1. © The McGraw-Hill Companies, 2002 0 The classical model of macroeconomics The CLASSICAL model of macroeconomics is the polar opposite of the extreme Keynesian model. It analyses the economy when wages and prices are fully flexible. In this model, the economy is always at its potential level.

2. © The McGraw-Hill Companies, 2002 1 Excess demand or supply are rapidly eliminated by wage or price changes so that potential output is quickly restored. Monetary and fiscal policy affect prices but have no impact on output. In the short-run before wages and prices have adjusted, the Keynesian position is relevant whilst the classical model is relevant to the long-run. The classical model of macroeconomics (2)

3. © The McGraw-Hill Companies, 2002 2 The Taylor Rule again Previously it was assumed that prices were fixed and so we talked in terms of a simple Taylor Rule where interest rates responded to the output part of the rule. Here, we allow prices to vary and think in terms of the Taylor Rule where interest rates respond to both output and inflation. –In this case, higher inflation leads to the bank raising the interest rate, thus reducing aggregate demand and output.

4. © The McGraw-Hill Companies, 2002 3 The macroeconomic demand schedule Output Inflation MDS The macroeconomic demand schedule (MDS) shows the combinations of inflation and output for which aggregate demand equals output when the interest rate is set by a Taylor Rule. Higher inflation is associated with lower aggregate demand and lower output.

5. © The McGraw-Hill Companies, 2002 4 The slope of the schedule is determined by: –the reaction of interest rate decisions to inflation –and the responsiveness of aggregate demand to interest rate changes Consequently: –It will be flat when interest rate decisions respond a lot to inflation and aggregate demand is highly responsive to interest rate changes. –It will be steep when interest rate decisions do not respond much to inflation and aggregate demand responds little to interest rate changes. The macroeconomic demand schedule (2)

6. © The McGraw-Hill Companies, 2002 5 Aggregate supply and potential output Potential output depends upon: –the level of technology –the quantities of labour demanded and supplied in the long-run, when the labour market is fully adjusted –When wages and prices are fully flexible, output is always at the potential level In the short-run we can treat potential output as given

7. © The McGraw-Hill Companies, 2002 6 The classical aggregate supply schedule The classical model has an aggregate supply curve which is vertical at potential output This means that equilibrium output can be reached at different levels of inflation In the classical model, people do not suffer from money illusion Consequently, only changes in real variables influence other real variables

8. © The McGraw-Hill Companies, 2002 7 The classical aggregate supply schedule (2) Output Inflation Potential output is the economys long-run equilibrium output. This schedule shows the output firms wish to supply at each inflation rate. AS Y* When wages and prices are flexible, output is always at its potential level (Y*).

9. © The McGraw-Hill Companies, 2002 8 The classical aggregate supply schedule (3) Better technology will shift AS to the right and hence increase potential output. Increased employment will also shift AS to the right and increase potential output as will the use of more capital. In the short-run, we can treat potential output as given.

10. © The McGraw-Hill Companies, 2002 9 Equilibrium inflation Output Inflation AS Y* Overall equilibrium is shown where MDS = AS at the potential output level Y* and inflation level *. MDS * A At A, the goods, money and labour markets are all in equilibrium.

11. © The McGraw-Hill Companies, 2002 10 AS 1 A beneficial supply shock raises potential output by shifting AS 0 to AS 1 and lowers inflation to 2 * at D. D 2 * Y1*Y1* Equilibrium inflation: a supply shock Output Inflation MDS 0 0 * Y0*Y0* A AS 0 If the central bank pursues its target of 0 * when the economy is at potential output, it must respond by reducing its target real interest rate. This will lead to an increased amount of money being demanded: to achieve, money market equilibrium at this interest rate, the bank must supply more money. MDS 1 C

12. © The McGraw-Hill Companies, 2002 11 Equilibrium inflation: a demand shock Output Inflation MDS 0 0 * Y0*Y0* A AS 0 Since potential output is the same at B, the bank must tighten its monetary policy in order to hit its target of 0 *. Beginning at A, an increase in aggregate demand brought by an increase in investment say, would shift MDS 0 to MDS 1 moving us to a new equilibrium B. At B, potential output is the same but is higher at 1 * MDS 1 B 1 * Since the bank follows a Taylor rule, it will increase the target real interest rate and thereby reverse the increase in MDS.

