According to classical economists, the economy tends to be at equilibrium at full employment because the desires of consumers exceed the capacity of the businesses to satisfy them. People produce in order to consume what they have produced or have acquired by exchanging what they have produced for what others have produced. This is reflected in Say's Law, which states that supply creates its own demand. When the economy is not in equilibrium at full employment, this is caused by a lack of price flexibility.
Classical economics suggests that everything will work out fine when markets are competitive and flexible so that prices can adapt fairly quickly. According to classical economics it is better that governments do not interfere with the economy, except for making markets more flexible and competitive. Unemployment is a consequence of inflexibility of the labour market. If markets have price flexibility then problems will resolve themselves quickly and recessions will be short lived.
Demand for goods and services
Classical economics assumes that if there is a surplus of goods or services, they will drop in price until they are consumed (see figure 1). Lower prices will make it more attractive to buy those goods and services while it be less attractive to produce them. Consumption will rise and production will drop and a new equilibrium will be achieved.
figure 1: quantity sold and price level by Natural Money
figure 1: quantity sold and price level
the demand for goods and services drops from D1 to D2, there will be
a surplus at price level P1 and only Q2 products will be consumed. As
long as prices have not dropped to P2, there will be a surplus of
products. After some time there will be a new equilibrium at a price
level of P2 and and a quantity of Q3. This may create a surplus of
Labour supply and demand
Classical economics assumes that if there is a surplus of labour, it will drop in price until there is full employment (see figure 2). At lower wages, working is less attractive so there will be less people willing to work. At lower wages, it will be more attractive to hire people so employment will rise at lower wages.
figure 2: labour supply and demand by Natural Money
figure 2: labour supply and demand
the demand for labour drops from D1 to D2, the number of people
employed drops from N1 to N2 if the real wage level remains W1. As
long as the real wage level has not dropped to W2, there will be some
unemployment. After some time a new equilibrium has arrived at a real
wage of W2 and a number of people employed of N3.
The value of money
When prices drop, then the value of money rises. This means that the money stock increases in the equation Money Stock (M) * Velocity (V) = Price (P) * Quantity (Q). According to classical economics, people will feel richer as a consequence and start to spend more and save less. Even if they do not spend more in money terms and velocity does not change, they spend more in real terms. Demand will rise again as will employment.
National income is consumption plus investment, which is reflected in the equation National Income (Y) = Consumption (C) + Investment (I). If consumption drops, there is more money in the form of savings available for investment. At the same time businesses need to reduce production so the investment demand for money will also drop (see figure 3).
figure 3: savings supply and investment demand by Natural Money
figure 3: savings supply and investment demand
According to classical economists , people save money in order to have more in the future. Because people have a time preference and prefer present consumption above future consumption, they only postpone consumption if interest rates are high enough.