Classical Economics and Say's Law

Long before John Maynard Keynes published his General Theory in 1936, macroeconomic thinking was dominated by the classical school — Adam Smith, David Ricardo, John Stuart Mill, Alfred Marshall and A. C. Pigou. Classical economists held that a market economy, left free of government interference, is self-adjusting: whatever is produced automatically finds a buyer, and the economy naturally gravitates toward full employment of its resources. This unit of the Andhra Pradesh Intermediate Economics (BIEAP) syllabus places the classical position first because the Keynesian theory that follows was built as a direct reaction against it.

Say's Law of Markets

The centrepiece of classical macroeconomics is Say's Law of Markets, named after the French economist Jean-Baptiste Say. It is popularly summarised as "supply creates its own demand." The reasoning runs as follows: every act of production simultaneously generates income — wages to labour, rent to land, interest to capital and profit to the entrepreneur — exactly equal in value to the goods and services produced. Since this income has nowhere else to originate, the very act of producing a given value of output automatically creates an equal value of purchasing power in the hands of the community. When this income is spent (directly on consumption, or indirectly through savings that are lent out and invested), demand in the aggregate must equal supply in the aggregate. General overproduction of everything at once was therefore held to be logically impossible; only a partial glut — too much of one commodity and too little of another — could occur, and market forces (falling prices, resources moving to the scarcer line of production) would correct even that in the short run.

Assumptions behind Say's Law

1. Money is a mere veil. The economy is essentially one of barter; money simply facilitates exchange and does not affect real decisions to produce or spend, so it cannot cause a general deficiency of demand.
2. All savings are automatically invested. Whatever part of income is not consumed is saved, and the loanable-funds market equates savings and investment through a perfectly flexible rate of interest. Savers save so that investors can invest — there is no leakage from the circular flow.
3. Wages and prices are perfectly flexible. In the labour market, any tendency toward unemployment is removed by wages falling until the market clears, so involuntary unemployment cannot persist.
4. Laissez-faire and minimal government. Since the economy is self-regulating, government intervention in the market mechanism is unnecessary and, classical economists argued, often positively harmful.

Implications for employment

On these assumptions, full employment is the normal state of a market economy, and any unemployment observed is merely frictional (workers between jobs) or voluntary (workers unwilling to accept the going wage) — never a sustained, economy-wide shortage of jobs. Because supply creates its own demand, the classical economists saw no need for the state to manage the level of aggregate demand; the appropriate role of government was confined to maintaining law, order, defence and a stable currency, and to running a balanced budget so as not to disturb the working of the free market.

Why the classical position broke down

The Great Depression of the 1930s, when output collapsed and unemployment in industrial economies stayed at 20–25 percent for years despite wages and prices falling, was the empirical event that discredited Say's Law as a description of how a modern monetary economy actually behaves. Wages did not fall enough, or fast enough, to restore full employment — and even where they did fall, lower wages reduced workers' incomes and hence their spending, which could deepen rather than cure the depression. It was this real-world failure of the "supply creates its own demand" prediction that Keynes set out to explain in the theory covered in the next section: he argued that savings and investment decisions are made by different people for different motives and need not be equal at the full-employment level of income at all.