1. Chapter 2: Classical Macroeconomics: Output and Employment
Macroeconomics originated in 1930s after the great depression in 1929.
The problems of great depression added urgency to the study of macroeconomic questions.
The book containing the theory, “The General Theory of Employment, Interest and Money” by J M Keynes published in 1936.
J M keynes termed “Classicals” to refer all the economists who had written macroeconomic issues before 1936.
They are;
Adam Smith Wealth of nations 1776
David Ricardo Principles of Political Economy 1817
John Stauart Mill Principles of Political Economy 1848
A Marshall Principles of Economics 1920
A C Pigou Principles of Economics 1933.

2. Classical Macroeconomics: Equilibrium Output and Employment
Classicals and Neoclassicals differ on Microeconomic issues
However, they are same on the macroeconomic issues
Classical economists emphasized the importance of real factors in determining the wealth of nations
They believe on the free market mechanism concepts
Money plays the role of facilitating transactions as the medium of exchange
They also mistrusted the role of government
Stressed the role of individual self interest in solving macroeconomic issues.

3. Classical Theory of Employment and Output - Outline
The Production Function
The Demand for Labor
The Supply of Labor
Labor Market Equilibrium

4. The Production Function
The production function summarizes the relationship between total output and total input assuming a given technology.
Y = F(K, N) (1)
Parameters;
y = total output
K = stock of capital
N = quantity of labour

7. The Demand for Labor
How much labor do firms want to use?
Firm owners are the purchasers of labour (demand for labour)
Assumptions
Hold capital stock fixed—short-run analysis
Workers are all alike
Labor market is competitive
Firms maximize profits

8. The Demand for Labor The marginal product of labor and labor demand
The firm owner will employ the labour till the point where the marginal cost of producing a single output = marginal revenue received from its sale.

9. Demand for labour MC = marginal labour cost (labour is the only input)
MC = w/MPN
Where w = wage and MPN = number of units produced by additional units of labour.
With the condition of profit maximization as MC = P;
P = W/MPN
Or W/P = MPN
Or W = MPN.P (MRPN)
So, the firm owner will hire up to the point where revenue obtained from additional output produced by one more worker (MPN.P) is equal to the money wage paid to the worker.
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10. The Demand for Labor How much labor do firms want to use?
Analysis at the margin: costs and benefits of hiring one extra worker
If real wage (w)  marginal product of labor (MPN), profit rises if number of workers declines
If w  MPN, profit rises if number of workers increases
Firms’ profits are highest when w = MPN
Note: w = (W/P)

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12. Summary

13. The Demand for Labor
Labor demand curve shows relationship between the real wage rate and the quantity of labor demanded
It is the same as the MPN curve, since W/P = MPN at equilibrium
So the labor demand curve is downward sloping; firms want to hire less labor, the higher the real wage

14. The Demand for Labor Factors that shift the labor demand curve
Note: A change in the wage causes a movement along the labor demand curve, not a shift of the curve
Supply shocks: Beneficial supply shock raises MPN, so shifts labor demand curve to the right; opposite for adverse supply shock
Size of capital stock: Higher capital stock raises MPN, so shifts labor demand curve to the right; opposite for lower capital stock

15. Aggregate labor demand
The Demand for Labor
Aggregate labor demand
Aggregate labor demand is the sum of all firms’ labor demand
Same factors (supply shocks, size of capital stock) that shift firms’ labor demand cause shifts in aggregate labor demand

16. Figure 3.6 The effect of a beneficial supply shock on labor demand

17. Summary

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19. The Supply of Labor Supply of labor is determined by individuals
Aggregate supply of labor is the sum of individuals’ labor supply
Labor supply of individuals depends on labor-leisure choice
Which in turn the income-leisure trade-off
Utility depends on consumption and leisure
Need to compare costs and benefits of working another day
Costs: Loss of leisure time
Benefits: More consumption, since income is higher
If benefits of working another day exceed costs, work another day
Keep working additional days until benefits equal costs

