Say's law and Fisher's equation (Quantity Theory of Money)

Say's law and Fisher's equation (Quantity Theory of Money)

            Say's law also depends upon the classical quantity theory of money which is propounded by Irving Fisher depending on transaction approach. It states that general price level is function of money supply. Fisher's equation is MV = PT, where, M is the supply of money, V is velocity of money, P is general price level and T is volume of transaction or total production. This equation tells that total money supply (MV) equals the total value of output (PT) in economy. Assuming V and T constant, a change in the money supply (M) causes a proportional change in the general price level (P). Thus in monetary economy, it may acts as only medium of exchange to maintain full employment level.

Labour Market (Pigou's Version)

            Pigou's Version has given final touch to classical theory of employment, who formulated Say's law in terms of labour market. According to Pigou, under free competition the tendency of economic system is to automatically provide full employment in labour market. Flexibility in wage rate assures equilibrium in labour market with full employment. Real wage rate is determined by the forces of demand and supply of labour in market. Demand for labour is negative function of real wage rate. In classical model of employment, changes in money wages and real wages are directly related and are proportional. Therefore, demand for labour increases with a fall in real wage rate and decreases with rise in real wage rate.

            On the other hand, supply of labour is positive function of real wage rate. Supply of labour increases if wage rate increases and it decreases when wage rate falls. Wage rate is determined at the level where demand for labour and supply of labour are equal. This level of wage rate represents full employment equilibrium level. According to Pigou, "with perfectly free competition, there will always be at work a strong tendency for wage rates to be so related to demand that everybody is employed. He has given a equation to explain it

            N = qY/W, here N is the number of workers employed, q is fraction of income earned as wages, Y is national income and W is money wage rate, N can be increased by reducing W. Thus, the key to full employment is a reduction in money wage. This is explained in following figures.

            In above figure-(A), S_L is supply of labour and D_L is demand for labour. At point e, two curves interest each other, it is point of full employment. N_F and the real wage wage w/p at which full employment is recurred. If the real wage increased at a higher level than w/p. Supply of labour exceeds the demand labour by TR. In this situation N₁N_F number of labours are unemployed. Unemployment dis-appears only when the wage is reduced to w/p level. Thus full employment is attained.

            In lower figure-(B), MP_L is marginal productivity of labour which slopes downward as more labour are employed. Since every labour is paid wages equal to its marginal product, therefore the full employment level N_F is reached when the wage rate falls from w/p₁ to w/p.

Criticism of classical theory

            Keynes has attacked the classical theory of employment for its unrealistic assumptions. He criticised classical theory on the following grounds:

(1)  Unrealistic assumption of full employment:

            According to Keynes, in free capitalist economy under employment equilibrium are found in reality and full employment equilibrium is exception. Because in such economies investments are not only inadequate but also usually fluctuate.

(2)  Say's law ineffective:

            Keynes criticised Say's law of market which tells that supply creates its own demand and that there is no over production and unemployment. According to Keynes income is not automatically spent and unemployment according to Keynes is on account of future to spent current income on consumption and capital goods. In free market economy supply can't create automatically enough demand within the economy. But actual state in such economy is fluctuating level of income, output and employment which depends upon effective demand.

(3)  Equality of saving and investment:

            According to Keynes saving depends upon not on the rate of interest but upon level of income and upon marginal efficiency of capital. A low rate of interest can't increase investment if business expectations are low.

(4)  Pigou's formulation hold not good:

            Keynes attacked on Pigou's thought that a cut in money wage could achieve full employment in economy. It is applicable for a particular industry not for whole economy. If wages are reduced in economy that leads to reduction in employment as a result aggregate demand falls and it leads to decline in employment.

(5)  Long-run equilibrium:

            Classical economists believe in long run full-employment equilibrium through a self adjustment process. But Keynes believed that "In the long-run we are all dead."

(6)  Laissez-faire and self-adjustment:

            Keynes did not agree with view of the laissez-faire policy is essential for an automatic and self adjustment of full employment equilibrium. He believed that capitalist system is not self-adjusting, because in such economy, there are two classes rich and poor. Rich people do not spend whole of their income on purchase of their commodities which lacks aggregate demand and leads to over production and to depression. Keynes therefore advocated state intervention for adjusting supply and demand within the economy through fiscal and monetary measures.