C HAPT E R 4

The Classical School:

Forerunners
Classical School

 Began in 1776 when Adam Smith published

his Wealth of Nation and ended when W.
Stanley Jevons, Carl Menger and Leon
Walras published works on neoclassical
theories
 Two revolutions were significance to the
classical thought (1) Scientific revolution and
(2) Industrial revolution
 Scientific Revolution
• In 1687 Isaac Newton (1642 –1727) greatly advanced
Kepler’s earlier scientific laws of motion and Galileo’s
mathematical laws of movement of bodies on earth.
• The revolution had three major merit
1. Scientists relied heavily on experimental evidence
2. Newton popularized the already existing idea that the
universe is governed by natural laws
3. Newton system was static view of the universe
• This had impact the classical thought where the
restrictive controls of mercantilism were no
longer necessary.
• Created a mechanism that worked harmoniously
and automatically without interference.
• Natural laws would guide the economic system
and the action of people
• Society would be best served if people were free
to follow the natural law of self interest
Industrial Revolution
• In 1776 England as the most industrially efficient
and powerful country in the world, benefited form
free international trade
• As the entrepreneurs become stronger, they no
longer had to rely on government subsidy,
monopoly privileges and tariff protection
• Free, mobile, low paid and hardworking labor force
also emerged
 Major Tenets

1. Minimal government involvement

• Free competitive market would guide production,
exchange and distribution
• Self adjusting and tending toward full employment
2. Self-interested economic behavior
• Self-interest where producers and merchants
provided goods and services to make profits,
workers for wages and consumers purchase
products to satisfy their wants
3. Harmony of interests
• By pursuing their own individual interests, people
served the best interests of society
4. Importance of all economic resources & activities
• Classical pointed out resources (land, labor, capital
and entrepreneurial ability) and economic activities
(agriculture, commerce, production and international
trade) contribute to the nation’s wealth
5. Economic laws
• Focus on explicit economic theories, law of
comparative advantage, law of diminishing return
and others
Whom Did Benefit?

 Served all society because its theories

promoted capital accumulation and economic
growth

 Ultimately benefited owners of businesses

Which Became Lasting?

 Laid the foundation of modern economics as

a social science such as;
– Law of diminishing return
– Law of comparative advantage
– Consumer sovereignty
– Importance of capital accumulation
– Importance of market mechanism
 Sir Dudley North (1641 – 1691)

 Called as the world’s first free trader

 Trade is a mutual advantage
 Wealth should not be measured by a country’s
stock of precious metals
 Argued for laissez-faire
 Disagreed with the mercantilist concept that war
and conquest enrich a country
Richard Cantillon (1680 – 1743)

 Born in Ireland but spent life in Paris

 In 1734, he was robbed and murdered
 Published his only book, Essai sur la
Nature du Commerce en General in
French, 1755
 Predated physiocrats:-
1. First used the term entrepreneur
2. Writing before Quesnay published
Tableau Economique
Cantillon’s Contribution
 Attempted to reduce economics to a few
elementary principles.
 Emphasis on monetary concerns.
 Concept of equilibrium across markets.
 Mechanical linkages across economic elements,
driven by individuals pursuing self-interest.
 Motivated by Newton’s writings on mechanics in
physics.
 Modern method.
Land is Source of Wealth

 Cantillon was aware that a country’s total

production depends on both land and labor.
 But the availability of labor depends on the
availability of land and therefore, cannot be
considered an independent source of a nation’s
wealth.
 Without adequate land, the labor force will either
starve to death or be forced to migrate. Therefore,
a nation’s prosperity depends only on its
endowment of land.
 This idea was further developed by the
Physiocrats.
Macroeconomic Theory
 Cantillon constructed a macroeconomic theory:-
• By imagining an economy with two sectors—
agriculture and manufacturing
• Three social classes—landowners, entrepreneurs
and hired workers
 Describing how the output of each sector ends up
distributed among the three social classes as their
consumption and among the two sectors as their raw
materials.
 Cantillon’s analysis amounts to the circular flow of
income model that almost every economics textbook
of today starts out with.
 The notion that income equals expenditure or that
each person earns what others must have spent is
clear in Cantillon’s description.
Monetary Theory
 In Cantillon’s monetary theory, the purchasing
power of money (that is, the value of money) does
not change when the quantity of money changes.
 In Cantillon’s time, money consisted of gold and
silver coins. This is called commodity money.
 Since gold is a commodity like any other
commodity, its value is measured by the amount of
land embodied in the production of a unit of gold
 As long as the way gold is produced does not
change, its value in terms of land cannot change
and therefore its purchasing power (measured in
terms of the amount of any good that a gold coin
can buy) cannot change.
 Eventually the economy would reach the limit of
what it was able to produce. When that point is
reached, the increased spending by those who
have the newly mined gold would simply drive up
prices
 This would reduce exports and increase imports.
 The resulting trade deficit would be accompanied
by an outflow of gold to foreign countries. In the
long run, the additional gold that was discovered
would simply flow out of the country and the value
or purchasing power of gold (that is, money) would
return to its original level.
 This result is a version of the price specie-flow
mechanism that David Hume (1711-1776) later
became famous for.
David Hume (1711-1776)
 Hume entered the University of Edinburgh at 12
and left at 15
 Refused a chair in philosophy because his
skeptical spirit and unorthodox thinking
 Hume accepted John Locke’s quantity theory of
money (the price level is determined by the
quantity of money available, given the velocity and
quantity of output)
 Hume condemned on John Law’s disastrous
schemes: in the long run money does not raise
output and increase the number of jobs, it only
raises prices and in the same proportion as the
increase in the quantity of money.
Price Specie-Flow Mechanism
 Mercantilists failed to state whether the
monetary stimulus applied in the short run or the
long run and Hume made it clear that that effect
existed only in the short run and was completely
absent in the long run
 Hume also criticized the mercantilist view that an
increase in the quantity of money reduced
interest rates saying that the effect evaporates in
the long run.
 Hume’s doctrine that changes in the quantity of
money affect nominal variables but not real
variables is known as monetary neutrality.
 Hume addressed the issue of money by
likening money to grease that makes a
wheel turn smoother
 Hume also gave a clear description of the
specie flow mechanism.
 Cantillon had explained this much earlier,
but Cantillon’s book was published after
Hume had published his analysis.