Although formally correct, the classical model we have been discussing is oversimplified because it fails to break aggregate demand down into demand for consumption goods and demand for capital goods. This means that it does not recognize the processes of saving and investment.

Saving and Investment

We must now recognize that not every dollar of income earned in the course of production is spent for consumption goods; some part of this income is withheld from consumption, or saved. Clearly, unless there is a dollar of planned investment spending for every dollar of income saved, Say’s Law is invalidated. Another part of classical theory provides the mechanism that presumably assures that planned saving will not exceed planned investment.

This mechanism is the rate of interest. Classical theory treated saving as a direct function of the rate of interest and investment as an inverse function, as illustrated in Figure 17-6. The investment curve is simply the curve of the marginal efficiency of investment (MET), whose derivation was explained in some detail in Chapter 11. There it was a part of our development of Keynesian theory; here we see that this was actually a part of the classical theory taken over by Keynes. It is important to note, however, that although both theories show investment as an inverse function of the rate of interest, this is not to say that both assign equal importance to the rate of interest as an influence on investment spending. The whole question of the elasticity of the investment demand schedule is involved, a topic we discussed at length in Chapter 13. Keynes and most economists since Keynes have argued that the curve is relatively inelastic. If it is elastic, a relatively small change in the rate of interest will be sufficient to call forth a relatively large change in investment; relatively small changes in the rate of interest will then be all that are required to keep planned saving and planned investment in balance as the saving and investment schedules shift. If it is inelastic, relatively large changes in the rate of interest will be required for this purpose. ¹⁴ The question then arises as to whether the

14. It is also conceivable that both the investment and saving curves are so inelastic that a shift to the right in the saving curve or a shift to the left in the investment curve or a combination of the two may result in an intersection of the two curves only at a negative rate of interest. However low the rate of interest might fall, it assuredly could not fall below zero. The result is an impasse at which the rate of interest is completely powerless to equate saving and investment. See W.S. Vickrey, op. cit., pp. 172-73.

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rate of interest will fluctuate freely over the wider range necessary to equate saving and investment. To simplify the exposition of the classical system, let us assume here that the curve is indeed elastic, so that investment is relatively responsive to changes in the rate of interest. Small changes will then keep saving and investment in balance.

The saving curve of Figure 17-6 is new. Here saving is made a direct function of the interest rate; in Keynesian theory, saving is a direct function of the level of income. The rate of interest may have an influence on saving, but it is of minor importance in the Keynesian scheme. In classical theory, the rate of interest is all important, and the level of income is of minor importance. Since the classical model argues that full employment is the normal state of affairs in the economy, the level of income is in effect ruled out as a variable in the short run, and so it is ruled out as an influence on the amount of saving. The problem in classical economics is to explain how saving will vary at the full-employment level of income, and the solution is provided by the rate of interest. The higher the rate of interest, the greater the amount of the full-employment income that is withheld from consumption or devoted to saving.

Given saving and investment curves such as S and I of Figure 17-6, competition between savers and investors would move the rate of interest to the level that equated saving and investment. If the rate were above r_1, there would be more funds supplied by savers than demanded by investors, and the competition among savers to find investors would force the rate down. If the rate were below r₁, competition would force the rate up. When the rate is at r₁, equilibrium is established, with every dollar saved or withheld from consumption spending matched by a dollar borrowed and devoted to investment spending.

It is important to see that this transfer of money from savers to investors also involves a transfer of resources. The decision to save part of current income is a decision by income recipients not to exercise their claims to the full amount of output that results from their productive services. This releases resources from the production of consumption goods and makes them available for the production of capital goods. These resources will be fully absorbed in the production of capital goods only if investors choose to purchase exactly the amount

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of capital goods that can be produced by the resources released as a result of saving. This means that if the rate of interest were above r₁ and somehow stayed above r₁, unemployed resources would appear, for the excess of S over I at an interest rate above r₁ reflects, in real terms, an excess of resources released from the production of consumption goods over the amount absorbed in the production of capital goods. One of these resources is, of course, labor, and the excess of S over I also means that there is an excess of labor available over labor employed. In a word, there is unemployment. Thus, in the classical system, if the rate of interest fails to equate saving and investment, it also fails in its assigned task of promptly reallocating the resources released from production of consumption goods to the production of capital goods, and unemployed resources are the result.

