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On the other hand, the supply of labour by the households in the economy depends on their pattern of preference between income and leisure. Since no part of income is saved as is being assumed here the entire income will be spent on consumer goods produced. The Classical Theory of Income and Employment is premised on three conjectures. Now, let us discuss the theory in detail: The Demand for Labour: The demand for labour is assumed to depend inversely on the real wage. 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, In the short run the stock of capital (i.e. where K denotes a constant capital stock and L denotes quantities of variable input, labour. Classical Theory of Income, Output and Employment Determination 1. This is illustrated in Fig. An economy considers a number of capital projects in each time period. The effect of increase in the quantity of money is graphically shown in Fig. 3.6. 3.1 A) the excess supply of labour equal to KE0 will emerge at this initial real wage rate W0/P0. The entire labour force cannot be absorbed in productive employment, because there are not enough instruments of production to employ them. Capital is an exogenous variable determined by the given inversion in the previous period. This is the famous law of diminishing returns of the classical economics. Now, according to classical theory, with a fixed capital stock as employment of labour increases, marginal product of labour would diminish. Thus, quantity demanded will be equal to the supply of output produced. 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. It may be noted that real wage rate is given by nominal wage rate divided by the general price, level, that is, real wage rate = W/P where W is the nominal or money wage rate and P is the average price level. The only way for equilibrium output to change in this classical model can be attributed to a shift in labour demand or labour supply curve. This means that changes in money stock affect only absolute prices and money wages proportionately. 3.2 that, given the stock of fixed capital and the state of technology, employment of ONF labour produces OYF output. Lecture Note on Classical Macroeconomic Theory Econ 135 - Prof. Bohn This course will examine the linkages between interest rates, money, output, and inflation in more detail than Mishkin’s book. The corresponding equilibrium level of output (at the equilibrium level of employment) is YF. This excess supply of savings will put downward pressure on the rate of interest and as result interest will fall to i1, at which saving and investment are again equal. Say's Law of Market. (a) Classical theory of employment (b) Keynesian theory of employment. The marginal product schedule is the firm’s demand curve for labour. The basic contention of classical economists was that if wages and prices were flexible, a competitive market economy would always operate at full employment. At a higher rate of interest i2, the investment demand is less than the intended supply of savings. The classical theory assumes full employment without inflation. The classical theory assumed the prevalence of full employment. If this does not happen, then the problem of insufficient demand for the output (i.e., corn) will emerge which will ultimately lead to reduction in output and employment and hence to the emergence of involuntary unemployment. Determination of income and employment: Role of money and prices. Real-wage is too high because money-wages don’t adjust and this goes back to the notion that workers refuse to accept money-wage cuts. Classical economists maintain that the economy is always capable of achieving the natural level of real GDP or output, which is the level of real GDP that is obtained when the economy's resources are fully employed. The classical theory assumes that in the short run when population does not vary, supply curve of labour slopes upward. 3.2, wages earned by ONF quantity of labour employed and profits earned by the entrepreneurs will be spent on OYF output. However, in the classical full employment model this excess supply of labour (i.e. For this, they have to determine the level of output to be produced and the number of workers to be employed. Copyright 10. 4. Equation 3.10 states that people hold cash balance since there is a gap between money receipts and expenditures. The loan market will be in equilibrium at the rate of interest at which the demand for investment is equal to the supply of savings. The Classical Theory of Income and Employment is premised on three conjectures. Given wageprice flexibility, there are automatic forces in the economic system that tends to maintain full employment and produce output at that level. Further, due to operation of Say’s law and wage-price flexibility full employment of resources occur in the economy. 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. 3.Money does not matter: the classical economists treat money only as a medium of exchange .In their terms the role of money is only to facilitate transaction and has no deterministic impact on output and employment.The level of output and employment is determined by availability of real resources in the market: labor and capital. 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. Classical Theory of Employment: Definition and Explanation: Classic economics covers a century and a half of economic teaching. The pertinent questions is how with changes in price level, which in the classical theory depends on the quantity of money, leave level of employment and output unaffected. market, i.e., his basic theory can be presented without abandoning the classical labor supply function, and (4) the Keynesian aggregate demand function can be transformed and superimposed on the classical employment diagram. Classical Theory of Employment and Output (With Diagram) 1. It needs to be emphasised that under such conditions, two things ensures full employment. But money supply does not have any impact on Y which is determined in the real sector and Y is fixed due to full employment. In the classical model the equilibrium levels of income and employment … 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. between these types of activity, not the domains in which they are carried out. When real wage rate rises, two effects work in opposite direction. This equilibrium between supply and demand for labour at the real wage rate W/P implies that all those who offer their labour services at this wage rate are in fact employed. In Fig. Classical Theory of Output and Employment Propounded by Adam Smith in his classic entitled ‘An Inquiry into the Nature and causes of the Wealth of Nations’. The classical theory assumes perfect competition in both the factor and product markets. Thus, demand for labour depends inversely on real wage. The level of output and, hence, the level of employment is established in the labour market by the demand for and supply of labour. The classical theory had propagated a free market economy, which classical economists believed would automatically lead to full employment. 1 It is true that the neo-classical theory of the firm and especially the marginal productivity theory of wages (with a given plant and equipment) imply a close or predictable relation between labor input and physical output. According to Keynes full employment is not a normal situation as stated in the Classical theory. Keynes theory of output and employment is often called a monetary theory of employment. The classical theory has the following characteristics: It is built on an accounting model. Classical Theory of Income and Employment: Aggregate Demand, Money and Prices: Now, we shall examine how full employment of labour is assured in the classical theory even when money is introduced in the system. Fig. Value of output produced will therefore be equal to the income generated in the process of production. The classical economist did not formulate any specific theory of employment as such. Classical economists maintain that the economy is always capable of achieving the natural level of real GDP or output, which is the level of real GDP that is obtained when the economy's resources are fully employed. Perfect competition exists in both product market and factor market. It therefore follows that increase in the quantity of money causes price level to rise. Aggregate labour demand function, shown in equation (3.7), is also inversely related to the real wage rate. This implies that aggregate supply curve of output is perfectly inelastic. The investment demand is stipulated to be decreasing function of the rate of interest . Share Your PDF File Income and employment theory, a body of economic analysis concerned with the relative levels of output, employment, and prices in an economy. Consider Fig. The description of the various equations in the model is as follows: 1. Since the classical model is a supply-determined one, it says that equiproportionate increases (or decreases) in both money wage and the price level will not change labour supply. It is possible to have macroeconomic equilibrium at less than full employment. The short- run classical theory of income and employment can be explained through the following three stages: 1. With this at the initial rate of interest i0, the supply of savings exceeds investment by KE. It was developed during the 1930’s to try and understand the Great Depression. Classical economists maintain that the economy is always capable of achieving the natural level of real GDP or output, which is the level of real GDP that is obtained when the economy's resources are fully employed. Classical Theory Output and Employment. However, there could be voluntary unemployment, frictional and structural unemployment. Classical view that forces or mechanisms exist to restore a position of full employment. We consider what determines real output. Now, an important question is why in classical model, aggregate supply curve is perfectly inelastic. Introduction The classical economists believed in the existence of full employment in the economy. The Classical Theory Of Employment amd output The fundamental principle of the classical theory is that the economy is self-regulating. 2. 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. To them, full employment was a normal situation and any deviation from this regarded as something abnormal. Quantity theory of money is generally expressed by Fisher’s equation of exchange, income version of which is stated as under: V – Income velocity of circulation of money, Y = Level of aggregate output (or real income). Determination of income and employment when there is no saving and investment; 2. 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