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What is classical theory of income and employment?

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Quick Answer

According to the University of Rhode Island's Economic Department, the classical theory of income and employment is supply-side economics. As the overwhelming view before Keynesian economics, it suggests that in times of economic downturn, wages stabilize at a lower rate and full employment returns. The classical model focuses on long-term economics.

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Full Answer

A main component of the classical economic model is crowding out. According to Georgia State University, crowding out occurs when interest rates due to government spending are too high for private sector businesses to borrow money. The government has the ability to borrow money through the sale of bonds at higher rates than the private sector. The increase of bonds on the market increases the interest rate set by the Federal Reserve. As the supply and demand curves shift, fewer private sector businesses are willing and able to borrow funds, which results in the crowding out of the private sector. If fewer businesses borrow funds, fewer businesses also hire new employees, invest in new technology or expand. According to this theory, this affects wages and the employment rate.

In contrast, Keynesian economics places the emphasis on the demand-side of economics. It suggests that the elasticity of demand drives the economy. The consumer purchasing power of Keynesian economics focuses on the short term.

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