ECO 104: Introduction to Microeconomics [Course Instructor: Saima Khan(Sai)]

Sec : 1, 3, 15 SPRING 2010

Understanding Classical Economics: Key

Points of Ch. 8
In Chapter 8, we are introduced to the Classical School of Thought. In this Lecture, the key assumptions and the key
policy prescriptions are HIGHLIGHTED so that you can better understand the purpose of each of the sections
included in Chapter 8. This lecture should be used as a supplement to the book. I will be referring to the diagrams in
the book as Exhibit 5, Exhibit 6 and so on.

Key Assumptions
The Key assumption of Classical Economics is that prices, wages and interest rates are FLEXIBLE – they move up and
down as need be due to changes in Supply and Demand.

 If there is a change in the Supply or Demand in the goods market, then prices adjust ( move up or down) in
order to bring the goods market to an equilibrium.
 If there is a change in the Supply or Demand of Labour, then wages adjust ( move up or down) in order to
bring the Labour market to an equilibrium.
 If there is a change in the Saving (Supply of Loanable Funds) or Investment (Demand for Loanable Funds) in
the goods market, then prices adjust (move up or down) in order to bring the goods market to an
equilibrium.

Classical Economists also believe that this adjustment of Prices, Wages and Interest Rates happens in a very short
time, i.e., prices, wages and interest rates respond very quickly to changes in Supply or Demand.

Key Policy Prescriptions

NO GOVERNMENT INTERVENTION
The key policy prescription of Classical Economists is that there should be NO GOVERNMENT INTERVENTION.
Classical Economists believe that the economy goes to its long run equilibrium by itself. So government is not needed
to help the economy reach its equilibrium. To justify their stance that there should be no government intervention,
Classical Economists use the concepts of:
1. Say’s Law in the simple Barter Economy
2. Say’s Law in the money economy
3. Exhibit 5 and 6 of Chapter 8.

DEMAND SIDE POLICIES VS. SUPPLY SIDE POLICIES

Demand Side Policies are policies that affect the AD – they shift the AD Curve rightwards or leftwards. Supply Side
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Policies are policies which affect the LRAS – they shift the LRAS Curve rightwards. Classical Economists believe that if
the government wishes to increase the Natural Real GDP of the economy, then it must use Supply Side policies –
NOT Demand Side Policies. They show that Demand Side policies are successful in achieving a higher real GDP in the
short run, but in the long run such policies only affect the Price Level – they have no impact on the natural Real GDP
at all. To prove this point, they use the examples shown in Exhibit 7 of the book.
ECO 104: Introduction to Microeconomics [Course Instructor: Saima Khan(Sai)]
Sec : 1, 3, 15 SPRING 2010

Understanding Say’s Law

Say’s Law: Supply creates its own Demand

SAY’S LAW IN THE BARTER ECONOMY

Say’s Law can be best understood if we first look at a barter economy. In a Barter Economy, people do not use paper
money, gold or silver coins to purchase goods or services. Instead they exchange one good for another good. So,
suppose there are two people in an economy: Josh and Groban.

 Josh produces bread while Groban produces shirts

 Josh produces bread because he wants a shirt – Groban will NOT give him the shirt for free. Groban will
only give him a shirt, if Josh gives Groban a loaf of bread.
 Similarly, Groban produces shirts because he wants bread. Josh will NOT give him any bread for free. So the
only way in which he can get some bread is if he gives Josh some shirts in return.
 So when Josh supplies bread, he does it because he wants shirt – i.e. supply of bread creates a demand for
shirt.
 Similarly, when Groban produces shirts, he wants to exchange shirts for bread – i.e. supply of shirts creates
a demand for bread.
 Thus in a simple barter economy, since each individual produces one good in order to exchange it for
another good, supply of one good automatically generates demand for another good at the time of
exchange. Hence Supply creates its own Demand holds for a simple barter economy.

DO NOT CONFUSE

 Many students of economics mistakenly think that ‘Supply creates its own Demand’ is referring to only ONE
GOOD. That is NOT the case. Supply creates its own Demand DOES NOT MEAN that when a company
produces leather bags, people demand these leather bags and so supply of leather bags leads to a demand
for leather bags.

NO GOVERNMENT INTERVENTION: USING SAY’S LAW AS JUSTIFICATION

In the simple barter economy, since every individual exchanges one good for another good there is:

 No overproduction in the economy

 No underproduction in the economy

Thus for the barter economy, the market clears – that is, Supply equals Demand and the economy automatically
comes to equilibrium. Since the Economy automatically reaches its equilibrium, government intervention is not
needed – in other words government does not need to help the economy reach its equilibrium.

