Classical Classical MacroeconomicMacroeconomic

ssIntermediate MacroeconomicsIntermediate Macroeconomics

ECON-305 Spring 2013ECON-305 Spring 2013Professor DaltonProfessor Dalton

Boise State UniversityBoise State University

Who are the Who are the Classicalists?Classicalists?

History of Economic ThoughtHistory of Economic Thought Smith to Marginal RevolutionSmith to Marginal Revolution Growth theory to Allocation theoryGrowth theory to Allocation theory

KeynesKeynes All those (contemporaneous and prior to All those (contemporaneous and prior to

Keynes) who viewed the market system Keynes) who viewed the market system as a self-coordinating mechanism.as a self-coordinating mechanism.

A Classical Model?A Classical Model? Monetary theory; Business cycle theoryMonetary theory; Business cycle theory

A “Classical” A “Classical” ModelModel

Underlying AssumptionsUnderlying Assumptions

1.1. Agents are maximizers (firms-profits, Agents are maximizers (firms-profits, households-utility)households-utility)

2.2. Markets are perfectly competitiveMarkets are perfectly competitive Perfect knowledgePerfect knowledge Trading occurs at market-clearing pricesTrading occurs at market-clearing prices Agents have stable expectationsAgents have stable expectations

Markets always Markets always clear.clear.

Three ComponentsThree Components

1.1. “Classical” theory of “Classical” theory of Employment and OutputEmployment and Output

2.2. Say’s Law of MarketsSay’s Law of Markets

3.3. Quantity Theory of MoneyQuantity Theory of Money

““The Classical Dichotomy”The Classical Dichotomy”

A Classical Model A Classical Model of Output and of Output and EmploymentEmployment

Output and EmploymentOutput and Employment

Short-run Production FunctionShort-run Production Function Y = A F(K,L)Y = A F(K,L)

A – index of total factor productivity A – index of total factor productivity (technology and other growth influences)(technology and other growth influences)

1.1. Positive relationship between L and Y, Positive relationship between L and Y, given A and Kgiven A and K

2.2. Diminishing returns Diminishing returns

3.3. Increases in A or K increase Y for a given LIncreases in A or K increase Y for a given L

Y

L

W/P, MPL

L

Y= A F(K,L)a

Y1

Y0

b

Positive relationship between L and Y

(as labor input increases from L0 to L1, movement from a to b on the production function, output grows from Y0 to Y1).

L0 L1

Y

L

W/P, MPL

L

Y= A F(K,L)

MPL

MPLa

a

a

Y1

Y0

b

b MPLb

Diminishing returns occurs; MPL falls as labor input expands (MPL

a > MPLb).

L0 L1

L0 L1

Y

L

W/P, MPL

L

Y= A F(K,L)

Y*= A* F(K,L)

MPLc

MPL

MPL*

MPLa

a

c

a

cY1

Y0

Increases in A or K increase Y for a given L (movement from a to c).

L0

L0

Y

L

W/P, MPL

L

Y= A F(K,L)

Y*= A* F(K,L)

MPLc

MPL

MPL

*

(W/P)a=MPL

a a

c

a

cY1

Y0

b

b(W/P)b=MPL

b

Positive relationship between L and Y

(as labor input increases from L0 to L1, movement from a to b on the production function, output grows from Y0 to Y1).

Diminishing returns occurs; MPL falls as labor input expands (MPL

a > MPLb).

Increases in A or K increase Y for a given L (movement from a to c).

L0 L1

L0 L1

Demand for LaborDemand for Labor

Profit-maximization occurs whereMRi = MCi

In a perfectly competitive market: Pi = MRi

Therefore: Pi = MCi

Pi∆Qi = Wi∆Li

Which is equivalent to: ∆Qi/∆Li = Wi/Pi

A profit-maximizing firm hires labor until the marginal product of labor equals the real wage rate.

Y

L

W/P, MPL

L

Y= A F(K,L)

DL

(W/P)a=MPL

a a

a

Y1

Y0

b

b(W/P)b=MPL

b

When the real wage is (W/P)a…

then L0 labor is hired.

As a result Y0 output is produced.

If the real wage falls to (W/P)b, then at L0, the MPL exceeds the real wage…

the firm reacts by hiring more L until

(W/P)b = MPLb …

and output expands to Y1.

