Classical model of employment

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Main features of the Classical theory of employment and income. Automatic equilibrium achievement of the market.

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Classical model of employment

  1. 1. UNIT 2 CLASSICAL THEORY OF EMPLOYMENT Prof. Prabha Panth
  2. 2. 18-Jul-13 2 Classical theory According to Classical theory: • The economy is always in equilibrium, • No government interference (laissez faire) • Market forces ensure equilibrium. • Full employment achieved due to flexible prices and wages. • Unemployment is due to high wage rate. • If wage rate is reduced, employment increases. (Pigou’s law of wages) • If D S, prices adjust and restore equilibrium.
  3. 3. 18-Jul-13 3 Pigou’s law of wages 0 Employment MP of L Output w1 a N1 w2 b N2 If w falls from w1 to w2, total employment increases from N1 to N2. So low wage rate, high level of employment
  4. 4. 18-Jul-13 4 Market Clearing 0 P Q Market D Market S P0 D0 S0 D < S, P falls P1 S1 D1 S < D P rises E, S = D Pe
  5. 5. 18-Jul-13 5 Savings = Investment According to Classical theory: • Savings = Investment, and determines it (important). • S is positively related to rate of interest. S = f(i) • Investment is negatively related to rate of interest. I = - f(i) • Those who save are same as those who invest. • So S will always be equal to Investment. • If they are not equal, then rate of interest will adjust to achieve equilibrium.
  6. 6. 18-Jul-13 6 Savings = Investment 0 Interest % Funds Investment Saving i0 I0 S0 I < S, i falls i1 S1 I1 S < I i rises E, S = Iie
  7. 7. 18-Jul-13 7 Say’s Law of Markets Say’s Law: “Supply creates its own demand” At the macro level, total output = total expenditure = total income. Y = C + S. Y = C + I Therefore there cannot be over production, or unemployment in the economy. The Macro economy is always at full employment equilibrium.
  8. 8. 18-Jul-13 8 Say’s Law of Markets Output = Rs.1000 C = 800 S = 200 I = 200 Y = C+ S Y = C + I
  9. 9. 18-Jul-13 9 Full employment, full capacity equilibrium • So in a capitalist market, with perfect competition, there is:- 1. Full employment due to adjustment in w- rate 2. Market clearing, because D = S, due to adjustment by Ps. 3. No inflation, no deflation. 4. No trade cycles.
  10. 10. Classical Fallacies • Classical and Neo-classical economists were unable to explain why trade cycles occur. • According to them the market prices will always adjust to bring about equilibrium. • But during the Great Depression of 1929, prices, incomes, and employment fell continuously. • The Market could not ensure equilibrium. • Keynes showed that what is true at the Micro level is not true at the Macro level. • We look at Keynesian arguments in the next lesson. 18-Jul-13 10

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