3 pages essay

The Classical Model Kuixiang Shen

Background ● First book treat economics as a distinct field of study

The wealth of Nations by Adam Smith(1776)

● Refined by David Ricardo, Jean-Baptiste Say, and John Stuart Mill ➔ Fully developed and influential model of the early business cycle theories

3 assumptions of the classical model ● Perfect competition exists in all markets ➔ everyone is price taker

➔ wages and prices are perfectly flexible

➔ all information is given in the market so no waste

● Real values, not nominal values, are used when making decisions ➔ no money illusion

● Representative agents or individuals that have same taste and life pattern ➔ no real distinction between mac and mic behavior(individual=whole)

Function ● Y=F（L,K） ➔ Y=output

➔ L=labor

➔ K=capital

● Diminishing Marginal Returns:

input is fixed+adding additional input=output may decrease

(marginal product of labor may decrease)

➔ more worker in lower wage

2 effect of change in real wage ● Substitution effect ➔ higher real wage workers

❖ more wokers

❖ work longer

● Wealth effect ➔ increase wealth and less incentive to work

In Classical model, we assume sub>wealth

which means people are willing to work and labor supply curve is upward sloping

3 elements changes output/supply ● Labor ➔ immigrantion&population growth

➔ public policy: tax and regulation

● Capital ➔ incentive to invest

➔ government intervention

➔ natural resources

● Technology ➔ more pruduction

➔ incentive to hire and invest

➔ tax incentive, fund, patent, and education

➔ could be bad>expensive

Demand ● Quantity theory of money demand originally developed by philosopher David

Hume in Mid-1700

● MV=PY ➔ M=supply of money

➔ V=velocity

➔ P=price PY=nominal expenditure

➔ Y=GDP

● Downward slope ● Demand-->only price level

--> No influence on real aggregate output

Business cycles DO NOT EXIST in classical model ● At least not in the traditional sense of temporary deviations of output form a

long-term trend. Classical changes are permenent.

● Aggregate supply --> output --> need substitute to supply

why supply ?

➔ In classical model, government policy is bad!!!

➔ Tax for income --> labor and salary

capital stock and marginal product of labor cause labor

➔ Policies like rights, national defense, monopolies and public education

lower efficiency and output and lead to inflation

Criticism of Classical Model ● the irrelecance of aggregate demand is troubling to many economists ● assumption can be questioned: is price and wage really flexible? ● financial systems play essentially no role in progaging business cycles

financial system simply rise and fall in response to changes in the general

economy

● world may not in equilibrium in output and demand

Thank you!