20. Horizontal axis represents the leisure per day (24 hr. max)
Vertical axis represents the real income (W/P) x (Number of hours worked).
U1 U2 U3 are the indifference curves and shows the combination of income and leisure that the individual get equal satisfaction.
The slope of the indifference curve gives the rate at which individual is willing to trade off leisure for income.
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21. All the points on U3 yields greater satisfaction than U2 than U1.
Labour Supply
The increase in income that the individual gains to be just well off after giving up an unit of leisure.
The cost of choosing each hour of leisure is the real wage, as the individual is choosing not to work for each hour of leisure.
All the points on U3 yields greater satisfaction than U2 than U1.
Starting with 24 hours of leisure, the individual can trade off leisure for income at the rate equal to hourly real wage.
Hence, the slope of the budget line is the real wage.
Higher is the real wage, steeper is the budget line.
A rise is the wage rate, goods become cheaper and leisure become costlier as each individual buys more goods than before.
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22. The Supply of Labor Real wages and labor supply The labor supply curve
Increase in the current real wage should raise quantity of labor supplied 
Labor supply curve relates quantity of labor supplied to real wage
Real wage increases from 2 to 3 to 4, labour hour increases from 6 to 8 to 9.
Labor supply curve slopes upward because higher wage encourages people to work more

23. The Supply of Labor
An increase in the real wage has offsetting income and substitution effects
Substitution effect: Higher real wage encourages work, since reward for working is higher
Income effect: Higher real wage increases income for same amount of work time, so person can afford more leisure, so will supply less labor

24. The Supply of Labor
The substitution effect and the income effect together: a long-term increase in the real wage
The reward to working is greater: a substitution effect toward more work
But with higher wage, a person doesn’t need to work as much: an income effect toward less work
The longer the high wage is expected to last, the stronger the income effect; thus labor supply will increase by less or decrease by more than for a temporary reduction in the real wage

25. The Supply of Labor Empirical evidence on real wages and labor supply
Overall result: Labor supply increases with a temporary rise in the real wage
Labor supply falls with a permanent increase in the real wage.

26. Figure 3.4 The labor supply curve of an individual worker

27. Factors that shift the labor supply curve
The Supply of Labor
Factors that shift the labor supply curve
Wealth: Higher wealth reduces labor supply (shifts labor supply curve to the left, as in Fig. 3.4)
Expected future real wage: Higher expected future real wage is like an increase in wealth, so reduces labor supply (shifts labor supply curve to the left).

28. Figure 3.5 The effect on labor supply of an increase in wealth

29. Aggregate labor supply
The Supply of Labor
Aggregate labor supply
Aggregate labor supply rises when current real wage rises
Some people work more hours
Other people enter labor force
Result: Aggregate labor supply curve slopes upward

30. Aggregate labor supply Factors increasing labor supply
The Supply of Labor
Aggregate labor supply
Factors increasing labor supply
Decrease in wealth
Decrease in expected future real wage
Increase in working-age population (higher birth rate, immigration)
Increase in labor force participation (increased female labor participation, elimination of mandatory retirement)

31. Summary

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34. Equilibrium Output and Employment:
In the classical model the level of output and employment is determined by real forces.
Monetary factors have no role to play in determining the level of output and employment.
If price increases, the demand for labour curve will shift to right and creates gap between demand and supply and create pressures the wage to increase.
So, wage will increase till the W/P is same as earlier to remove the gap between supply and demand.
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36. Aggregate Supply Function:
When the price increases from P1 to P2 to P3, the wage increases from W1 to W2 to W3, such that W1/P1 = W2/P2 = W3/P3.
Hence, relating P and Y, the aggregate supply function is vertical.
Whatever is the price, the output is not changed.
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37. Figure 3.10 Labor market equilibrium

38. Labor Market Equilibrium
Classical model of the labor market—real wage adjusts quickly
Determines full-employment level of employment and market-clearing real wage
Problem with classical model: can’t study unemployment

39. Labor Market Equilibrium
Full-employment output
Full-employment output = potential output = level of output when labor market is in equilibrium
affected by changes in full employment level or production function (example: supply shock, Figure below)

40. Figure 3.11 Effects of a temporary adverse supply shock on the labor market
Sources: Producer price index for fuels and related products and power from research.stlouisfed.org/fred2/series/PPIENG; GDP deflator from research.stlouisfed.org/fred2/GDPDEF. Data were scaled so that the relative price of energy equals 100 in year 2000.

41. Unemployment Why there are always unemployed people?
Frictional unemployment
Search activity of firms and workers due to heterogeneity
Matching process takes time
Structural unemployment
Chronically unemployed: workers who are unemployed a large part of the time
Structural unemployment: the long-term and chronic unemployment that exists even when the economy is not in a recession
One cause: Lack of skills prevents some workers from finding long-term employment
Another cause: Reallocation of workers out of shrinking industries or depressed regions; matching takes a long time

42. Cyclical Unemployment: Unemployment is related to Business Cycle.
Seasonal Unemployment: when people are unemployed in certain time of the year due to nature of the work.
Voluntary Unemployment: when a person is unemployed due to his/her choice.
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