As agreed $60
BUS327: Macroeconomics B
Lecture 2
The Classical Macroeconomic Thought
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BUS360: Macroeconomics B: Lecture 2
Who are the Classics?
Adam Smith: Wealth of Nations 1776
Thomas Robert Malthus: An Essay on the Principle of Population 1798
David Ricardo: On the Principles of Political Economy and Taxation 1817
Nassau Senior: An Outline of the Science of political Economy 1836
John Stuart Mill: Principles of Political Economy 1848
Karl Marx: Capital Volume 1, 1867
BUS360: Macroeconomics B: Lecture 2
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The Classical View : Say’s Law
“A product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value....the mere circumstance of the creation of one product immediately opens a vent for other products”( Jean- Baptiste Say, Treatise on Political Economy, 1803)
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BUS360: Macroeconomics B: Lecture 2
Say’s Law
“Supply creates its own demand” (Keynes). Keynes actually distorted the true meaning and implications of Say’s law.
Say’s law was originally meant for a barter economy, where, by definition, the act of supplying one good unavoidably implies the demand for some other good.
Ricardo and Mill believed however, that the law holds true even in a monetary exchange economy. Money according to them was nothing more than a medium of exchange.
BUS360: Macroeconomics B: Lecture 2
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Implications of Say’s Law:
A country cannot have too much capital.
Investment is the basis for economic growth.
Consumption not only provides NO stimulus to wealth creation but is actually contrary to it.
Demand is constituted by production. (QxP=w,r,i,p)
Demand deficiency (i.e., over-production) is never the cause of economic disturbance. Economic disturbance arises only if goods are not produced in the correct proportions to each other.
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BUS360: Macroeconomics B: Lecture 2
Two Versions of Say’s Law
Weak Version: This implies that each act of production and supply necessarily involves the creation of an equivalent demand for output in general. Equilibrium and not full employment is guaranteed.
Strong Version: In a competitive market economy there will be an automatic tendency for full employment to be established. It implies that the equality of aggregate demand and supply will be consistent with labour market equilibrium. In other words, there is no obstacle to the achievement of full employment in terms of a deficiency of aggregate demand.
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BUS360: Macroeconomics B: Lecture 2
The Five Segments of the Classical Model
The production function
The labour market
The AS, AD curves
Money – Wage determination
Interest rate determination
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BUS360: Macroeconomics B: Lecture 2
Assumptions of the Classical Model
All economic agents are rational: maximizing utility or profits.
Do not suffer from money illusion.
Perfectly competitive markets.
Perfect knowledge about market and prices
Trade takes place only when market clearing prices have been established in all markets.
Agents have stable expectations.
No cross border factor movement
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BUS360: Macroeconomics B: Lecture 2
The production function:
In the classical model production assumes a given technology, capital stock, and labour. Output (Y) is determined by the level of employment (N).
Y = f (N)
(Diagram 1)
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BUS360: Macroeconomics B: Lecture 2
O
Y
N
Y = f(N)
Y1
Y2
Y3
A
B
C
D
N1
N2
N3
Diagram 1
Production Function
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BUS360: Macroeconomics B: Lecture 2
BUS360: Macroeconomics B: Lecture 2
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ON1 = N1N2 = N2N3 but OY1 > Y1Y2 > Y2Y3 which reflects the diminishing marginal productivity of labour.
The economy will never be in danger of ‘slipping off’. It travels from point A to B and to C, but never to D. Moving to D would imply that some of the extra output would remain as unsold stock of finished goods.
The labour market:
Supply of labour (SN) or the number of people willing to work is dependent upon the real-wage (ω). These two variables are positively related, i.e., ↑ ω → ↑SN (Diagram 2). The demand for labour (DN) is inversely related with the real wage, i.e., ↑ω → ↓DN (Diagram 3).
Demand curve for labour assumes perfect competition in both labour and product markets. Under a perfectly competitive environment profit-maximizing firms will be willing to pay workers a real wage equal to the marginal product of labour due to diminishing returns in the product market. This we saw in the production function. Real wages have to come down in order to induce employers to hire more workers. Thus the demand curve for labour slopes downwards.
