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The classical explanations accounted for the prices of goods and services in different markets, using their theory of value. They used the same theory of value to explain wage rates in different labor markets, the price (cost) of loanable "capital" or interest rates at different degrees of risk associated with borrowers, as well as the value of money (currency) itself or the price level. The classical economists also believed that a correct application of the theory of value in such contexts better informs the formulation of policies to promote economic growth. Thus, understanding that interest rates are determined by the supply and demand for savings or "capital" may encourage policymakers to keep taxation of income low in order to encourage more savings out of disposable income-increased supply of loanable funds. (Johnson 2000) The same understanding would encourage policymakers to refrain from attempting to engineer low interest rates by inflating the volume of currency through the central bank, which ultimately would only lower the value of the currency or raise the price level.
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To facilitate informed policy formulation to assist economic growth, the classical economists also clarified the nature of certain economic variables. They explained that saving is the investment of nonconsumed income in financial or income-earning assets. They carefully distinguished saving from the holding of income in cash or hoarding, which yields the security of cash as a ready means of purchasing goods and services, but not interest or dividends. Thus increased saving promotes economic growth because it releases the purchasing power of nonconsumed income to producers who borrow the funds, while hoarding withdraws the purchasing power of income from circulation.
Such an understanding of the role of saving in an economy also underlies the classical argument that, in the absence of increased hoarding, a mismatch or misalignment of supply and demand for goods in certain markets would soon be resolved by changes in relative prices and interest rates to clear the markets, and that there cannot be an over-supply of all goods, including money, at the same time-Say's Law of Markets. (Richardson 1997) Even in the face of an increased demand for cash or hoarding, which would create an excess supply of goods and services (to match the excess demand for money) and raise the value of money, a quick response by the monetary authorities in increasing the money supply would prevent a persistent glut of the goods and services in the marketplace.
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Another of the important economic concepts the classical economists defined differently from modern macroeconomics is money. Money was specie or coined precious metals. Paper money issued by banks substituted for specie in circulation, and for as long as free convertibility of paper into specie prevailed, prudent banks would not issue more notes than they could redeem on demand. The classical economists clarified the financial intermediation function of banks-receiving savings in order to extend loans-differently from the "money supply" process as now perceived in modern macroeconomics.
That way it was easier to apply the theory of value to loans in explaining interest rates and to money or its paper substitute to explain the price level. Furthermore, the classicals could explain longterm economic growth by increases in savings or loans and not by increases in the supply of money. Increases in the supply of money may increase real output and employment in the short run, while prices are yet to adapt fully to the increased supply, a process the classical economists called forced saving. But ultimately, only the price level and nominal wages would rise in response to the increased supply of money.
Such understanding of the role of money in an economy also informed what we may call classical monetary policy. Where money was specie, there was no need to regulate its quantity, since the production of specie or receipts of money through payments for net exports would take care of the supply. (Johnson 2000) But in a fiat money system, its supply by a central bank would have to be regulated in order to maintain the price level, the same mechanism inherent in the commodity or specie money system.
Adam Smith laid out in elaborate detail the theory of value or "the principles which regulate the exchangeable value of commodities", which many subsequent developers of classical and neoclassical economics have followed. (Richardson 1997) Relative scarcity or supply and demand determine the exchange value of commodities; the cost or difficulty entailed in bringing an item to market determines its supply while the utility or usefulness of the item to buyers determines its demand. In the short run, demand may be the more important determinant of exchangeable value or price since supply can hardly respond to changes in demand. In the long run, the cost of production is the more important regulator of value or price. (Richardson 1997)
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In developing this principle, Smith first lays aside the notion of "value" that is not subject to objective or observable analysis, namely, the appreciation that individuals have for commodities in their possession-subjective utility. It goes without saying that an item in anyone's possession may have some utility (usefulness) or value. But without the possessor declaring its degree of usefulness to him or her, no one else may know of it. One also may argue that to part with money or some other useful object for another, one must have some use for the object taken in exchange. But such understanding of the relation between objects and individuals does not directly lead to a calculation of the magnitude of their usefulness or utility. (Johnson 2000) And given the differences in peoples' tastes and preferences, it is hopelessly difficult to say anything meaningful in the aggregate from such knowledge about the relation between objects and their usefulness to different individuals.
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Smith's designation of diamond as a commodity of "scarce any value in use" may have been an unhelpful choice of words. (Johnson 2000) Diamond has beauty and certainly has a great deal of usefulness as ornament. That description by Smith is the source of what often has been referred to as Smith's water-diamond paradox of value. But, Smith's choice of words becomes less puzzling when interpreted in the proper context. By value in use, Smith was focusing on the "necessaries and conveniences of life" or "commodities which are indispensably necessary for the support of life", which he distinguished from luxuries (Weizner 1999). Thus, no one needs diamonds to live, but life is impossible without water. Cleared of the ambiguity, Smith's theory of value is simply one of the determination of market prices by supply and demand.
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Supply is determined by the labor and toil (costs) involved in bringing a product to market. For activities that require more than the use of human labor, costs in the short run include payments for the use of land, machinery, buildings, raw materials, and borrowed capital, besides wages. Undertakers of business enterprises expect some reward for their management skills as well as their entrepreneurship, which includes bearing the risk of being unable to pay the contracted costs to the hired factors of production. Thus, the failure of revenues to more than cover the costs and make it worthwhile for proprietors to continue with their enterprises in the long run-when there are no longer any contractual obligations to the hired factors-may cause production to cease. Therefore, the cost of production in the long run must include profits to entrepreneurs, according to Smith.
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The classical economists, with a few exceptions, also recognized consumption as the ultimate goal of all production. But they were quick to point out that production provides both the means and the objects of consumption, and that without increased production, made possible by increased savings to enhance productive capacity, there could not be increased consumption over time. This is why, instead of the modern Keynesian focus on consumption spending as the driving force of an economy's growth, via the so-called expenditure multiplier, the classics focused on savings to provide the funds for increased production. (Abel 1992)
Several of Keynes's contemporaries, particularly A.C. Pigou, R.G. Hawtrey, D.H. Robertson, Jacob Viner, and Frank Knight, recognized the fundamental errors he had made in his criticisms of classical macroeconomics, and tried to point them out. Most of the corrections took the form of restatements of classical propositions, but without focusing on Keynes's changed meaning of classical concepts. Few also made direct references to the classical literature Keynes had misrepresented. Keynes thus could not properly be directed to reread what he had misinterpreted.
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The younger generation at the time, being much less familiar with the classical literature, for example, J.R. Hicks, Richard Kahn, Joan Robinson, and Nicholas Kaldor, also could not appreciate the extent of Keynes's misrepresentations of the classics. (Richardson 1997) The creation of the IS-LM model as a device through which the disputes between Keynes and his contemporary neoclassical defenders of classical macroeconomics could be resolved also has helped to mask Keynes's misrepresentations of classical concepts. In the end, the model has served only to convey Keynes's arguments, to the disadvantage of the classical alternative.