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Classical economists called for a self-regulating economy with flexible incomes, interest rates, and inflation. They concluded that supply generates demand, and that at maximum jobs, services are fully used. This segment examines the theoretical ramifications of traditional economic policies.
A company's goal is to increase profit. This behaviour, as depicted in a production function, is determined by labor's marginal productivity (MPL). The median income output of labour is the product of MPL and marginal revenue (MRPL). A business seeking to maximize profits will claim labor before the MRPL equaled the wage. Furthermore, the labor supply depends on population resources and the preferences of workers for consumption and leisure. If real wage increases, unemployed workers would seek jobs. Some of would work overtime or take additional jobs to earn more income while others would create more leisure time. Thus, the rise in real wage has a minimal economic effect on the amount of labor supplied in the economy.
The real wage adjusts to equate labor demand and supply in the classical model. Since firms are concern about real wage and not money wage, if prices doubled, they would double their real wage proportionately, and this would restore labor demand and supply to market equilibrium. At this equilibrium, all workers who chose to work at the given wage would be employed.
In the classical model, the capital stock is fixed while labor is variable. Thus, equilibrium level of output depends on employment of labor. The labor employed is determined by the labor supply and demand. Labor demand increases until MPL equal real wage. The supply of labor also depends on real wage. Thus equilibrium employment occurs where labor supply equal labor demand. At this point, there is full employment output level.
According to Say’s law, at full employment and in a system of competitive markets, the income received from the production of certain commodities by some, allow them to purchase good produced by others. The law assumes that every dollar used to buy output is equal to the dollar received. Thus product market will always be in equilibrium.
Say’s Law help to equate saving to investment in loanable funds market. At equilibrium, both investment and saving are equal at given interest rate. A rise in interest rate makes the saving to exceed investment. However, due to flexibility, the interest rate will fall motivating investors to demand savings. Therefore, the rise in saving leads to increase in investment through fall in interest rate and this restores the economy to equilibrium employment.
Similarly, the growth in money supply increases the real money balances as interest rate falls. The level of consumption and investment (aggregate demand) increases. The rise in aggregate demand only leads to increases price level since supply is constant. Likewise, reduction in the money results in a decline in real money and interest rate. Thus consumption and investment fall moving the price back to equilibrium.
In a nutshell, the classical economic policies have various implications in the labor market, good market and money market. The changes in money supply only affect the aggregate demand and price level and not the potential output since supply is constant.
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