Classical economics

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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.

Adam Smith's The Wealth of Nations in 1776 is usually considered to mark the beginning
of classical economics. The school was active into the mid 19th century and was
followed by neoclassical economics in Britain beginning around 1870, or, in Marx's
definition by "vulgar political economy" from the 1830s. The definition of classical
economics is debated, particularly the period 1830–70 and the connection to neoclassical
economics. The term "classical economics" was coined by Karl Marx to refer to
Ricardian economics – the economics of David Ricardo and James Mill and their
predecessors – but usage was subsequently extended to include the followers of Ricardo.

History

The classical economists produced their "magnificent dynamics"[2] during a period in

which capitalism was emerging from feudalism and in which the industrial revolution
was leading to vast changes in society. These changes raised the question of how a
society could be organized around a system in which every individual sought his or her
own (monetary) gain. Classical political economy is popularly associated with the idea
that free markets can regulate themselves.[3]

Classical economists and their immediate predecessors reoriented economics away from
an analysis of the ruler's personal interests to broader national interests. Adam Smith, and
also physiocrat Francois Quesnay, for example, identified the wealth of a nation with the
yearly national income, instead of the king's treasury. Smith saw this income as produced
by labour, land, and capital. With property rights to land and capital held by individuals,
the national income is divided up between labourers, landlords, and capitalists in the form
of wages, rent, and interest or profits.

[edit] Modern legacy

Classical economics is generally agreed (but see section 5 below) to have developed into
neoclassical economics – as the name suggests – or to at least be most closely represented
in the modern age by neoclassical economics, and many of its ideas remain fundamental
in economics. Other ideas, however, have either disappeared from neoclassical discourse
or been replaced by Keynesian economics in the Keynesian revolution and neoclassical
synthesis. Some classical ideas are represented in various schools of heterodox
economics, notably Marxian economics – Marx being a contemporary of the classical
economists and their immediate successors – and Austrian economics, which split from
neoclassical economics in the late 19th century.

[edit] Classical theories of growth and development

Analyzing the growth in the wealth of nations and advocating policies to promote such
growth was a major focus of classical economists. John Hicks & Samuel Hollander,[4]
Nicholas Kaldor,[5] Luigi L. Pasinetti,[6][7] and Paul A. Samuelson[8][9] have presented
formal models as part of their respective interpretations of classical political economy.

[edit] Value theory

Classical economists developed a theory of value, or price, to investigate economic

dynamics. William Petty introduced a fundamental distinction between market price and
natural price to facilitate the portrayal of regularities in prices. Market prices are jostled
by many transient influences that are difficult to theorize about at any abstract level.
Natural prices, according to Petty, Smith, and Ricardo, for example, capture systematic
and persistent forces operating at a point in time. Market prices always tend toward
natural prices in a process that Smith described as somewhat similar to gravitational
attraction.

The theory of what determined natural prices varied within the Classical school. Petty
tried to develop a par between land and labour and had what might be called a land-and-
labour theory of value. Smith confined the labour theory of value to a mythical pre-
capitalist past. Others may interpret Smith believed in value as derived from labour.[10] He
stated that natural prices were the sum of natural rates of wages, profits (including
interest on capital and wages of superintendence) and rent. Ricardo also had what might
be described as a cost of production theory of value. He criticized Smith for describing
rent as price-determining, instead of price-determined, and saw the labour theory of value
as a good approximation.

Some historians of economic thought, in particular, Sraffian economists,[11][12] see the

classical theory of prices as determined from three givens:

1. The level of outputs at the level of Smith's "effectual demand",

2. technology, and
3. wages.

From these givens, one can rigorously derive a theory of value. But neither Ricardo nor
Marx, the most rigorous investigators of the theory of value during the Classical period,
developed this theory fully. Those who reconstruct the theory of value in this manner see
the determinants of natural prices as being explained by the Classical economists from
within the theory of economics, albeit at a lower level of abstraction. For example, the
theory of wages was closely connected to the theory of population. The Classical
economists took the theory of the determinants of the level and growth of population as
part of Political Economy. Since then, the theory of population has been seen as part of
Demography. In contrast to the Classical theory, the determinants of the neoclassical
theory value:

1. tastes
2. technology, and
3. endowments

are seen as exogenous to neoclassical economics.

Classical economics tended to stress the benefits of trade. Its theory of value was largely
displaced by marginalist schools of thought which sees "use value" as deriving from the
marginal utility that consumers finds in a good, and "exchange value" (i.e. natural price)
as determined by the marginal opportunity- or disutility-cost of the inputs that make up
the product. Ironically, considering the attachment of many classical economists to the
free market, the largest school of economic thought that still adheres to classical form is
the Marxian school.

