Classical Theory of Employment Notes

CONTENTS
Objectives
Introduction
5.1 Classical Theory of Employment
5.2 Summary of Complete Classical Model
5.3 Keynes’ Criticism of Classical Threory
5.4 Summary
5.5 Keywords
5.6 Review Questions
5.7 Further Readings

Objectives
After studying this unit, students will be able to:
 Know the classical principle of Employment.
 Know the summary of full classical model.
 Criticise classical principle by Keynes.
 Discuss Say’s law.

Introduction

John Maynard Keynes is directly hit on the element base of classical on his book. ‘The Theory of
Employment, Interest and Money, (1936). He developed a new economics; it brought revolution in
economic viewpoint and policy. General Theory was written in the background of his viewpoint.
According to Keynes, classicals were the follower of Ricardo. In this, specially J.S.Mil, Marshal and
Pigou are involved. Keynes disclaimed that customary and institutional economics, which was
constructed till more than one century and fixed his dominance on economic viewpoint and
tradition till before ‘Great Depression’. Because the economics of Keynes is dependent on the
criticism of classical economics, so it is necessary to understand the above nature, it is involved in
the principle of employment.

5.1 Classical Theory of Employment

Classical principle believes that the full employment is found without inflation in capitalist
economy. Being the flexibility in labour prices, the automatic power of economics system able to
keep continuing the situation of full employment and has ability of production on that level. So full
employment is considered as a normal situation and there are some abnormal situations of
deviation by that level which were towards for their full employment.
Notes Assumptions
The classical principle of employment and production is dependent on following assumptions:
1. Full employment is found without inflation.
2. A close laissez faire capital economy is found without foreign business.
3. Full competition is found in labour and things markets.
4. Total production of economy is divided in the expenditure of investment and consumption.
5. The quantity of currency is given.
6. Wages and prices are flexible.
7. Currency wages and actual wages have proportional relation.
8. Capital stock and technology knowledge are given.

Notes Classical principle believes that the full employment is found without inflation
in capital economics.

Say’s Law of Market

Say’s law of market is the element of the classical principle of employment. In the starting of 19th
century this establishment is presented by French writer Jean Bapiste Say that “Supply creates its
own demand”. It’s called the rule of Say. In the words of Say, “Production created market for things.
As anything produced then it creates market for other things which are similar to its price. The
supply of other items is according to the demand of the item and not more than that. “ This rule is
applied on the barter economy, where finally things are sold in place of things. Every thing brought
in the market is the demand for any other thing. According to Say, doing work is not interesting, so
if any person is not wanting to exchange his favourite thing with any other things then he did not do
work for the production of that thing. So the demand is involved in the work of supply of things. In
that situation, more production is not possible because the supply of things will not be more than
total demand. It may be possible that one special thing is more produced, because customers
wrongly assessed the quantity of those things, which is necessary for others. However, this situation
is temporary, because that special thing is more produced to reduce the production of others. So
supply getting creates its own demand so unemployment is not possible.
This basic rule is not changed after getting the currency. As Prof. Hansen says that, “The market rule
of Say is the description of things- exchange economics. This rule is true by the viewpoint that the
main source of demand is that flow of source-income, which is created by the process of own
production." When producer make use of different inputs (land, labourer and capital) are used in
production process, then they create the necessary income which got to sources owner as interest,
wages and tax. Above it creates demand for produced things. So supply creates its own demand.
This logic is based on that perception that all income earned by source-owner is expended to buy
that things they helped in that production. The part of income which is not spent, it is saved and it
is invested. So saving will be equal to the investment. If both have any difference, then by the
median of rate of interest, similarity is established. Interest is the reward of saving according to
classical economist. The rate of interest will be more according to savings. Opposite to it the rate of
interest will be as low,
the demand of situation for investment
Notes
will be as more and vice-versa. If at certain
time the saving is increased from
investment, then the rate of interest will
fall. Investment will be increased and then
savings will be reduced whenever both are
not same at the level of full employment.
It is because saving considers the
increasing function of interest rate and
investment is considers the decreasing
function of interest rate.
The similarity of savings and investment is
shown in Fig. 5.1 where SS is saving curve
and II is investment curve. Both curves
intersect each other at point E, where Or is
the interest rate, and savings and
investment both are equal to OA. If Figure. 5.1
investment increases then investment
curve is shifted right side and becomes I’I’
and OC investment is more
than OA savings at Or interest rate. According to classical economists, saving curve remains at its
before situation when investment is increased. Interest rate will increase for continuing similarity
in saving and investment. In this figure, Or has increased to Or’. At that interest rate, saving curve
SS is intersecting at E’ to investment curve I’I’. Saving and investment both are equal on OB.
In currency economy the validity of the rule of Say’s is dependent on the classical magnitude
principle which tells that price-level is the function of supply of currency. As Algebra, MV = PT where
M,V,P,T are the supply of currency, the operating velocity of currency, price level and the
transaction by currency. This equation tells that the total currency-inflation is equal to MV in
economies and the total price of production is PT, if we assume V and T are constants then supply
of currency (M) is proportionate to change in price level (P) by change. It is based on that
assumption that currency is source of exchange.
The quantity of currency, total production and price level is shown in Fig. 5.2 where price is on
vertical and total production is on horizontal
level. MV is the currency supply curve
which is a rectangular hyperbola. It is
because that the equation MV = PT is
involved on all points of curve. When
production level OQ is given then there
will be one price-level OP similar with
the quantity of currency as there is m
point on MV curve. If the quantity of
currency is increased then MV curve is
shifted left side and will become M1V.
So when the
production level OQ is given, then the
price level will become OP to OP 1. That
increment of price level is proportional
with the increment of the quantity of
currency, mean PP1=MM1.
According to classical economist, if the
quantity of currency is double then the
Figure. 5.2
price level will become double. Opposite
it, if the quantity of currency is half then
Notes price level will become half. So currency is only a veil, its main work is to decide the normal price
level on which the things and services are exchanged.

