|Classical economics was the dominant theory of economics from the 18th century until it was refined in the 20th century into neoclassical economics. Classical economists such as Adam Smith, David Ricardo and John Stuart Mill, held that the pursuit of individual self-interest produced the greatest collective benefits.
The classical school believed that an economy is always either in equilibrium or moving towards it. Equilibrium, the theory went, is ensured by movements in wages (the price of labour) and the rate of interest (the price of capital).
The rate of interest moves to ensure equality between savings and investment. If, for instance, entrepreneurs suddenly decide (perhaps because of technological improvements) that they want to invest more, then firms boost their borrowings, and so bid up interest rates. Higher interest rates have two effects. The first is that households are prepared to save more, and so, indirectly, lend more to the investing firms. The second is that some firms gradually reject the idea of investing more, because of the higher cost of borrowing. These two forces work on each other to produce a new equilibrium where savings equal investment.
This theory is founded on two assumptions: first, that the investment is highly sensitive to interest rates; and second, that the rate of interest is free to vary, so that savings and investment are quickly equalized. As for wages, they adjust to ensure that the equilibrium level of national income is that which produces full employment. If there is unemployment, then wages fall and so the demand for labour increases to mop up the unemployed. Conversely, if an economy is heading for unsustainable growth in national income wages rise to choke off the demand for labour.
The classical and neoclassical schools were eclipsed between the mid-1930s and the mid-1970s by the followers of John Maynard Keynes (see Keynesian Theory). Keynes attacked the two main classical tenets, arguing (1) that the rate of interest is determined or influenced by the speculative actions of bondholders; and (2) that wages are inflexible downwards, so that national income may be in apparent equilibrium at a point below full employment. Recently, attention has turned back towards some of the logic of classical and neoclassical economics.