Unit 8: Classical Theory

THE AD-AS Question: Will markets self-correct?

We left the last unit with these questions:

THE AD-AS Question: Will markets self-correct? Now we get to the most important question in the macro-economics of the real sector. Do markets self-correct? Will an economy in an inflationary gap (expansionary gap),self-correct and return to equilibrium (LRAS) without inflation? Will an economy in a recessionary gap (contractionary gap) self-correct and return to full-employment (LRAS)? In other words, will a market system be self-correcting and always achieve our macro-economic goals? Or, is government intervention necessary to achieve stability and full-employment?

In economics, there are two major views or theories that attempt to answer these questions. Strictly speaking, we should think of these as “major categories of theories” since there are actually many different variations of either Classical or even Keynesian theory.  But for our purposes, it’s useful to think of them as two different “theories”, Classical and Keynesian.  These two theories have very different conclusions with regard to the desirability of government involvement in the economy. To understand the essence of these two theories, and why they reach the conclusions they reach, we will focus on their assumptions about how people make decisions, how markets really work, and ook at the two “gap situations”, a recessionary gap and an inflationary gap. (they are also called contractionary and expansionary gaps). Each of the two major theories offers a different view on how decisions will be made in the economy and how an economy will react when it is in one of these gaps. We will look at the Classical theory first.

“Classical” Theory

The economists who first developed AD-AS analysis are called “Classical” economists: folks like Jean Baptiste Say, David Ricardo, John Stuart Mill, Alfred Marshall, Leon Walras, and even Karl Marx (more about that below!). Most of the original Classical economists lived in the 19th century when the Industrial Revolution was young and agriculture and small businesses still dominated economy. These economists took it for granted that markets were competitive. Microeconomics teaches us that IF markets are competitive, then they will achieve efficient production and efficient distribution.

The Classical economists pointed out that, if you assume that markets are indeed very competitive, then the AD-AS model of shifts and reactions to changing prices, costs, incomes, etc., leads us to see that the macroeconomy will always be at a full-employment equilibrium. Or, at the least, any disturbance (a recession, etc) that puts AD-AS out of equilibrium will quickly be corrected. Further, these equilibria for the macroeconomy will all happen to be at the full capacity of the economy to produce – in other words, we will always get back quickly to an equilibrium that’s on LRAS! That’s significant! If true, it means that we would always, or at least very quickly, regain full employment! Depressions and inflations will be short-lived. Further, this full employment (being on LRAS) will be accomplished without government involvement or interference — it will be the natural outcome of market forces. Further, it suggests that once equilibrium is attained, there is no reason for the price level to go up. That means there would be no inflation unless some shock (usually attributed to govenment monetary policy) happens! Note that it means we will have achieved two of our macro goals: full employment and no inflation. And, we would accomplish it without government involvement or management of the economy.

It is important to note the assumptions that Classical Economists make about the nature and structure of the economy. Initially, Classical economists were trying to analyze how a pure market economy would/could behave without government intervention, largely as a counter-argument to Mercantilists who urged the government to manage the economy through controlled prices, limited trade, and anti-industrial revolution policies. In analyzing the economy, Classical economists make a few assumptions about how it is structured. First, they assume that all goods,resources, and even finances are allocated through competitive markets. By “competitive” markets, they particularly emphasized that prices, wages, and interest rates bring these markets into equilibrium by going up-and-down. They are assuming the standard micro-economic situation of supply-and-demand in all these goods, resource, and financial markets. As it turns out, the most critical aspects of this assumption is the ideas that

  • Wages are flexible and bring labor markets into equilibrium. This means that involuntary unemployment doesn’t really exist.  If we see large numbers of unemployed people (excess supply of labor), it means that these people are simply refusing to work at the “market wage”. In other words, unemployed people are really demanding a wage higher than they are worth.  They are in effect “choosing leisure” instead of work.
  • Interest rates are flexible and bring financial markets into equilibrium. The implications of this assumption are subtle. On it’s surface, this means that total savings in the economy (S) is equal to total investment spending (I).  Rephrased, it’s a way of saying that the total supply of loanable funds (S) is equal to the total demand for borrowing those funds (I). If true, this is very significant.  It means there is no leakage of income from the circular flow. If consumers don’t spend all their income (they Save), it’s OK because that Savings gets spent as investment spending.  Income does produce GDP with no leakage. B

But for these assumptions that interest rates (i) are the “price”of loanable funds and that competitive financial markets make S = I to be valid, Classical economists must make some further assumptions about the motivations of people in financial markets. Classical economists assume that the only reason for households to save part of their income (instead of spending all of it on consumption) is because the interest rate is high enough to be attractive. Essentially, Classical economists believe that the interest rate alone determines how much households are willing to save. Households or consumers have a desire to spend all their income immediately unless “bribed” to “wait” (save) by a high enough interest rate. Further, firms are assumed to have an unlimited number of opportunities to invest capital goods spending. These opportunities vary in profitability. Thus, when interest rates are low, firms borrow more and do more investment spending, even on low-profit margin opportunities. If the interest rate is high, then firms cut back their investment spending, choosing only high profit opportunities.

