2

Classical Macroeconomics

In this chapter we shall introduce the main elements of classical macroeconomics.

In particular, we shall discuss the following aspects:
Basic postulates of classical macroeconomics
Classical quantity theory of money
Classical theory of saving and investment

2.1 BASIC POSTULATES OF CLASSICAL MACROECONOMICS

The classical macroeconomic structure is built upon the writings of famous
classical economists like Adam Smith, David Ricardo, J.B. Say, T.R. Malthus,
A.C. Pigou, Irving Fisher to mention the greatest few. Their scattered writings,
when put together, produce a systematic and coherent macroeconomic framework.
To understand this framework, one needs to bear in mind the basic postulates/
assumptions that classical economists built around their macroeconomic
conclusions. These are, broadly, as under.

2.1.1 Full Employment

Classicals believed that there will always be full employment (or, near full
employment) in the economy – full employment not only of labour but also of
other major resources such as land, capital and other factors of production. In
case of labour, for instance, they held the view that all labour will normally find
employment in a free enterprise capitalist economy with ‘flexible labour market’
(explained below). However, such full employment does not mean that temporary
unemployment (i.e., unemployment for a temporarily short period) will not
exist. But unemployment of relatively longer period or what Keynes later termed
‘involuntary unemployment’ is totally ruled out by the classicals. For instance,
temporary unemployment may occur due to maladjustment between demand and
supply of resources in a capitalist economy or frictions in the economy – workers
changing jobs, locations, etc. – or change in the structure of the economy such
24 A Textbook of Modern Macroeconomics

as old industries shutting down and new ones coming up or unemployment that
occurs during business cycles (recessions or depression).
Full employment will, then, occur only in the long run. So, long run
perspective is implicit in all these postulates. The classicals generally ignore
short run problems however serious they may be. In the long run, total demand
for labour will always be equal to total supply of labour and total output (of
goods and services) will be at its full potential level.
Lapses from full employment, classicals suggest, may be corrected by
appropriate wage cut given sufficient flexibility in the wage system. Thus,
classical economists viewed unemployment as a passing phase in the development
of capitalist economy while full employment being a normal phenomenon.

2.1.2 Wage-Price Flexibility

Classical economists postulated that in the capitalist system, wages as also prices
(including interest rates) are flexible and not rigid. This means that these rates
are capable of moving upward and downward under normal pressures of demand
and supply in their respective markets. In other words, the demand and supply
curves are fairly responsive to prices and wages – or, to say the same thing,
demand and supply curves are price-elastic (as also wage-elastic).
In the case of wage rate flexibility, it is argued that, this is always in the
interest of both the employers and workers. Employers gain from wage rate
reduction because this reduces their wage cost and hence increases their profit
margin. They will, therefore, be tempted to employ more workers and thereby
increase output. Workers will gain in terms of increased employment of labour
force (though not in terms of wage rate or wage per worker). Wage rate rise,
similarly, works in opposite direction. On the other hand, workers will respond
by increasing their supply when wage rate is higher and decrease their supply
when wage rate is lower. These outcomes are, in fact, based on explanations, at
the micro level from both employer’s and worker’s normal decision behaviour.
The implication is that in case of any deviations from equilibrium occurring
anywhere in the economic system, wage price flexibility will ensure that such
deviations will soon disappear and the economy will eventually return to the
equilibrium position.
Two other implications need clarification in this context.
Wage rate here means “real wage rate” and not money wage rate. Any
change in money wage rate is suitably adjusted by change in price level so that
the impact of price level change on real wage rate is neutralized. To state it
differently, money wage and price level move in the same direction and to the
same extent to leave the real wages unaffected. In case both do not move in the
same direction or to the same extent, this would mean real wage rate is either
rising or falling.
 Classical Macroeconomics 27

sector is known as absolute price level or nominal price level or simply ‘level
of prices’. On the other hand, the price level determined in the real sector is
known as relative price level (price of one product in terms of other product). For
understanding the underlying meaning of this classical dichotomy, we take an
example. Let us suppose there are two goods: wheat and potato whose nominal
prices are ` 10.00 per kg and ` 15.00 per kg respectively (or, their real price
ratio is 1.5 units of wheat: 1 unit of potato). If, for some reason, the supply of
money in the economy suddenly doubles, the prices of wheat and potato also
double to ` 20 per kg and ` 30 per kg. But their relative price ratio remains
the same, i.e., 1.5 units of wheat : 1 unit of potato. This is because the relative
price level is something determined by factors such as, relative factor supplies
of goods services and technology of production which are independent of the
factors affecting the monetary sector.
Surprisingly, however, the reverse causation is not true, so that changes in
the real sector do influence the monetary sector.

