of circular flow of income. Savings by households are leakages of money from the income flow, while investment expenditure is injection of money into it. Given the full-employment level of output as determined by labour-market equilibrium and short-run aggregate production function, if the leakage (i.e., saving) from income flow that measures full-employment output (income) is equal to injection (investment) into it, the aggregate expenditure (i.e., aggregate demand for goods and services) would equal full-employment level of output (income). Thus, the product market will continue to be in equilibrium and money flow will continue undisturbed at full-employment level of income. Classical Theory of Income and Employment : Money, Prices and Inflation Now, we shall examine how full employment of labour is assured in the classical theory even when money is introduced in the system. The introduction of money does not affect the result of the classical theory that problem of deficiency of aggregate demand would not be experienced by the free-market system and therefore full employment of labour is guaranteed. The quantity of money, according to the classical theory, determines only the price level of output and in no way affects the real magnitudes of saving and investment. Further, since quantity of money determines the price level W of output, it also affects real wage rate, that is, the ratio of money wages to the price level, or. P But with increase in money supply, money wages and price level change in such a way that real wage  Classical Full Employment Model 63 rate in the equilibrium situation remains constant and equilibrium in the labour market is automatically restored. Besides, with the increase in money supply and consequent change in the price level, saving-investment equilibrium will not be disturbed and therefore deficiency of aggregate demand will not arise. Quantity Theory of Money : Determination of Price Level. Let us first explain how in classical theory price level in the economy is determined. Classical economists believed in the Quantity Theory of Money according to which it is the supply of money that determines price level in an economy. Quantity theory of money is generally expressed by Fisher’s equation of exchange2, income version of which is stated as under: MV = PY...(i) MV or P = ...(ii) Y where M = Quantity of money V = Income velocity of circulation of money Y = Level of aggregate output (or real income) P = Price level of goods and services Income velocity of money is defined as the number of times a unit of money is used for purchase of final goods and services in a period, say during a year. In classical theory velocity is assumed to be constant. Besides, in classical theory level of aggregate output is determined by the supply of productive resources (i.e., capital stock, availability of labour, land etc.) and the state of technology which do not change in the short run. Further, due to operation of Say’s law and wage-price flexibility full employment of resources occurs in the economy. Thus, with a given amount of productive resources such as labour and capital stock and constant technology and with further assumption that they are fully utilised and employed, the aggregate output (Y) is held constant at full-employment level of output in the short run. Now, with velocity of money (V) and aggregate output (Y) remaining constant, price level is determined by the money supply (M) and increases in money supply brings about rise in price level in the same proportion. The supply of money is fixed by the monetary policy of the Government or its Central Bank (e.g. Reserve Bank of India). The important question is what determines the demand for money. In the classical theory the function of money is to serve as medium of exchange and therefore demand for money is determined by the money value of transactions occurring in the economy. The aggregate output (Y) multiplied by the price level (i.e., PY) indicates the total money value of goods and services transacted (i.e., sold and purchased). Now, since a unit of money is used to make transactions of goods and services more than once in a year as measured by the velocity of money (V), a given amount of money can be used to make transactions of a larger amount of goods and services constituting GDP transacted during a period. PY is the nominal value of GDP 1 1 and in equation (ii) above is the inverse of velocity of money. has another name k used by V V Cambridge economists. In this Cambridge version of Quantity of Theory, M d = kPY where k is the proportion of national income (i.e., GDP or PY) which is held (i.e., demanded) by the people to make transactions of goods and services during a period. As stated above, price level as determined by the interaction of supply of money and demand for money in equilibrium. Thus in equilibrium : 2. Quantity theory of money and Fisher’s Equation of Exchange will be explained and critically examined in detail in a separate chapter. 