L0 L1

(W/P)a

(W/P)b

Changes in the Real Changes in the Real WageWage

What causes a fall in the real wage What causes a fall in the real wage and an increase in employment?and an increase in employment? An increase in the price of outputAn increase in the price of output A fall in the nominal wage rateA fall in the nominal wage rate

What causes a rise in the real wage What causes a rise in the real wage and a reduction in employment?and a reduction in employment? A decrease in the price of outputA decrease in the price of output An increase in the nominal wage rateAn increase in the nominal wage rate

Y

L

W/P, MPL

L

Y= A F(K,L)

Y*= A* F(K,L)

MPLc

DL

DL*

(W/P)a=MPL

a a

c

a

c

Y2

Y0

d

d

An increase the quantity of capital or an increase in total factor productivity will shift the production function and increase the marginal product of labor…

At current employment L0, the MPL exceeds the current wage (W/P)a…

and the firm reacts by hiring more labor until (W/P)a = MPL

a …

and output expands to Y2.

L0 L2

(W/P)a

Aggregate Labor Aggregate Labor DemandDemand

In each market MPIn each market MPLLii = D = DLL

ii = D = DLLii(W(Wii/P/Pii))

Aggregating across marketsAggregating across markets

DDLL = D = DLL(W/P)(W/P) In the short run, the demand for labor is In the short run, the demand for labor is

an inverse function of the real wagean inverse function of the real wage Lower nominal wage increases QDLower nominal wage increases QDL L and and

increases Yincreases Y Higher price level reduces the real wage, Higher price level reduces the real wage,

increasing the QDincreasing the QDLL and increasing Y and increasing Y

Supply of Labor Aggregate supply of laborAggregate supply of labor

SSLL = S = SLL(W/P)(W/P) Labor force participationLabor force participation

LLTT = L = LTT(W/P)(W/P) Higher real wages increase labor force Higher real wages increase labor force

participation and the labor supply, participation and the labor supply, given preferences and population of given preferences and population of workersworkers Substitution effect dominates income effectSubstitution effect dominates income effect

Y

L

W/P, MPL

L

Y= A F(K,L)

DL

Given worker preferences, there is a real supply curve of labor and a labor force participation curve.

Given technology and the quantity of capital there is a real demand curve for labor.

SL LT

Y

L

W/P, MPL

L

Y= A F(K,L)

DL

(W/P)a=MPL

aa

aY0

If the real wage is at (W/P)a…

then the QDL < QSL…

Firms employ where (W/P)a = MPL

a…

employment is at L0

and output is Y0.

An excess supply of labor exists.

Unemployment equals LT

1 – L0.

(LT1 – LS) is

voluntarily unemployed…

(LS – L0) is involuntarily unemployed.

L0

(W/P)a

SL LT

LS LT1

U

Y

L

W/P, MPL

L

Y= A F(K,L)

DL

(W/P)a=MPL

a

Y0

L0

(W/P)a

SL LT

Le LTe

U

With an excess supply of labor, nominal wages are bid down.

As the nominal wage falls, the excess supply of labor shrinks until QDL = QSL.

Firms employ where (W/P)e = MPL

e…

employment is at Le

and output is Ye.

Unemployment equals LT

e – Le.

All unemployment is voluntary. Full employment exists.

(W/P)e=MPL

e

eYe

U

Output and Employment

Output and employment are determined by technology, total factor productivity, the quantity of capital, labor preferences and population.

The real wage adjusts through nominal wage adjustments to bring about labor market equilibrium.

Changes in L and Y are due to shifts in DL and SL.

Will aggregate Will aggregate demand be demand be sufficient to sufficient to purchase full purchase full employment employment

output?output?

Say’s LawSay’s Law

Say’s Law

Conventional version:“Classical economists believed in Say’s Law and therefore could not explain prolonged massive unemployment. Keynes rejected Say’s Law and was able to lay the foundations for modern macroeconomics.”

What is Say’s Law?

Jean-Baptiste SayJean-Baptiste Say

““It is worthwhile to remark, that a product is no It is worthwhile to remark, that a product is no sooner created, than it, from that instant, sooner created, than it, from that instant, affords a market for other products to the full affords a market for other products to the full extent of its own value… When the producer extent of its own value… When the producer has put the finishing hand to his product, he is has put the finishing hand to his product, he is most anxious to sell… Nor is he less anxious to most anxious to sell… Nor is he less anxious to dispose of the money he may get for it… the dispose of the money he may get for it… the mere circumstance of the creation of one mere circumstance of the creation of one product immediately opens a vent for other product immediately opens a vent for other products.”products.”

- Book I, Chapter XV,- Book I, Chapter XV, Treatise on Political Economy, Treatise on Political Economy, (1821)(1821)

Snowdon and Vane

“Supply creates its own demand” captures the essence of Say’s Law…

“…there could be no impediment to full employment caused by a deficiency of aggregate demand.”

