Classical Macroeconomics

Classical Macroeconomics
Classical economists were well aware that a capitalist market economy could
deviate from its equilibrium level of output and employment. However, they
believed that such disturbances would be temporary and very short-lived.
Their collective view was that the market mechanism would operate relatively
quickly and efficiently to restore full employment equilibrium. If the
classical economic analysis was correct, then government intervention, in the
form of activist stabilization policies, would be neither necessary nor desirable.
Indeed, such policies were more than likely to create greater instability.
As we shall see later, modern champions of the old classical view (that is,
new classical equilibrium business cycle theorists) share this faith in the
optimizing power of market forces and the potential for active government
intervention to create havoc rather than harmony. It follows that the classical
writers gave little attention to either the factors which determine aggregate
demand or the policies which could be used to stabilize aggregate demand in
order to promote full employment. For the classical economists full employment
was the normal state of affairs. That Keynes should attack such ideas in
the 1930s should come as no surprise given the mass unemployment experienced
in all the major capitalist economies of that era. But how did the
classical economists reach such an optimistic conclusion? In what follows we
will present a ‘stylized’ version of the classical model which seeks to explain
the determinants of an economy’s level of real output (Y), real (W/P) and
nominal (W) wages, the price level (P) and the real rate of interest (r) (see
Ackley, 1966). In this stylized model it is assumed that:
1. all economic agents (firms and households) are rational and aim to
maximize their profits or utility; furthermore, they do not suffer from
money illusion;
2. all markets are perfectly competitive, so that agents decide how much to
buy and sell on the basis of a given set of prices which are perfectly
flexible;
3. all agents have perfect knowledge of market conditions and prices before
engaging in trade;
4. trade only takes place when market-clearing prices have been established
in all markets, this being ensured by a fictional Walrasian auctioneer
whose presence prevents false trading;
5. agents have stable expectations.
These assumptions ensure that in the classical model, markets, including the
labour market, always clear. To see how the classical model explains the
determination of the crucial macro variables, we will follow their approach
and divide the economy into two sectors: a real sector and a monetary sector.
To simplify the analysis we will also assume a closed economy, that is, no
foreign trade sector.
In examining the behaviour of the real and monetary sectors we need to
consider the following three components of the model: (i) the classical theory
of employment and output determination, (ii) Say’s Law of markets, and (iii)
the quantity theory of money. The first two components show how the equilibrium
values of the real variables in the model are determined exclusively in
the labour and commodity markets. The third component explains how the
nominal variables in the system are determined. Thus in the classical model
there is a dichotomy. The real and monetary sectors are separated. As a result,
changes in the quantity of money will not affect the equilibrium values of the
real variables in the model. With the real variables invariant to changes in the
quantity of money, the classical economists argued that the quantity of money
was neutral.