Thus, by using Say’s Law in the simple barter economy, classical economists prove that government intervention is
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not needed – as long as Say’s Law holds, government DOES NOT need to intervene.
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ECO 104: Introduction to Microeconomics [Course Instructor: Saima Khan(Sai)]
Sec : 1, 3, 15 SPRING 2010

SAY’S LAW IN THE MONEY ECONOMY

Does Say’s Law hold in the money economy? The best way to see this is by using the example of Josh and
Groban again.

 Say Josh produces bread worth $10 – so the Supply increases by $10
 Say Josh buys a shirt from Groban for $7 – so C = $7. He saves the remaining $3 – so S= $3.
 Recall that AD = C + I + G + NX – as C increases by $7, AD increases by $7 too.
 Thus far, it looks like Say’s Law is NOT holding – because Supply has increased by $10, but AD has
increased by only $7. ( For Say’s Law to hold, as Supply increases by $10, Demand should also
increase by $10).
 However, Classical Economists say that because of interest rate flexibility, when Saving increases,
Investment increases by the same amount. This can easily be shown in Exhibit 1 of Ch. 8.
o Initially at i1, S = I and the loanable funds market is in equilibrium at E1.
o When Saving increases, by say $3, at the existing interest rate i1, then there is disequilibrium
in the loanable funds market. This is because at the existing interest rate, even though
Saving has increased, Investors are not willing to increase investment. So at i1, Saving is
more than Investment. S>I
o However, when S>I, and there is excess of funds in the market, the interest rate starts to
fall. It continues to fall until Saving again equals Investment – at i2 , the loanable fund
market is again at equilibrium.
 So, Classical Economists say that in an economy, Saving will always equal Investment because
interest rates are flexible and thus will adjust (rise or fall) until S=I is achieved.
 So, when Josh saves $3 in a bank, the bank lends out this money to firms who then invest this $3
i.e. they use this $3 to purchase new capital, real estate etc. Thus an increase in S by $3 leads to an
increase in I by $3.
 Since I is also a component of AD, when I increases by $3, AD increases by $3.
 So we see that :

AS= $10 C= $7 I = $3 AD= $10

 In words, when Josh supplies bread, Supply in the Economy rises by $10. When he buys shirt
C increases by $7. When he Saves $3, Investment increases by $3 and thus AD increases in
total by $10 too.
 Thus in the money economy, we see that as Supply increases by $10, Demand also increase
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by $10. Hence we see that Say;s Law holds in the money economy.
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ECO 104: Introduction to Microeconomics [Course Instructor: Saima Khan(Sai)]
Sec : 1, 3, 15 SPRING 2010

THE NECESSARY CONDITIONS FOR SAY’S LAW TO HOLD IN MONEY ECONOMY

As shown in this Flow Chart, Say’s Law in the money economy will only hold if Saving equals Investment. Saving will
only equal Investment if there is interest rate flexibility. So, the two conditions that ensure that Say’s Law holds are
S=I and interest rate flexibility.

Say's Law HOLDS

in Money Economy

S=I

Interest Rate
Flexibility

NO GOVERNMENT INTERVENTION: USING SAY’S LAW AS JUSTIFICATION

As long as Say’s Law holds, there will be no overproduction or underproduction in the whole economy. Thus, the
economy will reach its long term equilibrium on its own. Hence there is no need for the government to intervene
and bring the economy to its equilibrium.

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ECO 104: Introduction to Microeconomics [Course Instructor: Saima Khan(Sai)]
Sec : 1, 3, 15 SPRING 2010

EXHIBIT 5: THE SELF REGULATING ECONOMY

AND RECESSIONARY GAP
Note: The Economy reaches long run equilibrium at QN. At this long run equilibrium real output, both the goods
market and the labour market is at equilibrium. However, when the economy is in a recessionary or an inflationary
gap, even though the goods market is at equilibrium, the labour market is in disequilibrium. It is this labour market
disequilibrium that triggers off a change in wages and thus a change in the SRAS. On the other hand, at Q N, since the
labour market is at equilibrium, there is no reason for the wage and subsequently the SRAS to change. Thus once the
economy reaches QN, there is no incentive for the economy to move away from that point.

When the economy is in a recessionary gap, according to Classical Economists, the economy automatically reaches
the long run equilibrium at QN($ 10 trillion in this case). This can be easily observed in Exhibit 5 (a) and (b).