Index

Changes in Saving and Investment

As long as the interest rate adjusts upward and downward to correct any disequilibrium, shifts in the saving and investment functions will lead to the establishment of new equilibrium positions. Suppose that income recipients become more thrifty; at each rate of interest they choose to save a larger part of their current income. This appears in Figure 17-6 as a shift to the right from S to S’ in the saving curve and a decrease in the rate of interest from r₁ to the new equilibrium level r₂. A numerical example such as those presented earlier is given below to bring out the effects of an increase in thrift in the classical system. The first row indicates the values of the variables at the original full-employment equilibrium. Full employment of the labor force is N of 100, and full-employment output is O of 300. With the interest rate at r₁, say 6 percent, the real income of 300 was divided into 250 of consumption and 50 of saving; r of 6 percent also produced equilibrium with saving of 50 and investment of 50. If the saving curve now shifts to the right and the interest rate drops to r₂, say 4 percent, a new equilibrium is established at which saving of 75 (in real terms, O of 300 less C of 225) equals investment of 75. With no shift in the production function or the supply of labor, full-employment output remains at 300. The only change is in the distribution of output from 250 of consumption goods and 50 of capital goods to 225 of consumption goods and 75 of capital goods. Thus we see that the increased thriftiness of the public has produced a reallocation of resources - one away from the production of consumption goods and to the production of capital goods - but with the total production of goods unchanged at the full-employment level of 300.

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If the saving function shifted in the opposite direction so that there was less saving at each rate of interest, we would have a higher rate of interest at which a smaller flow of saving would be equated with a smaller flow of investment but still with the flow of aggregate output unchanged from the full-employment level with which we started. The effects of shifts in the investment curve resulting from shifts in the MEC curve may be traced in the same way. Whatever the shifts in the saving and investment curves, however, the possibility of “oversaving” or “underconsumption” could not arise as long as the interest rate succeeded in balancing saving and investment.

Does the interest rate always promptly adjust as required to maintain equality between saving and investment? The Swedish economist Knut Wicksell (1851-1926) was one of the first to point out that there are conditions under which it would not. However, the full-employment conclusion would still result if prices and wages were sufficiently flexible. If the interest rate did not promptly adjust, there would be an excess of planned saving over planned investment or planned investment over planned saving. According to Keynesian theory, a fall or rise in income (output and employment) would be required at this point to bring saving and investment back into balance. This was not the case in classical theory, however. An excess of saving over investment would mean a deficiency of aggregate demand at the existing price level. This would lead to a deflation of prices and wages but would not interfere with the maintenance of the real wage consistent with full employment. Aggregate demand that had become deficient at the original price level would now be adequate to purchase the full-employment level of output at a lower price level. Conversely, an excess of planned investment over planned saving would mean an excess of aggregate demand at the existing price level. This would lead to an inflation of prices and wages but again would not interfere with the maintenance of the real wage consistent with full employment.

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Summary Statement

The purpose of this chapter has been to show, in terms of a simple model, how classical theory answered the fundamental questions of macroeconomics. What determines the levels of employment, output, consumption, saving, investment, prices, and wages? Our discussion may now be summarized in a list of the basic propositions that make up classical theory. Each of these propositions will be related to the graphic apparatus of Figure 17-7, which adds nothing new but brings together the saving-investment branch of the classical system with its other branches, presented in two steps in the preceding pages. -

1. As shown in Part B, the supply, S_L, and demand, D_L, for labor are both functions of the real wage, W/P. Because of diminishing returns, the demand curve slopes downward to the right (i.e., more labor is hired only at a lower real wage). Because of the essential disagreeableness of work, the supply curve slopes upward to the right (i.e., more labor is offered only at a higher real wage).

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The intersection of the supply and demand curves thus determines both the real wage (W/P)₁ and the level of employment N₁.

2. With fixed techniques of production and fixed capital stock, output in the short run becomes a function of employment, as shown by the production function in Part A. With employment determined in Part B as N₁, output is determined in Part A as O₁.

3. The price level, P, is determined by the supply of money, M, the curve MV in Part C defining the particular supply of money and a stable velocity of money. With output determined in Part A as O₁, the price level of that output is determined on Part C as P₁.

4. The money wage, W, adjusts to the price level to produce the real wage required for equilibrium. With the equilibrium real wage determined in Part B as (W/P)₁ and the price level determined in Part C as P₁, the required money wage is determined in Part D as W₁.