64 Macroeconomics : Theory and Policy M = M d where M stands for money supply, Md for demand for money PY or M = V MV P = Y Monetary equilibrium in the classical theory is shown in Fig. 3.5 where demand for money ( ) PY V is shown by a rising straight line PY V ( ) which indicates that with V and Y being held constant demand for money increases proportionately to the rise in price level. As price level rises people demand more money for transaction purposes. Y PY V P1 E1 Demand for money Price Level P0 E0 O X M0 M1 Quantity of Money Fig. 3.5. Determination of Price Level : Classical Quantity Theory of Money Now, if supply of money fixed by the Government (or the Central Bank) is equal to M0, the demand for money ( ) PY V equals the supply of money, M0 at price level P0. Thus, with supply of money equal to M0 equilibrium price level P0 is determined. If money supply is increased, how the monetary equilibrium will change? Suppose money supply is increased to M1, at the initial price level P0 the people will be holding more money than they demand at it. Therefore, they would want to reduce their money holding. In order to reduce their money holding they would increase their spending on goods and services. In response to the increase in money spending by the households the firms will increase prices of their goods and services. As prices rise, the households will need and demand more money to hold for transaction purposes (i.e. for buying goods and services). It will be seen from Fig. 3.5 that with the increase in money supply to M1 new equilibrium between demand for money PY and supply of money is attained at point E1 on the demand for money curve and price level has V risen to P1. CLASSICAL AGGREGATE SUPPLY CURVE Aggregate supply curve describes the relationship between aggregate supply of output with price level. Classical theory regards aggregate supply curve to be perfectly inelastic. Now, an important question is why in classical model, aggregate supply curve is perfectly inelastic. As explained above, aggregate output YF is determined by the equilibrium level of employment NF, given the aggregate  Classical Full Employment Model 65 production function, Equilibrium level of employment along with real wage rate is determined by labour market equilibrium, that is, equilibrium between demand for and supply of labour. Thus, in classical theory aggregate supply curve is determined by supply-side factors, namely, preferences of households or individuals regarding work and leisure, the stock of capital (and other factor endowments), the state of technology. Supply of labour, as seen above, is determined by individual preferences between work and leisure and demand curve for labour is determined by marginal product of labour. Thus in classical model aggregate supply curve reflects supply-determined nature of output and does not depend on the aggregate demand and price level. The classical aggregate supply curve is shown by AS curve in Fig. 3.6. The pertinent question is how the changes in price level which, in the classical theory depends, on the quantity of money, leave the levels of employment and output unaffected. The reason for this is that changes in price level cause equal proportionate changes in W money wage rate with the result that the equilibrium real wage rate which is given by remains P constant and therefore equilibrium level of employment does not get affected. The adjustment process works in the following way: If due to the increase in supply of money price level rises, with a given money wage rate (W), W real wage rate, which is equal to , will fall. At a real wage rate lower than the equilibrium real P wage rate, the quantity demanded of labour will exceed the supply of labour. This disequilibrium between labour demand and supply will cause money wage rate to rise to the level so that original real wage rate determined by labour market equilibrium is restored. Suppose that in labour-market equilibrium money wage rate is W1 and given the price level equal to P1, and the equilibrium real W wage rate will be 1. Now, if price level is doubled to 2P1 money wage rate rises to 2W1, then the P1 2W1 W equilibrium real wage rate will become equal to = 1. Thus, with equal proportionate increase 2 P1 P1 in money wage rate as a result of rise in price level, equilibrium real wage rate and level of employment will remain unaffected. Thus, with rise in AS AS1 Y price level, level of employment remains unchanged and, given the aggregate production function, level of output will P3 remain constant. This implies that aggregate Price Level supply curve of output is perfectly inelastic. Thus whatever the price level, money wage P2 rate changes in such a way that equilibrium real wage rate, level of employment and P1 therefore output remain constant. Thus in classical theory aggregate supply of output is determined by supply-side real variables such as labour supply, stock of fixed capital O Output YF YF  and state of technology and does not depend Aggregate Output on money and prices. Fig. 3.6. Classical Aggregate Supply Curve Now, what causes shift in aggregate supply curve, It is changes in real supply-side factors such as supply of labour, change in capital stock through investment and change in technology that cause