1. Initially, the economy is in a short run equilibrium at Q1($ 9 trillion) and P1.
2. Here the economy is in a recessionary gap where :
A. Q1< QN i.e., Real GDP is less than the Natural real GDP
B. U1>UN , i.e., Unemployment in the short run is greater than the natural rate of unemployment.
3. This means that unemployment is unusually high and thus there is a surplus in the labour market. In other
words there are many people willing to work at the existing wage rate but very few finding such
employment.
4. With surplus labour, there is a downward pressure on wages.
5. As wages fall, firms hire more labour and thus
A. production increases at the existing price level.
B. SRAS increases
C. which means that the SRAS shifts to the right from SRAS1 to SRAS2.
6. This leads to a fall in the price level from P1 to P2.
7. At the lower price level, consumers are willing and able to buy more and thus quantity demanded of real
output rises from Q1 ($9 trillion) to QN($10 trillion).

Conclusion/End Result:

 When the economy finds itself in a recessionary gap, it automatically comes to the long run equilibrium.
 This is only possible because Classical Economists believe that wages and prices are flexible, i.e., they adjust
to bring the labour market and the goods market to equilibrium.
 Policy Prescription: Since, the economy can automatically get itself out of a recession; there is no need for
government intervention.

Note: Recall that we said each of the examples in this chapter help to justify the classical position of NO
GOVERNMENT INTERVENTION. Exhibit 5 is one such case.
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ECO 104: Introduction to Microeconomics [Course Instructor: Saima Khan(Sai)]
Sec : 1, 3, 15 SPRING 2010

EXHIBIT 6: THE SELF REGULATING ECONOMY

AND INFLATIONARY GAP
When the economy is in an inflationary gap, according to Classical Economists, the economy automatically reaches
the long run equilibrium at QN ($ 10 trillion in this case). This can be easily observed in Exhibit 6 (a) and (b).

1. Initially, the economy is in short run equilibrium at Q1 ($11 trillion) and P1.
2. Here the economy is in an inflationary gap where:
 Q1> QN, i.e., Real GDP is more than the Natural Real GDP
 U1<UN, i.e., Unemployment in the short run is smaller than the natural rate of unemployment.
3. This means that unemployment is unusually low and thus there is shortage in the labour market. In other
words, firms are putting pressure on the limited supply of labour.
4. With labour shortage, there is an upward pressure on wages.
5. Thus wages rise , firms hire less labour and hence:
A. production decreases at the existing price level.
B. SRAS decreases
C. which means that the SRAS shifts to the left from SRAS1 to SRAS2.
6. This leads to a rise in the price level from P1 to P2.
7. At the higher price level, consumers are willing and able to buy less and thus quantity demanded of real
output falls from Q1 to QN.

Conclusion/End Result:

 When the economy finds itself in an inflationary gap, it automatically comes to the long run equilibrium of
QN.
 This is only possible because Classical Economists believe that wages and prices are flexible, i.e., they adjust
to bring the labour market and the goods market to equilibrium.
 Policy Prescription: Since, the economy can automatically get itself out of an inflationary gap, there is no
need for government intervention.

Note: Recall that we said each of the examples in this chapter help to justify the classical position of NO
GOVERNMENT INTERVENTION. Exhibit 6 is one such case.

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ECO 104: Introduction to Microeconomics [Course Instructor: Saima Khan(Sai)]
Sec : 1, 3, 15 SPRING 2010

Exhibit 7(a): Using Demand Side Policy to increase Real GDP – A

Policy Perspective
In Exhibit 7 (a), we examine how successful demand side policies are in increasing real GDP.

1. Initially the Economy is at its Long Run Equilibrium at P1 and QN.

2. Then suppose Government decides to increase government purchase, i.e. G.
3. Since G is a component of AD, an increase in G, increases AD and so AD shifts outwards from AD1 to AD2.
4. This leads to an increase in the price level from P1 to P2.
5. Suppliers respond to this by increasing quantity supplied
6. Thus in the short run, real output increases from QN to Q1.
7. However, at Q1, the economy is at an inflationary gap where:
 Q1> QN, i.e., Real GDP is more than the Natural Real GDP
 U1<UN, i.e., Unemployment in the short run is smaller than the natural rate of unemployment.
8. This means that unemployment is unusually low and thus there is shortage in the labour market. In other
words, firms are putting pressure on the limited supply of labour.
9. With labour shortage, there is an upward pressure on wages.
10. Thus wages rise , firms hire less labour and hence:
A. production decreases at the existing price level.
B. SRAS decreases
C. which means that the SRAS shifts to the left from SRAS1 to SRAS2.
11. This leads to a further rise in the price level from P2 to P3.
12. At the higher price level, consumers are willing and able to buy less and thus quantity demanded of real
output falls from Q1 to QN.