“Say’s Law was originally set forth in the context of a barter economy…”

“…aggregate demand and aggregate supply are always guaranteed equality…”

Two Versions of “Say’s Law”1

Weak version – each act of production and supply creates an equivalent demand for output in general; true at all output levels – no guarantee of full employment.

Strong version – in a competitive market economy there are automatic tendencies for full employment to be established.

1Trevithick (1992)

From Say’s Law to the Loanable Funds Market

The quote that Snowdon and Vane use to exemplify Say’s Law seems to line up best with the “weak version”.

Immediately turn to the classical theory of Saving, Investment and Interest to justify the “strong version”.

Isn’t it reasonable to conclude that Say’s Law is not sufficient for full employment?

Say’s PrincipleSay’s Principle

Say’s Principle

Clower and Leijonhufvud Not the mnemonic “supply creates

its own demand.” Rather, “the net value of an

individual’s planned trades is identically zero.”

Distinguishes transactors (economic behavior) from thieves and philanthropists Steven Keen

Say’s Principle

SP defines set of theoretically admissible budgets

pxdx + pydy – sm,0 ≡ 0

Extensions(1) hold money for future use

pxdx + pydy + (dm–sm,0) ≡ 0

(2) supplier of non-money commodities px(dx–sx,0) + py(dy–sy,0) + (dm – sm,0) ≡ 0

Say’s Principle

(3) large number of commodities (m) p1(d1–s1,0) + p2(d2–s2,0) + …

+ pm-1(dm-1–sm-1,0) + (dm – sm,0) ≡ 0

(4) simplify, defining EDi ≡ xi ≡ di–si

p1x1 + p2x2 + … + pm-1xm-1 + xm ≡ 0

(5) large number of transactors (k)

Say’s Principle

p1x1,1 + p2x2,1 + … + pm-1xm-1,1 + xm,1 ≡ 0

p1x1,2 + p2x2,2 + … + pm-1xm-1,2 + xm,2 ≡ 0

p1x1,k-1 + p2x2,k-1 + … + pm-1xm-1,k-1 + xm,k-1 ≡ 0

p1x1,k + p2x2,k + … + pm-1xm-1,k + xm,k ≡ 0

p1X1 + p2X2 + … + pm-1Xm-1 + Xm ≡ 0

where Xi =∑xi,j for all i, j

Aggregate Say’s Principle

Aggregate Version SP: “The net value of the sum of all

aggregate EDs is identically zero.”

1. Valid for any set of prices2. No statement can be directly made

about value of sum of subset of EDs3. SP refers to plans not outcomes

Interpretations “A general glut is impossible.” “Supply creates its own

demand.” “Supply of a commodity at a price

gives rise to an equal demand at that price.”

“No one plans to supply without also planning for the use of the proceeds.

“Given prices, planned supplies must equal planned demands.”

“Given prices, planned sales create means to finance planned buys.”

True

False

True

True

False

General Equilibrium and SP

General equilibrium exists when price vector exists such that Xi = 0 for all i

“All planned transactions are executed.”

Is GE consistent with SP?Yes

Does SP imply GE will exist?No

Disequilibrium and SP Take a typical macro model existing of

money (M), bonds (b), labor (L), and goods (G).

By SP, M + pBB + pGG + pLL ≡ 0

Suppose ESL exists. What does that imply?

∑EDM,B,G = ESL

It also tells us the price adjustments that are necessary to reach GE.

Does NOT tell us that the adjustments will occur!

National Income Theory and SP

“…aggregate demand and aggregate supply are always guaranteed equality…” (Snowdon and Vane)

True or False?True, if AD and AS refers to all commodities

(including the monetary commodity).

In modern macro theory, AD and AS refers to final goods and services , a subset of all commodities. So, False; SP does not imply AD ≡ AS.

Classical Theory Classical Theory of Saving, of Saving,

Investment and Investment and Interest RatesInterest Rates

Theory of Loanable Funds

E =Y E = C(r) + I(r) Y – C(r) = S(r) dC/dr < 0; dS/dr > 0 → S(r) = I(r)

Flow of saving = Supply of loanable funds

Flow of investment expenditure = Demand for loanable funds

Theory of Loanable Funds

Higher interest rates increase the cost of funds to purchase capital goods and therefore reduce capital purchases

→ dI/dr < 0

Real interest rate equilibrates the supply and demand for loanable funds

r

S, I

DLF = I

SLF = S

If r is flexible, the classical model assures that E = Y at full employment. Why?

Let Ye be full employment output; then E0 is AD that equals Ye.

