The level of output and, hence, the level of employment is established in the labour market by the demand for and supply of labour. Quantity of money does not influence the real variables of the system- output, employment, and the interest rate. But money supply does not have any impact on Y which is determined in the real sector and Y is fixed due to full employment. The classical theory is based on the automatic self equilibrating tendency of the economic forces. What is required for stable price level is the stable money supply since quantity of money determines the price level. 3.6. At a real wage rate lower than the equilibrium real wage rate, the quantity demanded of labour will exceed the supply of labour. Saving curve (S) and investment curve (I) are equal to each other at point E where the equilibrium volume of saving (SE) is equal to the equilibrium value of investment (IE). Thus, it is at rate of interest I that loan market is in equilibrium, i.e., investment is equal to savings (I = S). The state of technology and the population are also assumed to be constant in the short ran. At a higher rate of interest i2, the investment demand is less than the intended supply of savings. 2. In fact, the former coincides with the latter. Say’s law, as mentioned above, states that supply creates its own demand, that is, acts of production of goods create demand equal to the value of output of goods produced. Wage-Price flexibility is all that is required. On the other hand, the savings of the people are taken to be the increasing function of the rate of interest, that is, higher the rate of interest, the larger the savings and vice versa. Although it is correct that produc­tion of output generates an equal amount of income but what is the guarantee that all income earned by factors/households will be actually spent on goods and services produced. TOS4. The first three describe how the economy works. Their conviction in wage flexibility. He in his book 'General Theory of Employment, Interest and Money' out-rightly rejected the Say's Law of Market that supply creates its own demand. People save in the current period to have larger income or consumption at a future date. Saving (S) is an increasing function of rate of interest (i). The point of effective demand, which gives the equilibrium level of employment, also indicates the equilibrium level of national income and output. Now, if price level is doubled to 2P1 and money wage rate rises to 2 W1, then the equilibrium real wage rate will become equal to 2W1/2P1 = W1/P1. This implies that aggregate supply curve of output is perfectly inelastic. Now an important thing to know about classical theory is when due to decline in profit expecta­tions of business firms if investment falls as it happens at times of recession or depression how it then explains that demand deficiency problem would not arise and equilibrium will continue to remain at full employment. That is, economic forces would always be generated so as to ensure that the demand for labour was always equal to its supply. The aggregate demand curve for labour is the horizontal summation of all individual firm’s demand curve for labour. As employment increases, output … 2. Employment-Output Determination: Labour Market: 2. Given wageprice flexibility, there are automatic forces in the economic system that tends to maintain full employment and produce output at that level. Thus, if a part of income is saved (that is, not spent), supply of output produced would not create sufficient demand for itself. plant and equipment) is assumed to be fixed. Determination of income and employment when there is no saving and investment; 2. This is based on the assumption that households or individual workers maximise their utility or satisfaction in their choice of work (which yields them income) and leisure. There is neither excess supply of labour, nor excess demand for labour. Say's Law of Market. “General Theory of Employment, Interest, and Money” which elucidated the thoughts of Keynes as economist (Froyen, 2006). But with increase in money supply, money wages and price level change in such a way that real wage rate in the equilibrium situation remains constant and equilibrium in the labour market is auto­matically restored. Equilibrium level of employment along with real wage rate is determined by labour market equilibrium, that is, equilibrium between demands for the supply of labour. Households can be assumed to both produce and consume without altering the basic result, and there is no intrinsic need for a market for labour, as opposed to goods produced by the self-employed household. Due to the excess supply of savings, the rate of interest would fall to i. The classical theory assumes full employment without inflation. Classical Theory of Employment and Output (With Diagram) 1. Investment refers to the creation of additional stock of capital. Classical Theory of Output and Employment Propounded by Adam Smith in his classic entitled ‘An Inquiry into the Nature and causes of the Wealth of Nations’. This excess supply of savings will put downward pressure on the rate of interest and as result interest will fall to i1, at which saving and investment are again equal. The classical theory had propagated a free market economy, which classical economists believed would automatically lead to full employment. In other words, in Figure 3.5 MV represents aggregate expenditure or aggregate demand (AD) curve which slopes downward to the right. The Keynesian theory of employment is also called the theory of income and output. According to this law, “Supply creates its own demand.” J. Aggregate supply curve describe the relationship between aggregate supply of output with price level. 