Classical Theory, Gaps, and AD-AS

For more detail about how a competitive “Classical” economy responds to a contractionary or expansionary gap, see the Classical AD-AS Closer Look.

In the Classical Model, all of the action involves aggregate supply curves, SRAS and LRAS. Aggregate demand, the money people want to spend at various price levels, is static and doesn’t really shift much, if at all (there is an exception -dealt with below).  The analysis starts with the assumption that the economy is at full-employment long-run equilibrium – the case where LRAS, SRAS, and AD all intersect at the same point corresponding to full employment GDP.

So how do gaps, either inflationary or recessionary, get created? Shifts in LRAS create “supply shocks” and put the economy into one of the gaps. If some external supply shock happens to make the economy more productive, such as new technology, new resources (like discovering oil), or population growth, then the LRAS, the capacity of the economy to produce at full employment, shifts rightward. AD stays where it is and SRAS initially stays, creating a recessionary or contractionary gap. On the other hand, a negative supply shock such as war or natural disaster destroying labor force and capital stock, or a sudden upward increase in the price of a totally imported critical resource (like oil for us), then the LRAS shifts leftward creating an inflationary gap.

Adjusting to Gaps

Classical theory says the adjustment to these “gaps” is then made through shifts in SRAS. In other words, in a recessionary gap, there are widespread market surpluses (unemployed workers, unsold goods). In an inflationary gap, there are widespread shortages of workers and resources as firms try to satisfy a demand that is greater than they can produce long-run. Firms and workers react to unemployment and goods surpluses (recessionary gap) by lowering their prices and wages. If shortages exist in an inflationary gap, then firms and workers raise prices. If the economy is, for example, in a recessionary gap with significant unemployment, then the unemployed people offer to work for less (lower the price of labor). This ultimately results in a lower price level and in a shift of the SRAS curve. The lower wages make business seem more profitable and hence the SRAS shifts rightward – firms produce more and hire more workers, albeit at a lower wage. Similarly, when resource shortages happen because firms are trying to produce more than the economy has resources for, prices in general rise and SRAS shifts again (this time leftward) as firms slowly catch on that things aren’t as profitable as they had hoped because of the inflation. In the Classical view, it is Supply, the SRAS, that helps the economy adjust. Classical economists assumed that if people were employed,  all their income would get spent, either directly or through S becoming I. So the key, in Classical theory, is how to get supply, the SRAS, to decide to produce enough goods and employ everybody. This assumption, often described as “supply creates it’s own demand”, is called Say’s Law after the economist Jean-Baptiste Say. Say’s Law effectively says that “if we can produce it, we will, and we’ll sell it to ourselves, and the income from producing it provides us the ability to buy it.”

Turning to the other two macro goals: growth and stability, the Classicals observed that with markets naturally driving AD-AS to equilibrium at the LRAS all the time, the only events that might disturb the equilibrium would be some kind of “supply shocks”. What’s a supply shock you ask? A supply shock means that some event has seriously altered or changed the fundamental Production Possibilities of the economy and shifted LRAS. In other words, significant new real resources have been found, or significant resources have been lost, or a new technology has been developed. Any of these “supply shock” events could disturb the equilibrium temporarily until a new equilibrium is achieved by markets adjusting to the changed supply. What would be examples of such shocks? Well, the industrial revolution itself was quite a technological supply shock – it lowered the general cost & price of most commodities by improving productivity. Wars typically destroy productive resources (not the least of which are young men) and constitute a negative supply shock in the nation fighting the war. Similarly, population growth or conquering new nations or developing new knowledge all constitute positive supply shocks. (positive, that is, unless you are the conquered nation).

* While Classicals believe supply shocks (shifts in LRAS) are the most common and primary cause of inflationary or contractionary gaps, they also observed that, in their model, if government doesn’t follow a balanced budget, then G will not equal T and that could create a “gap”.  Specifically they were most concerned about government deficits. A government deficit shifts AD to the right and could create an inflationary gap if the economy was already at full employment.

