Question

Why does money pose a problem for Say’s Law? How do the Classicals preserve Say’s Law given the presence of money? Use the loanable funds model to explain why an increase in saving will be offset by an increase in investment spending.

Answer 1

Say's law is explained on the basis of a barter economy. The role that money plays in an economic system is not taken into consideration. He believed that the economic activities are not affected by the presence of money. Whatever be the goods produced in the market, it will fetch a demand . This was the underlying principle of the Say's law.

The classical economists was of the opinion that the presence of money doesn't change the basic idea of the Say's law. According to them the factors of production involved in the production process, land , labour and capital, receives income in the form of rent, wages and interest. When there is supply of commodities in the market as a result of the production process the demand will be created out of the income generated by the same process.

An increase in saving will be offset by an increase in investment spending, according to the loanable funds model. This is explained with the help of the bank credit, a source of supply of loanable funds. Here not only the interest rate but also the bank credit plays a vital role. The actual equilibrium condition can be explained by taking into consideration both the interest rate and bank credit.

The demand for loanable funds is inversely related to the interest rate and directly related to the supply of loanable funds.