E0 = C0 + I0

At r0, I0 = S0

→ C0 = E0 – I0

Suppose increase in desired saving.

r falls, I and S rise, and C falls by (E0 – I1)

∆C = ∆I

→ Ye = E0 = C0 + I0

= E1 = C1 + I1

r

S, I, E

DLF = I

SLF = S

Y E = Y

Ye

E0

r0

I0

SLF1

= S1

r1

I1

C0

C1

= E1

Loanable Funds and Aggregate Demand

The real interest rate changes to reconcile desired saving and desired investment and maintain real expenditures.

The real sector of the economy consists of the labor and loanable funds market; together they determine realreal Y, L, E, S, I, C, w and r.

What determines the price level and nominal values?

Quantity Theory Quantity Theory of Moneyof Money

Quantity Theory of Money

Two versions Cambridge cash-balances approach

Marshall, Pigou Fisher’s equation of exchange

Cambridge QTM

Md – transactions demand for money

- demand to hold - positive relationship with

level of money expenditures

Cambridge QTM

Md = k(PY)

k: fraction of money income desired to be held for transactions

k can vary in both the short and long runs, but to begin with consider it constant

Cambridge QTM

In equilibrium, Ms = Md

MS = k(PY) Y is determined by production function

and operation of the labor market k fixed

→ ∆MS = ∆P Changes in the money supply lead to

proportionate changes in the price level

Fisher’s Equation of Exchange

MV ≡ PY Quantity of money expenditures on final

goods is identical to the money income from sale of final goods

V is income velocity of circulation Average number of times a monetary unit

used to conduct final transactions Constant in short run due to technology of

exchange

Fisher’s Equation of Exchange

M = (1/V)(PY) Y determined by operation of labor

market and production function V fixed

→ ∆M = ∆P Changes in the money supply lead to

proportionate changes in the price level

Monetary Equilibrium Theory

Return to 4-commodity model (B,G, M, L)

In GE, EDM = 0; Md = Ms

Suppose an increase in MS

Creates an ESM

By SP, corresponding ED created What markets are likely to have direct ED? Bond market and Goods market Increase in PB (fall in r) and PG

Aggregate Aggregate Demand, Demand,

Aggregate Aggregate Supply, and Price Supply, and Price

Level Level DeterminationDetermination

Classical Aggregate Demand

Money is the one commodity traded for all other commodities. Aggregate demand is simply aggregate money expenditures.

AD = MV With M and V, AD shows all

combinations of P and Y that yield same level of money expenditures.

AD is negatively sloped (rectangular hyperbola)

P

YW/P

LDL

SL

Y = A F(K,L)

AD

W0

The southwest quadrant shows the demand and supply of labor for given real wages.

The southeast quadrant shows the production function for given A and K.

The northeast quadrant represents AD and AS.

Where’s AS?

The northwest quadrant shows the relationship between the real wage and the price level for given nominal wages.

W1

W2

P

YW/P

LDL

SL

Y = A F(K,L)

L0

Y0

AS0

w0

AD

P0

W0 Begin in the labor market –the real wage w0

equilibrates the market and yields employment of L0.

Employment of L0 yields an output of Y0…

which determines the AS curve, AS0.

AS and AD determine the price level P0.

The only nominal wage consistent with the price level P0 and the real wage w0 is the nominal wage W0.

W2

W1

P

YW/P

LDL

SL

Y = A F(K,L)

L0

Y0

AS0

w0

AD

P0

W0

Suppose an increase in the money supply.AD increases to AD1.

At the current price level, P0, ED for goods appears, increasing prices to P1.

At P1 and W0, the real wage falls to w1, creating an ED for labor.The nominal wage rises to W2 in order to restore labor market equilibrium.

At w0, employment of L0 yields an output of Y0…

Consistent with goods market equilibrium.

W2

AD1

w1

ED

P1

Monetary NeutralityMonetary Neutrality

A change in the money supply A change in the money supply produces changes in nominal values produces changes in nominal values but not real valuesbut not real values Example previous pageExample previous page

Increase money supply increased nominal Increase money supply increased nominal wage rate and (nominal) price levelwage rate and (nominal) price level

Did not change any real values (real wage, Did not change any real values (real wage, employment, output)employment, output)

What about real interest rate?What about real interest rate?