2.1.5 Absence of Money Illusion

According to this postulate, there is complete absence of money illusion in the
economy. All groups of people in the economy – the workers, employers, savers,
investors, etc., are completely free from money illusion. For instance, if workers
are influenced by the money value (or, nominal value) of their wage rate and not
by their real value (or real wage rate), we say workers are guided by the money
illusion. If, instead, workers are only guided by real wage rate, they are said to
be free from money illusion. Accordingly, if workers are willing to supply more
working hours/days at higher real wages and not high money wages, we say
there is no money illusion in the labour market. Similarly, if savers are guided
by the real rate of interest (money rate of interest minus the rate of inflation)
they are said to be not suffering from any money illusion. Also, another related
assumption is that money is neutral – it does not affect any other price like
interest rate. Needless to say that this particular assumption of the classicals also
holds a key position and frees them from many complications which the later-
day economists notably Keynes and his followers incorporated in their analytical
framework.

2.2 THE CLASSICAL QUANTITY THEORY OF MONEY

One of the basic tenets of classical macroeconomics is the quantity theory of
money. Simply put, this theory states that the supply (or quantity) of money
determines the level of prices (or, general price level) in the economy. Essentially,
quantity theory has two approaches: (a) transaction approach and (b) cash balance
(or, Cambridge) approach. The transaction approach, in turn, has two versions,
Fisherian equation of exchange or pure transaction version and aggregate income
28 A Textbook of Modern Macroeconomics

or national income version. The latter version has become more popular and
convenient expression of quantity theory.
The Fisherian version of quantity theory is expressed in terms of the following
equation:
MV=PT (2.1)
where M = Supply of money used for purchase-sale of goods, V = velocity of
circulation of money, T = Total volume of transactions of all goods, P = Average
price level.
Equation (2.1) is an expression that simply equates two sides of transactions
(purchase and sale) of all goods in the economy, with the help of money, during
a certain period of time. The right hand side of equation (2.1) shows the total
quantity of goods sold valued at their average price level while the left hand
side shows the total amount of money required for goods bought. This seems
to be an obvious fact and shows the equilibrium condition of the economy. The
explanation of the terms (M, V, P and T) is as follows:
M, the supply of money, refers to the money in circulation (notes and coins)
as also bank money (demand deposits). M is supposed to be exogenously given.
At the time when quantity theory was originally developed, M was supposed
to constitute only the currency in circulation. However, when transactions by
individuals and businesses included operations through banks, bank deposits
were also included in M.
V, the velocity of circulation of M, stands for the average number of times
money is used up in the process of transaction of goods during the specified
period of time. In other words, individual units of money (for instance, individual
coins or notes of different denominations) may be used up different number of
times, but V stands only for their average number.
T refers to the total volume of goods transacted. It includes all goods –
intermediate (goods used as inputs to industries) as well as final goods.
P is the average price-level, i.e., money prices of all goods taken at their
average value.
Referring back to equation (2.1), T is assumed given and constant and is
also independent of M and V. Recalling the dichotomy postulate which states
that goods sector (or, real sector) is independent of monetary sector, the
constancy of T can be better understood. T, representing the total outputs of
goods is determined by the factor supplies and technology. The total volume of T
signifying total output of the economy, is constant at its maximum feasible level.
In other words, full use of available technology and resources (including labour)
is assumed to have been made to produce total volume of T (or, supply of goods)
at full employment. V is a significant factor in the equation. It is also constant
and unrelated to either M or T. It is determined by institutional and structural
 Classical Macroeconomics 29

