The Classical Theory

The fundamental principle of the classical theory is that the economy is self-regulating. Classical economists maintain that the economy is always capable of achieving the natural level of real GDP or output, which is the level of real GDP that is obtained when the economy's resources are fully employed. While circumstances arise from time to time that cause the economy to fall below or to exceed the natural level of real GDP, self-adjustment mechanisms exist within the market system that work to bring the economy back to the natural level of real GDP. The classical doctrine — that the economy is always at or near the natural level of real GDP — is based on two firmly held beliefs: Say's Law and the belief that prices, wages, and interest rates are flexible.

Say's Law. According to it, when an economy produces a certain level of real GDP, it also generates the income needed to purchase that level of real GDP. In other words, the economy is always capable of demanding all of the output that its workers and firms choose to produce. Hence, the economy is always capable of achieving the natural level of real GDP.

The achievement of the natural level of real GDP is not as simple as Say's Law would seem to suggest. While it is true that the income obtained from producing a certain level of real GDP must be sufficient to purchase that level of real GDP, there is no guarantee that all of this income will be spent. Some of this income will be saved. Income that is saved is not used to purchase consumption goods and services, implying that the demand for these goods and services will be less than the supply. If aggregate demand falls below aggregate supply due to aggregate saving, suppliers will cut back on their production and reduce the number of resources that they employ. When employment of the economy's resources falls below the full employment level, the equilibrium level of real GDP also falls below its natural level. Consequently, the economy may not achieve the natural level of real GDP if there is aggregate saving. The classical theorists' response is that the funds from aggregate savings are eventually borrowed and turned into investment expenditures, which are a component of real GDP. Hence, aggregate saving need not lead to a reduction in real GDP.

Consider, however, what happens when the funds from aggregate saving exceed the needs of all borrowers in the economy. In this situation, real GDP will fall below its natural level because investment expenditure will be less than the level of aggregate saving.