1. 3
THE CLASSICAL MODEL
Mankiw’s Text
CHAPTER

2. History of Economic Ideas (briefly)
Pre-classical Economic Ideas:
Scholastic thought (Thomas Aquinas)
Mercantilism ( )
Physiocracy ( )
Classical Political Economy:
Adam Smith, David Ricardo, J.S. Mill, Karl Marx…
Neoclassical Economics:
W.S. Jevons, Carl Menger, and Leon Walras
Alfred Marshall

3. The Classical Model: A Preview
The classical model is a model of the economy that determines the real variables—real GDP, employment and unemployment, the real wage rate, consumption, saving, investment, and the real interest rate—at full employment.
The classical dichotomy, states:
At full employment, the forces that determine real variables are independent of those that determine nominal variables.
Most economists believe that the economy is rarely at full employment but that the classical model provides a benchmark against which to measure the actual state of the economy.

4. The Classical Model: A Preview
This model assumes that the economy automatically ensures that supply equals demand for every commodity. The economy is at full-employment.
Say’s Law: Supply creates its own demand.
Supply and demand are made equal by fast-acting prices that quickly close the gap between supply and demand whenever there is one. Prices are flexible in all markets.
Market-Clearing Model: Prices freely adjust to equilibrate supply and demand.

5. Long-term growth trend and cycles

6. Outline of the classical model
A closed economy, market-clearing model
Aggregate Supply side
factor markets (supply, demand, price)
determination of output/income
Aggregate Demand side
determinants of C, I, and G
Equilibrium
goods market
loanable funds market
It’s useful for students to keep in mind the “big picture” as they learn the individual components of the model in the following slides.

7. The Labor Market and Potential GDP
To understand how potential GDP is determined, we study:
The demand for labor
The supply of labor
Labor market equilibrium
Potential GDP

8. MPL and the production functionY
output 1
MPL
As more labor is added, MPL  1
MPL
(Figure 3-3 on p.51)
It’s straightforward to see that the MPL = the prod function’s slope: The definition of the slope of a curve is the amount the curve rises when you move one unit to the right. On this graph, moving one unit to the right simply means using one additional unit of labor. The amount the curve rises is the amount by which output increases: the MPL.
Slope of the production function equals MPL
MPL 1 L
labor

9. MPL and the demand for labor
Units of output
Units of labor, L
Each firm hires labor up to the point where MPL = W/P.
MPL, Labor demand
Real wage
Quantity of labor demanded
It’s easy to see that the MPL curve is the firm’s L demand curve.
Let L* be the value of L such that MPL = W/P.
Suppose L < L*. Then, benefit of hiring one more worker (MPL) exceeds cost (W/P), so firm can increase profits by hiring one more worker.
Instead, suppose L > L*. Then, the benefit of the last worker hired (MPL) is less than the cost (W/P), so firm should reduce labor to increase its profits.
When L = L*, then firm cannot increase its profits either by raising or lowering L.
Hence, firm hires L to the point where MPL = W/P.
This establishes that the MPL curve is the firm’s labor demand curve.

10. The equilibrium real wage
Units of output
Units of labor, L
Labor supply
The real wage adjusts to equate labor demand with supply.
MPL, Labor demand
equilibrium real wage
The labor supply curve is vertical: We are assuming that the economy has a fixed quantity of labor, Lbar, regardless of whether the real wage is high or low.
Combining this labor supply curve with the demand curve we’ve developed in previous slides shows how the real wage is determined.

11. The equilibrium real rental rate
Units of output
Units of capital, K
Supply of capital
The real rental rate adjusts to equate demand for capital with supply.
MPK, demand for capital
equilibrium R/P
The previous slide used the same logic behind the labor demand curve to assert that the capital demand curve is the same as the downward-sloping MPK curve.
The supply of capital is fixed (by assumption), so the supply curve is vertical.
The real rental rate (R/P) is determined by the intersection of the two curves.

12. The Neoclassical Theory of Distribution
Our theory of the distribution of total income between labor and capital is called the neoclassical theory of distribution.
It states that each factor input is paid its marginal product.
The total real income of labor is MPL x L = W/P × L
The total real income of capital is MPK x K = R/P × K
When I teach this theory, after saying “accepted by most economists” I append “at least, as a starting point.” This theory is fine for macro models with only one type of labor. But taken literally, it implies that people who earn low wages have low marginal products. Thus, this theory would attribute the entire observed wage gap between white males and minorities to productivity differences, a conclusion that most would find objectionable.

13. How income is distributed:
total labor income =
total capital income =
If production function has constant returns to scale, then
The last equation follows from Euler’s theorem, discussed in text on p. 54.
national income
labor income
capital income

14. Measuring Economic Inequality
The census bureau defines a household’s income as money income, which equals market income plus cash payments to households by the government.
Market income equals wages, interest, rent, and profit earned by the household in factor markets, before paying income taxes.

15. Measuring Economic Inequality
The mode income is the most common income and was about $12,500 in 2000.
The median income is the level of income that separates the population into two groups of equal size and was $42,148.
The mean income is the average income and was $57,054.

16. Measuring Economic Inequality
The poorest 20% of the population in 2001 received only 3.5% of the total income.
The middle 20% of the received 14.5% of total income.
The richest 20% received 50.1% of total income.

17. Who Are the Rich and the Poor?
The median income in 2005 was $46,326.
Education is the single biggest factor affecting household income distribution.
Source of data: Current Population Survey, HINC-01. Selected Characteristics of Households, by Total Money Income in 2008.

18. Who Are the Rich and the Poor?
Size of household, marital status, and age of householder are also important.
Race and region are the least important.

19. Distribution of Nation’s Wealth
U.S. households in the top 20 percent of the income
distribution earn own well more than 80 percent of the nation's wealth
The wealth gap in America has long been in the making. In the 30 years between 1975 and 2005, U.S. households in the bottom 80 percent income bracket saw their share of national income actually fall. Those in the bottom 40 percent saw a drop in their incomes when adjusted for inflation. Only the top 20 percent of households experienced an increase their share of the total national income; much of that went to households in the highest 5 percent of the income bracket.

20. Comparing top-half Vs bottom-half inequality
Figure 1 shows the national trends in inequality in the top and bottom halves of the distribution from 1967 to 2005, according to U.S. Census Bureau data on household income. Household income is primarily wages and salaries, but it also includes income from self employment, interest, dividends, rentals, retirement, and certain government transfers. Top-half inequality refers to the 95/50 interpercentile ratio (that is, the ratio of the 95th percentile to the 50th percentile of the income distribution) and bottom-half inequality refers to the 50/20 interpercentile ratio. We chose these ratios (as opposed to, say, 90/10 and 50/10) since these data

21. The Dynamic Classical Model
Changes in Productivity
Labor productivity is real GDP per hour of labor.
Three factors influence labor productivity.
Physical capital
Human capital
Technology

22. The Dynamic Classical Model
Human capital is the knowledge and skill that has been acquired from education and on-the-job training.
Learning-by-doing is the activity of on-the-job education that can greatly increase labor productivity.

23. The Dynamic Classical Model
The percentage increase in labor hours exceeded the percentage increase in the population because the increase in capital and technological advances increased labor productivity, which increased the real wage rate, which in turn increased the labor force participation rate.

24. THE END