5. As shown in Part E, saving, S, is a direct function of the rate of interest; and investment, I, is an inverse function of the rate of interest. With the rate of interest as a measure of the reward for saving, the higher the rate of interest the greater will be the volume of saving. With the interest rate as the “price” of capital goods, the lower the interest rate, the greater will be the volume of

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investment. The rate of interest is determined by the intersection of the saving and investment functions, and it determines how real income is allocated between saving and consumption and how production (equal to real income) is allocated between consumption goods and capital goods.

These propositions are the basis for answers to the questions originally posed. But another equally important question lies behind the first and most critical one: Will the level of employment be that which equates the supply of and the demand for labor? Will it be the full-employment level? An affirmative answer to this question follows in classical theory as soon as we add a final proposition:

6. Both prices and wage are flexible, which simply means that the money wage will fall if unemployment appears, and the price level will fall if the existing level of output cannot be sold at going prices. If such flexibility does in fact exist, then the automatic full-employment conclusion follows logically. It also follows that output will be that which can be produced with a fully employed labor force, that the price level will be that at which the money supply with its given velocity will purchase this full-employment level of output, and that the money wage will be so related to the price level as to make it profitable for employers to produce the full-employment level of output.

The classical conclusion that the economy has an automatic tendency to move toward a full-employment equilibrium is not widely accepted today. But this and other conclusions of classical employment theory can be rejected only by rejecting the assumptions on which that theory rests, for the theory itself appears to be internally consistent. Once its assumptions are granted, the theory inevitably leads to the indicated conclusions.

We will not enter here into Keynes’s specific attack on the assumptions that underlie classical theory, but most economists agree that his attack was successful. Not only did he offer persuasive arguments against these critical assumptions, but he replaced the rejected assumptions with others that appeared much more consistent with the facts of ordinary observation and statistical evidence. To the extent that the assumptions on which the classical theory was based could be shown to be unacceptable, the conclusions, including the automatic full-employment conclusion, reached by that theory also became unacceptable.

A CONCLUDING NOTE

If the classical analysis of the process by which the levels of employment, output, and prices are determined is unacceptable, at least in its application to the modern economy, it may appear that this lengthy chapter is basically unnecessary. To this there are a number of replies.

First, it is not altogether correct to label the classical theory of employment. output. and prices as unacceptable or in some sense “wrong”. Since the aim of this chapter was to do no more than introduce the broad outlines of

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that theory, it could do no more than draw broad conclusions and compare these with the somewhat more detailed conclusions so far derived from our study of Keynesian theory. The omission of refinements that would give us a more accurate picture of classical theory leaves us with little choice but to categorize the basic propositions of classical theory as correct or incorrect, and such categorization is itself inherently incorrect. Alfred Marshall once said that every short statement about economics is misleading (with the possible exception of this one). Our statement here, relative to what is involved in a complete treatment, is such a short statement and unavoidably somewhat misleading.

Second, one’s understanding of a new theory is surely enriched when that theory is contrasted with the old theory that it seeks to displace. The classical system was the accepted explanation of macroeconomic phenomena for well over a hundred years. A discussion of this theory, which is partially correct and a product of the not so distant past, helps us understand and appreciate the changes in macroeconomic theory that have occurred since the Great Depression.

Finally, it is important to note that, despite the dramatic success of Keynesian theory over the past three decades, classical theory is still the theory on which many men in positions of great responsibility, both in government and business, were raised. It is not even necessary for them to have received formal training in economics as young men - the stuff of which economics is made has a way of permeating men’s minds and influencing their outlooks without any awareness on their part. At the very end of the General Theory, Keynes expressed this thought in what has come to be a much-quoted statement:

the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. ¹⁵

The defunct economists who continue to influence many of these men today are the economists who constructed the classical theory.

In a similar vein, we find the very last sentence in Alexander Gray’s classic little handbook on economic thought:

No point of view, once expressed, ever seems wholly to die; and in periods of transition like the present, our ears are full of the whisperings of dead men.¹⁶

For more than one reason, the teachings of the classical economists are of something more than historical interest today. The few reasons here given should be sufficient to make this point. The “Keynesian Revolution” did not so completely wipe out the “old order” that no sign of it remains today. So far at least, for both academic and practical reasons, a proper introduction to macroeconomic theory should include the fundamentals of the theory that held sway for more than a century before Keynes.

15. General Theory, p. 383.

16. The Development of Economic Doctrine, Longman, Green, 1931, p. 370.

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