(Neo-)Classical Theory - Theories

Classical theories revolved mainly around the role of markets in the economy. If markets worked freely and nothing prevented their rapid clearing then the economy would prosper. Any imperfections in the market that prevented this process should be dealt with by government. The main roles of government are therefore to ensure the free workings of markets using 'supply-side policies' and to ensure a balanced budget . The main theories used to justify this view were:

• Free market theory
• Say's Law
• Quantity Theory of Money

Free market theory

The Classical economists assumed that if the economy was left to itself, then it would tend to full employment equilibrium . This would happen if the labour market worked properly. If there was any unemployment, then the following would happen:

unemployment (a surplus of labour)

fall in wages

increased demand for labour

equilibrium restored at full employment

This can be shown on a diagram of the labour market. Wages are initially too high and there is unemployment of ab. This causes wage rates to fall and employment increases as a result from Q1 to Q2. Any unemployment left in the economy would be purely voluntary unemployment - people who have chosen not to work at the going wage rate.

The same would also be true in the 'market for loanable funds' . If there was any discrepancy between savings and investment the equilibrium would change in the market. This would again require a free market and flexible prices. In this market the price is the rate of interest . Say, for example, investment increased, then the following process would occur to restore equilibrium:

increase in investment

increased demand for money

increased rate of interest

increased savings as borrowers are attracted by higher rates of interest

equilibrium is restored

Say's Law

Say's Law is imaginatively named after an economist called Say. Jean Baptiste Say was an economist of the early nineteenth century. His law says (excuse the pun!) that:

'Supply creates its own demand.'

This once again provides a justification for the Classical view that the economy will tend to full employment. This is because, according to this law, any increase in output of goods and services (supply) will lead to an increase in expenditure to buy those goods and services (demand). There will not be any shortage of demand and there will always be jobs for all workers - full employment. If there was any unemployment it would simply be temporary as the pattern of demand shifted. However, equilibrium would soon be restored by the same process as shown above.

Quantity Theory of Money

The classical economists view of inflation revolved around the Quantity Theory of Money, and this theory was in turn derived from the Fisher Equation of Exchange . This equation says that:

MV = PT

where:
M is the amount of money in circulation
V is the velocity of circulation of that money
P is the average price level and
T is the number of transactions taking place

Classical economists suggested that V would be relatively stable and T would (as we have seen above) always tend to full employment. Therefore they came to the conclusion that:

M P

In other words, increases in the money supply would lead to inflation. The message was simple: control the money supply to control inflation.

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