Study GuideEconomics–Classical and Keynesian Theories: Output,Employment1. The Classical Theory1.1Basic Idea of the Classical TheoryTheclassical theoryis built on one main idea:The economy is self-regulating.Classical economists believed that the economy naturally moves toward itsnatural level of realGDP.This natural level meansfull employment, where all available workers and resources are being usedefficiently.Sometimes the economy may producemore or lessthan this natural level.However, classical economists believed thatmarket forces automatically correct these problemsand bring the economy back to normal—without government help.This belief is based ontwo key ideas:1.Say’s Law2.Flexible prices, wages, and interest rates1.2Say’s Law: “Supply Creates Its Own Demand”According toSay’s Law, when goods and services are produced,enough income is created to buythem.In simple words:•Producing output = paying wages, rent, interest, and profits•This income is then spent to buy the output•So,total demand equals total supplyBecause of this, classical economists believed the economy can always reach thenatural level ofreal GDP.Preview Mode
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