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Criticism of Classical Theory and Say'S Law

The document discusses several key assumptions of classical economic theory and Say's Law that John Maynard Keynes criticized. It summarizes Keynes' view that: 1) Aggregate demand may not equal aggregate supply if income is saved rather than spent, unlike what Say's Law suggests. 2) Employment cannot be increased through a general wage cut as classical theory believed, since macroeconomic situations differ from microeconomic ones. 3) Classical economists viewed wages only from the employer's perspective as a cost rather than income, and there is no direct link between wages and employment as they claimed.

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Yusra Najam
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124 views

Criticism of Classical Theory and Say'S Law

The document discusses several key assumptions of classical economic theory and Say's Law that John Maynard Keynes criticized. It summarizes Keynes' view that: 1) Aggregate demand may not equal aggregate supply if income is saved rather than spent, unlike what Say's Law suggests. 2) Employment cannot be increased through a general wage cut as classical theory believed, since macroeconomic situations differ from microeconomic ones. 3) Classical economists viewed wages only from the employer's perspective as a cost rather than income, and there is no direct link between wages and employment as they claimed.

Uploaded by

Yusra Najam
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as DOC, PDF, TXT or read online on Scribd
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CRITICISM OF CLASSICAL THEORY AND SAY’S LAW

1. Supply may not create its own demand when a part of the income is saved.
Aggregate demand is not always equal to aggregate supply.

Comment: I will go with the favor of this assumption.


Justification: In Keynes's theory, some micro-level actions of individuals and firms can
lead to aggregate macroeconomic outcomes in which the economy operates below its
potential output and growth. Some classical economists had believed in Say's Law, that
supply creates its own demand, so that a "general glut" would therefore be impossible.
Keynes contended that aggregate demand for goods might be insufficient during
economic downturns, leading to unnecessarily high unemployment and losses of potential
output. Keynes argued that government policies could be used to increase aggregate
demand, thus increasing economic activity and reducing unemployment and deflation.
http://www.absoluteastronomy.com/topics/Post-Keynesian_economics

2. Employment in the economy as a whole can not be increased by the means of a


general wage cut though it may be possible in a particular industry. It is wrong to
apply microeconomics principles to macroeconomic activities or situation.

Comment: I will go with the favor of this assumption.


Justification: Microeconomics is the study of decisions that people and businesses make
regarding the allocation of resources and prices of goods and services. This means also
taking into account taxes and regulations created by governments. Microeconomics
focuses on supply and demand and other forces that determine the price levels seen in the
economy. For example, microeconomics would look at how a specific company could
maximize it's production and capacity so it could lower prices and better compete in its
industry. (Find out more about microeconomics in Understanding Microeconomics.)

Macroeconomics, on the other hand, is the field of economics that studies the behavior of
the economy as a whole and not just on specific companies, but entire industries and
economies. This looks at economy-wide phenomena, such as Gross National Product
(GDP) and how it is affected by changes in unemployment, national income, rate of
growth, and price levels. For example, macroeconomics would look at how an
increase/decrease in net exports would affect a nation's capital account or how GDP
would be affected by unemployment rate.
http://www.investopedia.com/ask/answers/110.asp

3. The classical economists looked at wages only from the employer’s point of view,
i.e., the cost aspect and ignored the income aspect of wages. There is no direct
relationship between wages and employment, nor is unemployment due to wage
rigidities or artificial resistance.

Comment: I am against with this assumption.


Justification: Wages and spending
During the Great Depression, the classical theory defined economic collapse as simply a
lost incentive to produce. Mass unemployment was caused only by high and rigid real
wages.

To Keynes, the determination of wages is more complicated. First, he argued that it is not
real but nominal wages that are set in negotiations between employers and workers, as
opposed to a barter relationship. First, nominal wage cuts would be difficult to put into
effect because of laws and wage contracts. Even classical economists admitted that these
exist; unlike Keynes, they advocated abolishing minimum wages, unions, and long-term
contracts, increasing labor-market flexibility. However, to Keynes, people will resist
nominal wage reductions, even without unions, until they see other wages falling and a
general fall of prices.

He also argued that to boost employment, real wages had to go down: nominal wages
would have to fall more than prices. However, doing so would reduce consumer demand,
so that the aggregate demand for goods would drop. This would in turn reduce business
sales revenues and expected profits. Investment in new plants and equipment—perhaps
already discouraged by previous excesses—would then become more risky, less likely.
Instead of raising business expectations, wage cuts could make matters much worse.

Further, if wages and prices were falling, people would start to expect them to fall. This
could make the economy spiral downward as those who had money would simply wait as
falling prices made it more valuable—rather than spending. As Irving Fisher argued in
1933, in his Debt-Deflation Theory of Great Depressions, deflation (falling prices) can
make a depression deeper as falling prices and wages made pre-existing nominal debts
more valuable in real terms.
http://www.absoluteastronomy.com/topics/Post-Keynesian_economics

4. Interest-rate adjustment cannot solve savings-investment problems. Savings and


investment are not interest-clastic.

Comment: I am against with this assumption.