2. MC of labour is equal to the money wage divided by the marginal product of labour, MPL, i.e.. where W is the money wage, P is the absolute price level, and W/P is the real wage. This is illustrated in Fig. 3. Classical Theory of Employment. The unemployment occurs when the aggregate demand function intersects the aggregate supply function since the economy cannot experience a full employment level. With velocity of money V, aggregate expenditure on final goods and services will be equal to M1V and corresponding to this aggregate demand curve AD1 has been drawn in Fig. Equation 3.10 states that people hold cash balance since there is a gap between money receipts and expenditures. The implication . The classical employment analysis is based on the Market Law of the French economist J. They argued that every rupee saved by households will be invested by businessmen, that is, investment expenditure will be equal to savings done by households. According to the Classical Theory, the level of water in the "Bathtub" (employment, income, and output) is always at the maximum because _____ is (are) assumed to create Demand. For instance, at a real wage (W/P)1 there exists a situation of unemployment. Besides, with the increase in money supply and consequent change in the price level, saving-investment equilibrium will not be disturbed and therefore deficiency of aggregate de­mand will not arise. It therefore follows that increase in the quantity of money causes price level to rise. Classical Theory of Income, Output and Employment Determination 1. 3.2 where in addition to the supply of and demand for labour, the aggregate production func­tion (OY) representing the relation between em­ployment of labour (N) and total output (K) is shown. 3. The description of the various equations in the model is as follows: 1. Adam Smith wrote a classic book entitled, 'An Enquiry into the Nature and Causes of the Wealth of Nations' in 1776.Since the publication of that book, a body of classic economic theory was developed gradually. Further, assuming that the firms which undertake the task of production attempt to maximise profits, they will employ labour until the marginal product of labour is equal to the given real wage rate. Individuals do not suffer from money illusion. Monetary sector is not concerned with relative prices and real variables. Classical economists believed in the Quantity Theory of Money according to which it is the supply of money that determines price level in an economy. Keynes theory of output and employment is often called a monetary theory of employment. Quantity theory of money is generally expressed by Fisher’s equation of exchange, income version of which is stated as under: V – Income velocity of circulation of money, Y = Level of aggregate output (or real income). Say’s law of markets is the central pillar of the whole classical theory. 3.1 that excess supply of labour equal to AB would emerge. Thus, supply goes on creating its own demand and Say’s law applies. More labour is demanded at a lower wage. It was J. M. Keynes who first analyzed the frequent problem of unemployment and fluctuating levels of real output or national income. For this, they have to determine the level of output to be produced and the number of workers to be employed. 3.3 shows how equilibrium rate of interest is determined in the classical model, independent of the monetary sector. The ‘Great Depression’ of 1929 to 1934, engulfing the entire world in widespread unemployment, low output and low national income, for about five years, upset the classical … Share Your PPT File, Keynesian Theory of In­voluntary Unemployment (With Diagram). The classical theory of employment is grounded in Says Law, the classical interest rate mechanism, and downwardly flexible prices and wages. Keynes seriously questioned the validity of self adjusting and self correcting economy as portrayed by classical theory. That is, employment of labour and output (income) rise or fall together. Second, real wage rate changes quickly to bring about equilibrium between demand for and supply of labour. How is the general price level determined? Interest rate that guarantees that changes in the particular components of demands do not affect the aggregate level of commodity demand. This will result in deficiency of demand or expenditure on output of goods produced. Like labour demand, aggregate labour supply function also depends on the real wage rate, but in a direct manner. Assumptions of Classical Theory of Y ,O, N: Money-wage stickiness. According to the Keynesian theory, the changes in aggregate demand have short run effects on employment and output unlike in the prices. Classical Theory of Employment and Output Determination. 4. It follows from above that the quick changes in the real wage rate upward or downward ensures that neither excess supply of labour, nor excess demand for labour will persist and thus equilibrium will be reached with full employment of labour in the economy. On the other hand, the supply of labour by the households in the economy depends on their pattern of preference between income and leisure. In other words, there is no involuntary unemployment of labour in this equilibrium situation. It will be seen from Fig. Now, what is the rational behind the upward-sloping supply curve of labour. Perfect competition exists in both product market and factor market. This induces the individual to work more (i.e. Thus, shift in investment demand curve to the left results in lowering of rate of interest which leads to more investment and consumption demand so that aggregate demand is not affected. Thus, with equal proportionate increase in money wage rate as a result of rise in price level, equilibrium real wage rate and level of employment will remain unaffected. Content Guidelines 2. They showed that Say’s law that supply creates its own demand holds good even in the presence of saving. Thus, the demand curve for labour is derived from the marginal product curve of labour. Price Level Determination: Money Market: 3. An investment is something that is used to create value in future. Keynesian economics was developed by the British economist John Maynard Keynes. Thus, in classical theory aggregate supply curve is determined by supply-side factors, namely, preferences of households or individuals regarding work and leisure, the stock of capital (and other factor endow­ments), the state of technology. On the contrary, if somehow real wage rate in the labour market is (W/P)2 the firms would demand more labour than is offered at this real wage rate. It was J. M. 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