Intermediate Macroeconomics

Topic Two:  The Classical Model

“Main” Cast of Characters:

            Adam Smith, An Inquiry Into the Nature and Causes of the Wealth of Nations (1776)

            David Ricardo, Principles of Political Economy (1817)

            John Stuart Mill, Principles of Political Economy (1848)

            Jean-Baptiste Say, Treatise of Political Economy (1803)

Broad message: 

Equilibrium: 

Long-run economists: 

Government policies: 

Full Employment: 

This version of the classical model seeks to explain the determinants of an economy’s level of:

1.         

2.         

3.         

4.         

Assumptions:

1.         

2.         

3.         

4.         

5.         

6.         

All of these assumptions (1-5) will assure that markets will always clear.

Two Sectors: 

            Money is neutral:

Three Components of the Model: 

1.         

2.         

3.         

Employment and Output Determination

Micro foundations: 

Short-run production function: 

Inputs: 

Aggregate (GDP = Y): 

So we can write the short run aggregate production function as:  Y = AF(K,L)

Where:

Y = real output per period

K = the quantity of capital inputs used per period

L = the quantity of labor inputs used per period (or employment)

A = an index of total factor productivity (or an autonomous growth factor which captures the impact of improvements in technology and any other influences which raise the overall effectiveness of an economy’s use of its factors of production, and

F = a function which relates real output to the inputs of K and L

Graphically:

Three Important Points:

1.        For any given values of A and K, there is a positive relationship between employment (L) and output (Y), shown as a movement along the production function from a to b (example).

2.        The production function exhibits diminishing marginal returns to the variable input – the slope declines as employment increases.  Marginal product of labor (MPL) = DY/DL declines as employment expands.  This is shown by a downward sloping MPL curve.

3.        The production function will shift upwards if the capital input is increased and/or there is an increase in the productivity of the inputs represented by an increase in the value of A (i.e, and increase in technology).

So now we know how the aggregate level of output is determined in the model – depends upon how much labor and capital are employed.  So the next obvious question is:

How is aggregate employment determined?  Or in the other words, how do we find the demand and supply of labor?

Profit maximizing firm:

MR = MC  

The Demand for Labor is determined in a similar way:

If a firm hires labor, it must pay a money wage = W. 

The additional cost of hiring an extra unit of labor = W times the change in labor units.

MPL - Marginal Productivity of Labor = The additional revenue generated by hiring an additional worker = P times Q (where Q is the extra output produced).

Example:

If the wage rate = $10 hr. and the MPL = $20 (for this particular worker), should we hire him/her?

Yes.  The worker is contributing more to the firm than he/she is costing the firm.

Remember that the MPL declines as the amount of labor is employed (diminishing marginal returns), the MPL curve is downward sloping.  Since the profits will be maximized when a firm equates the MPL with W/P, the marginal product curve is equivalent to the firm’s demand curve for labor (DL).  In other words, the firm will always hire the number of workers where MPL = real wage (W/P).

Graphically:

The demand for labor then is a function of the real wage (inverse relationship).  If the real wage increases, the demand for labor decreases (in order to increase the MPL to meet the higher real wage).

DL = DL(W/P)

The Supply of Labor

Labor/leisure tradeoff:

Substitution effect: 

Income effect: 

Competitive Equilibrium Output and Employment

Graphically:

Full Employment: 

Unemployment (voluntary or frictional -- choosing not to work at the market wage) =. 

Aggregate Supply or Productivity or Output

Now, once the level of employment is determined in the labor market, the level of output is determined by the position of the aggregate production function.

So what will change these values?

1.         

2.         

Graphical example:  An increase in technology that increases the MPL.

The Exception – Government Intervention

Graphically:

What about demand?  Would all of the productivity be consumed? 

Say’s Law: 

Strong Version - equilibrium version with full employment: 

This is backed up by the:

Classical theory of interest rate determination, savings and investment:

E (aggregate expenditures) = C + I = Y

Both C and I are a function of the interest rate (r).

Y = C + S

S = function (r) (+) (reward for thrift) – supply of loanable funds

So therefore, C = function (r)  (-)

I = function (r)  (-) – demand for loanable funds

Graphically:

So if C falls, no problem because I will go up – if C increases, I will go down.  Expenditures are maintained at the same level.

What determines the price level in the Classical model?

The Quantity Theory of Money

Fisher (income version) Approach:

The equation of exchange:  MV = PY

V = velocity of money (the average number of times a unit of money is used). 

Note that V is the reciprocal of the demand for money.  If V is high, the proportion of $ national income held (money demand) is low and vice versa.

V changes very slowly (institutional factors).

So with V and Y constant –  an increase in M will just cause P to increase.

The bottom line is that money is simply a veil – it does not create real wealth (productivity) in the economy.

Aggregate Demand/Aggregate Supply and Changes in M (how the price level is determined)

AS is vertical or perfectly inelastic:

Graphically:

Assume there is an increase in the money supply in an attempt to increase output and employment.

Money is neutral.  It does not contribute to real productivity in the economy.