[edit] Monetary theory

British classical economists in the 19th century had a well-developed controversy

between the Banking and the Currency school. This parallels recent debates between
proponents of the theory of endogeneous money, such as Nicholas Kaldor, and
monetarists, such as Milton Friedman. Monetarists and members of the currency school
argued that banks can and should control the supply of money. According to their
theories, inflation is caused by banks issuing an excessive supply of money. According to
proponents of the theory of endogenous money, the supply of money automatically
adjusts to the demand, and banks can only control the terms (e.g., the rate of interest) on
which loans are made.

[edit] Debates on the definition of classical economics

The theory of value is currently a contested subject. One issue is whether classical
economics is a forerunner of neoclassical economics or a school of thought that had a
distinct theory of value, distribution, and growth.

Sraffians, who emphasize the discontinuity thesis, see classical economics as extending
from Petty's work in the 17th century to the break-up of the Ricardian system around
1830. The period between 1830 and the 1870s would then be dominated by "vulgar
political economy", as Karl Marx characterized it. Sraffians argue that: the wages fund
theory; Senior's abstinence theory of interest, which puts the return to capital on the same
level as returns to land and labour; the explanation of equilibrium prices by well-behaved
supply and demand functions; and Say's law, are not necessary or essential elements of
the classical theory of value and distribution.

Perhaps Schumpeter's view that John Stuart Mill put forth a half-way house between
classical and neoclassical economics is consistent with this view.
Sraffians generally see Marx as having rediscovered and restated the logic of classical
economics, albeit for his own purposes. Others, such as Schumpeter, think of Marx as a
follower of Ricardo. Even Samuel Hollander[13] has recently explained that there is a
textual basis in the classical economists for Marx's reading, although he does argue that it
is an extremely narrow set of texts.

Another position is that neoclassical economics is essentially continuous with classical

economics. To scholars promoting this view, there is no hard and fast line between
classical and neoclassical economics. There may be shifts of emphasis, such as between
the long run and the short run and between supply and demand, but the neoclassical
concepts are to be found confused or in embryo in classical economics. To these
economists, there is only one theory of value and distribution. Alfred Marshall is a well-
known promoter of this view. Samuel Hollander is probably its best current proponent.

Still another position sees two threads simultaneously being developed in classical
economics. In this view, neoclassical economics is a development of certain exoteric
(popular) views in Adam Smith. Ricardo was a sport, developing certain esoteric (known
by only the select) views in Adam Smith. This view can be found in W. Stanley Jevons,
who referred to Ricardo as something like "that able, but wrong-headed man" who put
economics on the "wrong track". One can also find this view in Maurice Dobb's Theories
of Value and Distribution Since Adam Smith: Ideology and Economic Theory (1973), as
well as in Karl Marx's Theories of Surplus Value.

The above does not exhaust the possibilities. John Maynard Keynes thought of classical
economics as starting with Ricardo and being ended by the publication of Keynes'
General Theory of Employment Interest and Money. The defining criterion of classical
economics, on this view, is Say's law.

One difficulty in these debates is that the participants are frequently arguing about
whether there is a non-neoclassical theory that should be reconstructed and applied today
to describe capitalist economies. Some, such as Terry Peach,[14] see classical economics
as of antiquarian interest.

Sometimes the definition of classical economics is expanded to include the earlier 17th
century English economist William Petty and the contemporary early 19th century
German economist Johann Heinrich von Thünen.

Classical Theory of Economics

?
The classical theory of economics, which dominated in the 18th and early 19th centuries, laid
the foundation for much of modern economics. Sometimes referred to as laissez faire
economics, classical theory emphasized growth, free trade, and competition, as free from
government regulation as possible. Under classical thought, when individuals pursue their
own interest, society as a whole benefits.
Famous Ties
o Key classical economists include Adam Smith, author of the "The Wealth of
Nations," David Ricardo and John Stuart Mill.

Features
o Classical economic theory argues for the self-regulating market. Under this
viewpoint, the concern for profit ensures that society's resources are used in the
most beneficial manner, without direction by government.

Benefits
o Under classical economics, the self-regulating market transforms a
seemingly chaotic process of buying and selling among consumers and producers
into an orderly system of transactions that meets individual needs and increases
national wealth.

Role of Government
o Under classical economics, the role of government is to provide national
defense, a system of justice that includes enforcement of contracts and a system of
public works, including infrastructure and education.

Influences
o Classical economics gave rise to neoclassical economic thought in the late
19th century. Neoclassical built on Classical ideas, giving them greater mathematical
support and precision

Classical Theory: Government has minimal role in the economy, and the macro-economy is
self adjusting; meaning consumers and businesses will correct any problems with the economy
automatically over time. Classical theory focuses on long-term goals.

Keynesian Theory: Government has a large role in the economy, and focuses on short-term
goals. Used mostly in times of recession, government spending is a good way to put money
back into the GDP and in turn increase unemployment.

