MACRO E conomics Created: by Jim Luke. This work is licensed under the Creative Commons Attribution-NonCommercial License Unit 8: Classical Theory The moment that government appears at market, the principles of the market will be subverted. - Edmund Burke

MACRO E conomics Slide 2 Evolution of Macro Economic Theories Classical Theory Is a market-system stable? What role does a government play in a market system? How to react to “supply shocks” (war, industrial revolution, population growth) Explain periodic inflation/deflation Keynesian Theory Explain Great Depression Role of government in industrialized economy Can government “manage’ industrial economy? Modern Issues Explain role of fiat money & banking Persistent inflation & govt deficits Effects of expectations Global/open economies

MACRO E conomics Classical theory evolved in 1800’s to explain business cycle and justify free-market policies.

MACRO E conomics Slide 4 Why Classical Theory? Context  Agricultural Productivity Improved  Industrial Revolution  Evolution of war  Rapid but erratic growth  Periodic inflations/deflations  Frequent financial panics/depressions

MACRO E conomics The Classical Theory Using AD-AS Model

MACRO E conomics Slide 6 Major Concerns of Classical Economists ‘Persistent glut' possible?  Rapid Growth  Industrial Revolution  Agricultural Productivity Improved Will technology make unemployment inevitable? Why inflation? Can government: improve welfare? “manage” economy?

MACRO E conomics Classical Theory Assumptions All markets are competitive  Goods, resource, financial markets  Equilibrium prices in all markets:  no shortages or surpluses Government balanced budget: G=T Households spend all income  unless high interest rates “bribe” them to save. Firms borrow to finance I. Financial markets make sure S = I. No R.O.W. Say's Law --> improved supply drives economy

MACRO E conomics Circular Flow - Classical Economy. Balanced Budget: G =T. What ever is taken away from consumers as taxes gets spent anyway as G. There is no govt borrowing. Competitive financial markets cause S = Firm Borrowing.. Firms borrow to finance I. So, S=I. In effect, whatever households save gets spent eventually as I anyway.. Ignore ROW. It’s a closed economy model.

MACRO E conomics Classical Model Assumptions: Implications Real GDP (real output) depends on Firms’ production plans  SRAS and LRAS drive everything  AD doesn’t change much Say’s Law : Supply Creates Demand (people will spend all of their income)

MACRO E conomics Created: Jan 2008 by Jim Luke. This work is licensed under the Creative Commons Attribution-NonCommercial License Recessionary Gap: High unemployment P Price Level (price index) Real Price start LRAS SR-AS AD Real GDP if we had full employme nt Gap represents amount of unemployment

MACRO E conomics Recessionary Gap: Classical Adjustment As wages and resource prices drop, the profitability of production improves. SRAS shifts right. As firms hire more workers, firms produce more. Newly hired households spend more. Result: one-time drop in price level (deflation) increase in Real GDP return to full employment. P Price Level (price index) Real Price Index after start LRAS SR-AS initial AD Real GDP full employmen t SR-AS after after

MACRO E conomics Created: Jan 2008 by Jim Luke. This work is licensed under the Creative Commons Attribution-NonCommercial License Expansionary Gap: - Shortages of workers/resources - Dropping inventories P Price Level Real start LRAS SR-AS AD Inflationary pressure

MACRO E conomics Created: Jan 2008 by Jim Luke. This work is licensed under the Creative Commons Attribution-NonCommercial License Expansionary Gap: Classical Adjustment Firms bid up resource prices Firms raise product prices to replace inventory Result: one-time increase in price level (inflation) decrease in Real GDP return to full employment. Shortages end. P Price Level Real start LRAS SR-AS intial AD after SR-AS after Full Em p. GD P

MACRO E conomics Created: Jan 2008 by Jim Luke. This work is licensed under the Creative Commons Attribution-NonCommercial License In Classical theory Contractionary Gaps are caused by Supply Shocks. Price P Price Level Full Emp. Real GDP start LRAS SR-AS AD LRAS supply shock SRAS supply shock

MACRO E conomics Slide 15 Classical Policy Rx Market Economy will  Return to Full-Employment Equilibrium  BY ITSELF!  No government intervention needed Laissez-Faire Policies  Small government  Promote markets & capitalism  Balanced budget  Taxes = G (C+I reduced by G)

MACRO E conomics Slide 16 Classical Model Predictions ‘Supply Shocks' Determine Real GDP & Business Cycle  Recessionary gaps  temporary then deflation  'Inflationary' gaps  temporary then inflation Gold standard or “hard money” stabilizes prices Market economies are stable & tend to equilibrium Persistent 'glut' impossible Long-run Growth from technology & capital accumulation

MACRO E conomics Slide 17 Classical History Reasonable approximation of much:  19th & early 20 th century experience  Better explanation than alternative at the time High-growth & rising living standards