Pigou’s Version
Pigou provided the last form to classical principle of employment who formulated the rule of Say
in the reference of labour market. According to Pigou, the nature of
economic system is within the free competition that labour market
itself provides full employment. Hardness in the structure of wages,
provides unemployment by interference in the causation of free
market economics. When states interfere to give the assumptions to
trade union and apply the low wages rules and adopts the labour
monopoly system, then wages increases and unemployment starts.
If the interference of states removes and the power of competition is
given to work freely, thus by increasing and decreasing the wages
rate unemployment will be fulfilled. As per Pigou’s objective, “By
the independent competition…..always one such tendency will be
operational in which the rate of labourer will be so aligned to
demand that every person has employment.” Pigou presented an
equation N = qY/W which describes all the proposals. N is the
employed labours in equation, q is the half part of national income
earned as wages and salary, Y is the national income and if we
reduce W then N can be increased. So the key of full employment
is that currency wages to
reduce. It is cleared in Fig. 5.3. In the part (A) of figure, S is the supply
curve and D is the demand curve. The cut of both curves on E shows
Figure. 5.3
the point No of full employment and actual wages W/P on which full
employment is available. If actual wages kept on high level W/P1, then by the demand of labour
supply sd increased and NoNF labourer is unemployed. When wages are reduced and take on the
point W/P then unemployment finished and got the level of full employment. It shows in the part
(B) of figure. MPL is the curve of frontier productivity of labour, which is slant at down as demand
curve. Its reason is that when more labour is applied on employment then the frontier productivity
is reduced because every labour got wages according to their frontier productivity so when wages
become W/P1 to W/P then economies got the full employment level N F.
In the classical model of employment, the change in currency-wages and actual wages are directly
related or proportionate. When currency is cut then actual wages are also reduced in the same
quantity, which reduce the unemployment and finally economies took full employment. This
relation is based on the perception that prices are proportionate to the quantity of currency. The
logic is that the decrement in currency-wages in competition economies reduces the prices of things
and cost of production so the demand increases. To complete the increasing demand of things more
labourers are kept for employment. When employment increases then
total productivity also increases till it attains the situation
of full employment. When economy is on the level of full
employment then total employment becomes constant. So
with the availability of stock of capital and knowledge of
engineering a relation between total production and number
of employment is made. Total production is the increasing
function of wages number. It is shown in Fig. 5.4. that
Q = f(K,T,N) in which total pr oduc tion is Q ,
function is f, capital stock is K, technical knowledge Figure. 5.4
is T and the number of labourers is N. This production function shows that total production,
capital stock and technical knowledge are increasing functions of the number of labour. In
Notes
Fig. 5.3 total production OQ is analogy to full employment level Nf.
Classical economist believed that in the normal competitive situation, full employment will
continue without inflation. In spite of competition among the owners for putting labourers to work,
wages will not be more than full employment level. Now because of applying the Say’s rule, the full
employment of production will generate the demand on that level. The increment in all the
demands is the reason of inflation. But the mechanism of the rate of interest stops more increment
in all demands. Again, inflation is also because of that when the currency increases that increasing
production cannot consume it. But it is also not possible because the increment in the quantity of
currency increases only at absolute price level not relative. So full employment is got without
inflation in classical system.