Read more:
http://wiki.answers.com/Q/What_are_some_differences_between_Classical_Economic_Theory
_and_Keynesian_Economic_Theory#ixzz1OEsooDjy

The Classical Theory

The fundamental principle of the classical theory is that the economy is self-
regulating. Classical economists maintain that the economy is always capable of
achieving the natural level of real GDP or output, which is the level of real GDP
that is obtained when the economy's resources are fully employed. While
circumstances arise from time to time that cause the economy to fall below or to
exceed the natural level of real GDP, self-adjustment mechanisms exist
within the market system that work to bring the economy back to the natural
level of real GDP. The classical doctrine—that the economy is always at or near
the natural level of real GDP—is based on two firmly held beliefs: Say's Law and
the belief that prices, wages, and interest rates are flexible.

Say's Law. According to Say's Law, when an economy produces a certain level
of real GDP, it also generates the income needed to purchase that level of real
GDP. In other words, the economy is always capable of demanding all of the
output that its workers and firms choose to produce. Hence, the economy is
always capable of achieving the natural level of real GDP.

The achievement of the natural level of real GDP is not as simple as Say's Law
would seem to suggest. While it is true that the income obtained from producing
a certain level of real GDP must be sufficient to purchase that level of real GDP,
there is no guarantee that all of this income will be spent. Some of this income
will be saved. Income that is saved is not used to purchase consumption goods
and services, implying that the demand for these goods and services will be less
than the supply. If aggregate demand falls below aggregate supply due to
aggregate saving, suppliers will cut back on their production and reduce the
number of resources that they employ. When employment of the economy's
resources falls below the full employment level, the equilibrium level of real GDP
also falls below its natural level. Consequently, the economy may not achieve
the natural level of real GDP if there is aggregate saving. The classical theorists'
response is that the funds from aggregate saving are eventually borrowed and
turned into investment expenditures, which are a component of real GDP. Hence,
aggregate saving need not lead to a reduction in real GDP.

Consider, however, what happens when the funds from aggregate saving exceed
the needs of all borrowers in the economy. In this situation, real GDP will fall
below its natural level because investment expenditures will be less than the
level of aggregate saving. This situation is illustrated in Figure 1 .
 Figure 1 Classical theory of interest rate adjustment in the money market

Aggregate saving, represented by the curve S, is an upward-sloping function of

the interest rate; as the interest rate rises, the economy tends to save more.
Aggregate investment, represented by the curve I, is a downward-sloping
function of the interest rate; as the interest rate rises, the cost of borrowing
increases and investment expenditures decline. Initially, aggregate saving and
investment are equivalent at the interest rate, i. If aggregate saving were to
increase, causing the S curve to shift to the right to S′, then at the same interest
rate i, a gap emerges between investment and savings. Aggregate investment
will be lower than aggregate saving, implying that equilibrium real GDP will be
below its natural level.

Flexible interest rates, wages, and prices. Classical economists believe that
under these circumstances, the interest rate will fall, causing investors to
demand more of the available savings. In fact, the interest rate will fall far
enough—from i to i′ in Figure 1 —to make the supply of funds from aggregate
saving equal to the demand for funds by all investors. Hence, an increase in
savings will lead to an increase in investment expenditures through a reduction
of the interest rate, and the economy will always return to the natural level of
real GDP. The flexibility of the interest rate as well as other prices is the self-
adjusting mechanism of the classical theory that ensures that real GDP is always
at its natural level. The flexibility of the interest rate keeps the money market,
or the market for loanable funds, in equilibrium all the time and thus prevents
real GDP from falling below its natural level.

Similarly, flexibility of the wage rate keeps the labor market, or the market
for workers, in equilibrium all the time. If the supply of workers exceeds firms'
demand for workers, then wages paid to workers will fall so as to ensure that the
work force is fully employed. Classical economists believe that any
unemployment that occurs in the labor market or in other resource markets
should be considered voluntary unemployment. Voluntarily unemployed
workers are unemployed because they refuse to accept lower wages. If they
would only accept lower wages, firms would be eager to employ them.

Graphical illustration of the classical theory as it relates to a decrease in

aggregate demand. Figure 2 considers a decrease in aggregate demand from
AD1 to AD2.

Figure 2 Classical theory of output and price level adjustment during a recession

The immediate, short-run effect is that the economy moves down along the SAS
curve labeled SAS1, causing the equilibrium price level to fall from P1 to P2, and
equilibrium real GDP to fall below its natural level of Y1 to Y2. If real GDP falls
below its natural level, the economy's workers and resources are not being fully
employed. When there are unemployed resources, the classical theory predicts
that the wages paid to these resources will fall. With the fall in wages, suppliers
will be able to supply more goods at lower cost, causing the SAS curve to shift to
the right from SAS1 to SAS2. The end result is that the equilibrium price level
falls to P3, but the economy returns to the natural level of real GDP.