1. LECTURE NOTES ON MACROECONOMICS ECO306 FALL 2011 GHASSAN DIBEH

2. Chapter 2 The Classical Model  With the advent of capitalism markets for labor, capital, land, commodities and all domains and resources were established and a very important question that wasn’t asked before arise: will the economic system now left to the workings of the market, generate full employment of resources?  In the 18 th and 19 th century Karl Marx invented the name “classical economists” to include Ricardo, James Mill and other economists of the 18 th and 19 th century that answered by “yes”

3. The three pillars of the Classical Model  Say’s law  there is a logical impossibility of supply exceeding demand in the economy  Output and employment are determined by the supply side of the economy and in particular in the labor market  The quantity theory of money  Neutrality of money or equivalence of a money economy with a moneyless one.

4. Says Law  Supply creates its own Demand  The law states that to supply more of the final commodity firms will necessarily hire more of the factors of production whose revenues from their services will be the same in value as the commodities they produce.  Assuming there are only two economic agents: the firms and the households. Consumers provide labor and capital to the firms. Firms use the capital and labor to produce both consumption and capital goods. Firms pay consumers for their capital and labor services interest and wages respectively. Households use their income to buy consumption (C) and capital goods (I).

5. Says Law  The relation can be described as follows  Thus since the value of goods produced is equal to the value of incomes generated then supply creates its own demand and there can be no overproduction in the economy.

6. I. Says Law  Says Law can be written as:  However David Ricardo stated that production is either sold or consumed and every sale is used to buy and consume some other commodity. This can be translated into Savings (S) = Investment (I)  For the Classicals the economy cannot experience generalized gluts, overproduction crises or cyclical recessions as result of deficiency of demand.

7. Output and employment determination Since according to the Says Law aggregate demand is irrelevant to output determination thus the supply is the determinant of production

8. The Classical Production Function  It can be presented as K=capital stock, L=labor hours, and A= technology  Later in the 20 th century the Cobb-Douglas function was introduced With 0< α<1

9. Labor demand in the economy  Assuming we are working in a short run situation (K=constant) and that all firms maximize their profits we obtain the aggregate profit maximizing condition: or:  The profit maximizing condition is thus: or:

10. II. Employment determination  The workings of the labor market are 1. Labor demand MPL 2. Labor supply: it is given by workers’ maximization of a utility function that balances the real wage vs. the disutility of labor.. The labor supply function is then a function of the real wage or 3. The money wage w that is flexible

11. Employment determination  The labor market can be represented graphically  The full employment is L * at a wage of

12. Employment determination  The production would thus be  Or graphically

13. The Great Depression  An industrial production drop of 50% and unemployment reaching 25%. How can that happen?  The Great Depression was associated with a deflation  The decline in the general price level led to an increase in real wages. Nominal wage rigidity can lead to such results

14. The Great Depression  A drop in the general price level will shift the marginal revenue product of labor to the left  If wages are flexible, the nominal wage will drop until the equilibrium employment reaches full employment again L* at the same real wage but at a lower nominal one.

15. The Saving-Investment in the Classical Model  Financial markets are made of the market for loanable funds  The supply is the savings of households in the economy  The demand is the investment in the economy  The determinant of savings and investments is the interest rate  So with  And with

16. The Saving-Investment in the classical model  if there is a negative investment shock in the economy, the investors turned pessimistic. The initial drop in investment leads to lower savings and a compensating increase in in consumption.  Output will remain at full employment but its composition between the production of consumption goods and the production of capital goods

17. Fiscal policy in the Classical model  Government intervention in the economy is not necessary to cure recessions because the capitalist economy has internal mechanisms that ensure the return to full employment.  The government budget can be defined as where T = taxes and G=government expenditures This budget is either a surplus (B>0), a balance (B=0) or a deficit (B<0). Thus we now have two saving agents: the households and the government. The savings function becomes: where

18. Fiscal policy in the Classical model  Given that total savings in the economy must still equal to investment at equilibrium then we have  The only mechanism that determines the market for loanable funds is still the interest rate

19.  The flow diagram becomes: Fiscal policy in the Classical model

20. Fiscal policy in the Classical Model  We can derive the equilibrium condition from the expenditure side  Rearranging it and using we obtain:  The equilibrium condition in the presence of the government becomes:

21.  If the government increases expenditures from G to G’ total savings will decrease shifting the curve to the left.  The result is that interest rates increase, reducing investment in the economy and increasing private savings  Hence, the increase in government expenditures has no effect on output Government expenditures increase

22. III. The Quantity Theory of Money  It is represented by the following equation: where M= stock of money V= income velocity of money P= the price level Y= real output  The velocity of money measures the number of times a unit of money (say $1) exchanges hands in a given period.

23. The Quantity Theory of Money  This equation in essence is a tautology i.e. it is true by definition, however, the classicals transformed it into a theory (QTM) when they made two assumptions: 1) Y is determined by real factors from equilibrium in the labor market  2) Velocity of money is constant.  The Cambridge equation for money demand is: Where 0<k<1 and constant

24. The Quantity Theory of Money  In the classical system the only reason for holding money is for transactions. Imposing the equilibrium condition that money supply and money demand should be equal then  Comparing this to the Quantity theory of money equation  constant

25.  We have:  But the assumptions of the model imply that  And thus  This implies that the price level is determined solely by the money available in the economy The Quantity Theory of Money

26. The classical aggregate demand  We can define a relationship between the price level and output  Which can be graphically represented as

27.  If we add to the graph above the classical aggregate supply determined by ) which is vertical at full employment output then The classical aggregate demand

28. The classical Dichotomy  In the classical model, money has no effect on real factors (Y,S,I…) but it determines the price level