Classical Theory of Employment

A formal theory of national income was first

given by JM Keynes
The Classical theory is not a single theory
which may be called as Classical theory. They
put forward some Postulates. The modern
economists worked on these postulates. These
postulates are-
There is always full employment. In this state
there may be frictional and voluntary
unemployment
The economy is always in equilibrium
Acc. To them full employment of resources
generates incomes on the one hand and
goods and services on the other. The value of
goods and services is always equal to income.
There is no general overproduction and no
general underproduction
There is no general overproduction and
general underproduction
This postulate is based on the assumption
that the economy works on the principle of
laissez - faire

Money does not matter
The classical economists treated money only as
a medium of exchange. Acc. To them the role
of money only as a facilitator of transactions.
It does not play any role in determination of
output and employment. The levels of output
and employment are determined by the
availability of real resources, i.e . labour and
capital

Says Law
The law states that supply creates its own
demand. The logic is that supply of goods
itself generates sufficient income to generate a
demand equal to the supply of goods. This law
is regarded as the core of classical
macroeconomic thought
A laissez faire system is one in which
There is complete absence of govt. control or
regulation of private enterprise, except to
ensure free competition;
There is complete absence of monopolies and
restrictive trade practices if there is any it is
eliminated by law;
There is complete freedom of choice for both
the consumers and the producers;
The market forces of demand and supply are
fully free to take their own course
Classical Model of Employment
As reconstructed by Keynes it consists of two
components
Aggregate production function
Labour supply and demand function


Aggregate production function
Y= f(K,L)
where y = aggregate real output
K = capital(fixed)
L = Labour (homogenous) required to
produce Y
assumptions -
stock of capital K is fixed
Technology used by the firms is given
Population is constant
Successive units of labour yields diminishing
returns - Y/ L, decreases with increase in
employment (graph)
Labour market : labour supply and demand
Acc. to the Classical Theory of Employment,
equilibrium of Labour market determines the
level of employment.
The level of employment determines the level
of national output
Level of employment is determined by labour
and demand supply functions and so also the
wages
Labour supply
Supply of labour depends on real wages
L
S
= f(W
r
), L
s
/W
s
> 0 (graph)
Labour demand
Demand for labour depends on its marginal
revenue productivity of labour and real wage
L
d =
(W
r
, MRP
L
) ,
given the wage rate, then
MRP
L
=

MPP
L
X P, in perfectly competitive market,
P is constant, therefore, MRP
L
=

MPP
L



MPP
L
can be taken to represent labour demand
function. So in order to derive labour demand
curve

MPP
L
has to be derived.
This can be derived from the production
function . Algebraically
Q = bL cL
2

Lets assume, Q = 55L 5L
2
The 1st derivative of the production function
gives the MPP
L



MPP
L
decreases with increase in employment
A profit maximising firm employs where real
wages (W
r
) equals

MPP
L
i.e.
MW
r
=

MPP
L
(MC = MR)


Aggregate production schedule and labour
supply and demand curves can be used to
determine full employment and aggregate real
output in in classical model



Intersection of demand and supply curves
determines simultaneously
equilibrium wage rate and full employment of
labour. Given the short run conditions, this is
the full level of employment of labour
Determination output can be shown by placing
the production function on the same scale,
with labour market equilibrium (graph)

An important feature of classical model is that
factors operating on the supply side of the
market determine the level of employment
and output
Equilibrium in the money market
Goods market equilibrium gives equilibrium
rate of interest, saving, and investment
Interest rate and savings is directly related
Interest rate and investment is inversely related
Equilibrium level of employment, real wage
rate, real output are determined independently.
Money market will only determine nominal
income, whereas real income is determined in
the goods market

Given the real income, nominal income will
enable to determine price level
The money market
M
d
= kPy - demand for money
K = constant
P = price level
Y = real national income or output
M
s
= supply of money
Equilibrium condition -
M
d
=

M
s



The classical model money market conditions
will only determine the general price level
Thus all the nominal values can be determined
from the nominal Py
o
This is

referred to as Classical Dichotomy
separating real and monetary sectors. Thus
real variables of the system are determined
independently of the money market
conditions