Did You Know? The nature of economic system within free competition is that full employment
is provided automatically in labour market.

Self Assessment
Fill in the blanks:
1. The market rule of Say is the heart of.....................................employment.
2. According to Say, supply creates its own ……………… .
3. The market law of Say, in the broad form free...............is the description of economics.

5.2 Summary of Complete Classical Model

The Classical Principle of employment is based on the assumption of full employment, according to
it a normal situation of full employment in economies is got and the abnormal situation of
unemployment remains abnormal. In Classical Principle, the selection of production and
employment is based on labour of economy, things and currency market, which is given in Fig. 5.5.
The power of supply and demand in this market will bring the full employment. By any interference
of government there will not full employment.
Production and all production functions of employment in the Classical analysis are decided by the
demand of labourer and supply of labourer. Due to stock of capital, technical knowledge and other
inputs have certain relation in the quantity of total production and employment it is Q = f (K, T, N)
as shown in the Fig. 5.5 panel (B). In other words, total production is the function (f), capital stock
(K), technology (T) and labour number (N). When K and T are given then labourer number function
is Q = f(N). But when more labourer goes after a limit then get the diminishing marginal returns.
The demand of labour and supply of labour in labour market distract the level of production and
employment in economics. The demand of labour is dependent on total production. More
production increase the demand of labour and the demand of labour is dependent on its frontier
physical productivity (MPP) which reduce to apply more tax. The supply of labour is dependent on
the labour rate Dl = f (W/P)which is the increment function of labour rate. Other side, the demand
of labour is dependent on labour rate S l = f (W/P) and it is the diminishing function. So the demand
and supply of labour is because of the actual wages rate (W/P). The intersection point E of demand
and supply
of labour decides the full employment on wages rate (W/P), D l = Sl–Nf, as shown in panel (C).
Notes

Figure. 5.5
Commodity market, savings and equality of investment (I = S) are in balance so the similarity in
both on full employment point E is by the mechanism of interest rate so demanding quantity of
things on full employment is equal to the quantity of supply. Savings is the function of interest rate,
I = f(r) and investment is the opposite function of interest rate, S = f(r).
Currency market is balanced by the demand and supply of currency. It is elaborated by the currency
magnitude principle. According to it, price level is the function of currency supply, P = f(MV). The
change in price is proportionate to the quantity of currency. Balance is described by the equation
MV = PT in currency market where MV is the supply of currency and PT is the demand of currency.
The balances of currency market describe the similarity with full employment of the production of
price level, which are penal (E) and (B). Line MQ is related with MQ.
Price level OP is decided by the total production (Q) and the quantity of currency (MV) as shown
in panel (B) and (E). Now actual wages are decided with currency wages. As shown in panel (D) by
W/P curve. When currency wages are increased by increasing the price level then actual wages W/P
are reduced so there will be effect on level of production and employment. So the conclusion is that
to get the level of full employment, currency wages should be reduced. So continuing the situation
of full employment, classical economists were in favour of flexible price-wages.

TaskExpress your ideas on the Classical Principle of employment.

Self Assessment Notes
Multiple Choice Questions:
4. Classical economists consider the savings of interest as ........... .
(a) reward (b) measurement
(c) part (d) none of these.
5. This basic.....................................is not change on getting the currency.
(a) principle (b) rule
(c) exchange (d) non of these
6. Saving is considered as the increasing function and investment is considered as the —.
(a) diminishing function (b) increasing function
(c) cost (d) none of these.

