Question

Consider classical labor markets. Let prices rise. If nominal wages increase equi-proportionally with prices there will be no effect on equilibrium employment. Why? Illustrate what happens in the labor market.

Answer 1

The two main blocks of classical theory are the Say’s Law of Markets and the Quantity Theory of Money. The classical economists believed in the Say’s Law of Markets, which states that supply creates its own demand. They also believed in wage-price flexibility. These two assumptions, viz., the operation of Say’s Law and flexibility of wages and prices would ensure automatic full employment. This was the basic postulate of the classical economists. So the classical economists ruled out the possibility of unemployment in free-market capitalist economies.If there were any unemployment in the classical model, it would be of a temporary nature. The cause of such unemployment would be too high a real wage. But this could not persist for long. Unemployment implies excess supply of labour, which would cause the money wage rate to fall. This, in its turn, would lead to a fall in the cost of production and the price level and vice vers. So , If nominal wages increase equi-proportionally with prices there will be no effect on equilibrium employment and this will cause a deficit in supply of labour .