Macro Project 2 Important Final Assignment $ Any Takers?
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handout_mac_21p_classicists.docHandout MACRO #21P
Classical View of the Economy
Build It and They Will Come
Classicists believe the economy will fix itself, based on Say’s Law. That law states that supply creates its own demand and production will create sufficient demand to purchase all goods and services produced. The supplying of goods is simultaneously the demanding of other goods. Aggregate supply (AS) will always equal aggregate demand (AD).
Why would someone produce more than they would consume? In order to trade it for something else they want being produced by someone else. This is how the production of a good creates a demand for other goods.
According to the classicists, Say’s Law works in both a barter and money economy. In a money economy, producers receive money for the goods they produce. But they don’t have to spend all the money they receive on other goods—they can save it: savings equals disposable income minus consumption. That would seem to mess up Say’s Law—supply of goods might not create sufficient demand for all goods and services produced because part of the money stream would leave the consumption stream.
The classicists’ answer to the Say’s Law dilemma is to assume flexible interest rates.
If there is a decrease in consumption (C) with a corresponding increase in savings, the supply of loanable funds will increase. That, of course, drops the interest rate. With a lower interest rate, borrowers increase the quantity of loanable funds demanded for investment. So in our GDP equation, C + I + G + NX = GDP, the classicists state that through lower interest rates, when C goes down, I goes up. Or when C goes up, higher interest rates will cause I to go down. Everything will still stay in balance with SRAS still equaling AD.
Classicists also assume that prices and wages are fully flexible and can adjust to changes in the economy.
The Self-Regulating Economy
Under these assumptions, the economy is self regulating. In other words, if things get out of whack, the economy will naturally move back to equilibrium, on its own.
Suppose aggregate demand decreases. There is now a recessionary gap, output is lower than natural real GDP and there is a surplus in the labor market. The surplus causes both real and money wages to fall.
As wages fall, reducing costs, the SRAS curve moves out, increasing output closer to the natural real GDP level. The price level decreases and the quantity demanded of real GDP increases. The same process will continue until output equals natural real GDP.
Suppose there is an increase in aggregate demand. There is now an inflationary gap, output is higher than natural real GDP and there is a shortage in the labor market. The shortage causes real and money wages to rise.
As wages rise, increasing costs, the SRAS curve moves in, decreasing output closer to the natural real GDP level. The price level increases and the quantity demanded of real GDP decreases. The same process will continue until output equals natural real GDP.
In both cases, the economy moves back to the long run equilibrium level of output at the natural real GDP level. However, the price level will be different. In the case of the recessionary gap, the price level will be lower after all adjustments in the long run. In the case of the inflationary gap, the price level will end up higher in the long run.
Inflationary Gaps
So, in a self correcting economy, when there is an initial change in aggregate demand, the AD curve will shift right or left. In the case of an increase in aggregate demand, we see an inflationary gap.
In the short run, QE > QN , U < UN and P has increased. Now that the economy is in an inflationary gap, the economy begins to correct itself in the long run through the labor market. Because U < UN, there is a shortage in the labor market which exerts upward pressure on wages. As wages rise, so do costs for producers so there is a decrease in SRAS and it moves left. The process continues until the economy is back at full employment level of real GDP.
The economy ultimately ends up at long run equilibrium at the natural rate of unemployment, full employment level of real GDP, but at a higher price level (inflation).
Recessionary Gaps
In the case of a decrease in aggregate demand, we see a recessionary gap.
In the short run, QE < QN , U > UN and P has decreased. Now that the economy is in a recessionary gap, the economy begins to correct itself in the long run through the labor market. Because U > UN, there is a surplus in the labor market which exerts downward pressure on wages. As wages fall, so do costs for producers so there is an increase in SRAS and it moves right. The process continues until the economy is back at full employment level of real GDP.
Fiscal Policy Choices
Fiscal policy, or what actions the government should take when the economy is not at full employment, for the classicists is fairly simple: do nothing to interfere with the natural economic processes. This public policy of non-interference is known as lassez-faire. If the economy will regulate itself, any interference by the government will just get in the way. Classicists rely on the invisible hand.
Long Run Aggregate Supply
Long-run aggregate supply is associated with the institutional PPF and potential GDP. The physical PPF shows possible output in the economy given the physical restraints of finite resources and the current state of technology. The institutional PPF shows the possible output including any institutional constraints. An institutional constraint is anything that prevents the economy from achieving the maximum real GDP that is physically possible, such as laws like minimum wage or the normal structure of the economy. For example, a major cause of the difference between the physical and the institutional PPF is job search time for frictional and structural unemployment. This is normal to the economy and means that 100% of all labor resources will never be employed—the norm is for the economy to operate at its natural unemployment rate. So the institutional PPF will always be less than the PPF.
Anything that increases the PPF and institutional PPF, such as economic growth or an increase in resources and/or technology, will increase both short-run aggregate supply and long-run aggregate supply. Both SRAS and LRAS curves will shift right, reflecting the fact that the economy now has a higher level of potential GDP and can produce a higher level of real GDP in both the short run and the long run.
When SRAS and LRAS shift, a new long-run equilibrium is established for the economy. QN increases and the price level drops.
ie
Loanable Funds
Interest Rate (i)
S
Qe
D
S1
ie1
Qe1
Real Wage
Labor Demand (Businesses)
At QN
Labor Hours
Labor Supply (Households)
Surplus of Labor
We1
We
Too High Now
Labor Demand1 (Businesses)
At Qe<QN
QL1
Less than
QN Full Employment
U<UN
QLe
At
QN Full Employment
U=UN
Price Level
LRAS
Qe1
AD2
Real GDP
Short run equilibrium
SRAS1
QN
P1
P2
AD1
SRAS2
Real Wage
Labor Demand (Businesses)
At QN
Labor Hours
Labor Supply (Households)
Shortage of Labor
We1
Labor Demand1 (Businesses)
At Qe>QN
QL1
Greater than
QN Full Employment
U<UN
QLe
At
QN Full Employment
U=UN
We
Too Low Now
Price Level
LRAS
Qe
AD2
Real GDP
Short run equilibrium
SRAS1
QN
P1
P2
AD1
SRAS2
Price Level
Qe
AD1
Real GDP
Short run equilibrium
SRAS
QN
P1
P
AD
Short Run:
(AD ( (P (QE>QN (U<UN
Inflationary Gap
LRAS
Long run equilibrium
Price Level
Qe
AD1
Real GDP
Short run equilibrium
SRAS
QN
P1
P2
SRAS1
Long Run:
Labor shortage ( (Wages ( (Costs ( (SRAS to QN ( (P (QE=QN (U=UN
Long Run Equilibrium
LRAS
Price Level
LRAS
Qe
AD
Real GDP
Short run equilibrium
SRAS
QN
P
P1
AD1
Short Run:
(AD ( (P (QE<QN (U>UN
Recessionary Gap
Long run equilibrium
Price Level
LRAS
Qe
SRAS1
Real GDP
Short run equilibrium
SRAS
QN
P2
P1
AD1
Long Run:
Labor surplus ( (Wages ( (Costs ( (SRAS to QN ( (P (QE=QN (U=UN
Long Run Equilibrium
Institutional PPF U=UN
Physical
PPF
QN
Price Level
LRAS
Real GDP
SRAS
QN
P
AD
Institutional PPF U=UN
QN
QN1
Price Level
LRAS
Real GDP
SRAS
QN
P
AD
LRAS1
SRAS1
QN1
P1
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3/20/13
