Classical Model of Income

Determination
Module 3 (Chapter 4 Vanita Agarwal)
B.Chatterjee
School of Commerce
NMIMS
 What do we mean by income determination?

Determination of Equilibrium Income/GDP

Concept of the equilibrium:

The economy is in equilibrium when Aggregate Supply= Aggregate Demand
The classical economists believed that the economy is always at
equilibrium.
Why?
They believed that whatever the household earns are spent on goods
and services. There is no savings.
Whatever income is generated due to production of goods and services
are spent on goods and services. So whatever is supplied is demanded.
If there is less demand for a certain commodity, then there must be
more demand for any other commodity. Overall, AS=AD
“Supply create its own demand”: Say’s law
Classical Model of Income determination

• the economy operates in its full capacity

• Prices, wages are flexible

• All income earned are spend on goods and services

LABOR DEMAND CURVE

Labor demand is a function of real wages W/P

Ld=Ld(W/P)
Ld

Individual demand curve for labor can be summed up to arrive at the

aggregate demand curve for labor.

Ld
LABOR SUPPLY CURVE

Labor Supply is a function of real wages W/P

LS=LS(W/P)
LS
Individual Supply curve for labor can be summed up to arrive at the
Aggregate Supply curve for labor.

LS
LABOR MARKET EQUILIBRIUM

The equilibrium level of real wage and employment is determined at W/P

(W/P)* and L*. Ld
LS
Here Aggregate Supply of labor=Aggregate Demand for Labor

If labor supply and demand are not equal, then real wage will adjust W/P*
accordingly.

So the labor market is always in equilibrium.

L* LS /Ld

Therefore there is no unemployment.

 FULL EMPLOYMENT OUTPUT

The aggregate production function is W/P Y

characterized as follows: Ld Y=F(L, K)
Y=F(L, K) , where Y=real output, LS
L=labor, K=Capital Y*

The stock of capital (plant,

equipment) and technology is
constant W/P*

If L* is the amount of labor

demand/supply in the economy, then
the total output produced with L* L* Ls/Ld L* L
and the given amount of capital is
Y*=F(L*, K), which is called the full
employment output
The Aggregate Supply Curve in
the Classical Model

Full employment output is the output when the economy is using the given P AS
amount of capital and all its labor force to produce the maximum possible
output.

No change in output is possible since all the resources are exhausted, all
capital is used up and labor is at full employment.

Hence, producers in the economy cannot supply more even if the want to.

Y* Y
Key Implication of the
Classical model P AS

“SUPPLY CREATES ITS OWN DEMAND” — SAY’S LAW

NO ROLE OF GOVERNMENT AD
AD
AD
Y* Y
Criticisms of Classical Model: The Keynesian
approach to income determination
• Classical assumption of wage and price flexibility is unrealistic

• The assumption that whatever goods and services are either sold on
the market or self-consumed (supply and demand are always equal) is
untrue.

• There exists role of the government