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BUS360: Macroeconomics B: Lecture 2
O
ω
N
SN
ω 1
ω 2
ω 3
A
B
C
N1
N2
N3
O
ω
N
N1
ω 1
ω 2
ω 3
N2
N3
DN
Diagram 2
Diagram 3
Labour Supply Curve
Labour Demand Curve
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BUS360: Macroeconomics B: Lecture 2
Labour Market Equilibrium
The model assumes that real wages are flexible and will adjust instantaneously to a level that clears the labour market. The dynamics of the labour market is shown in Diagram 4.
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BUS360: Macroeconomics B: Lecture 2
O
N
ω
SN
DN
E
N2
N1
ω 2
ω 3
ω 1
Diagram 4
Labour Market Equilibrium
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BUS360: Macroeconomics B: Lecture 2
The AD – AS Curves
The classical AD, AS curves are shown in Diagram 5.
AD is derived from the quantity theory of money. Assuming that money is only a medium of exchange it passes from one individual to another at a constant velocity, V.
If V is multiplied by the nominal stock of money, M, that will yield the nominal value of income, PY. Hence,
MV = PY
Since V is assumed to be constant in the short run a given nominal money stock, M, will yield a relationship between P and Y.
If MV = PY , then Y = MV/ P and P = MV/Y
(contd....)
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BUS360: Macroeconomics B: Lecture 2
O
P
Y
AS
AD
P1
YF
P2
Y2
P3
Y3
E
Diagram 5
Aggregate Demand and Aggregate Supply
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BUS360: Macroeconomics B: Lecture 2
As shown in Diagram 5, for a given M and V, the level of AD will be Y2 if the price level is P2, and Y1 = YF if the price level is P1.
Monetary Policy Implications
It is assumed that the government, via the Reserve Bank or Central Bank, can control the quantity of money in circulation, and therefore can control the position of the classical AD curve. (So what should be the role of the government?)
Why is AS vertical? Because it is perfectly inelastic to P since real output is determined by the labour market conditions.
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BUS360: Macroeconomics B: Lecture 2
Money-wage Determination
Diagram 6 suggests that higher the price level (P), the higher will be the money wage(W) to maintain any given real wage(ω).
The real wage (ω) is defined as the money wage (W) divided by the price level (P), i.e.,
ω = W/P or W = Pω
For any real wage, ω, there is a relationship between money wage and the price level which yields a straight line through the origin. The line in the diagram corresponds to the real wage ω2. It shows that such a real wage could be achieved with a money wage W2 and price level P2 or W1 and P1.
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BUS360: Macroeconomics B: Lecture 2
O
P
W (Money Wage)
ω 2 (Real Wage)
P1
P2
W1
W2
Diagram 6
Money Wage Determination
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BUS360: Macroeconomics B: Lecture 2
Interest Rate Determination
The classical theory of interest rate determination plays a crucial role in ensuring that a deficiency of aggregate demand does not arise.
Assume a simple economy consisting only two sectors - the households and the firms. In classical model both the consumption expenditure of households and investment expenditure of firms depend on the rate of interest. In equilibrium the aggregate expenditure (E) must equal aggregate output (Y). This can be expressed as follows:
E = C(r) + I(r) = Y ................ (1)
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BUS360: Macroeconomics B: Lecture 2
Since households do not automatically spend all their income, but save part of it, we can also write down the equation as
Y – C(r) = I (r) …………. (2)
But, Y – C(r) = S(r) ............ (3)
Combining 2 & 3 we can write,
S(r) = I(r) ................... (4)
Investment (I) and rate of interest (r) are inversely related, because, for given expectations about future net returns or profits from investment, the higher the rate of interest, the greater is the cost of borrowing to finance investment. Hence the investment function (I) is downward sloping (Diagram 7).
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BUS360: Macroeconomics B: Lecture 2
BUS360: Macroeconomics B: Lecture 2
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O
r
S , I
S (Supply of Capital)
I (Demand for Capital)
r
S , I
E
Diagram 7
Interest rate, Saving & Investment
The marginal efficiency of capital (MEC), which represents the expectations about revenues and costs, and the rate of interest (r) determines the level of investment. Diagram 8 shows how investment projects are ranked in the light of MEC and r. If r = 6%, only projects A and B will be selected for investment and projects C and D will be rejected. If r falls to 5%, C will also be selected but not D. This explains the level of investment expenditure (IE) and hence the downward slope of the investment curve.
