macroecon notes-unit3.docx - 3.01 Classical Economics and...

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3.01 Classical Economics and Say's Law The Classical theory views full employment as the norm of a capitalist economy. This theory holds that the best way to achieve price stability, full employment, and steady economic growth is for the government to stay out of the economy. This hands-off approach is termed laissez-faire. Classical economics was founded in part on the ideas set forth in Adam Smith's The Wealth of Nations . Smith observed the economy at a time when factories were in use and labor was fully employed. Society was at potential GDP. Written in 1776, Smith outlined the capitalist economic system, stating particularly that the economy would self- regulate if left alone. In theory, without any government interference, the economy would take care of itself —"the invisible hand," as Smith called it. Classical economists focus on the long-run. Because wages, prices, and interest rates are fully flexible, the economy quickly stabilizes so the government does not need to interfere with the economy. Classical economists believe that the economy is always at full employment of resources, which is one reason why the short-run aggregate supply curve would be more vertical. o Because the economy is at full employment, prices rise and fall as aggregate demand changes. As a result, prices act as a rationing system for goods and services exchanged within the economy. When prices rise, fewer people are willing and able to purchase the higher-priced goods and services. When prices fall, more people will purchase the commodities. o For a Classical economist, the amount of resources and improvements in technology are what really determine growth in an economy. Finally, Classical economists believe that any increase in the money supply will directly affect total spending in the economy. This means that a Classical economist would say that the Federal Reserve, the regulatory agency that controls the money supply in the U.S., actually causes prices and wages to rise when it increases the money supply. Say’s Law He observed that tradesmen made extra goods, so they could trade them for goods that they might need themselves; otherwise, there was no reason to create the extra goods. Therefore, these goods (the supply) would be traded (the demand) for other goods and services. To carry this further, Say and other Classical economists believe that producers will only produce the goods that people are willing to buy. If they won't buy them, then inventories build up until producers lower the price. At that point, people will demand the current supply once again. Thus, "supply creates its own demand" is a concept that is called Say's Law today. 3.02 Aggregate Supply The short-run aggregate supply is the total amount of goods and services that firms are willing and able to produce within the economy. Aggregate supply should be studied in the immediate short-run, the short-run, and the long-run as the economy looks different at various time periods.
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The immediate short-run supply curve is a horizontal line at a fixed price.
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