5.3 Keynes’ Criticism of Classical Theory

Keynes’ criticized this principle because of the unreal perception of Classical Principle of
employment. He writes in his book ‘General Theory’ that, “Classical Principle is continuing to
assume those specifics, they did not keep relation with that economic society in which we live, its
result is that when we apply it on reality experience, then its training is proved doubtful and
destructive. Whatever behaviour we hope from our economy it expresses that type of facility. But it
consider that it happens, is like closing the eyes in difficulties.”
Keynes’ attacked on classical principle because of following reasons—
1. Under-employment Equilibrium: Keynes rejected the basic classical perception of
balanced full employment in economics. He told unreal to this perception. He considers
full employment a specific condition. Under-employment is the normal situation in
socialist economy. Its reason is that capitalism does not work according to the rule of Say
and supply is always increased by demand. We see that lakhs of labourers are ready to
work on present wages and less than that, but they did not get work. So the existence of
voluntary unemployment in capitalism economy proved that under-employment is the
normal situation and full employment balanced situation is abnormal and immediate.
2. Over-production Possible: Keynes’ disclaimed the market rule of Say that supply creates its
own demand. His perception is that all income earned by sources-owner is not spent in
purchase of those things which are helpful for production. Some parts are saved from the
earned income, which are not automatically invested because saving and investment are
two separate work. So when all earned income is not spent on consumer goods and some
part remains, then total demand reduces. Resultantly, it is normal hyper production,
because all could not be sold which has been produced, further, it leads to common
unemployment. So by this taking the support of this rule proved Say’s rule to be
meaningless.
3. Self:adjustment Impossible in the Economy: Keynes’ was not satisfied by this idea of classical
economist that for the self process of full employment balance, laissez faire is necessary.
He declared that capitalism system is not self adjust because of unequal structure of their
society. There are two major classes– rich and poor. “Rich have more money but they did
not spend all money on consumption.” The poor have no money for purchasing things. So
in the comparison of total supply there are normal low levels of total demand by this there
are over-production and unemployment in economy, then it never happens. So ‘big
depression’ was the result of it. If capitalism arrangement became self adjusted and self
arranged, then
Notes this will never happen. So Keynes supported that thing that states interfere for adjust the
demand and supply under economies by the median of exchequer and oral method.
4. Equality between Saving and Investment through Income Changes: It was the belief of
classical economists that saving and investment are equal at the level of full employment
and if there is any deviation, then the mechanism of the rate of interest brings similarity in
them. According to Keynes’, the level of saving is dependent on the level of income. So the
rate of interest of investment is also decided by the productivity of frontier. If the business
expectancy is less then in the low rate of interest, investment will not increase. If saving
increases from investment, then it means that people have spent less on consumption.
Resultantly, the demand reduces, and high production starts and investment in income
and production reduces. By this, with the change of interest equality between investment
and savings on account is maintained.
5. Refutation of Wage Cut: Keynes’ had disclaimed this principle of Pigou that full
employment can be got in economy to cut the currency-wage. In the analysis of Pigou the
big doubt is that the logic of specific industry is applied on all economy. In one industry
the decrement in the rate of wage can increase the employment to increase the cost and
demand but this type of employment is reduced for all economy. When normal wage is cut,
then the income of labour reduces resultantly total demand reduces and employment also
reduces.
Behaviourally Keynes’ never supported the policy of cut in wage. Labourers establish a
strong trade union in present era which protests the policy of reduced wage. They will
agitate in its protest. As a result, whatever disturbance will generate in economies, by that
income will reduce. Now, social justice demand is also that if profit is not disturbed then
wage should not be reduced.
Keynes has also not accepted that opinion that there is directly proportionate relation
between currency wage and actual wage. According to him, they have opposite relation
between them. When total wages are reduced, then actual wages are increased and vice
versa. So as the believers of the traditions that, as not happen and being the reduction on
currency-wage the actual wages are not reduced but increase, the cost of wage and price
will be reduced more to cut the currency-wage. So the opinions of traditions are not
outstaying that employment will increase to reduce the actual wage. But the believe of
Keynes was that employment can increase more to reduce the currency-wage by the
medium of currency and exchequer. Now the institutional protest is stronger of decrement
of prices and wage so that type of policy cannot be continued in trend.
6. Support of State Intervention: Keynes was not satisfied by Pigou's opinion that ,“The
failure of temporary is responsible to full use of our productive power.” Capitalism
arrangement is that if it fells alone, then it is not able to use full use of production power.
So it is necessary for the interference of state. State can directly invest to increase the level
of economic activity, or supplemented the self-investment. We make laws for
determination of wages of workers, relief to the workers through medium of social security
measures and they affiliated the trade unions. So as the opinion of Dillard, “To protest, the
rule of labour and labour union are understood good at the sight of economics, but it is
bad at the political sight." So Keynes supported the states processing for complete use of
the source of economy for full employment.
7. Short-run Analysis: In the long duration Keynes believed in full employment. Keynes had
no patience that he can wait for long time, because he believed that “After long time we all
die.” As the objective of Shumpeter, “His life’s philosophy was fundamentally of short
duration.” His analysis was limited till short duration sources. Opposite to traditionalists
he believed
that nature, method of production and labour are certain during short time he leaves the
long duration impact on demand. Assuming that consumption demand is certain, he
forced
 on those things that investment demand increases to remove the unemployment. But by
Notes
this the balance is achieved, it is the short duration employment level not full employment
level.
8. Importance of Speculative Demand: Classic economists believed that currency is demanded
for the objective and transaction. They did not consider the speculative demand because
for the speculative objective currency is related to remains. But Keynes is not satisfied by
this opinion. He kept his attention on the importance of speculative demand. He tells that
earned interest by property to keep the transaction objective, can be less on low interest
rate. But on low interest rate the speculative demand will be more. So the rate of interest
will not fall by a special lowest level and the speculative demand of interest will be fully
flexible. It is the liquidity trap of Keynes, classical economists were failed to analyze it.
In this connection, Keynes cleared that being on positive interest rate possibly to more
from the investment of savings. Liquidity trap is stopped to fall down from a certain lowest
rate of interest rate. It is shown in Fig. 5.6. where SS is the saving curve and II is the
investment curve. If liquidity traps on Or 1 i.s. interest rate then it stops to fall on Or of
interest rate. In
the situation of liquidity trap of Or1 interest rate is more than i1s1of saving to investment. So
economy will not establish on the full employment
level E where savings and investment are equal but
on short employment level where more saving is
possible.
Keynes told later that saving will be more even the
rate of interest level falls to zero. It shows in Fig. 5.6
where II curve is shifted and becomes I 1I1 and shows
decrement in investment. Such a situation is found.
On
zero interest rate saving ioso is more from
investment. In that situation, classical saving and
investment curve are intersected on E1 point when
Or’ is negative on interest. It is the inconsistent
situation.
9. Money not Neutral: Classical economists believed that Figure. 5.6
currency was not effective. So they did not involve
the
production, employment and interest rate in currency principle. According to him, the
level of production and employment and balance rate of interest are decided by actual
powers. Keynes criticizes the classical opinion that currency principle is different from
value principle. He joined the production principle and currency principle with value
principle and brought interest principle in the currency sector in which he considered rate
of interest as currency principle. So by this he showed established relation between the
quantity of currency and price level. For example, when the quantity of currency increases
then interest rate decreases, investment increases and income, production increase,
demand increases, sources cost and wage increase, related prices increase and normal
price level increases. So by this Keynes joined the currency and actual field of economics.
So the classical principle employment is not able to solve the present economic problems
of capitalism world.

