The Classical Macro Model The Simple Classical Model

The Classical Assumptions Classical economics stressed the role of real as opposed to nominal factors in determining real output. Money was only important as a medium of exchange. Classical economics stressed the self-adjusting nature of the economy. Government policies to insure full employment were unnecessary and generally harmful. Classical economists assumed: Perfectly flexible wages and prices. Perfect information.

A Classical Model of Output Determination The Starting point is the Production Function Y = F(K, N) where Y = National output K = Capital N = labour And F is a functional notation Assume K is constant in the short run so that Y varies directly with N. So to determine output, we need to know what determines employment, N. Employment is determined from the labour market. In the labour market, we have the demand and the supply sides.

Properties of the Production Function With K given, output varies directly with the level of N From the production function, we can compute the following: Marginal product of labour can be derived from the production function using calculus. FN=MPN=dF/dN=dY/dN>0 FNN=d2F/dN2<0 i.e. the economy is subject to the law of diminishing returns. Does the following production function exhibit these properties? Y=K0.5N0.5, K=1

The Demand for labour Curve Producers are willing to hire up to the point where the real wage (W/P) = MPN. Notice that in the range of diminishing returns, the demand curve for labour is downward sloping. The demand for labour can be expressed in both real and nominal terms. Figure1: Production Function and Marginal Product of labour Curve

The Labour Market Note: Firms demand labour services and households supply labour services. The labour market comprises a) The Demand for labour side b) The Supply of Labour side : Assumptions 1. Firms are profit maximizers 2. Households maximize their utility 3. Firms take the price level and money Wage as given; households take the money wage as constant The labour market is ALWAYS in equilibrium.

Demand for Labour Firms employ labour to maximise profits and the condition hat must be must is: P.MPN=W (1) where; P= the price level of output MPN=marginal product of labour W= money/nominal wage. (1) can be rewritten in a familiar form: MPN= W/P (2). So for the firm to maximize profit, equations (1) and (2) must hold. In fact, the two equations are the same but their use depends on the question under consideration.

Demand for Labour Cont’d From equation 2, MPN= W/P, for the firm to maximize profit in hiring labour, it must employ labour at the point where the marginal product of the last worker equals the fixed money wage. Because of diminishing returns, we consider the falling segment (the downward sloping portion) of the MPN curve. The profit maximising level of labour demand can be graphically determined using equations 1 or 2 as shown in diagrams below.

Real vs. Nominal The demand for labour can be expressed in real terms, i.e., Figure 2a (Top) Firms maximize profits where W/P = MPN. Or, alternatively, firms maximize profits where W = MPN x P. Labour demand can be expressed in nominal terms, as in Figure 2b (Bottom) We will use both, depending on the situation. Figure 2a labour Demand for a Firm in real Terms Figure 2b The Demand for labour in Nominal Terms

Determinants of the Demand for labour Demand We conclude from the two diagrams that labour demand is a negative function of the real wage meaning as the real wage increases, labour demand decreases and vice versa: Nd = f (W/P) (-)  That is, the demand for labour is a negative function of the real wage, i.e., the higher the real wage, the lower the demand for labour. Can you use economic intuition to explain this?                or,

Deriving the Labour Demand Function  

Labour Supply Classical economists assumed that individuals maximize their utility or satisfaction.  Utility was generated by real income earned through the disutility of work that could then be used to purchase marketable goods and services as well as leisure.  There is therefore a trade-off between real income resulting from working and the pleasures or utility of leisure, doing your own thing. U=f(Consumption, Leisure) with the following constraint: W+L=H, H=24 hours

Labour Supply Ns = g (W/P) (+) or, the supply of labour is a positive function of the real wage, i.e., the higher the real wage, the higher the supply of labour. Classicals believed that the substitution effect of a money wage change outweighed the income effect. So when plotted against the real wage, the labour supply curve is upward sloping.

Equilibrium Output and Employment To determine what the equilibrium output and level of employment will be in an economy, according to the Classical model, the supply and the demand for labour must be equal i.e.        Ns = Nd      where Y = F (K*, N) Nd = f (W/P) Ns = g (W/P)  

Equilibrium in the labour Market Equilibrium in the labour market yields the market real wage (W/P)0 and the level of employment (N0). Given the (N0) level of employment, the level of income is determined at (Y0). The economy automatically adjusts to full employment at (N0). Figure 3 Classical Output and Employment Theory

Effect of a Change in Price Price level change has no effect on real variables. As P , W  in the same proportion, so that (W/P) and N are unchanged. Effect can be shown to be the same: no matter whether we use real wage (W/P) as in part a, or nominal wage (W) as in part b, price level changes have no real effect in the classical system. Figure 4 labour Market Equilibrium and the Money Wage

The Aggregate Supply Curve If we plot various levels of prices (the absolute price level) and their respective level of Y, we plot out a vertical aggregate supply curve. The level of real output is not affected by nominal variables. Real output is affected only by real variables. Figure 5 Classical Determination of Aggregate Supply

