A Classical Overview

The work by Smith was refined and enhanced by scores of others over the ensuing 150 years, including Jean-Baptiste Say, John Stuart Mill, David Ricardo, Thomas Robert Malthus, and Alfred Marshall, to name just a few. Their work led to the creation of a sophisticated body of principles and analyses that offered insight into a wide range of economic phenomena--both microeconomic and macroeconomic. Many of these principles remain essential to the modern microeconomic theory. And while classical economics was largely discredited by John Maynard Keynes and advocates of Keynesian economics from the 1930s through the 1970s (due in large part to the Great Depression), it has reemerged (albeit with modifications) in recent decades.

Flexible Prices

The most important macroeconomic dimension of this assumption applies to resource markets, especially labor markets. The unemployment of labor, particularly involuntary unemployment, arises if a surplus exists in labor markets. With a surplus, the quantity of labor supplied exceeds the quantity of labor demanded--at the exist price of labor (wages). With flexible prices, any surplus is temporary. Wages fall to eliminate the surplus imbalance and restore equilibrium--and achieve full employment.

If, for example, aggregate demand in the economy takes a bit of a drop (perhaps due to fewer exports of goods to other countries), then production also declines (temporarily) and so too does the demand for labor, creating a surplus of labor and involuntarily unemployed workers. However, flexible prices mean that wages decline to eliminate the surplus.

Say's Law

Say's law is occasionally misinterpreted as applying to a single good, that is, the production of a good is ensured to be purchased by waiting buyers. That law actually applies to aggregate, economy-wide supply and demand. A more accurate phrase is "aggregate supply creates its own aggregate demand." This interpretation means that the act of production adds to the overall pool of aggregate income, which is then used to buy a corresponding value of production--although most likely not the original production.

This law, first and foremost, directed attention to the production or supply-side of the economy. That is, focus on production and the rest of the economy will fall in line. Say's law further implied that extended periods of excess production and limited demand, the sort of thing that might cause an economic downturn, were unlikely. Economic downturns could occur, but not due to the lack of aggregate demand.

Saving-Investment Equality

If this happens, then producers reduce production and lay off workers, which causes a drop in income and induces a decline in consumption, which then triggers further reductions in production, employment, income, and consumption in a contractionary downward spiral.

However, if this $10 million of saving is matched by an equal amount of investment, then no drop off in aggregate demand occurs. Such a match between saving and investment is assured in classical economics through flexible prices. However, in this case price flexibility applies to interest rates. Should saving not match investment, then interest rates adjust to restore balance. In particular, if saving exceeds investment, then interest rates fall, which stimulates investment and curtails saving until the two are once again equal.

Keynesian Critique

• Flexible Prices: First up is the classical proposition that wages and prices are flexible. Keynes argued that prices are really inflexible, especially in the downward direct. This inflexibility or rigidity of prices results because sellers, both output produces and resource owners, are unwilling or unable to accept lower prices. Inflexible prices thus prevent markets from eliminating shortages and surpluses. In particular, rigid wages allow a surplus of labor (that is, involuntary unemployment) to persist.


• Say's Law: Keynes was perhaps most critical of Say's law that supply creates its own demand. Keynes questioned whether or not supply does in fact create demand. While, in principle, revenue generated by production ultimately ends up as household income, this does not happen instantaneously. In the meantime, households can only spend the income that they actually have. If they have less income, then they spend less, less is sold, less is produced, and less revenue is generated.


• Saving-Investment Equality: The assumed equality between saving and investment was also criticized by Keynes. The lack of flexible prices might also prevent equilibrium in financial markets. Should interest rates not adjust, then saving might not match investment. Moreover, the attainment of equilibrium might actually require negative interest rates. Keynes suggested that interest rates were not the only or even most important factors affecting saving and investment. Factors such as a dismal outlook on the economy might reduce investment well below saving at any positive interest rate. A such, a disequilibrium in which saving exceeds investment means aggregate demand falls short of aggregate production and is just the sort of thing that would create a sustained depression.