The Classical View
Prior to the Great Depression, orthodox economic thought could be described as classical. Today, classical refers not only to those economists with pre-Depression notions of the economy, but also can be used to describe a much broader group of economists who favor market-based solutions to economic problems. The classical camp espouses what is best described as a laissez faire philosophy.
The classical view of the economy is one that emphasizes the inherent stability of aggregate demand and aggregate supply. Efficient markets are able to quickly and effectively reach equilibrium conditions, so periods of extended unemployment are not possible. When consumers stop spending, they are saving instead. This increased saving reduces the real interest rate and spurs investment in capital, so any decreases in consumption are offset by increases in investment. This leads to the conclusion that AD is stable. If shocks do occur to the economy, flexible wages and prices allow the economy to quickly adjust to changes in the price level as rational economic actors take into account all available information when making decisions. For example, workers will accept lower wages in response to deflation and demand higher wages in response to inflation. This quick response implies that the economy tends to remain at its long-run equilibrium of full employment. Government interference is not warranted given this assumption, and as a result, laissez faire is the best policy.
One of the assumptions at the heart of classical economic thought is Say's law. French economist Jean Baptiste Say believed that supply creates its own demand, and as a result, surpluses and gluts could not be sustained in a market economy.
The classical response to economic recession is to do nothing. A decrease in AD leads to lower GDP and a lower price level. The resulting high unemployment puts downward pressure on wages as workers will willingly go back to work for less money. These lower wages encourage firms to increase SRAS, and the economy returns to equilibrium at full employment. No government action is necessary as market forces are working to bring the economy back to full employment.
The classical response to inflation is also to do nothing. Increased AD leads to a higher GDP and higher price level. As the unemployment rate falls below the natural rate, considerable upward wage pressure results. With few unemployed workers available, firms compete with each other for already employed workers; this means offering higher wages to entice them to leave their current jobs. This intense competition for workers and other resources increases the costs of production for businesses. They eventually reduce production, and the economy returns to full employment at a higher but stable price level. Once again, no government intervention is necessary because market forces return the economy to its long-run full employment equilibrium.