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BUS360: Macroeconomics B: Lecture 2
O
MEC %
IE
A
B
C
D
6
r = 6%
5
r = 5%
7
8
1
2
3
4
Diagram 8
Ranking of Investment Projects
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BUS360: Macroeconomics B: Lecture 2
Saving (S)
Saving is consumption delayed or foregone. (r), from consumers’ point of view, is reward for abstinence or thrift. A dollar today is worth more than a dollar tomorrow. Thus if expected reward or benefit for today’s saving increases, more will be saved. Hence, the price of saving is (r). As r rises, S too will rise. This explains the positive slope of the saving curve in Diagram 7. Interest rate is a cost to investors but revenue for savers.
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BUS360: Macroeconomics B: Lecture 2
The classical model assumes that the rate of interest adjusts to equate the supply of loanable funds created by the act of saving to the demand for such funds generated by investment.
That rate would be r in Diagram 7. in the classical model I = S always holds.
BUS360: Macroeconomics B: Lecture 2
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Complete Model
(Diagram 9)
In Diagram 9.1, the labour market determines the real wage and employment, ω and N, and at ω and N the market clears.
In 9.2, the production function shows the corresponding level of output, Y at the market clearing , ω and N.
In 9.3 the AS is fixed a the Y level. The AD curve is derived from the quantity theory equation MV = PY. With a constant supply of money M1 and constant V, a higher price level must be associated with a lower level of real output.
(contd...)
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BUS360: Macroeconomics B: Lecture 2
N
Y
O
N
ω
O
SN
DN
Y
N
N
W
O
P
Y
AS
AD0 (M0)
AD1 (M1)
AD2 (M2)
O
P
ω
ω
P1
P2
W 1
W 2
2. Production Function
1. Labour Market
3. AS – AD Curves
4. Money – wage Determination
Diagram 9
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BUS360: Macroeconomics B: Lecture 2
AD1(M1) shows how, for a given supply of money, MV can be split up among an infinite number of combinations of P and Y. Since V is fixed, the nominal value of all transactions in the economy is determined by the supply of money. With higher prices each transaction requires more units of currency and therefore the quantity of goods and services that can be bought must fall. Since the AD curve is drawn for a given quantity of money, an increase in money supply will shift the AD curve to the right, as shown by AD2M2.
Finally 9.4 shows how the money wage W is related to the price level for a given real wage, ω. If P increases W has to increase to maintain the given ω.
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BUS360: Macroeconomics B: Lecture 2
Classical Model and Unemployment
According to the classical model, labour market clears via real wage adjustment, and that the demand for labour depends only on the properties of the production function.
Implicit in the classical model is the view that the price system works, in that price adjustments ensure that all markets clear, as shown in the complete model.
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BUS360: Macroeconomics B: Lecture 2
As such, there is a little role for government in macroeconomic management of the economy. Any unemployment that occurs in the economy is seen as being caused by rigidities that could disrupt the price mechanism from adjusting successfully. For example, Trade Unions pressure, minimum wage legislations may prevent the real wage from operating at its market-clearing level.
If left to its own devices, a freely functioning competitive economy will automatically produce a state of full employment. Keynes on the other hand, rejected the classical notion that real wage would adjust to clear the labour market. Keynes view on involuntary unemployment will be discussed in the next lecture.
Neo-liberalism is trying to go back to the classical model? Can it work? (Thought for the day for students)
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BUS360: Macroeconomics B: Lecture 2
Production Function:
Y = AF(K, L)
Cobb-Douglas Production Function:
Y = AF(KαL1-α )
Aggregate Demand:
MV = PY .................. (1)
Y = MV/P ................. (2)
∆M = ∆P .................. (3)
Interest Rate Determination:
E = C(r) + I(r) = Y ....... (1)
Y – C(r) = S(r) ............ (2)
S(r) = I(r) ................... (3)
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BUS360: Macroeconomics B: Lecture 2
| L | TPL | MPL | TRPL | MPRL |
| 1 | 10 | 10 | 100 | 100 |
| 2 | 22 | 12 | 220 | 120 |
| 3 | 35 | 13 | 350 | 130 |
| 4 | 48 | 13 | 480 | 130 |
| 5 | 60 | 12 | 600 | 120 |
| 6 | 70 | 10 | 700 | 100 |
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Here, P = $10 and W = $130
BUS360: Macroeconomics B: Lecture 2