a shift in aggregate supply curve. For example, if supply of labour increases, the full-employment level of labour will increase. Given the aggregate production function, increase in full-employment level of labour will bring about rise in 66 Macroeconomics : Theory and Policy potential GDP which is another name for aggregate supply. This will cause shift in aggregate supply curve to the right as shown in Fig. 3.6. Further, if as a result of investment capital stock (K) increases, short-run aggregate production function will shift upward and therefore with a given supply of labour, potential GDP or aggregate supply will increase leading to the rightward shift in aggregate supply curve. Similarly, introduction of new technology that raises productivity of workers will cause an upward shift in the short-run aggregate production function and with a given supply of labour will raise potential GDP or aggregate supply. CLASSICAL THEORY OF OUTPUT AND EMPLOYMENT : COMPLETE CLASSICAL MODEL* We now illustrate the complete classical model of income and employment determination in an economy in Fig. 3.7. In panel (a) of this figure labour market equilibrium is shown wherein it will W  be seen that the intersection of demand for and supply of labour determines the real wage rate  0 .  P0  At this equilibrium real wage rate the amount of labour employed is NF and, as explained above, this is full-employment level. As depicted in panel (b) of the figure this full-employment level of labour NF produces YF level of output (or income). In panel (c) of Figure 3.7 we have drawn 45° line that is used to transfer the level of output on the vertical axis in panel (b) to the horizontal axis of panel (c). In panel (d) we have shown the determination of price level through intersection of the curves of aggregate demand for goods and services and aggregate supply of output, as conceived by the quantity theory of money. In the classical theory, aggregate supply curve AS is a vertical straight line at full- employment level of output YF. Thus, given the constant velocity of money V, the quantity of money M0 will determine the expenditure or aggregate demand for goods and services equal to M0V according to which aggregate demand curve for goods and services (with flexible prices) is AD0 as shown in panel (d) of Fig. 3.7. It will be seen from panel (d) of Fig. 3.7 that intersection of vertical aggregate supply curve AS at full-employment level of output YF and aggregate demand curve AD0 determines W  the price level P0. With price level at P0, the money wage rate is W0 so that  0  is the real wage  P0  rate as determined by the intersection of demand for and supply of labour [see panel (a) of Fig. 3.7]. Now, a relevant question is how this equilibrium level of real wage rate, prices, employment and output (income) will change following the increase in the quantity of money. Suppose the quantity of money increases from M0 to M1. With the given capital stock (as we are considering the short-run case) and the labour force being already fully employed, the output cannot increase. Therefore, as depicted in panel (d) following the increase in money supply to M1 aggregate demand or expenditure will increase to M1V and thereby causing aggregate demand curve to shift to AD1. As a result, price level rises from P0 to P1. However, as explained above, with the given money wage rate W0 , the rise in price level from P0 to P1 will cause a fall in real wage rate. As will be seen from panel (a), with the rise in price level W to P1, real wage rate falls to 0. This will cause temporary disequilibrium in the labour market. At P1 W0 the lower real wage rate , more labour is demanded than is supplied. Given the competition P1 among the firms, this excess demand for labour will cause the money wage rate to rise to W1 level W W so that the real wage is bid up to the original level 1 = 0. With the real wage rate being quickly P1 P0 * This section is meant for higher level courses in macroeconomics.  Classical Full Employment Model 67 Y S Y N AS Real Wage Rate W0 W0 Price Level W0 = E P1 P0 P0 P1 W0 P1 P0 AD1, (M1V) d N AD0, (M0V) O X X NF O YF Panel (a) : Labour Market Equilibrium Panel (d) : Aggregate Output Y Y Output (Real Income) Y Aggregative output YF YF 45° O NF X O YF X Employment Aggregate Output Panel (b) : Production Function Panel (c) Fig. 3.7. Determination of Income and Employment : Complete Classical Model restored to the original level, employment of labour NF and total output or income YF will remain unaffected. To sum up, the result of increase in money supply is to raise money wages and prices in equal proportion, leaving real wages, employment and output unaffected. The results of decrease in money supply can be similarly worked out. NEUTRALITY OF MONEY AND CLASSICAL DICHOTOMY An important conclusion which follows from the classical theory of output and employment is that changes in the quantity of money affect only nominal variables (i.e., money wages, nominal interest rate, nominal GNP, money balances), and have no influence whatsoever on the real variables of the economy such as real GNP (i.e. output of goods