Classical economics

The United States suffered very bad recessions, even depressions, in the 1830s, 1870s, and 1890s, but always did eventually recover. If the government tried to get the country out of a recession, said the classicals, it only made things worse.

The classical school of economics was mainstream economics from roughly 1775 to 1930. Adam Smith's The Wealth of Nations, a plea for laissez-faire (no government interference), was virtually the economics bible through most of this period. The classicals believed our economy was self-regulating. Recessions would cure themselves, and a built-in mechanism was always pushing the economy toward full employment.

The centerpiece of the classical system was Say's law: Supply creates its own demand. Everything produced gets sold. Why? Because people work so that they can spend.

What if people save some of their incomes? No problem, said the classicals, because that savings will be invested. With that, they pointed to Figure 1, which shows a graph of saving and investment. The two are equal at an interest rate of 10 percent.

What if the amount of money people wanted to save at 10 percent interest were greater than the amount business people wanted to invest? Still no problem, said the classicals. The interest rate would fall automatically. People would be inclined to save less at lower interest rates, and business people would be inclined to invest more. Eventually, the interest rate would fall far enough so that savings and investment would be equal.

The classicals also assumed downwardly flexible wage rates and prices. If there happened to be a temporary recession and business firms could not sell their entire inventories, they would simply lower their prices until their inventories were depleted. Similarly, if some workers were unemployed, they would offer to work for lower wages and would find new jobs.

Another basic classical tenet was the quantity theory of money. Stated in its crudest version, when the money supply changes by a certain percentage, the price level changes by that same percentage. Thus, when the money supply is increased by 5 percent, the price level rises by 5 percent.

Resorting once again to the equation of exchange

MV = PQ

What do these letters stand for? Mrepresents the number of dollars in the nation's money supply - the currency and demand deposits.

The velocity of circulation, or the number of times per year each dollar in our money supply is spent, is represented by V.

P represents the price level, or the average price of all the goods and services sold during the year. Q stands for the quantity of goods and services sold during the year.

If M rises by 5 percent and P rises by 5 percent, that means V and Q remain constant. We shall hold a full-scale debate between the Keynesians and the monetarists about the stability of V and shall conclude that V is stable during nonrecession and peacetime years. And Q? Well, Q, the output of goods and services, rises during nonrecession years and falls during recession years.

Where does all this leave us as regards the quantity theory? In its crude version, which the classicals espoused, we could hardly expect V and Q to stay constant from year to year. So much, then, for the crude quantity theory.

Finally, let's take a closer look at the classical contention that recessions are temporary phenomena, which, with the help of Say's law, the interest rate mechanism, and downwardly flexible wages and prices, cure themselves. This leads to the basic classical macroeconomic policy when there is a recession: Do nothing! If the government attempted to cure a recession by spending more money or cutting taxes, these measures would not get the economy out of the recession. Why not? Because the recession would cure itself. Government intervention could not help, and it might even hurt.

What about monetary policy? If there were a recession, the standard monetary policy would be to increase the rate of growth of the money supply. What would this accomplish? Ask the classicals. Because the recession would be curing itself, output, Q, would go up automatically. Because V would be stable, a rise in M would simply be translated into a rise in P, so the attempt to cure the recession by means of monetary policy would only cause inflation.

The classical school dominated economic thought until the time of the Great Depression. If recessions cure themselves automatically, asked John Maynard Keynes in the 1930s, why is the entire world economy dragging along from year to year in unending depression? And if the economy isn't curing itself, said Keynes, government intervention is in order.

11.2. Are these statements true or false? Correct the false ones.

a) According to the classical school of economics recessions cure themselves and push the economy toward full employment.

b) Supply generates its demand because people spend as they earn.

c) The quantity theory of money says that if the money supply alters by a certain percentage the price level remains unchanged.

d) Government can't cure recessions.

11.3. Speak briefly about basic classical tenets. Use the plan and the key words and phrases to help you.

a) Adam Smith’s plea for laissez-faire (mainstream; no government interference; the economics bible; self-regulating; recession; to cure themselves; a built-in mechanism; to push the economy; full employment);

b) Say’s Law (supply and demand; to create; to produce; to save; savings; to invest; to be inclined; to sure; to be equal);

c) Quantity theory of money (tenet; the crudest version; money supply; by a certain percentage; price level; velocity of circulation; average price; stability; no recession; espoused; hardly expect to stay);

d) Government can’t cure recession (to attempt; to cure a recession; government information; rate of growth; output; monetary policy; to cause inflation).

12.1. Read texts 12 and 13. The answer to the following question can be found in these texts: According to John Maynard Keynes, what was the basic problem during recessions, and what was its solution?

TEXT 12

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