UNIT Title of Unit Content of Unit
1 Approaches to Classical Vs. Modern Economic approach, Micro and Macro Meaning,
Macroeconomics Circular flow of Income- Concept of National Income: GNP, NNP, GDP,
NDP, PI, DPI, PCY, National Income at factor cost and Market price,
Estimation of National income- Product-Income- Expenditure Met,
Difficulties of Estimation, National income and economic welfare
Classical theory:
Classical economics is widely regarded as the first modern school of economic thought. Its major
developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John
Stuart Mill.
Classical economists claimed that free markets regulate themselves, when free of any intervention.
Adam Smith referred to a so-called invisible hand, which will move markets towards their natural
equilibrium, without requiring any outside intervention.
Assumptions of Classical Approach
1. There is existence of full employment without inflation
2. There is a laissez faire capitalist economy without government interference
3. It is a closed economy without foreign trade
4. There is a perfect competition in labour and product markets
5. Total Output of the economy is divided between consumption and investment expenditure
6. The quantity of money is given and money is only the medium of exchange
7. Wages and Prices are perfectly flexible
8. Constant Technology
9. Equality between saving and investment
Say’s Law of Market: According to Say’s Law “Supply creates its own demand”, i.e., the very
act of producing goods and services generates an amount of income equal to the value of the goods
, produced. Say’s Law can be easily understood under barter system where people produced (supply)
goods to demand other equivalent goods. So, demand must be the same as supply. Say’s Law is
equally applicable in a modern economy. The circular flow of income model suggests this sort of
relationship. For instance, the income created from producing goods would be just sufficient to
demand the goods produced.
Relation between Saving-Investment: There is a serious omission in Say’s Law. If the recipients
of income in this simple model save a portion of their income, consumption expenditure will fall
short of total output and supply would no longer create its own demand. Consequently there would
be unsold goods, falling prices, reduction of production, unemployment and falling incomes.
However, the classical economists ruled out this possibility because they believed that whatever is
saved by households will be invested by firms. That is, investment would occur to fill any
consumption gap caused by savings leakage. Thus, Say’s Law will hold and the level of national
income and employment will remain unaffected.
Wage Flexibility: The classical economists also believed that a decline in product demand would
lead to a fall in the demand for labour resulting in unemployment. However, the wage rate would
also fall and competition among unemployed workers would force them to accept lower wages
rather than remain unemployed. The process will continue until the wage rate falls enough to clear
the labour market. So a new lower equilibrium wage rate will be established. Thus, involuntary
unemployment was logical impossibility in the classical model.
Keyne’s Criticism of Classical Theory:
J.M. Keynes criticized the classical theory on the following grounds:
1. According to Keynes saving is a function of national income and is not affected by changes in the
rate of interest. Thus, saving-investment equality through adjustment in interest rate is ruled out. So
Say’s Law will no longer hold.
2. The labor market is far from perfect because of the existence of trade unions and government
intervention in imposing minimum wages laws. Thus, wages are unlikely to be flexible. Wages are
more inflexible downward than upward. So a fall in demand (when S exceeds I) will lead to a fall
in production as well as a fall in employment.
3. Keynes also argued that even if wages and prices were flexible a free enterprise economy would
not always be able to achieve automatic full employment.
1 Approaches to Classical Vs. Modern Economic approach, Micro and Macro Meaning,
Macroeconomics Circular flow of Income- Concept of National Income: GNP, NNP, GDP,
NDP, PI, DPI, PCY, National Income at factor cost and Market price,
Estimation of National income- Product-Income- Expenditure Met,
Difficulties of Estimation, National income and economic welfare
Classical theory:
Classical economics is widely regarded as the first modern school of economic thought. Its major
developers include Adam Smith, Jean-Baptiste Say, David Ricardo, Thomas Malthus and John
Stuart Mill.
Classical economists claimed that free markets regulate themselves, when free of any intervention.
Adam Smith referred to a so-called invisible hand, which will move markets towards their natural
equilibrium, without requiring any outside intervention.
Assumptions of Classical Approach
1. There is existence of full employment without inflation
2. There is a laissez faire capitalist economy without government interference
3. It is a closed economy without foreign trade
4. There is a perfect competition in labour and product markets
5. Total Output of the economy is divided between consumption and investment expenditure
6. The quantity of money is given and money is only the medium of exchange
7. Wages and Prices are perfectly flexible
8. Constant Technology
9. Equality between saving and investment
Say’s Law of Market: According to Say’s Law “Supply creates its own demand”, i.e., the very
act of producing goods and services generates an amount of income equal to the value of the goods
, produced. Say’s Law can be easily understood under barter system where people produced (supply)
goods to demand other equivalent goods. So, demand must be the same as supply. Say’s Law is
equally applicable in a modern economy. The circular flow of income model suggests this sort of
relationship. For instance, the income created from producing goods would be just sufficient to
demand the goods produced.
Relation between Saving-Investment: There is a serious omission in Say’s Law. If the recipients
of income in this simple model save a portion of their income, consumption expenditure will fall
short of total output and supply would no longer create its own demand. Consequently there would
be unsold goods, falling prices, reduction of production, unemployment and falling incomes.
However, the classical economists ruled out this possibility because they believed that whatever is
saved by households will be invested by firms. That is, investment would occur to fill any
consumption gap caused by savings leakage. Thus, Say’s Law will hold and the level of national
income and employment will remain unaffected.
Wage Flexibility: The classical economists also believed that a decline in product demand would
lead to a fall in the demand for labour resulting in unemployment. However, the wage rate would
also fall and competition among unemployed workers would force them to accept lower wages
rather than remain unemployed. The process will continue until the wage rate falls enough to clear
the labour market. So a new lower equilibrium wage rate will be established. Thus, involuntary
unemployment was logical impossibility in the classical model.
Keyne’s Criticism of Classical Theory:
J.M. Keynes criticized the classical theory on the following grounds:
1. According to Keynes saving is a function of national income and is not affected by changes in the
rate of interest. Thus, saving-investment equality through adjustment in interest rate is ruled out. So
Say’s Law will no longer hold.
2. The labor market is far from perfect because of the existence of trade unions and government
intervention in imposing minimum wages laws. Thus, wages are unlikely to be flexible. Wages are
more inflexible downward than upward. So a fall in demand (when S exceeds I) will lead to a fall
in production as well as a fall in employment.
3. Keynes also argued that even if wages and prices were flexible a free enterprise economy would
not always be able to achieve automatic full employment.
