Classical Economics Classical economics is one of the main theories of economics, besides Keynesian economics, although classical economics is considered the first school of thought in economics, probably only due to timing. Although others have contributed ideas and theories to the classical school of thought, Adam Smith is the person behind the Classical economics school of thought. The Classical economics theory teaches and is based on the idea that the economy can stabilize and run effectively on its own, without any type of assistance.
There are three basic assumptions of Classical Economists theories. One is that all prices must be susceptible to flexibility downward just as easily as upward. This is proven not to be the case for downward prices because of factors such as laws or unions. Another assumption is what is called, “Say’s Law”. This law preaches that “supply creates its own demand”. However, this is also proven to not work effectively because in most economies today production is based on demand not the other way around.
The third assumption is that the savings of every consumer should match their investment. This, we all know from experience, not to be the case. Classical economics believes the economy is a type of self- correcting mechanism and needs no assistance or intervention to function effectively. Unemployment in an economy is considered to be a temporary disequilibrium due to excess labor at the current wage rate. Also, whenever wages are high, Classical economics points out that there are always more people willing to work at that ongoing rate and this is what they name as unemployment.
Furthermore, if the economy is a Classical one, wages are perfectly flexible, so this would cause the wage rate to fall. This would, in turn, rid the excess labor available and reduce the unemployment back to equilibrium levels. This is how Classical economics believes an economy is the perfect solution. It relies on the idea that employers will always act in their own best interest. But, by doing so they will also help the economy. When employees are still available at a lower price, he will have no incentive or reason to pay them more.
He will then adjust the wage lower and still be promoting for the overall benefit of its society without any extra effort. The Classical economy school of thought also teaches that the commodities markets will also always be in equilibrium because of flexible prices. It believes that if the supply is high with adequate demand, the situation is temporary. Just like when producers adjust their prices lower to lure a consumer into buying it when it has not sold, the prices for the commodity, also, lower down to match the demand and supply, thus once again, bringing the situation back to an equilibrium level.
Capital Markets are no exception for Classical economics. In the classical economics school of thought, no human intervention is required to lead the capital markets to equilibrium as well. Classical economics theorize if savings exceed investment, the interest rates fall and equilibrium follows. Contrary, if savings fall short of investments, the interest rates will rise and once again reach equilibrium, with help from that invisible hand. One potential problem with the classical theories is that Say’s law may not be true.
This could happen because not all the income earned goes towards consumption, misinterpreting the missing potential demand which will cause a dis-equilibrium. When supply falls short of effective demand like this, several problems can arise. For example, producers reduce their production, employees are laid off, wages decrease, thus leading consumers with less income, this will have a downward spiral. Classical Economists believe that what occurred to the savings is what started the problem and is where the solution lies.
They believe all that is needed is for the savings to go in as investments. This will then allow the interest rates to adjust and bring equilibrium to the economy once again. But, once again, are our savings actually invested? Sadly, mine are not. Nonetheless, Classical economists argue all these solutions could work with no government intervention. Furthermore, they argue government intervention would actually hurt an economy in the long run.
In conclusion, the Classical economics school of thought hold that Say’s law proves “costs of output are always covered in the aggregate by the sale-proceeds resulting from demand”. Also, Classical economists explain how the theory of the invisible hand is far more effective than any government intervention, with no monetary policy during an economic crisis. With Classical economics, the long run is targeted for an economy’s successful growth, leaving short run losses to be tackled at a later date.
Classical economists believed investments did not hurt an economy in any way but will actually help because of their fluctuating ability. There are contradictions to any theory, but most can agree on the idea that the future expectations of any economy will affect its consumers. We will inevitably use our human instincts of survival and attempt to do what we think is best for our and our loved ones’ survival regardless of what we think is the best thing to do in “the long run” for our economy’s growth and stability.