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Macroeconomic Theory 

1. Product Market

2. Factor Market

3. Money Market

Classical Theory

IS‐LM Model(Hicks & Hansen)

Output, Price, Employment and Interest Rate Determination 

Keynesian Theory

Long‐run Short‐run

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Economic Growth Business Cycles

The Economic Equilibrium

The price of a 6.5 Oz bottle of Coca‐Cola remained unchanged at 5 cents from1886–1959?

• Great Depression, Prohibition, two World Wars, and several recessions occurred.

• Price of sugar tripled.• Structure and technology changed in industry.

Why???• Originally claimed to be a “patent medicine” sold as single servings.

• The ability for consumers to buy a single serving.• Daniel Levy and Andrew T. Young argue three factors account for price rigidity.

• From 1899 to 1921, Coca‐Cola was obligated by long‐term contracts with Syrup at $0.92 per gallon. After 1921, the syrup price fluctuated.

• Technology of vending machines could only accept a single coin.• Firm felt it was important that consumers could buy a Coke with a single 

coin.• Prices for many firms typically fully adjust within a year or two.

• Short‐run shifts in demand and supply may result in multiple price changes, but in 

long run come to equilibrium point.

Did You Know That...The Curious Case of the 5‐Cent Coke

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The Classical Theory

Theory of Output(Y) and Employment (E)Mac

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The Classical Macroeconomic Theory

• Classical economists: Adam Smith, J.B. Say, David Ricardo,John Stuart Mill, Thomas Malthus, A.C. Pigou, and others—wrote from 1770s to 1930s.

• Main Question:   

– How to increase the Output (means Real GDP) of a nations  in the Long Run??????

• Output 

• Long Run

– Why prices didn’t change over a period of time?

Economic Growth with Stability

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The Classical Macroeconomic Theory

Classical Assumptions/Postulatesa. The Economy is characterized by Capitalist Economy.

b. Perfectly Competitive Markets, Invisible hands, Lassiz‐fair Policy, Division ofLabor and Free Market Economy

a. Economy is always in equilibrium. The problems in the macro economy will betemporary and the market will correct itself.

b. Factor Market: Always Full Employment: Labor is the only variable factor ofproduction, so there is always full employment in the economy. In long run aspeople are motivated by self interest.

c. Capital Market:

No Role of Money:Money is used only for transaction purpose

No Money Illusion: People cannot be fooled my money illusion

d. Flexibles Prices (P) and Wages (W): An increase or decrease in it ensure that theeconomy operates at full employment and restore equilibrium. Prices are stable.

e. No Role of Government

f. Long run Output: Say’s Law.

The Classical Macroeconomic Theory: The Foundation

Classical Say’s Law (J.B Say 1776‐1832): 

– A dictum of economist J.B. Say is that Supply creates its own demand” both in 

• barter economy

• monetized economy

– Producing goods and services generates the income and the willingness to purchase other goods and services.

So, Aggregate  Supply = Aggregate Demand

• No general underproduction 

• No general over production

• No Unemployment– Only voluntary and frictional unemployment is there

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Say’s Law and the Circular Flow

Values of Total Production(Σpiqi)=Cost of ProductionCost of Production= rent+wages+interest+profit

Rent+wages+interest+profit= Factors IncomeFactor Income=Total Expenditure

Total Expenditure=Values of Total ProductionTotal Demand=Total Supply

The Classical Theory of Output and Employment

The Classical Theory first attempted to explain

a) National Levels of Output (Real GDP) and Price Level: 

(Through  Goods Market Equilibrium)

– determinants of the Output and Price level with AS and AD

b)  National Levels of  Employment (E) 

(Through Labor Market Equilibrium)

– determinants of  Employment and Real Wage rate with DL and SL

– Determinants of National Level of Y, P and E ( wage rate)

c) National Level of Interest  Rates  

(Through Money Market Equilibrium)

– National Consumption(C), Saving (S) and Investment (I)

– Determinates of Interest rates (S and I)

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Question: How national output is produced and price is determined?

Answers:• Output is produced through various factors of production

•Price is determined through interaction between aggregate demand and aggregate supply

The Classical Theory of Output and Employment

A. The Goods Markets

A. Aggregate Supply of Output(National Output):

• Aggregate Production or Supply Function

Y = F(K ,L)

• Relate output to factors of production

Technology constant

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K= K (capital Fixed)

L = N (amount of homogeneous

labor)

The Production Function:

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Youtput

The Total and MP ( of L)

Llabor

F K L( , )

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MPL

1MPL

1MPL

As more labor is added, MPL

Slope of the production function equals MPL

A. Aggregate Supply of Output(National Output):

A. Aggregate Supply of Output(National Output):

An aggregate supply curve:

• Shows the relationship between realoutput and price level.

• is vertical at the full‐employment level ofreal output (production) indicating that thequantity of aggregate production isindependent of the price level.