Shifts in the Aggregate Supply Curve A change in the level of capital stock is a change in a real factor. As K, the production function shifts up, which shifts the labour demand curve, i.e., the MPN or Nd . The real wage (W/P) and the real level of employment (N). The level of real output is only affected by real variables. Real output is not affected by nominal variables. Figure 6 The Effect on Output, the Real Wage, and Employment of an Increase in the Capital Stock in the Classical System

The Classical Macro Model Money in the Classical System

Classical Aggregate Demand Classical economics is supply-side economics. Real output on the supply side is determined by the real factors of production—land, labor, capital, and entrepreneurial ability. Y=F(K,N) is real! All variables that are supply side determined are real variables—Y, N, MPN, W/P, S, I, C, r. Autonomous variables, such as G and T are real. The demand side is important only in determining the nominal variables—W, P, MPNxP. The money supply, M, is a nominal variable. The classical aggregate demand curve is an implicit aggregate demand. What is the role of money in determining aggregate demand?

Determination of Price in the classical model To classical economists, the quantity of money determines the price level. That is, P=f(Ms). To determine the direction and the extent to which price depends on money supply, we need a theory: The Quantity Theory of Money of which two versions will be used discussed – the Fisherien and the Cambridge Versions.

The Cambridge Approach to the Quantity Theory In the version, we move away from the mechanical nature of the version of the QTM by Fisher. As championed by A. Marshall & A.C. Pigou , the QTM is put in the context of demand for money where the average money holdings is a constant fraction of nominal income: Md=k(Py), k>0 and 0<k<1

The Cambridge Approach to the Quantity Theory Cont’d We can move from the equation of exchange to money demand: k= 1/v From the money market equilibrium, an increase in Ms results in excess supply of money and excess spending and given the fixed output supply, prices will go up. This is the economics behind this version of the QT: So the level price is determined by MS.

Classical Aggregate Demand The Classical aggregate demand curve plots combinations of price level (P) and real output (Y) consistent with the equation of exchange, MV = PY, for a given money supply (M) and a fixed velocity (V). Assume M = 300 and V = 4. Figure 4-1 The Classical Aggregate Demand Curve Points such as P = 12.0 and Y = 100 or P = 6.0 and Y = 200 (PY = 1200 = MV in each case) lie along the aggregate demand curve. An increase in the money supply to M = 400 shifts the aggregate demand curve to the right.

Effects of a Change in the Money Supply in the Classical System Successive increases in the money supply, from M1 to M2 and then to M3, shift the aggregate demand curve to the right, from Yd(M1) to Yd(M2) to Yd(M3). Figure 4.2 Aggregate Supply and Aggregate Demand in the Classical System The price level rises from P1 to P2 to P3. Output, which is supply-determined, is unchanged (Y1 = Y2 = Y3).

The Classical Theory of the Interest Rate In the classical system, the equilibrium interest rate was the rate which the amount of funds individuals & firms desired to hold was just equal to the amount of funds others desired to borrow. The market is the Loanable funds or the bonds market which has to two sides: the demand and supply sides Household, firms and government constitute the demand side of the loanable funds market Household, firms and government also constitute the supply side of the loanable funds market

The Classical Theory of the Interest Rate Cont’d The SSLF may also be called the saving function or the demand for bonds Similarly, the DDLF may also be called the Investment function or the supply of bonds Classical economists assume that the LF market is always in equilibrium, i.e. SSLF=DDLF and that the interest rate is perfectly flexible. With excess demand for funds, the interest rate increases and with excess supply the interest rate decreases. This flexibility in the interest rate guarantees that exogenous changes in the particular components of AD do not affect the level of AD

The SSLF and DDLF Schedules At higher interest rate, people are enticed to save more so this gives an upward sloping SSLF schedule. For the demand for Loanable funds curve, at higher interest rate, the cost of borrowing increases so demand for loanable funds will reduce so we postulate a downward sloping DDLF curve. At a given interest rate, an increase in the budget deficit which is bond-financed will increase the total demand for loanable funds and will thus shift the DDLF curve to the right.

The Loanable Funds Theory of Interest Rates The equilibrium interest rate (ro) is the rate that equates: The supply of loanable funds, which consists of new saving (S), With the demand for loanable funds, which consists of investment (I) plus the bond-financed government deficit (G -T). Figure 4-3 Interest Rate Determination in the Classical System NOTE: The Loanable Funds Theory is a real theory of interest rates.

Changes in Autonomous Spending An autonomous decline in investment shifts the investment schedule to the left from I0 to I1—the distance I. The equilibrium interest rate declines from r0 to r1. As the interest rate falls, there is an interest-rate-induced increase in investment—distance B. Figure 4.4 Autonomous Decline in Investment Demand

Changes in Autonomous Spending There is also an interest-rated-induced decline in saving, which is an equal increase in consumption—distance A. The interest-rate-induced increases in consumption and investment just balance the autonomous decline in investment. There is no change in real output. Figure 4.4 Autonomous Decline in Investment Demand NOTE: A change in autonomous spending changes only the composition of output!