(Note that from 7 – 11, the analysis is the same as that of Exhibit 6. This is nothing to get confused about since both
exhibit 6, and 7-12 of Exhibit 7(a) are simply dealing with the SAME THING – an inflationary gap).

CONCLUSION/ END RESULT:

When Demand Side Policies are undertaken:

 In the SHORT RUN

o Demand Side Policies are successful in increasing Real GDP above the Natural Real GDP
 In the LONG RUN
o the economy returns to its long run equilibrium output of QN
o So Demand Side Policies are unsuccessful in increasing Real GDP
o They only increase the Price Level – i.e., they actually harm the economy by bringing about inflation.
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ECO 104: Introduction to Microeconomics [Course Instructor: Saima Khan(Sai)]
Sec : 1, 3, 15 SPRING 2010

Exhibit 7(b): Using Demand Side Policy to decrease Real GDP – A

Policy Perspective
In Exhibit 7 (b), we examine how successful demand side policies are in decreasing real GDP.

1. Initially the Economy is at its Long Run Equilibrium at P1 and QN.

2. Then suppose Government decides to decrease government purchase, i.e. G.
3. Since G is a component of AD, a decrease in G, decreases AD and so AD shifts inwards from AD1 to AD2.
4. This leads to a decrease in the price level from P1 to P2.
5. Suppliers respond to this by decreasing quantity supplied
6. Thus in the short run, real output decreases from QN to Q1.
7. However, at Q1, the economy is at a recessionary gap where:
 Q1< QN i.e., Real GDP is less than the Natural real GDP
 U1>UN , i.e., Unemployment in the short run is greater than the natural rate of unemployment.
8. This means that unemployment is unusually high and thus there is a surplus in the labour market. In other
words there are many people willing to work at the existing wage rate but very few finding such
employment.
9. With surplus labour, there is a downward pressure on wages.
10. As wages fall, firms hire more labour and thus
A. production increases at the existing price level.
B. SRAS increases
C. which means that the SRAS shifts to the right from SRAS1 to SRAS2.
11. This leads to a further fall in the price level from P2 to P3.
12. At the lower price level, consumers are willing and able to buy more and thus quantity demanded of real
output rises from Q1 to QN

(Note that from 7 – 11, the analysis is the same as that of Exhibit 6. This is nothing to get confused about since both
exhibit 6, and 7-12 of Exhibit 7(a) are simply dealing with the SAME THING – an inflationary gap).

CONCLUSION/ END RESULT:

When Demand Side Policies are undertaken:

 In the SHORT RUN

o Demand Side Policies are successful in increasing Real GDP above the Natural Real GDP
 In the LONG RUN
o the economy returns to its long run equilibrium output of QN
o So Demand Side Policies are unsuccessful in increasing Real GDP
o They only increase the Price Level – i.e., they actually harm the economy by bringing about inflation.
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NOTE:

Crucial Assumption that ensures Exhibit 5, 6 and 7 work : Prices and Wages are flexible.
ECO 104: Introduction to Microeconomics [Course Instructor: Saima Khan(Sai)]
Sec : 1, 3, 15 SPRING 2010

A Policy Summary
 Say’s Law in Barter Economy
o Say’s Law ensures that there is no overproduction or underproduction in the economy.
o Thus, when Say’s Law holds, the economy automatically comes to equilibrium.
o Hence there is NO NEED FOR GOVERNMENT INTERVENTION.
 Say’s Law in the Money Economy
o Say’s Law holding in the money economy again means that the economy automatically comes to
equilibrium.
o Hence Government does not need to intervene to bring the economy to its equilibrium.
 Exhibit 5 & 6
o Since the Economy can get out of a recessionary gap and inflationary gap all by itself, there is NO
NEED FOR GOVERNMENT INTERVENTION.
 Exhibit 7 (a) and (b)
o When the government intervenes by changing the Aggregate Demand, we refer to them as Demand
Side Policies.
o These Demand Side Policies have an impact on the real output in the Short Run
o In the Long Run, they have NO IMPACT on the Real output – they only affect the Price Level
o So, to have an impact on the Real Output Level in the LONG RUN, Classical Economists recommend
that the economy undertake Supply Side Policies that affect the Long Run Aggregate Supply.

 THE END 

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