and services produced), level of employment (i.e. number of labour-hours or number of workers employed), real wage rate (i.e. wage rate in terms of its purchasing power). Actually, as seen above in Fig. 3.7 according to classical full-employment model, the nominal variables move in proportion to changes in the quantity of money, while real variables such as GNP, employment, real wage rate, real rate of interest remain unaffected. Classical economists explained that real variables such as GNP, employment, real wage rate are determined by real factors such as stock of capital, the state of technology, marginal physical product of labour, households’ preferences regarding work and leisure. In the classical model based on flexibility of prices and wages, changes in money supply affect only the price level and nominal magnitudes (i.e., money wages, nominal interest rate), while the real variables such as levels of labour employment and output, saving and investment, real wages, real rate of interest remain unaffected. That is, money is neutral in its effect on the real variables of the economy. In the classical theory real variables 68 Macroeconomics : Theory and Policy such as levels of output and employment, real wages, real rate of interest, as mentioned above, depend on the stock of capital (K), supply of labour (N) and the state of technology (T) and are not affected by changes in money supply. Thus the nominal variables and the real variables are determined by two different sets of factors. The independence of real variables from changes in money supply and nominal variables is called classical dichotomy. The neutrality of money can be graphically illustrated from Fig. 3.7. Suppose to begin with, the stock of money in the economy is equal to M0. With this, as will be seen from panel (d) of Figure 3.7, aggregate demand curve for output is AD0 which with interaction with aggregate supply curve AS determines price level P0. Given the price level P0, labour-market equilibrium determines money W wage rate W0 (i.e. real wage rate 0 ) and level of employment NF [see panel (a) of Fig. 3.7]. The P0 level of employment NF, given the production function, determines aggregate output YF in panel (b) of Figure 3.7. Now suppose there is expansion in money supply from M0 to M1 which causes an upward shift in the aggregate demand curve AD0 to AD1 [see panel (d) of Fig. 3.7]. As a result of this upward shift in the aggregate demand curve from AD0 to AD1, price level rises from P0 to P1. Now, as will be seen from panel (a) of Fig. 3.7, with money wage rate W0 and the higher price level equal to P1, real wage W rate falls to 0 at which demand for labour exceeds supply of labour. This will cause, according to P1 classical theory, money wage rate to rise to W1 in equal proportion to the rise in price level so that W W  real wage is restored to the original level  1 = 0  and labour-market equilibrium determines P  1 P0  the original level of employment NF. With the same level of labour employment aggregate output (i.e. GNP) will not be affected. Thus, we see that with the expansion in money supply, nominal wage rate and price level have risen, but real wage rate, level of employment and output remain constant. Hence it shows that money is neutral in its effect on real variables. Neutrality of Money : Changes in Money Supply and Saving-Investment Equilibrium According to the classical theory, money I performs the function of merely a medium Y S of exchange of goods and services and is I therefore demanded only for transaction S purposes. This means alternative to holding money is the purchase of goods and services. Real Interest Rate Therefore, demand for and supply of money R0 in the classical system does not determine the rate of interest. When the quantity of money increases, it will leave the real rate of I interest unchanged and hence the amount of S output saved and allocated to investment (i.e., I real savings and investment) will remain the S same as shown in Fig. 3.8. This means the increase in money supply does not disturb O Saving and Investment X the capital market saving-investment equality and consequently the continuation of full- Fig. 3.8. Capital Market Equilibrium employment equilibrium. However, it may be noted that the higher level of prices of commodities would mean that investment expenditure in money terms will increase in the same proportion as the rise in prices  Classical Full Employment Model 69 even though the output of commodities allocated for investment purposes remains the same. But this increase in monetary expenditure for investment is matched by the increase in monetary savings brought about by the rise in prices. The higher prices of commodities also mean a proportionate increase in the amount of money received from the sale of commodities so that savers are willing to provide proportionately larger amount of savings at a given rate of interest. Thus, with the increase in quantity of money, the supply curve of nominal savings and investment curves will shift to the right as shown by dotted S′S′ and I′I′ curves by the same proportion so that the same real rate of