Implications of Classical AD-AS Theory

The Classical Theory implies that a market-based economy is inherently self-regulating. It will achieve equilibrium on it’s own without government interference. That equilibrium will achieve our goals: full employment, no inflation, and stability (the recessions will be short). Growth can be achieved by obtaining more resources.

Of course, if a market-based economy will always achieve full-employment equilibrium on it’s own, without government interference, then we don’t need government to try to manage the economy. This is exactly the policy advice Classical Economists gave politicians. Classical economists advocated small governments that always had a balanced budget. In other words, they believed government should be small, and tax exactly enough to pay for that small government spending. Anything else was believed to interfere with and slow the adjustment of the market economy. This “hands-off” policy of government came to be called laissez-faire policy (pronounced “lay-say fare”). The “hands-off” or laissez-faire recommendations of Classical theory also made the Classical viewpoint very attractive to many economists and politicians in later years whose ideological bias wants to that conclusion.

 What Happened

The experiences of industrialized nations in the 1800’s and early 1900’s were inconclusive if considered as an empirical test of Classical theory. Those nations that followed so-called “laissez-faire” policies, that is, the governments were small, balanced their budgets, and didn’t interfere economically, grew the fastest. Recessions did come to an end eventually if government did little or nothing. Inflation was an occasional and often short phenomenon. There were periods of deflation but they were typically followed or paralleled depressions. The experience was somewhat in line with Classical theory predictions. But there were other facts that didn’t necessarily support Classical theory.  Depressions were anything but mild or short. A couple very long depressions happened, 1870′-90’s for example. Even nations that adopted laissez-faire policies (US and UK in late 1800’s-1920’s) still experienced persistent wild swings in the business cycle.  The long-run full employment equilibrium, if it existed, clearly wasn’t stable.

Nonetheless, Classical economics won the day in the minds of many/most leading economists and policy-makers.  By the 1920’s, almost everybody “knew” that Classical Theory was the way the world worked. This especially included politicians. Several are several reasons why Classical theory “won the day” despite a mediocre at best record in predicting economic performance. First, high quality quantitative macroeconomic data largely didn’t exist before the 1920’s, so it was difficult to do credible scientific analyses and tests. (imagine a world with no regular reports of GDP or unemployment!). Second, the alternative theories were not very comprehensive or well-argued.  Classical theory originally emerged as a counter-argument to mercantilism. By the 1850’s nobody argued for mercantilism anymore.. It was soundly defeated and it’s many problems exposed. There were some critics of Classical theory in the 1800’s and early 1900’s, but the only one with a credible critique and a comprehensive counter-theory was Karl Marx. Marx’s critique of Classical economics eventually proved pretty good, but unfortunately for Marx (and millions of people in the 20th century), his counter-theory of policy proposals, communism, didn’t fare as well.  It pretty much failed miserably. Marx’s ideas also suffered from the disadvantage of being totally unacceptable to the ruling and banking classes (revolution is never popular with people on top!). A comprehensive critique of Classical theory combined with a set of policy proposals that were consistent with democratic government would have to wait until the 1930’s.  In the 1930’s, Classical economics met a severe test: the Great Depression. Classical theory-inspired policies totally failed. Indeed, they made the Depression worse, but that’s for the next unit.

Today, there are still many “Classical” macroeconomists. Keynesian theory emerged as both a critique and counter-proposal to Classical theories in the 1930’s.  The Keynesian critique was powerful and persuaded most but not all economists.  After a few decades, the remaining Classicals struck back with revisions of Classical theory that included monetary policy. We will study this newer generation of Classical-inspired theories in Part III when we study money.   Economists that are labeled “Chicago School” or “Austrian School” or “freshwater” are essentially Classical. The “Classical” school theories have been updated and now often referred to as Neo-classical, New Classical, or Monetarist. The models they use today are more sophisticated and complex, but the critical assumptions are the same and the resulting implication is still the same: small government with a balanced budget and a laissez-faire policy, based on a faith that free markets will naturally achieve full-employment.

What’s Next

In the 1920’s there was a broad consensus in economics and politics that Classical theory was THE theory. Indeed, then there were no real competing theories except for Marxism, Leninism, or Socialism. The Great Depression of the 1930’s challenged Classical theory and led to the emergence of a new theory, Keynesian theory. Keynesian theory led to the large national governments as we know them today. We will study it in the next unit.