Justification: The role of interest rates in the process of economic development is
examined through an empirical inquiry into the interest rate-saving-investment nexus in
the Indian economy during the period 1955-95. The results are generally in support of the
financial liberalization school of thought. Higher real interest rates seem to promote both
financial and total savings, and stimulate private investment. On the investment side, the
combined salutary effect of interest rate increases operating through increased debt
intermediation and self-financed capital accumulation outweighs the direct cost effect on
investment. Overall, the study casts doubt on the robustness of results coming from the
vast cross-country literature on the subject and calls for systematic time-series analyses
covering a variety of country situations to inform the on-going policy debate.

http://www.informaworld.com/smpp/content~content=a787313218~db=all~order=page
5. The economic system is not so self-adjusting as it is supposed; hence government
intervention in the economic sphere becomes necessary. Wages and prices are not
so flexible as was supposed.

Comment: I will go with the favor of this assumption.

Justification: Market economies work on the assumption that market forces, such as
supply and demand, are the best determinants of what is right for a nation's well-being.
These economies rarely engage in government interventions such as price fixing, license
quotas and industry subsidizations.

While most developed nations today could be classified as having mixed economies, they
are often said to have market economies because they allow market forces to drive most
of their activities, typically engaging in government intervention only to the extent that it
is needed to provide stability. Although the market economy is clearly the system of
choice in today's global marketplace, there is significant debate regarding the amount of
government intervention considered optimal for efficient economic operations.
http://www.investopedia.com/terms/m/marketeconomy.asp

6. Assumption of free and perfect competition is not realistic.

Comment: I will go with favor of this assumption.


Justification: Perfect competition – a pure market

First, let's review what economic factors must be present in an industry with perfect
competition:

1. All firms sell an identical product.


2. All firms are price-takers.
3. All firms have a relatively small market share.
4. Buyers know the nature of the product being sold and the prices charged by each firm.
5. The industry is characterized by freedom of entry and exit.

These five requirements rarely exist together in any one industry. As a result, perfect
competition is rarely (if ever) observed in the real world. For example, most products
have some degree of differentiation. Even with a product as simple as bottled water, for
example, producers vary in the methodology of purification, product size, brand identity,
etc. Commodities such as raw agricultural products, although they can still differ in terms
of quality, come closest to being identical, or having zero differentiation. When a product
does come to have zero differentiation, its industry is usually consolidated into a small
number of large firms, or an oligopoly.

http://www.investopedia.com/ask/answers/05/perfectcompetition.asp
7. It is wrong to suppose that money is a mere medium of exchange and has no role
in affecting output and employment.

Comment: I am against with this assumption.


Justification: How Money Affects Real Output (Journal article by Joyce Manchester;
Journal of Money, Credit & Banking, Vol. 21, 1989)
HOW DOES MONEY MATTER in the determination of real output? Both
Keynesian models and some of the newer equilibrium theories assert that money affects
current real activity by altering agents' perceptions of the intertemporal terms of trade.
Other classical models rely on wealth effects to provide non-neutrality of monetary
shocks. This paper investigates the roles played by components of the money stock in the
determination of real output growth in an effort to identify the channels through which
money influences real economic activity. The main empirical findings indicate that
changes in the money multiplier rather than the monetary base are important in
determining real output growth, and that interest rates do not act directly as mediators in
this process. Further, behavior of the public and the Federal Reserve appear to be more
influential for real output growth than bank behavior during the twenty-five years
preceding the monetary policy change of 1979.
http://www.questia.com/googleScholar.qst?docId=5000104417

8. Say’s law cannot explain the occurrence of trade cycles.

Comment: I will go with favor of this assumption.


Justification: Trade cycle is a neoclassical concept of macro economics which tries to
explain the changes in the economic activities with respect to time. The concept of trade
cycle was initially developed by Joseph Schumpeter. The different phases in the trade
cycle are named in relation to the full employment level. Accordingly, there are six
phases of trade cycle:
1. Inflation
2. Boom
3. Deflation
4. Recession
5. Depression, and
6. Recovery
http://www.vazecollege.net/SYBCom_Economics_Part_I.pdf

9. The classical theory does not explain how the level of employment is determined. It
evades the problem by assuming full employment.

Comment: I will go with favor of this assumption.


Justification: Full Employment: Most important for macroeconomics, full employment
is attained because all markets, especially resource and labor markets, achieve
equilibrium. With equilibrium, a market has neither a surplus nor a shortage. A surplus in
any labor market would mean unemployment. With no surplus, there is no
unemployment. The surplus (or shortage) is, of course, eliminated due to flexible prices.
If a (temporary) surplus should emerge, then wages--the price of labor--decline until
equilibrium balance and full employment is restored.
Perhaps the most important implications of classical economics are that efficiency
and full employment are attained without government intervention. Government is not
needed to direct resources to the most desired activities--markets do this automatically.
Government is not needed to keep resources working--markets do this automatically.
In fact, taking this a step farther, any problems of inefficiency and unemployment
that might emerge are attributable to government intervention. From a classical
economics perspective, government is the problem, not the solution. Inefficiency and
unemployment arise because government prevents markets from achieving equilibrium
through regulations, taxes, or other forms of meddling.
http://english.caijing.com.cn/2009-02-16/110069400.html

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