• In the classical model, long‐termunemployment is impossible.

• Say’s law, coupled with flexible interestprices, wages and interest rates wouldtend to keep workers fully employed.

Price Level

Output

Shape of the Agg Supply Curve: LRASC is Vertical

Qty of Output( Real GDP)

Price LevelsLRASC

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• Demand for Product comes from the general public(alleconomic agent) and since supply creates its own demand,demand curve slopes downward from left to right accordingto law of demand.

Prices

AD

Price Level

Qty of output(GDP)

A. Aggregate Demand of Output(National Output):

AD

P1

P2

Y1 Y2

Y=C + I + G +Nx

Equilibrium: Aggregate Demand and Aggregate Supply

Classical economistsbelieved that Say’s law,flexible interest rates,prices, and wageswould always lead tofull employment at realGDP (Ex. at12 trillion)

A change in aggregate demand will cause a change in the price level, which is temporary.

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The Classical Theory of Output and Employment

B. Factor Market: The Labor Market 

• Question

– Would unemployment be a problem in the classical model?

– What’s the full employment level of output?

– How wage rate is determined?

• Answer

– No unemployment, there is always full employment, if at all only natural rate of unemployment.  

– classical economists assumed  wages would always adjust to the full employment level.

B. Labor Market: Supply of Labor

• Ns=f(w), Where w is real wage rate, Ns is labor supplySo, Real Wage rate, w= W/P

w

Labour (N)

Ns=f(w)

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B. Labor Market: Demand for Labor

Demand for labor depends upon Marginal Revenue Productivity of Labor(MRPL)

What is MRPL?????????

• Firms employ labor till MRPL=Wage rate

• Let’s define Profit = Revenue - Cost• So Profit = Revenue - Cost

= (P x MPL) – WHire labor until Profit = 0

i.e. P x MPL = Wi.e. MPL = W/P

So, Nd=f (MRPL ): where Nd is Demand for LaborMPL =f(w)

where, w is real wage rate, W is nominal wage rate

w=W/P

MPL and the demand for labor(DL)

Each firm hires labor up to the point where MPL

= W/P

Units of output, Y

Units of labor, L

MPL, Labor demand

Real wage, w= W/P

Quantity of labor demanded, L* P is flexible is classical model

Real wage, w =W/P

B. Labor Market: Demand for Labor

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Equilibrium: in the Labor Market

Equilibrium Between Product and Factor Market(Goods and Labor Market):

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Determination of Equilibrium Output, Prices and Employment

Real Wage rate w

N*

EmploymentF K L( , )Y*

RReal Output

DL

SL

Ew

N*

Y*

LRASC

P*

AD1

AD2

Y**

Price Level

Real output

P**

C. The Money & Credit Market: Equilibrium through S & I

Savings(S):

– When income is saved, it is not reflected in product demand

– It is a type of leakage from the circular flow of income and output, because saving withdraws funds from the income stream.

– So,  S= Y‐C

Investment (I)

– Classical economists contended each dollar saved would be matched by business investment.

– Leakages would thus equal to injections.

– At equilibrium, the price of credit—the interest rate—ensures that the amount  of credit demanded equals the  amount supplied.

The Classical Theory of Output and Employment

Supply of Funds: Savings Demand for Funds: Investment 

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Equating Desired Saving and Investment in the Classical Model

C. The Money & Credit Market: Equilibrium through S & I

Collapse of Classical Economics

Prevailed Until Great Depression (1930)

• Classical economist assumes that there is perfect competition in both labor and output markets which is unrealistic.

• Says’ law i.e. supply creates it’s own demand . This postulates failed during great depression

• Labor is the only factor of production in classical economists. However other factor of productions are also important.

• Classical talked about long run.

• Emergence of Keynesian Economics

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Classical and Keynesian Economics

Classical Economics • Classical economist assumes that 

there is perfect competition in both labor and output markets .

• Says’ law i.e. supply creates it’s own demand, No fluctuations is output . AS=AD.

• Problem of AS• Labor is the only varaible factor 

of production 

• Prices and wages are flexible.• Classical long run Analysis.• LRAS is Vertical• No role of Govt.• No Role of Money

Keynesian Economics:• The perfect competition in both labor 

and output markets is unrealistic. • The Postulates of Says’ law failed 

during great depression.. AS not equal to AD always. In fact fall in AD lead to Business cycle ( fluctuation in Output)

• Problem of AD• Apart from Labor  other factor of 

productions are also important.

• Prices and Wages are Sticky.• Everything is in short run.• SRAS is Upward sloping• Active Role of Govt.• Active Role of Money.

References

• Ch 5. Classical Theory of Employment and Output in Macroeconomic Theory and Policy by D N Dwivedi

• Ch3. National Income where it come from and where it goes in Macroeconomics by N Gregory Mankiw,7th edition

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Thank You All