View FREE Lessons!
Definition of Classical Economics:
asserts that economies are self-correcting and function best with minimal government intervention.
Classical economists believe in laissez-faire economics, or a hands-off government economic policy. The “invisible hand”, first introduced by Adam Smith, guides the economy towards supplying its demands at the lowest price and in the most efficient manner. Classical economists have a long-run perspective. They recognize that business cycles are inevitable but believe they are self-correcting and advocate minimal government intervention in managing the economy.
Classical economic theory can best be viewed with a graph. Classical economists believe that everything adjusts with price. Economic output is solely determined by the factors of production, or resources available. The aggregate output (aggregate supply) does not increase following an increase in prices, or decrease following a fall in the price level. The curve is vertical as shown on the graph below. This means that any change in the economy’s aggregate demand must result in a change in the price level to reach economic equilibrium.
Classical economists are not blind. They recognize that during the trough of a business cycle unemployment increases. The question is, “What is the best way to respond?” Classical economists have a long-run perspective. They recognize the cost of government spending. Government spending siphons capital from other investments. Taxes take money directly away from households and businesses, reducing their ability to purchase what they want within their means. The government could borrow to finance its needs, but their demand for money results in higher interest rates that “crowd out” investments in the private sector.
The classical economist’s approach to managing the economy contrasts with Keynesian economics, which advocates government intervention to manage the aggregate demand and flatten the business cycle. The government, according to Keynesian economists, should spend and cut taxes to stimulate the economy, which increases the aggregate demand during recessions – even if it means going into debt.
Dig Deeper With These Free Lessons:
Fiscal Policy – Managing an Economy by Taxing and Spending
Monetary Policy – The Power of an Interest Rate
Aggregate Supply – Relating Inflation and Production
Aggregate Supply and Demand – Macroeconomic Equilibrium
Factors of Production – The Required Inputs of Every Business
Causes of Inflation