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2.2 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


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.