factors of the economy and society such as payment system (payment habits and
patterns) as also the structure of the economy. For instance, if the receipt and
payment pattern of either an individual or business is once a week as against
once a month, the velocity of money in the case of the former will be greater
than in the latter. Similarly, if the structure of the economy requires that most
payments are made in cash than in any other form, the velocity will be higher.
Now, V is not only constant but its value will be maximum, given the assumption
that money is meant only for transaction purposes, and hence, people would
hold money for minimum period necessary. Constancy of V is also obvious from
the fact that it is the ratio between PT and M (V = PT/M) and while T part
is independent, M is exogenously determined and P, of course, is calculated
part depending on measurement yardsticks. Thus, if V is constant (at maximum
value), T is also constant, it is easy to establish that P varies proportionately
(and, of course, directly) with M. If M increases (decreases) by say 100 per cent,
P also increases (decreases) by 100 per cent.
Another version of the classical quantity theory, known as Income Version
has gained popularity on account of aggregation and of problem of measurement
of large number of physical goods under the volume of transactions (T) and the
problem of measurement of price levels of all such goods. The income version,
instead, can be stated as:
MW = P0Y (2.2)
where, M = money supply, W = income velocity of money, Y = real national
income or product P0 = average price level of Y. P0 can be defined as GNP
deflator also (an index number used to obtain real GNP – from GNP at current
prices to GNP at constant prices), see Chapter 1 page 7)
In equation (2.2), W is the average number of times M (or, units of money) is
used for transaction of final goods and services only, i.e., Y or GNP. Obviously,
the value of W is less than V since volume of Y is less than T.
In the present formulation also, the earlier conditions and implications of
equation (2.1) hold, viz., the constancy of W and Y, both being at their maximum
feasible levels as also both being independent of M or P0 for reasons explained
in the context of equation (2.1). Thus, the utilimate conclusion – M and P0 are
directly and proportionately related hold equally truly.
One significant implication of equation (2.2) is that now W, the velocity, can
be expressed as a ratio of nominal GNP (P0Y) and money supply (M). If both P0Y
and M change proportionately W remains constant. If, by assumption, Y is at full
employment level and hence constant, proportionate change in M will produce
proportionate change in P0.1

1
The constant velocity characteristic will further be discussed in the Theory of Demand for Money by
Milton Friedman in Chapter 6.
30 A Textbook of Modern Macroeconomics

2.2.1 Quantity Theory and Demand for Money

From the quantity theory formulation in equation (2.2), a demand for money
equation can be derived. This approach suggested by Cambridge economists in
general and Alfred Marshall in particular, is known as Cah Balance Approach
of quantity theory. A relationship between, Y, the real income (or, real GNP)
and the proportion of Y held in cash balance by the community is sought to be
established. This is opposite of spending of money for transaction purposes as
shown in equation (2.1). The demand for money equation can be expressed as:
Md = mP0Y (2.3)
where, Md = demand for money, P0 = average price level (the same as in
equation 2.2) Y = real national income or product (GNP) and m = fraction of
money national income (nominal GNP) that the community desires to hold in
cash balance.
From equation (2.3) it is evident that the value of m being high or low
suggests the high or low proportion of GNP kept in cash by the community. If,
for instance, m = 0.2, Md will be 20 per cent of GNP and if m = 0.4, Md will
be 40 per cent of GNP. However, just as V is assumed constant in the earlier
formulation, m is also assumed constant in the present formulation for reasons
not related to either M or Y. The value of m is opposite (reciprocal) of V, i.e.,
m = 1/V. Therefore, if V is at its maximum feasible level, m is at its minimum
feasible level. In other words, people hold money in cash only for the minimum
period necessary.
Now, if we divide through equation (2.2) by V, we get
M = 1/V P0Y (2.3a)
so that m = 1/V. Alternately, V = 1/m
Equation (2.3) is an equation in two unknowns, viz., demand for money
(Md) and price level (P0). This equation can be supplemented by the equilibrium
condition of the money economy, i.e., total demand for money is equal to its total
supply: Md = M, further, substituting this condition into equation (2.3) yields
M = mP0Y (2.4)
Equation (2.4) states that supply of money (nominal) is a fraction, M, of the
value of real national income. It is an equilibrium condition of the economy stating
that the community’s desired cash balance is always equal to the actual cash
balance at any point in time. If this equilibrium is disturbed by any discrepancy
between the desired cash balance and the actual cash balance, the economy
eventually regains its equilibrium by appropriate changes in community’s
expenditure. For instance, if money supply increases, so that actual cash balance
of the community is in excess of the desired cash balance (everyone finds his
balance more than he desires), people would be willing to spend this ‘excess’ for
purchasing goods and services. This would raise price level since total supply
 Classical Macroeconomics 31

