Classical Economics

Definition

Classical economics is an economic theory that originated in the late 18th and early 19th centuries. It is based on the idea of free markets, limited government intervention, and the pursuit of individual self-interest leading to the most efficient allocation of resources. This theory is closely tied to the concepts of Keynes' Law and Say's Law in the Aggregate Demand/Aggregate Supply (AD/AS) model.

5 Must Know Facts For Your Next Test

1. Classical economists believed that the economy would naturally reach full employment and that government intervention was unnecessary and potentially harmful.
2. The classical view holds that wages and prices are flexible, and markets will clear, meaning supply and demand will naturally balance out.
3. Classical economists argued that saving and investment would automatically adjust to maintain full employment, a concept known as Say's Law.
4. Keynes' Law, in contrast, states that aggregate demand, not supply, is the primary driver of economic activity in the short run.
5. The classical model assumes that the economy will self-correct and return to full employment equilibrium, while Keynes' model allows for the possibility of persistent unemployment.

Review Questions

• Explain how the classical economic view of the economy differs from Keynes' view in the context of the AD/AS model.
  • The classical economic view holds that the economy will naturally reach full employment equilibrium, where aggregate supply (determined by factors like labor, capital, and technology) will create its own aggregate demand. This is known as Say's Law. In contrast, Keynes' Law states that aggregate demand, not supply, is the primary driver of economic activity in the short run, and the economy may not automatically return to full employment. The classical model assumes wages and prices are flexible and will adjust to clear markets, while Keynes' model allows for the possibility of persistent unemployment.
• Analyze how the classical economists' belief in the 'invisible hand' and laissez-faire policies relates to the AD/AS model.
  • The classical economists believed that the pursuit of individual self-interest in a free market, guided by the 'invisible hand,' would lead to the most efficient allocation of resources and full employment. This aligns with the classical view that the economy will naturally return to a full employment equilibrium in the AD/AS model. The classical economists argued for limited government intervention and laissez-faire policies, as they believed the market would self-correct. This contrasts with Keynes' view that aggregate demand management through fiscal and monetary policy may be necessary to achieve full employment.
• Evaluate the implications of the classical economic theory for policymaking in the context of the AD/AS model.
  • The classical economic theory has significant implications for policymaking in the AD/AS model. Since classical economists believe the economy will naturally return to full employment equilibrium, they argue that government intervention is unnecessary and potentially harmful. They would oppose active fiscal and monetary policies aimed at managing aggregate demand, as they believe the market will self-correct. Instead, classical economists favor policies that promote flexible wages and prices, as well as the free flow of labor and capital. This laissez-faire approach contrasts with Keynesian policies that advocate for government intervention to stabilize the economy and achieve full employment.

Related terms

Laissez-Faire:

The economic policy of letting the market operate without government intervention, allowing individuals to pursue their own economic interests.

Invisible Hand:

The concept that individuals pursuing their own self-interest in a free market will ultimately benefit society, even if that is not their intent.

Supply and Demand:

The theory that the price of a good or service is determined by the balance between the supply of that product and the demand for it.