The Fisher EffectThe Fisher Effect

Real interest rate determines IReal interest rate determines I00 and S and S0 0

and equilibrates loanable funds marketand equilibrates loanable funds market Nominal v. real interest ratesNominal v. real interest rates

i = r + (∆P/P)i = r + (∆P/P) Dynamic equation of exchangeDynamic equation of exchange

(∆M/M) + (∆V/V) = (∆P/P) + (∆Y/Y)(∆M/M) + (∆V/V) = (∆P/P) + (∆Y/Y) (∆M/M) = (∆P/P)(∆M/M) = (∆P/P)

(∆M/M) (∆M/M)

∆i , but not r

i

S, I

DLF = I

SLF = S

i0

S0 = I0

i1

An increase in the money supply increases the inflation rate. As suppliers and demanders adjust to the higher inflation rate, suppliers will require a higher nominal interest rate to compensate for lost purchasing power, but demanders will be willing to pay a higher interest rate because inflation has increased nominal profits. Once both demanders and suppliers have fully adjusted, all that has changed is the nominal interest rate but the real interest rate stays the same.

DLF = I’

SLF = S’

An Alternative An Alternative interpretation ofinterpretation ofclassical theoryclassical theory

P

YW/P

L

DL

SL

Y = A F(K,L)

L0

Y0

AS0

w0

AD0

P0

Begin in equilibrium, at real wage w0, determining employment L0 and output Y0.Given the money supply, MV = AD0, so the price level is P0.

Suppose an increase in the money supply. The ESM creates an EDY, and prices rise.

As prices rise, profits rise. Higher profits cause firms to increase their output and quantity demanded for labor at the current nominal wage.

An ED exists for labor at the new real wage. Workers increase their nominal wage demands, raising the costs of supplying output and the AS curve shifts to the left. Wages and prices adjust until the new equilibrium is reached.

AD1

w1

ED

P1

AS1

P2

L1

Cycle as AdjustmentCycle as Adjustment

The “short-run” AS curve is positively The “short-run” AS curve is positively sloped. Changes in AD can lead to sloped. Changes in AD can lead to changes in overall output levels as changes in overall output levels as nominal wages adjust to new nominal wages adjust to new nominal AD levels.nominal AD levels.

Still not does not capture the full Still not does not capture the full flavor of classical economics.flavor of classical economics.

Say’s Law,Say’s Law,Say’s Principle,Say’s Principle,

andandWalras’s LawWalras’s Law

Demand Failure v. Demand Failure v. Coordination FailureCoordination Failure

While the Alternative Model captures While the Alternative Model captures the notion that output can change in the notion that output can change in the short run due to monetary the short run due to monetary changes, it fails to capture the changes, it fails to capture the importance of Say’s Law in classical importance of Say’s Law in classical reasoning.reasoning.

For classicalists, For classicalists, demand failure demand failure could not be the cause of recessions.could not be the cause of recessions.

A general glut was impossible!A general glut was impossible!

Demand Failure v. Demand Failure v. Coordination FailureCoordination Failure

Partial gluts - Partial gluts - due to the wrong goods being due to the wrong goods being produced produced – could lead to secondary – could lead to secondary ramifications that caused “general” ramifications that caused “general” recessions.recessions.

The cause of recessions in classical analysis The cause of recessions in classical analysis was was coordination failurecoordination failure, not demand failure. , not demand failure. Coordination failure means that capital and Coordination failure means that capital and labor are misallocated – unemployment in labor are misallocated – unemployment in recessions is primarily a recessions is primarily a structuralstructural problem. problem.

Profits and EmploymentProfits and Employment Coordination failures reveal Coordination failures reveal

themselves in losses for some themselves in losses for some products (those in ES) and higher products (those in ES) and higher than normal profits for other than normal profits for other products (those in ED).products (those in ED).

Firms react to these profit Firms react to these profit differentials to correct the differentials to correct the coordination failure. Moving capital coordination failure. Moving capital and retraining labor takes time!and retraining labor takes time!

““Classical” Classical” MacroeconomicMacroeconomic

PolicyPolicy

Fiscal and Monetary Fiscal and Monetary PolicyPolicy

Since the problem is not aggregate Since the problem is not aggregate demand, government spending can’t demand, government spending can’t solve the problem.solve the problem.

Partial gluts may spread into Partial gluts may spread into uncertainty and increased demands uncertainty and increased demands for money; central banks need to for money; central banks need to stand ready to provide credit to the stand ready to provide credit to the banking system at high rates of banking system at high rates of interest. (Assists the Gold Standard!)interest. (Assists the Gold Standard!)

Structural PolicyStructural Policy Government must not intervene to Government must not intervene to

counteract adjustments to revealed counteract adjustments to revealed coordination failures.coordination failures.

Government must not attempt to Government must not attempt to interfere with the price adjustments interfere with the price adjustments that will occur.that will occur.

Government can assist the Government can assist the unemployed.unemployed.