interest is maintained and the same amounts of real savings and investment in terms of commodities are made at the higher price level. A serious limitation of the classical concept of neutrality of money may be noted. As seen above, the neutrality of money is a basic result reached in the classical full-employment model based on flexibility of prices and wages. If increase in money supply and consequent rise in prices has no real effects, then inflation would not be a matter of concern. However, we know that inflation is a matter of serious concern as it lowers standards of living of the people and also adversely affects economic growth. Inflation affects the distribution of income in a society. It hurts the poor most. Therefore, efforts are made to control inflation and achieve price stability in the economy. KEYNES’S CRITIQUE OF CLASSICAL THEORY Keynes in his renowned book General Theory severely criticised the classical theory of income and employment. We explain below various criticisms of classical theory made by Keynes. Keynes challenged Say’s Law. Keynes criticised Say’s Law and proved that it was quite invalid. As we have said above, according to Say’s Law, every supply or production creates its own demand and therefore problems of over-production and unemployment do not arise. It is, of course, true that supply creates demand for goods because the various factors which are employed in a productive activity earn incomes from it, which in turn are spent on goods. For example, when factors of production are employed in producing cloth, then the incomes in the form of wages, rent, interest and profits accrue to them which they spend on various goods. But from this it does not follow that the supply of production will create its own entire demand. The incomes earned by the various factors of production are equal to the value of output produced, but this does not mean that the whole income received by the factors of production will be spent on goods and services. A part of the income is saved and the saved part does not necessarily create demand for goods and services. If entrepreneurs do not invest equal to the desired savings, then aggregate demand which, without government intervation, consists of demand for consumer goods and capital goods, will not be enough to purchase the available supply of output. Hence, if aggregate demand is not sufficient to purchase the available supply, the producers would be unable to sell their whole output due to which their profits would decline and as a result they would reduce their level of production giving rise to involuntary unemployment in the economy. In a given period, consumers spend a part of their income on consumption and the rest they save. Likewise, in a period, the entrepreneurs plan to spend on factories and machines, that is, they plan to invest. Aggregate demand is the sum of consumption demand and investment demand. But in a free market capitalist economy, the persons who save are often different from those who invest and further that the factors that determine savings are different from the factors that determine investment by the entrepreneurs. People save to provide for their old age, to accumulate money for education and marriage of their children and also save and hold money balances for speculative motive, that is, to buy stocks and bonds to earn profits in future. But investment by entrepreneurs depends upon marginal efficiency of capital (that is, expected rate of profit), rate of interest, population growth and technological progress. Keynes also explained that the equality between saving and investment cannot be brought about by changes in interest rate as saving mainly depends on income and it is changes 70 Macroeconomics : Theory and Policy in income that bring about equality between saving and investment rather than changes in rate of interest. But classical economists ignored the changes in level of income because of their assumption of full employment. To conclude, savers and investors are different people with different motives. Much of the economy’s saving is done by households while investment is mostly done by business firms on the basis of profit expectations and the amount of investment they want to make fluctuates widely from year to year and is unlikely to be equal to savings which households want to do. This affects aggregate demand and causes fluctuations in income, output and employment in capitalist economies. We thus see that there is no any mechanism in a free market economy which guarantees that investments made by the entrepreneurs are equal to the saving by the people. If the desired investment by entrepreneurs falls short of the amount of saving at full-employment level of income, the equilibrium of the economy will be at less than full-employment level and as a result involuntary unemployment will emerge in the economy. In this way, according to Keynes, there is no reason that sum of consumption expenditure and investment expenditure is necessarily equal to the value of output produced. In other words, there is no guarantee that aggregate demand will be equal to aggregate forthcoming at