Classical System Flashcards
What are the four basic elements of the classical system?
- Competitive and flexible labour markets, ensuring full employment
- Aggregate Demand for Say’s Law
- Theory of the price level derived from the quantity theory of money
- Law of diminishing return linking labour to the product market
When did the classical system dominate economic thinking?
From the 18th Century to the early 1930s.
Who are the two main classical scholars?
Adam Smith and David Ricardo
What are the two microeconomic assumptions of the classical system?
Perfect competition
Rational behaviour
What is Say’s law? What insight does this provide?
Say’s law states that the production of goods creates its own demand.
It suggests that the key to economic growth is to expand production rather than demand.
How does Say’s Law relate to financial institutions?
Any leakages of demand by monetary hoarding are reinjected by financial institutions
Why does Say’s Law not work in a monetary economy? What alleviates this?
Money can be used as a store of value, creating a glut. Banks can help this situation.
What is the equation for the quantity theory of money?
Mv = pY
What is Mv in the quantity theory of money equation?
Quantity of money needed in circulation to handle a given volume of transactions v
What is pY in the quantity theory of money equation?
Nominal value of output (GDP)
What determines Y in the quantity theory of money?
Y is determined by the production function and the labour market
Why is the quantity theory of money invalid?
The theory assumed that the central bank can control the money supply (M). It can’t.
What are the two main assumptions of the classical labour market?
All workers are the same in terms of skills
Workers do not suffer from money illusion (understand inflation)
What is the classical view on involuntary unemployment?
It doesn’t exist so long as wages remain flexible.
When real wages (W/p) rise, what do the substitution effect and income effect do?
Substitution effect causes the worker to work more when W/p rises.
Income effect causes worker to work less when W/p rises.
What does the quantity theory of money imply about the price level?
Suggests that the price level is determiend by the money supply p = f(M)
What happens in the classical labour market when there is a surplus of labour?
Firms cut the wage, moving the supply curve down to drive out supply
What happens in the classical labour market when there is a shortage of labour?
Firms offer a higher real wage, moving the supply curve up
What is the key assumptions of the classical labour market which may not be true?
Satisfaction from each unit of leisure = satisfaction of goods bought from wages
What two elements of the quantity theory of money stay the same?
v is constant and Y is given
Why does Ns slope up on the classical labour market diagram?
The higher the wage, the more work will be delivered
When does Nd shift on the classical labour market diagram?
Shifts when technological progress occurs which boosts productivity
When does the Ns curve on the classical labour market diagram shift?
Shifts when there is a change in population
Why does the curve for the production function flatten?
Workers are limited to working with a fixed amount of capital and marginal product of labour.
