ROLE OF SAVING INVESTMENT AND RATE OF INTEREST IN THE CLASSICAL THEORY OF FULL EMPLOYMENT

ROLE OF SAVING

 INVESTMENT AND RATE OF INTEREST IN THE CLASSICAL THEORY OF FULL EMPLOYMENT

        As the saving goes money Burns holes in people pockets, money is spent on consumer goods and the rest of it saved and invested. Whichever way it goes it is expenditure. Saving is converted into investment in three ways:

(i)  By purchasing capital goods.

(ii) By buying bonds.

(iii) By money in the saving accounts of banks.

        Classical economists believe that is always full employment in the country for which sufficient amount of saving and investment is automatically generated. The natural rate of interest is the mechanism which brings about the equilibrium between full employment saving and investment. (We know that the saving function is always positively correlated with the rate of interest).

          According to the classical economists, if at a certain time investment falls short of savings, it results in the rate of interest to fall. This induces investment to increase and thus the equilibrium is required again. The classical theory of interest can be further explained with the following diagram.

                                            

          In this diagram the SS curve represents saving function and I I curve represents the investment function. As we already know that the classical economists strongly uphold the concept of full emlpoyment and in the diagram this is achieved at point E where the equilibrium amount of saving and investment is OZ; OR is the rate of interest which bring about this equilibrium. A change in the rate of interest only occurs due to the change in investment. When the investment falls short of savings as shown by the i i curve above, it results in the interest falling to Or. This encourages investment to rise and hence the full employment equilibrium is restored again at point E.

CRITICISM ON THE CLASSICAL THEORY OF INTEREST:

1.                               Accourding to the classical economists, when investment falls short of full employment saving demand for consumer goods also due to excess savings. Thus,  entrepreneurs shift their resources to capital goods industries to avoid losses due to which investment increases to be equal to the full employment savings. However, this theory may not prove to be true because a fall in demand for consumer good swill lead to a fall of aggregate demand in the economy. Hence investment will fall instead of rising.

2.                                     Keynes believes that as a result of a higher rate of interest, investment squeezes and consequently National Income falls. Out of lower level of national income less savings would be generated to equate with the lower level of investment. Hence it is not necessary that saving would increases at a higher rate of interest as indicated by classical economists.

3.                                       With reference to the preceding diagram, Keynes believes that not only the investment function but also the savings function at full employment equilibrium can rise or fall. Thus, when investment curve I I falls to become i i, in the diagram saving curve SS must also fall to the left due to fall of national income. This means that a new equilibrium of saving and investment can take place at less than full employment level where the equilibrium rate of interest could be between OR and Or. This is in clear contradiction with the classical theory of full employment and rate of interest.

1.                  Involuntary unemployment: This is real form of unemployment. Individuals who fall in this category are those possess high qualification but do not find any jobs commensurate with the qualification which they possess.

2.                  Structural unemployment: Structural unemployment is the result of a change in the structure of the economy of the country. For Example, with a rapid pace of industrial advancement in the country people shift from agriculture sector to industries but do not find any jobs there. This type of unemployment is called structural unemployment.

3.                  Frictional unemployment: This from the unemployment takes place as a result of imperfections in the labour markets. These imperfections occur due to seasonal nature of jobs, natural calamities, imperfect mobility of labour shortage in the supply of raw materials, accidental breakdown of machinery, etc.

4.                  Technological unemployment: This occurs as a result of change in the production technology, e.g. replacement of workers by machines. Hence modern techniques of production used in reduce the cost of production are creating the problems of technological unemployment.

5.                  Cyclical unemployment: In this case unemployment takes place in the depression phase of the business cycle. Unemployment during the depression phase occur due to the fall in the level of investment and consequently that of national income.

                          Keeping in view the above kinds of unemployment classical economists believe that voluntary unemployment is not infect unemployment as it can be avoided and hence should not be considered. Involuntary unemployment is the real form of unemployment and the solution for this has been given by them the marginal productivity theory of distribution discussed an earlier. The solution is that the competitive wage rate should be allowed to fall to a point at which even the last man unemployed is gainfully employed. This means that if there is to be any unemployment it can be overcome by reducing the wage rate with the ever declining MRP so that they both are in equilibrium. Thus according to classical economists, there cannot be any problem of unemployment. Since this can happen in a laissez-faire economy, it is evident that classical economists are against strikes, collective bargaining and pressure tactics labourers. As far as the other forms of unemployment are concerned, these are said to be of only a temporary nature and are eliminated with the passage of time. Hence, the classical economists state that even in the presence of these forms of unemployment there is always a tendency towards full employment. Thus, on the basis of above arguments, classical economists strongly uphold the theory that there is always full employment in a laissez-faire economy and any divergence from it is only temporary in nature.