13. © The McGraw-Hill Companies, 2002 12 The speed of adjustment Adjustment in the Classical world is rapid, so the economy is always at potential output (full employment). If wages and prices are sluggish, then output may deviate from the potential level. A Keynesian world of fixed wages and prices may describe the short run period before adjustment is complete.

14. © The McGraw-Hill Companies, 2002 13 Supply-side economics The pursuit of policies aimed not at increasing aggregate demand, but at increasing aggregate supply. A way of influencing potential output, seen as critical in the classical view of the economy.

15. © The McGraw-Hill Companies, 2002 14 Adjustment in the labour market Short-run (3 months) Medium run (1 year) Long-run (4-6 years) WAGES HOURS EMPLOYMENT Largely given Demand- determined Largely given Beginning to adjust Hours/ employment mix adjusting Clearing the labour market Normal work week Full employment

16. © The McGraw-Hill Companies, 2002 15 Short-run aggregate supply If adjustment is not instantaneous, output may diverge from Y p in the short run. Firms may vary labour input –via hours of work (overtime or layoffs). Wages may be sluggish in falling to restore full employment in response to a fall in aggregate demand. The short-run aggregate supply schedule shows the prices charged by firms at each output level, given the wages they pay.

17. © The McGraw-Hill Companies, 2002 16 The short-run aggregate supply schedule Output Inflation Y* SAS 0 SAS 1 SAS 2 In time, the firm is able to negotiate lower wages, and the SAS shifts to SAS 1 and then to SAS 2, A A2A2 2 until equilibrium is restored at A 2. Suppose the economy is initially at Y* in full- employment equilibrium at A, with inflation 0 B In response to a fall in aggregate demand, firms in the short run vary labour input, thus moving along SAS to B. Y

18. © The McGraw-Hill Companies, 2002 17 The adjustment process When SAS and MDS are combined, changes in MDS lead mainly to a change in output in the short-run. Over time, deviations from full employment gradually change wage growth and short-run aggregate supply. The economy, therefore, gradually works its way back to potential output.

19. © The McGraw-Hill Companies, 2002 18 MDS' the inflation target is cut from * to 3 *: the raising of interest rates to achieve this shifts MDS to MDS'. Output Inflation Y* SAS * E MDS AS A lower inflation target Starting from long-run equilibrium at E: E' 1 * Given wage levels, firms adjust to E' in the short run. With inflation at ' but wages unchanged, the real wage rises bringing involuntary unemployment. 3 SAS 3 E3E3 Equilibrium is eventually reached at E 3, back at Y*. SAS' As the labour market (wage) adjusts SAS shifts e.g. to SAS. 2 * E2E2

20. © The McGraw-Hill Companies, 2002 19 A temporary supply shock e.g. an increase in the price of oil Y* MDS Output SAS E SAS' Higher oil prices force firms to charge more for their output, so SAS shifts to SAS. Y' Higher prices cause a move along MDS and output falls to Y. ' E' Equilibrium moves from E to E. If the bank maintains the inflation target of *, in time, unemployment reduces wages and SAS gradually shifts back to SAS ', so Y* is restored. Inflation * *'' E'' If the bank had accommodated the supply shock by relaxing its target, the economy could have moved straight back to Y*, at E.

21. © The McGraw-Hill Companies, 2002 20 Tradeoffs in monetary objectives Inflation targeting works well when all shocks are demand shocks. When shocks are supply shocks, stabilising inflation may lead to highly variable output. Conversely, a policy of stabilising output may lead to highly variable inflation.

22. © The McGraw-Hill Companies, 2002 21 Tradeoffs in monetary objectives (2) One way round this is to to steer a middle course by using a Taylor Rule, i.e. a rule that takes into account deviations of both inflation and output from their long-run levels. Another is to allow flexible inflation targeting –because the inflation target is a medium-run one, this allows some discretion for reducing variability in output