Question

1. The Classical view, when it started and who is a good representative of this school.
2. Says Law and the assumption that Savings = Investments.
3. Explain the importance of flexible interest rates, wages and prices in this model.
4. Understand and explain the shape of the investment and savings curves. This means explain the relationship between the interest rate and savings and the interest rate and investment.

Answer 1

The term ‘Classical economics’ is referred to as an economic thought prevailed in Great Britain during the last half of 18^th century and first half of 19^th century. The term “Classism” was first used by Karl Marx to denote the economic thoughts of a group of economists like Adam Smith, David Ricardo, Malthus and J.S Mill. The classical economics got popularity by the publication of An Enquiry into the Nature and Causes of Wealth of Nations by Adam Smith in 1776. Smith’s contribution to the economics laid a foundation of new era in economic thoughts. Thereafter Adam Smith is regarded as the father of modern economics.

Say’s Law

The foundation of classical economics is the ‘Say’s Law of Market’ profounder by a French economist Jean-Baptiste Say in 1803. According to this law supply creates its own demand. Every product brought into the market leaves sufficient income so as to generate its demand. The prime object of earning money is to spend. People never hold money as idle money. Holding money creates disutility and a man gets utility only when he spend the money. In such a situation whatever goods are produced will be sold out. There will be no situation of goods remaining unsold. Thus an economy’s normal situation is fullemployment. If there is any unemployment it will be automatically corrected through wage price flexibility. For example if there is deficiency in demand the price will fall the fall in price generate more demand for the unsold goods. If there is unemployment in the labour market, the wages will go down so as to provide employment to the unemployed. If any saving accumulated in the economy it will be automatically converted into investment through the flexibility of interest rate. If saving is greater than investment, the rate of interest falls and the fall in rate of interest generate sufficient demand for saving. Thus the classical economist established the equality of saving and investment through the flexibility of rate of interest.

In classical idea, if the saving exceeds investment, this excess saving will be channeled in to investment. At low interest rate the demand for saving or investment increases. When there is more demand for investment all savings will be utilized. Only on this ground of interest rate the classical economist can claim the normal situation of an economy as fullemployment.

Secondly the classical economist believed in wage flexibility. If wages are flexible in downward direction there is no room for workers remaining unemployed in the labour market. In any circumstance if unemployment exists, the competition among workers to get job will bring down the wage rate. The fall in wage create more demand for workers and the labour market will always be in equilibrium by the equality of demand for and supply of labour which is brought about by the downward flexibility of wage.

The classical economist believes that the commodity market is always in equilibrium by the equality of demand and supply of products. If there is a glut in the market, the prices will fall and the fall in price generates more demand and the unsold goods will be sold out.

In short the commodity market is in equilibrium through the flexibility in price and the labour market is in equilibrium through the wage flexibility and the money market also be in equilibrium through the flexibility of interest rate. In short in classical view, the normal situation of an economy is fullemployment and if any unemployment persists it will be automatically corrected through wage-price flexibility. The interest rate and wage price flexibility is the core of classical assumption on which the classical economist confirm that the normal situation of an economy as fullemployment.

The classical economist held that in the event of equality of saving and investment there will be equality of aggregate demand and aggregate supply. If however, saving and investment are not equal, the changes in rate of interest will equate saving and investment. Both saving and investment depends upon the rate of interest. Saving is an increasing function of the rate of interest. At higher rate of interest more will be saved and viceversa. Hence saving curve is an upward sloping curve. The investment is an inverse function of rate of interest. It means that when the rate of interest is high, there will be less investment and when the rate of interest is low, there will be more investment. Because of this inverse relationship between rate of interest and investment, the investment curve is a downward sloping curve.