Classical models of the macroeconomy

Main feature: The market should be left to resolve its own problems. Classical economists advocate a laissez-faire approach to the economy. What does this mean? The market should be left to resolve its own problems. Government should not intervene, since it would only make things worse. The only role of the government is to ensure that there are no obstacles in the way of the free working of the market.

Main Feature (continued): Example: A problem in the market might be a shortage of tomatoes, which results in a high price for tomatoes. The government should not intervene to cause the price of tomatoes to fall. They should leave the market alone, and the price will fall on its own when either supply increases or demand decreases.

Assumptions: Prices are always flexible. This means that prices can rise or fall very quickly to achieve equilibrium. Savings (by households) is always equal to investments (by firms). The amount of output produced generates enough income to exactly buy it back.

Two markets: Let us look at how the laissez-faire approach would work in 2 specific market: The market for labour The market for loanable funds

The classical labour market

The labour market should be left to itself to achieve equilibrium The labour market should be left to itself to achieve equilibrium. The government should not intervene to change wages (no mimimum wage) or unemployment (no helping those who do not have jobs). If a problem arises, such as unemployment, how could the market solve its own problem without the government intervening?

The problem: Unemployment in the labour market: Supply $500/hr Equilibrium Demand 2,000 5,000 Quantity of Labour Wages

How the market will solve this problem: Unemployment will cause some of the persons to offer themselves for a lower wage (wage drops) As each person costs less to hire, firms will hire more persons (quantity demanded increases) This would continue until there is equilibrium in the market (full employment)

Voluntary unemployment: Not everyone would be willing to offer themselves for a lower wage. Therefore some persons will choose to remain unemployed, until they find a job that meets their standards. These people are voluntarily unemployed. This is called voluntary unemployment or equilibrium unemployment.

10 minute activity: when left alone, how will the market resolve a shortage and achieve equilibrium? Supply Equilibrium $100/hr Demand 2,000 5,000 Quantity of Labour Wages

The loanable funds market

The supply of loanable funds come from savings The supply of loanable funds come from savings. The demand for loanable funds comes from persons willing to borrow the money for investment. The price that is paid for that money is the interest rate.

The problem: shortage of loanable funds Supply Equilibrium 1% Demand $5 million $ $15 million Quantity of Loanable Funds Interest rate

How the market will solve this problem: A low interest rate would cause savers to desire to save less and investors to desire to borrow funds to invest more (low supply but high demand leads to a shortage). As investors compete for limited funds, they would have to pay a higher price (interest rate will increase) A higher interest rate would attract more savings (quantity supplied will increase) but less investment (quantity demanded will decrease) This would continue until equilibrium is achieved.

10 minute activity: when left to itself, how will the market resolve a surplus of loanable funds and achieve equilibrium? Supply 5% Equilibrium Demand $5 million $ $15 million Quantity of Loanable Funds Interest rate

In general: The situations described with the labour market and the loanable funds market can be generalised to the entire economy. Aggregate demand is the sum of all components of expenditure in the economy (C + I + G + X – M). It shows the amount of goods and services in the entire economy that are demanded at a given price level. Aggregate supply refers to the value of all final output of goods and services which the economy can produce.

General equilibrium in the economy: Aggregate Supply Equilibrium Aggregate Demand Output (Y) Price Level (P)

Factors that can cause aggregate demand to shift: Changes in consumption: consumption in the entire economy can increase/decrease due to many factors, such as changes in income, season or employment. This will cause aggregate demand to shift to the right/left. Taxation: a decrease in the rate of taxation (direct and indirect) would allow consumers to have more disposable income, which they would then desire to spend. Thus, aggregate demand would increase. The reverse would occur if the rate of taxation is increased.

Factors that can cause aggregate demand to shift: Business confidence: the more confident that entrepreneurs are about the economy and the future, the more they would choose to invest, thus causing aggregate demand to shift to the right. The exchange rate: if the local currency appreciates (for example TT6 = US1 becomes TT4 = US1), then imports would be cheaper to purchase and thus aggregate demand would shift to the right. The reverse would happen if the local currency depreciates.

Factors that can cause aggregate demand to shift: Wealth: as the stock of wealth in the economy increases, spending habits will also change, causing aggregate demand to shift to the right. Government spending: the government can directly influence aggregate demand by its own demand for certain goods/services.

Factors that can cause aggregate supply to shift: Cost of production: if cost of production increases (e.g. The cost of hiring workers increases due to an announcement by government of a higher minimum wage), then firms would produce less, and aggregate supply would shift to the left. Investment: as more investment is undertaken by firms, such as investment in human or physical capital, they would produce more, thus aggregate supply would shift to the right.

Factors that can cause aggregate supply to shift: Technology: as new technological breakthroughs take place, more would be produced and thus aggregate supply would shift to the right. Development or discovery of new natural resources: as existing natural resources are developed or new resources are discovered, this would cause an increase in output produced in the economy in total, and thus aggregate supply would shift to the right.

General equilibrium in the economy in the long run: Aggregate Supply Equilibrium Aggregate Demand Output (Y) Price Level (P)

General equilibrium in the long run: In the long run, as the economy runs efficiently, full employment of resources would be achieved. Thus the economy would be producing as much as it possibly can, leading to a vertical aggregate supply curve. There is absolutely no spare capacity/resources left in the economy to produce anything more. Aggregate demand therefore has a great influence on price. As it shifts to the right, prices would increase, and as it shifts to the left, prices would decrease.

In the long run, shifts of Aggregate demand heavily influence the price level: Aggregate Supply P3 P1 P2 AD3 AD1 AD2 Output (Y) Price Level (P)