of goods or real income (Y) is constant. Subsequently, higher prices of goods

would necessitate the holding of cash balance of the community at a higher level.
Ultimately, the higher desired cash balance will be equal to actual cash balance
and the economy will again be in equilibrium.
The formulations in terms of equations (2.3) and (2.4) suggest that quantity
theory is, indeed, a theory of the demand for money which has, in the middle of
twentieth century, been taken up for further analysis by Milton Friedman and his
associates.

2.3 THE CLASSICAL THEORY OF SAVING AND INVESTMENT

In order to further ensure full employment, the classical economists provided
a separate theory of saving and investment. This theory also allows the Say’s
law to hold in an economy where all incomes are not spent but a part is saved
and also the same take the form of investment by entrepreneur class. Investment
refers to production and acquisition of any real capital asset such as factories,
raw materials, machinery, inventories of finished and semifinished goods etc. It
is the time rate of increase in capital asset.
At the outset, it ought to be remembered that the theory of saving and
investment explains the determination of the rate of interest, which in classicals’
view, is real phenomenon in the sense that interest rate is determined by real
factors. While productivity of capital is the main factor behind the behaviour of
investment, time preference is the factor behind the behaviour of savings. Both
these factors are real factors and are not influenced by monetary factors. Further,
interest rate acts as a mechanism for bringing about equality between volumes
of investment and savings. Let us elaborate these factors in some detail.
The meaning of investment is addition to capital stock. If, at any point in
time (say at the end of a year), the capital stock valued is rupees ` 500 crore and
at any other point in time (say at the end of next year), the capital stock is valued
at ` 550 crore, then this addition of ` 50 crore in one year period is investment.
The value must, however, be at constant price level so that ` 50 crore must,
necessarily be the addition to physical capital stock in real terms.
Now the classical economists believe that such investment takes place in the
economy mainly because capital is more productive. Now, the acquisition of new
capital asset, such as purchasing a new machine involves costs – costs in terms
of interest for borrowed fund from savers. But, as more and more investment
is taken up, the marginal productivity of capital declines just as the marginal
productivity of labour or any other factor declines with its increasing volume.
Therefore, any rational entrepreneur would be interested in acquiring more
capital assets (investment) so long as the marginal productivity of an additional
capital is higher than the interest cost. Hence, investment is higher at lower rate
 Classical Macroeconomics 33

volume of investment by CD amount. This disequilibrium point will, however,

automatically restore equilibrium through appropriate changes in the rate of
interest by competitive forces of demand and supply of saving and investment.
Thus, in equilibrium, S = I. Hence, we conclude that classical macroeconomics
provides a consistent set of theories, viz., an employment theory (in fact, a full
employment theory), a monetary theory and a saving-investment theory, each of
which, even though seemingly separate, is connected with other and supporting
one another.

