Jim’s Notes

Classical Theory

Why Classical Theory? Concerns of Classical Economists

Context: Background, Assumptions, Conclusions

How to react to ‘supply shocks’ (war, industrial revolution, population growth)

Rapid Growth

Industrial Revolution

Agricultural Productivity Improved

Markets ‘work’, but will an entire economic system of just markets ‘work’?

Is a market-system stable?

Is a ‘Persistent glut’ possible?

In other words, will rapid improvements in technology result in a world where it’s possible to produce a large amount of goods but since few workers are needed and paid to produce them that there are not enough people with the income to pay for and buy the goods?

Rapid Growth

Industrial Revolution

Agricultural Productivity Improved

Will technology make unemployment inevitable?

Explain periodic inflation/deflation and business cycle

Why does inflation occur?

Why does the business cycle happen?

What role does/should a government play in a market system?

Can gov’t improve welfare?

Can government policy ‘manage’ economy?

Ideological basis of Classical Theory

Capitalism, in particular industrial and financial capitalism, is good and should be regulated as little as possible

Privately managed and owned industrial and banking firms are beneficial to the economy.

Government is the source of tyranny and/or economic problems. Minimal government is best.

Market results are morally justified. (people get what they earn)


Classical (and New Classical) Theory Assumptions

All markets are competitive

Goods, resource, and financial markets

Equilibrium prices in all markets:

disequilibrium (micro) conditions are very temporary and do not last. Supply and demand in all markets are responsive.
no shortages or surpluses, or at least no shortages/surpluses that last very long before price-driven adjustments in quantities supplied and demanded restore equilibrium.

Markets are ‘efficient’ and prices reflect fundamentals, not irrational bubbles.

Financial market prices reflect true economic value (present value of future cash flows and risks), not an assumption that assets can be sold or ‘flipped’ to a ‘bigger sucker’ later.

Say’s Law holds:

‘Supply creates it’s own demand’ – in other words, people, both firms and households, only sell in order to buy something. The act of selling a product or labor produces an income which is then used fully to buy products or labor.

One implication of Say’s Law, if it were true, is that in aggregate neither firms nor households would ever decide to sell and then hold onto the proceeds (the income) as a cash asset for future use instead of immediately turning around and spending the income on purchasing newly current goods, services, or production.

Households prefer to spend all income now and not save it.

unless high interest rates ‘bribe’ them to save.
when interest rates are high, households will save more (S) and spend (C) less
when interest rates are low, households will reduce savings (S) and increase current spending (C)

Firms borrow or use retained profits to finance I.

Firms evaluate hypothetical technologically feasible real investment projects to see what real profitability rate they would return. The profitability of these projects is compared to the interest rate (cost of capital) to see if it makes sense to invest.
As interest rates rise, the number and size of rational attractive investment projects declines and firms borrow less.
As interest rates drop, the number of attractive investment projects rises and firms attempt to borrow more.

AD doesn’t change much

All private agents (firms, households, and banks) are perfectly rational utility-maximizing or profit-maximizing decision makers. (Rational Expectations)

All agents have equally good and accurate information

All risks in the future are knowable and quantifiable

Capital and financial markets prices are based on fundamentals (Efficient Markets Hypothesis)

Money supply in the economy is exogenously determined (fixed by something outside the system). (Loanable funds doctrine)

Financial markets will therefore make sure S = I + GovBorrowing

Banks and financial markets are simply assumed to be doing a matching process of connecting household savers to firm or government borrowers by letting interest rates funcion as the ‘price of loaned money’

Money supply is limited by the central bank and/or the amount of some physical substance (such as gold).

Government must compete with the private firms to borrow the available pool of savings. – Crowding out occurs.

Private production of goods or services is always more efficient than government production of goods or services.

This assumption is sometimes weakened by some Classical-oriented thinkers who accept necessity to have government produce limited public goods such as defense or policing.

Classical Theory Dynamics and Predictions

Market Economy will return to full-employment equilibrium BY ITSELF

No government intervention needed

Market economies are stable and tend to equilibrium

Natural state is full-employment equilibrium.

Supply Shocks drive everything

‘Supply Shocks’ Determine Real GDP and Business Cycle

SRAS and LRAS shifts are the cause of recessionary/contractionary gaps or inflationary gaps

Business Cycle (Recessionary/Contractionary or Inflationary Gaps) is fixed by changes in flexibility and changes in prices

Recessionary gaps are temporary and then deflation and reduced wages restores full employment at LRAS
Inflationary gaps are temporary and inflation reduces output/employment to sustainable LRAS level

Persistent ‘glut’ or persistent high unemployment is impossible

Long-run Growth from technology and capital accumulation

Classical Theory: Adjustment Process

Recessionary Gap: Classical Theory Response


High unemployment is a surplus of workers at current wage –> wages decline –> profitability increases –> SRAS shifts rightward increasing production –> increased production, lower wage costs, higher profits and competition drive output prices down –> deflation

Using Circular Flow

Using AD-AS Model

No R.O.W.
not really a necessary assumption, but a simplifing assumption for this course now. Adding R.O.W. doesn’t really change the conclusions.

Inflationary Gap: Classical Theory Response


Higher than capacity production and dropping inventories –> need to hire more workers and buy more inputs –> Shortages of workers/resources –> Rising prices (inflation) –> Rising input prices shift SRAS backward (leftward) –> inflation –> pressures stop when LRAS level achieved

Using Circular Flow

Using AD-AS Model

No R.O.W.
not really a necessary assumption, but a simplifing assumption for this course now. Adding R.O.W. doesn’t really change the conclusions.

Classical Policy Recommendations


Small government

Balanced budget: T = G

Taxes = G

Gold Standard or Central Bank control of money supply to stabilize Money and Prices

Promote markets and capitalism