The Classical Theory of Income and Employment explains how the level of national income and employment is determined in an economy. Classical economists like Adam Smith, Ricardo, and Pigou believed that the economy always operates at full employment level due to automatic adjustment mechanisms. According to them, unemployment is only temporary and self-correcting.
According to the classical theory, national income and employment are determined by the interaction of aggregate supply and aggregate demand under full employment conditions.
The classical economists believed in Say’s Law of Market, which states that “supply creates its own demand.” This means that whatever is produced in the economy will automatically be sold because production generates income equal to the value of output.
The level of employment depends on real wages. If wages are flexible, any unemployment can be eliminated by reducing wages. Lower wages increase demand for labour and restore full employment.
Savings and investment are equal due to adjustments in the rate of interest. If savings exceed investment, interest rates fall, encouraging investment. If investment exceeds savings, interest rates rise, encouraging savings. Thus, equilibrium is maintained.
Therefore, the economy automatically adjusts to full employment without any need for government intervention.
Full employment equilibrium where AD = AS
The Classical Theory provides a simple explanation of income and employment under full employment conditions. However, due to unrealistic assumptions and neglect of real-world problems like unemployment and demand deficiency, it has been widely criticized. Keynes later provided a more realistic approach to income and employment determination.