2.4 WAGE-PRICE RELATIONSHIP AND FULL EMPLOYMENT

In this section, we examine the relationship between wages and prices in the
classical system that would ensure full employment. We refer to Fig. 2.2(b), given
below, which shows the equilibrium condition in the labour market in terms of
total demand for labour being equal to the total supply of labour. The real wage
rate W/P, in this situation, is (W/P)0. In other words, the labour market clears
only at (W/P)0 real wage rate; hence this is the full employment equilibrium.
This is because employers optimize their resources in order to maximize their
profits at the output level of Yp- the potential output and at (W/P)0 wage rate.
According to classical, this situation is easily attainable the capitalist system
given sufficient flexibility of wages and prices.
It should be mentioned here that this presupposes the existence of full
competition in the labour market which means that the employers compete
among themselves for hiring labour.
Assuming for the time being that all labourers are homogeneous and wages
paid to them are standardized wages paid in terms of money, i.e., money wages
(w). This is because, normally all employers pay their workers in terms of
money wages. But how do they get at the real wages then? In other words, what
is the relevant price level to be chosen? Since workers generally consider the
average price level (taking all important items that enter their cost of living, may
be, including the price of the product of the firm in which they are presently
employed), the real wage rate is evaluated as money wage rate divided by the
average price level. Alternatively, money wage rate can be taken, for simplicity,
the economy-wide money wages since we are assuming homogeneized labour
force. Now we suppose there is unemployment in the labour market so that there
is excess supply of labour over the total demand for labour and the real wage rate
is well above the equilibrium wage rate (W/P)0. The actual output is also below
the potential level of Yp. Now, if there is flexibility of wage rate, the employers
will be induced to hire more labourers only when (W/P) falls from the present
level. Also, the unemployed labourers are prepared to accept lower wage rate
rather than remaining unemployed. This would, most likely, happen given the
type of competition we have assumed in the labour market. However, falling
(W/P) implies any of the following possibilities:
36 A Textbook of Modern Macroeconomics

DL curve is decreasing throughout. The supply of labour curve, SL, is rising

from left to right reflecting the labour supply behaviour – more and more labour
hours are offered at higher and higher real wage rates. This is consistent with the
normal behaviour of the labour at microeconomic level. Given such behaviour
of the labour market, the total available labour supply, No, is equal to its total
demand at the real wage rate equal to (W/P)0.
Panel (c) shows the demand for money for different levels of national
income (PY). The straight line mPY from the origin shows that given the value
of m – the proportion of PY demanded in the form of money – there are different
combinations of money supply (= demand) and national income. For instances,
for M0 money supply, the corresponding national income is (PY)0 and for M1
money supply, national income is (PY)1. The slope of the line mPY is 1/m since,
P0Y/Md = 1/m. (if for instance, m = 0.4, 1/m = 2.5; if m = 0.5, 1/m = 2 and so
higher the value of m, lower the value of the slope and lower the value of m,
higher the value of the slope). Interpreted otherwise, it shows that (PY)0 level
of national income can be sustained by M0 money supply and (PY)1 level of
national income can, similarly, be sustained by M1 money supply. But since Y
is constant at Y0, an increased money supply will simply push up the price level
from P0 to P1. Therefore, (PY) level of national income will be equal to the
original level of national income (Y0) measured at increased price level (P1); that
is (PY)1 = P1Y0.
Finally, we can determine the level of money wage rate for different price
levels such as P0 and P1 as shown in panel (d). The straight line W/P indicates
the real wage rate for different values of W and P, provided they change by
equal proportions. Thus, if M0 level of money supply generates P0 price level,
the corresponding money wage rate will be W0. Similarly, if M1 money supply
results in P1 price level, the corresponding money wage rate will be W1 and so
on, although the real wage rate, W/P is the same.
Thus, the diagrammatic representation of the classical macroeconomic
structure also tries to demonstrate the following results:
Real sector (labour and commodity) is independent of the monetary sector.
Employment and output and real wage rates are determined in the real sector.
Monetary sector determines the price level which, in turn, determines the
money wage rate.
Let us use mathematical equations for the graphical relations stated above.
Example 1 Let us suppose our aggregate production function is
Y = 10N – 0.1 N2 (1)
(since the total outputs Y is a non-linear function of labour input with dY/dN > 0
and d2Y/dN2 < 0)
38 A Textbook of Modern Macroeconomics

