Q.Critically examine the classical theory of employment.

The classical theory of employment rests on Say's law (supply creates its own demand) and the belief that flexible wages, prices and interest rates keep the economy at full employment, so involuntary unemployment can only be temporary. Keynes rejected this, arguing that demand can be deficient, wage cuts can deepen a slump, and the economy can rest at under-employment equilibrium, a view confirmed by the Great Depression.

The classical theory

The classical economists (Adam Smith, Ricardo, J.B. Say, Pigou and others) believed that a competitive free-market economy automatically provides full employment of labour and other resources. Its main propositions were:

• Say's Law of Markets: "Supply creates its own demand." The act of producing goods generates exactly enough income to buy those goods, so there can never be a general overproduction or a general deficiency of demand.
• Wage-price flexibility: If there is any unemployment, competition causes wages to fall; lower wages make it profitable to employ more workers, so full employment is restored.
• Flexible interest rate: Saving and investment are always brought into balance by changes in the rate of interest, so whatever is saved is automatically invested.
• Only voluntary or frictional unemployment is possible; involuntary unemployment is temporary.
• The policy conclusion was laissez-faire, i.e. no need for government intervention.

Critical examination (Keynes's criticism)

1. Say's law is not valid: All income earned is not automatically spent; part may be saved and not invested, so aggregate demand can fall short of aggregate supply.
2. Possibility of under-employment equilibrium: Keynes showed that an economy can be in equilibrium with large-scale unemployment, not just at full employment.
3. Demand deficiency causes unemployment: Unemployment arises mainly from a lack of effective (aggregate) demand, not from high wages.
4. Wage cuts are not a remedy: A general cut in money wages reduces workers' incomes and spending, which lowers aggregate demand and can increase unemployment rather than cure it.
5. Interest is not the only link between saving and investment: Saving depends largely on income, and investment on the expected profitability of capital, so the interest rate alone cannot guarantee their equality. …