Self Assessment
State whether the following statements are True or False
7. Hardness in the structure of wage and interference in the causation of market economic
brings unemployment.
8. If the quantity of currency is doubled, then price level also gets doubled.
Notes 9. The change in currency-wage and actual wage in classical model of employment are related
and disproportionate.
10. The classical model of employment is based on full employment.

5.4 Summary
 The classical principle believed that full employment is found without inflation in capitalist
economy. Giving the wage-price flexibility, the automatic power gets in economic system
which has nature to continue the full employment and does production on same level. So
full employment is considered a normal situation and deviation in abnormal situation at
that level which are the marching at full employment.

5.5 Keywords
 Law of Market: The rule of market.
 Barter: Exchange of things.

5.6 Review Questions

1. What is the classical principle of employment? Explain.
2. What is the market law of Say ? Explain.
3. Write the summary of full employment model.
4. Write a note on the ‘criticism of classical principle’ by Keynes.

Answers: Self Assessment

1. classical principle 2. demand 3. thing-exchange 4. (a)
5. (b) 6. (a) 7. True 8. True
9. False 10. False.

5.7 Further Readings

Books 1. Macroeconomics— S.K.Chakravarti, Himalaya Publication House,
2010.
2. Macroeconomics— Mohan Shrivastava, DND Publications, 2010.
3. Macroeconomics— Economic growth, Fluctuations and
Policy– Robert E. Hall and Devid H.Paipal, Vaina Books, 2010.