fi P = 225/75 = 3.00
So, P increases from 2.667 to 3.00, i.e., by 12.5%.
Thus, an increase in money supply raises price level by the same extent.
Therefore, the relationship between money supply and price level is
direct and proportionate. Let us examine if this change has any impact
on money wage rate.
The real wage rate, W/P is now W/3 = 5; giving W = 15.
But, W/P = 15/3 = 5.
W has now increased from 13.335 to 15.00, i.e., by 12.4859% or, 12.5%.
Thus, money wage rate has also increased by the same extent as the
price-level and money wage rate has changed by the same extent and in
the same direction but real wage rate remains the same.
(b) Secondly, we can analyse the impact of change in real sector variables
on the monetary sector in the following manner:
Let the supply curve of labour change from
15 + 2W/P to 20 + 2 W/P (a shift of the supply curve to the right)
The labour market equilibrium will now be solved by equating the
demand curve with the new supply curve of labour:
50 – 5W/P = 20 + 2W/P which gives W/P = 4.2857.
The corresponding demand and supply of labour will be 28.5714.
Substituting this value in eqn. (1) we obtain,
Y = 10 × 28.574 – 0.1 (28.5714)2
= 285.714 – 81.6325 = 204.0815
Thus output increases from 187.5 to 204.08, i.e., by 8.84 per cent. The
employment of labour increases from 25 to 28.57, i.e., by 3.57 units or,
by 14.28 per cent.
Now money supply remaining the same, i.e.,
200 = 0.4 PY,
and Y being higher now at 204.0815, by substituting we obtain,
200 = 0.4P (204.0815)
fi 200 = 81.6325 P
giving the value of P = 2.45.
Thus, price level is now lower as compared to 2.667 earlier. In percentage
terms, P has fallen by 8.14 per cent.
However, we have seen earlier that the real wage rate has already fallen
to 4.2857. Hence, money wage rate now is solved as 4.2857 = W/2.45
= 10.4999.
 Classical Macroeconomics 39

Thus, W has decreased from 13.335 to 10.4999, i.e., by 21.26 per cent
which is larger percentage fall than fall the price level.
Thus, the shift in the supply curve of labour to the right results in:
(a) Increase in output, (b) increase in employment, (c) fall in real wage
rate, (d) fall in price level and (e) fall in money wage rate.
In the similar vein, we can analyze the effect of change in technology
(shift in production function) on the real sector as well as monetary
sector variables (shift in production function upward means better and
improved technology)1

2.5.1 Critical Evaluation

In spite of many shortcomings and simplistic assumptions of the classical
macroeconomic system and Keynesian revolution in the post-1930s, the 1970s
and period thereafter has witnessed a kind of revival of classical system. The
new classical macroeconomics has focussed on further refinements of the basic
classical tenets and popularization of policy tools based on these tenets. The rise
of supply side economics with its root is Say’s law, market fundamentalism of
the capitalist economy with minimum government intervention in the functioning
of the economic system and rising importance of monetary policy vis-a-vis fiscal
policy are some of the recent developments in the macroeconomics field with
their application in most of the western capitalist economies and gradual policy
changes in emerging economies of the world. The most important drawback of
the classical/new classical economic policies being pursued in most of western
capitalist world based on free enterprise and market economy rules is the failure
of predicting correctly the occurrence of ‘crises’. Business cycles do occur
in spite of tall claims by the authors belonging to this group which virtually
jeopardize the functioning of the capitalist system.

SUMMARY
1. Classical macroeconomics is based on a set of postulates/assumptions
such as long period, Say’s law of market, full employment, flexibility
of wages and prices, neutrality of money, absence of money illusion
and dichotomy between real and monetary sectors. If these postulates
are accepted, classical macroeconomics produces a neat systematic and
logical theory to explain the working of the economy.
2. Long period is the key assumption which allow economic agents to
sufficiently adjust and revise their decisions and attain the new level of
equilibrium. Even though they do consider changes occurring during
short period, but such changes are not important for the classicals.

1
In this case the production function might be: Y = 16N – 0.1N2 or any higher value of the intercept.
 Classical Macroeconomics 41

3. R.L. Crouch, Macroeconomics, Harcourt Brace Jovanovich, 1972.

4. Joseph A Schumpeter, History of Economic Analysis, Oxford University
Press, 1954.
5. William J. Baumol, Economic Theory and Operations Analysis, Prentice-
Hall of India, 1966.
6. Edward Shapiro (ed.), Macroeconomics: Selected Readings, Harcourt
Brace Jovanovich, 1970.