Classical Theory of Unemployment

The defining part of the classical theory is that the economy is self regulating. It will always eventually fix itself and return back to equilibrium. It is based on two firmly held beliefs; Say’s law and the belief that flexible wages and prices will cause a competitive market economy to operate at full employment.

- Say’s Law - supply creates its own demand. The act of producing goods and services generates an equal amount of income to the value of the goods that are being produced. Therefore this will be just enough to create demand for the goods being produced.
- Flexible prices - A decrease in demand causes prices to fall, which then causes interest rates to fall. This causes investment spending to increase which increases demand. This shows how flexible prices fix a decrease in demand by itself.
- Wage flexibility keeps the labor market in equilibrium - If there is a surplus of workers, then wages will fall to keep the work force fully employed. Classical economists believe that any unemployment should be considered voluntary unemployment because if the workers would accept lower wages firms would be eager to employ them. This means that the work force is always fully employed.

These are some examples of how the economy can fix itself and the fundamentals of the Classical Theory. The circular flow diagram can also be used to explain this theory. This theory was believed in the 18th, 19th, and 20th century.

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