Question

Do you think the economy is self-regulating? Do you think economies will always go back to its potential as Classical view believes? Briefly discuss.

Answer 1

SELF REGULATING ECONOMY

Classical economists believe in self-regulating economy. Wage rate and prices are flexible. Through the market mechanism, economy will move towards long run equilibrium. Recessionary gap If real GDP < Natural real GDP (full employment GDP), then a recessionary gap exist. At the same time: Unemployment rate > natural rate of unemployment. Since more job seekers are in the market, they tend to settle with a lower wage. Lower wage will raise the short run AS curve and causing the price to decrease. Lower price will increase consumption. This process will continue until the economy reaches the long run equilibrium (natural real GDP). Inflationary gap If real GDP > Natural real GDP (full employment GDP), then an inflationary gap exist. At the same time: Unemployment rate < natural rate of unemployment. Since job seekers are less than job openings in the market, employers are forced to raise the wage to attract new workers. High wage will decrease the short run AS, and raise the price. Higher price will lower consumption. This process will repeat until the long run equilibrium is reached.

Before the publication of Keynes’ General Theory in 1936, econo­mists all over the world believed in classical view of the economy. The classical economists were little concerned with unemployment, because they adhered to the Say’s Law of Markets, put forward in 1803. According to the Say’s Law, ‘supply creates its own demand’. Therefore, overproduction or under-consumption is a logical impossibility.

The most important implication of Say’s Law is that there is no essential difference between a monetary economy and a barter economy. Whatever is produced by the economy will be automatically bought.

The Say’s Law is illustrated in Fig. 1. The classical economists assumed wage-price flexibility, i.e., wages and prices would always move up or down to eliminate any excess demand or supply. In Fig. 1 AS is the aggregate supply curve at full employment and OQ_F is the maximum output society is capable of producing.

Now, suppose, due to reduction in money supply or any other reason the aggregate demand falls. In this case the demand curve shifts down to AD₁ from AD₀, and the general price level will fall to OP₁ from Op₀. Thus according to Say’s Law, “supply creates its own demand as prices move to bal­ance demand with aggregate supply.” In other words, prices and wages adjust upward or downward to ensure that ag­gregate demand equals full em­ployment (potential) output. Output does not fall in the event of a fall in demand.

In fact, all major economic thinkers before Keynes sub­scribed to this view that over-production was impossible. As A.C. Pigou commented (in his famous book: The Theory of Unemployment): “with perfectly free competition there will always be a strong tendency toward full employment. Such unemployment as exists at any time is due wholly to the frictional resistances (that) prevent the appropriate wage and price adjustments being made instantaneously.”