Classical economics relates to the school of thought of economics that originated in Britain during the late 18th and early 19th centuries. The classical economists believed in the existence of full employment in the economy. It is believed that ‘The Wealth of Nations’ by Adam Smith published in 1776 marked the beginning of classical economics. J.B. Say, Alfred Marshall, A.C. Pigou are some of the famous classical economists.
This school of economics focused on the theory called the ‘invisible hand‘ being the highlight at the beginning stages of domestic and international supply and demand. They assumed the economy to be laissez faire capitalist. It was a closed economy with no foreign trade. Labour was a homogenous and wages were flexible. It assumed the economy to be in the long run.
The Classical school of thought is based on the Law of Markets given by J.B. Say. According to that law “supply creates it’s own demand“. Therefore there can never be the problem of overproduction or unemployment in the economy as whatever is produced is consumed. Unemployment may occur only in the short run and in the long run, economy tends towards full employment.
The Classical economists also believed in wage price flexibility. This concept was given by A.C. Pigou. It was basically the formulation of Say’s Law in terms of labour market. According to this, whenever there is unemployment in the economy, a general cut in money wages will restore full employment condition. Unemployment is a consequence of the rigid wage structure.
They also believed in the existence of equilibrium in the goods market. It is achieved when savings is equal to investment. This equality is usually brought by the mechanism of interest rate. Similarly, the money market is in equilibrium when the demand for money is equal to the supply of money. This concept was explained in the Quantity Theory of Money.
The Fall of Classical Economics:
During the time of The Great Depression i.e. 1929-1930’s, the classical theory failed to be applicable. It failed to solve the problem of depression that plagued for about 43 months. Keynes criticized the classical theory on several grounds.
First and foremost was the classical assumption of full employment equilibrium. Keynes considered it as unrealistic and argued that the situation in the capitalist economy is underemployment and full employment is a special case. He refuted Say’s law of market and stated that it was demand that created supply. He was also against the idea of laissez faire. He believed that self adjustment was not possible in a capitalist system and this was responsible for the Great Depression. He advocated state intervention within the economy through monetary and fiscal measures.
The wage price flexibility was also heavily criticised. In the modern world, where workers have trade unions, any cuts in wages will lead to strikes and industrial unrest. Keynes also stressed that equality between savings and investment was not brought by rate of interest but instead by the level of income and marginal efficiency of capital.
Lastly, the long run analysis of Classical economy was refuted on the grounds of inapplicability. Since it operated in the long run, it is incapable of solving present day economic problems.