(Neo-)Classical Theory - Policies

So, Classical economists are of the view that the economy is self-adjusting. We can therefore sum up their policy recommendations in a variation on a well-known phrase (you may well have heard it from your teacher or lecturer in its original form!):

'Don't just do something, sit there!'

Of course, taking this too literally would be unfair on Classical economists, but it would be true to say that because the economy tends to full-employment, there is no need to actively intervene in the economy. In fact intervention may simply be destabilising and inflationary. The key to long-term stable growth is therefore:

• Ensure free markets with no imperfections (through supply-side policies)
• Control the growth of the money supply to ensure low inflation

Supply-side policies

Supply-side policies can be used to reduce market imperfections. This should have the effect of increasing the capacity of the economy to produce (in other words the long-run aggregate supply). If the level of aggregate supply increases then Say's Law (the work of Jean Baptiste Say) predicts that demand will also increase. This will be the only non-inflationary way to get increases in output.

Using supply-side policies has increased the level of output from Qfe1 to Qfe2, but the price level has remained stable. Supply-side policies as we have said are ones that reduce market imperfections. They may include:

• Improving education & training to make the work-force more occupationally mobile
• Reducing the level of benefits to increase the incentive for people to work
• Reducing taxation to encourage enterprise and encourage hard work
• Policies to make people more geographically mobile (scrapping rent controls, simplifying house buying to speed it up, ......)
• Reducing the power of trade unions to allow wages to be more flexible
• Getting rid of any capital controls
• Removing unnecessary regulations

Money supply policies

The other area that Classical economists felt was important was to control monetary growth. In this way (as predicted by the Quantity Theory of Money) they would be able to maintain low inflation. Policies might include:

• Open-market operations
• Funding
• Monetary-base control
• Interest rate control

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