Theory of Full Employment and Income: Classical

Income and employment theory, a body of economic analysis concerned with the relative levels of output, employment, and prices in an economy. By defining the interrelation of these macroeconomic factors, governments try to create policies that contribute to economic stability.

Classical Theory of Income and Employment

The theory is ascribed to early Classical economists like Adam Smith, Ricardo, and Malthus and neo-classical like Marshall, Pigou and Robbins.

(i) An economy, as a whole, always functions at the level of full employment

i.e., full employment of labour and other resources .Full employment level of output of goods and services is the largest output that the economy is capable of producing when all its resources are fully employed. Full employment is regarded as a normal situation, yet there could be a temporary unemployment.

If at all there is unemployment, it must be a temporary one and it will be cured automatically through free play of economic forces. Classical behave that aggregate supply would always be at full employment level which is based on two assumptions, namely Say’s Law of Market and Wage-price flexibility as explained below.

(ii) Supply creates its own demand

Classical theory of employment is based on ‘Say’s Law of market’ which states that ‘supply creates its own demand’. This implies that supply creates a matching demand for it with the result that the whole of output is sold out. So, there is no deficiency in aggregate demand and hence no possibility of over-production and unemployment. Thus, equilibrium level of income and employment is established only at the level of full employment.

(iii) Flexible system of prices, interest rates and wages

(a) Price mechanism automatically brings equilibrium between demand and supply in the market.

(b) Flexibility of interest rates brings about equality between savings and investment.

(c) Flexibility of wage rates brings about full employment equilibrium. As a result, the aggregate supply is always at full employment level of output.