full- employment level of resources. Hence, it is not necessary that the economy will be in equilibrium at the level of full employment. This invalidates Say’s law, since according to it over-production and unemployment cannot occur. Keynes proved Pigou’s view that cut in money wages will restore full employment as fallacious. Keynes also criticised Pigou’s view that a general fall in wages and prices in times of depression will remove unemployment and automatically restore full employment in the economy if market mechanism is allowed to work freely without any obstruction by trade unions and Government. According to Keynes, a general fall in wages will not bring about increase in employment because the reduction in wages will reduce aggregate demand for goods. Keynes put forward the view that wages are not only the cost of production, they are also incomes of the workers which constitute the majority of the population of a country. As a result of a general fall in wages, the incomes of the workers will fall due to which aggregate demand will decline. As a result of decline in aggregate demand, level of production will have to be reduced and less labour will be employed than before. This will create more unemployment rather than reducing it. No doubt, as a result of a general cut in wages, cost of production of industries will fall but with the fall in costs, the demand for the products will not increase because due to the all-round cut in wages, purchasing power of the working class will decrease. Hence all-round cut in wages will reduce the level of employment by reducing aggregate demand and will thus deepen the depression. There is a fundamental difference between Keynes and Pigou in respect of the relationship between wages and employment. Pigou thought that level of employment in an economy depends upon the level of money wages and therefore reduction in money wages will promote employment. On the other hand, Keynes thought that the level of employment depends upon the aggregate demand and aggregate demand declines as a result of an all-round cut in money wages. Classical economists thought that a general cut in wages would reduce the cost of production of various industries but they ignored the fact that a general cut in wages will also reduce the incomes of the workers. In view of the fall in incomes and aggregate demand, how will manufacturers be able to sell their whole output? It is the sales of output that makes the wheel of trade, output and employment going. However, note that the classical theory is valid in case of an individual industry. With the decline in wages, the cost of the industry decreases and as a result the price of its product falls. The industry will be able to sell a larger amount of output at a lower price because it is not necessary that the goods produced by the industry are to be purchased by the workers employed in that industry whose wages have been reduced. But in the case of the economy as a whole, this is not valid because a general cut in wages will reduce the incomes of the working class and as a result enough demand  Classical Full Employment Model 71 will not be there for the output produced by the whole economy. This deficiency in demand will reduce demand for workers as a result of which unemployment will spread among them. Although W it is true that a reduction in real wages (i.e., money wages relative to the general price level, ) in P a single firm or industry is not likely to affect the overall demand for that product, it is quite wrong to assume that a general economy-wide reduction in wages of all workers has no effect on aggregate demand. Pigou and other classical economists committed a logical fallacy in their thinking by applying the analysis which is true for a particular firm or industry to the economy as a whole. Thus, the fundamental flaw in Pigou and other classical economists is that they applied partial equilibrium analysis, which is valid in the case of an individual industry, to the determination of income and employment in the whole economy. The determination of the level of aggregate income and employment in the economy should be explained with the aid of general equilibrium analysis rather Fig. 3.9. Wage-Price Flexibility : Keynes vs. Classics than with partial or particular equilibrium analysis of microeconomics. Sticky Wages and Unemployment : A basic idea of classical economists is that in a free market economy full employment is the normal state of affairs and any deviation from it will be automatically corrected through quick adjustment in prices and wages. As explained above, when during the period of great depression, 25 per cent of labour force in the USA was unemployed A.C. Pigeon wrote, “With perfectly free competition, there will always be a strong tendency toward full employment. Such unemployment as exists at any time is due wholly to the frictional resistances that prevent the appropriate wage and price adjustments being made instantaneously.”3 On the contrary, Keynes explained that unemployment that prevailed during depression was due to fall in aggregate demand and argued that prices and wages