Effect of Increase in Government Spending in the Classical Model At point E, the equilibrium interest rate r0 equates the supply of loanable funds, S, with the demand for loanable funds, I. Figure 4.5 Effect of Increase in Government Spending in Classical Model Adding government deficit spending, (G - T)1 shifts the demand for loanable funds to the right to point F. The interest rate rises from r0 to r1.

Effect of Increase in Government Spending in the Classical Model The increase in the interest rate causes a decline in the quantity of investment from I0 to I1, a distance B, and an increase in saving, which is an equal decline in consumption, from S0 to Sl, a distance A. Figure 4.5 Effect of Increase in Government Spending in Classical Model The decline in investment and consumption just balances the increase in government deficit spending, (G - T)1.

Crowding Out We have a name for what happened when the government increased the deficit. It is called crowding out—100% crowding out or complete or total crowding out in the Classical case. It crowds out private spending, partly from investors (less I) and partly from consumers (less C, that is to say, more S) The level of output (Y) does not change. The only change is in the composition of output. Is that change real or nominal? So we have seen that a bond-financed increase in G has no effect on output and employment!

Policy Implication of the classical Equilibrium Model Monetary policy Effects: Will monetary policy have real effects? That is, will it cause employment and output to change? The answer is no because the resultant change in price will not affect the real wage because the money wage will increase in proportion to the price level. So N, Y are not affected.

Expansionary Monetary Policy Effects in the classical equilibrium model Increases in the money supply from M1 to M2 and then to M3, shift the aggregate demand curve to the right, from Yd(M1) to Yd(M2) to Yd(M3). Figure 4.2 Aggregate Supply and Aggregate Demand in the Classical System The price level rises from P1 to P2 to P3. Output, which is supply-determined, is unchanged (Y1 = Y2 = Y3).

Fiscal Policy in the classical system Assume G goes up. We have to know how it is financed. There are 3 ways of raising the money: 1. Borrowing (increase in demand for loanable funds) – a bond-financed increase in G 2. Increase in Taxes (A Tax-financed increase in G) 3. Increase in money supply (Money-financed increase in G) For option 3, we already know the effect. Only prices will change but N, Y, Real wage, Interest rate will all not change. The AD curve will shift to the right on the vertical AS curve.

A bond-financed increase in G For a bond-financed increase in G, DDLF curve will shift to the right and at initial interest rate, there will be excess demand for funds so the interest rate increases. The increase in the interest rate has two effects on AD. 1. There is an interest rate induced fall in investment 2. With the interest rate increasing, saving will increase which is mirrored by an equal reduction in consumption (a component of AD)

A bond-financed increase in G Cont’d Because classical economists believed that the loanable funds market is always in equilibrium, the rise in the interest rate will cause reductions in consumption and investment whose magnitude will be equal to the initial increase in G. So on net there will be no change in AD; only that its components will change, consumption and Investment have reduced but G has increased. A bond-financed increase in G as no real effect!

A bond-financed Increase in Government Spending in the Classical Model The increase in the interest rate causes a decline in the quantity of investment from I0 to I1, a distance B, and an increase in saving, which is an equal decline in consumption, from S0 to Sl, a distance A. Figure 4.5 Effect of Increase in Government Spending in Classical Model The decline in investment and consumption just balances the increase in government deficit spending, (G - T)1.

Tax Policy There are two types of tax policies: A lump-sum tax Change (To) & a Change in the marginal tax rate (t) Demand -Side Effects 1. T=To+ tY, 0<t<1. Assume To (Lump-sum taxes) are reduced – this is expansionary fiscal policy. The resultant budget deficit (the revenue lost by the tax cut) can again be bond-financed or money financed and the effects have already been analysed – it has no real effects.

Tax Policy Cont’d Assume the government reduces the tax rate. This policy will have real effects as the after tax real wage will increase so labour supply will increase and employment will increase so through the production function, output will increase at a given price level. Thus, the AS curve shifts to the right on a constant AD curve so output increases and prices decline.

Supply-Side Effect In part a, a reduction in the marginal tax rate (from 0.40 to 0.20) increases the after-tax real wage for a given pretax real wage. The labor supply curve shifts to the right, moving from A to B. Employment and output increase, as shown in part b of the graph, moving from A to B on the production function. Figure 4.6 The Supply-Side Effects of an Income Tax Cut

Figure 4.6c The Supply-Side Effects of an Income Tax Cut This increase in output is represented by the shift to the right in the vertical aggregate supply curve in part c, from A to B. Income  from Y0 to Y1, while price  from P0 to P1.

An Alternate Version of Figure 4-6