were inflexible downward (i.e., sticky) and fall in aggregate demand causes decline in real output and employment. As a result, involuntary unemployment emerges. The Classical and Keynesian viewpoints are illustrated in Figure 3.9 through AS-AD model. According to classical economists, aggregate supply curve is vertical at full-employment output YF and is represented by AS. Keynes’s short-run aggregate supply curve is given by the horizontal line SAS. Suppose, to begin with, aggregate demand curve is AD0 which intersects aggregate supply curve AS at point E with price level equal to P0. Now suppose that aggregate demand declines due to the fall in investment demand or due to the contraction in money supply and as a result aggregate demand curve shifts leftward to the new position AD1 (dotted). According to the classical economists, prices and wages would adjust quickly so that equilibrium will be achieved at point T at the lower price level P1, level of national output remaining unchanged at full-employment output level YF. Thus, in the classical framework, if market system is allowed to work freely, even with the fall in aggregate demand, full employment tends to prevail and no involuntary unemployment can exist. 3. A.C. Pigou, The Theory of Umemployment, 1933 (Italics added). 72 Macroeconomics : Theory and Policy On the other hand, according to Keynes, prices and wages are sticky and therefore Keynes’s short-run aggregate supply curve is flat as is represented by SAS in Figure 3.9. Therefore, when there is leftward shift in aggregate demand curve due to decline in desired investment, the real national output will fall by EB or YFY1, price level and money wages remaining unchanged.4 We shall discuss in detail in a later chapter the Keynesian and Classical theories regarding wage-price flexibility and employment. Because of the above-mentioned shortcomings of the classical theory, there was a need for development of a new theory which could provide a correct explanation of the determination of income and employment in the economy. A capitalist economy cannot automatically attain a state of full employment. Keynes in his famous work General Theory of Employment, Interest and Money not only criticised the classical theory but also propounded a new one which is still regarded as substantially valid and correct. Conclusion We have discussed above Say’s law of classical economics. This is a basic law of the classical economics. In brief this law states that supply creates its own demand. From this, it has been concluded that in a free-enterprise capitalist economy, there is always a tendency towards full employment. According to them, if sometimes unemployment appears in the economy, then wages would decline, the rate of interest and prices would also fall. As a result, employment of labour would increase and unemployment will be automatically removed, provided the economy is allowed to work freely without any interference by Government and trade unions. Hence a state of full employment will be established. In this way due to the flexibility of wages, prices and interest rate, there can neither be general overproduction, nor unemployment in the economy for a long time. Therefore, classical and neoclassical economists thought that there was always a tendency toward full employment provided no restrictions were placed in the working of free and perfect competition. Thus, according to them, the Government need not interfere in the working of the economy and should follow a laissez faire policy. But Keynes proved this as invalid not only theoretically but also practically. Keynes put forward a new theory of income and employment which is the correct explanation of the phenomenon in a developed capitalist economy. For this purpose, Keynes invented new concepts such as propensity to consume, marginal efficiency of capital, liquidity preference which affect the level of income and employment in the economy. Keynes also proved that a cut in wages would not cure depression and unemployment, but would worsen them. Following Keynesian revolution in economic theory and the recognition of the fact that economic fluctuations or lapses from full employment will not be automatically corrected, it is now believed by many economists that Government should play an active and important role to promote economic stability at the level of full employment by taking appropriate fiscal and monetary measures. Laissez faire policy should not, therefore, be followed by the Government in the modern world. QUESTIONS FOR REVIEW 1. What is Say’s Law ? How did classical economists use this law to show that there could not be involuntary unemployment in the economy ? 2. “The supply creates its own demand.” How did classical economists justify this argument? How did Keynes challenge its validity ? 3. Explain briefly classical theory of income and employment. How does this theory show that 4. Note that modern Keynesians consider the short-run aggregate supply curve to be gently sloping upward. Therefore, when aggregate demand falls, there is a small fall in price but a large fall in real national output and employment.