Classical Macroeconomics IClassical Macroeconomics IChapter 3Chapter 3

Professor Steve Cunningham

Intermediate Macroeconomics

ECON 219

Classical RevolutionClassical Revolution

Classical economics emerged as a revolution against an earlier theory known as mercantilism.

Two tenets of mercantilism:– Bullionism: a belief that the wealth and power

of a nation were determined by its stock of precious metals, and

– Active Gov’t Policy: a belief in the need for government coordination to direct the development of the capitalist system.

BullionismBullionism

In practical terms, this lead countries to believe that the economic success of the country depended upon running a trade surplus—more exports than imports.

This results in a positive flow of payments to the country.

Because the payments would be in gold and silver, this leads to the country amassing a growing stock of “bullion”.

To achieve this, trade was carefully regulated, and the export of bullion prohibited.

Classical TheoryClassical Theory

Emphasized the importance of real factors and productive capacity in determining the “wealth of nations”.

Emphasized the optimizing tendencies of free markets in the absence of state controls.

Classical analysis was real analysis—growth of an economy was the result of the growth and quality of the workforce, capital, and technological advances.

Money only facilitates exchange. The desire to trade “reals for reals” is what motivates transactions.

Classical View of MoneyClassical View of Money

Money is simply a convenience, a means of exchange.

Money has no intrinsic value. People hold money only for the sake of the goods that it can purchase.

Mercantilists had argued that on the short run an increase in the supply of money would increase demand and stimulate employment and production. Classical economists argued that increases in the supply of money ultimately have the effect of only causing inflation.

MarketsMarkets

Mercantilists argued that the government needs to make sure that markets exist for all goods.

Classical economists argued that “consumption never needs encouragement”, that the free market mechanism would provide markets for any goods that were produced.

Classical economists argued that there will always be sufficient demand for whatever was produced.

Overview of the modelOverview of the model

The story being told in this chapter is about the classical view of the real sector of the macroeconomy, and how it produces optimal, stable outcomes (equilibria).

Labor MarketLabor Market

w/p

NN*

(w/p)*

Nd

Ns

Capital MarketCapital Market

S, I

r

S*, I*

r*

Investment (I) is thechange in the amount(stock) of capital.

I

S

Saving = supply of fundsInvestment = demand for funds

Production FunctionProduction Function

N

Y Y=F(N,K*)

N*

Y* The level of capital has alreadybeen established in the capital market.

Classical Real SectorClassical Real Sector

N

YY=F(N*,K*)

N*

Y*

S, I

r

S*, I*

r*

I

S

S*, I*, r*, K*

w/P

NN*

(w/P)*

Nd

Ns

(w/P)*, N*

YY*

P

1

2

3

4

LRAS

Labor Market AssumptionsLabor Market Assumptions

Differences among workers are not considered.

Wages are determined in fully competitive labor markets (with flexible wages).

Firms’ sole concern is profit maximization. In doing so, firms consider the marginal revenue product of labor (MRPN = P x MPN), comparing it to nominal wages.

The Firm Profit MaximizesThe Firm Profit Maximizes

Firm’s profit function: π = PY – wN – Pr(K – K0)

Maximize profit: Assume A=1, Y=F(N,K) and construct expressions for change in profit relative to changes in employment (N) and capital (K) and set to zero. Solve.

∆π = P(∆Y) – w ∆N = 0

∆π = P(∆Y) – Pr ∆K = 0

----------------------

∆Y/ ∆N = w/P

∆Y/ ∆K = r

The firm is profit- maximizing when these conditions are met.

Marginal Product of Labor = Real Wage

Marginal Product of Capital = Real Interest Rate

ImplicationsImplications

S, I

r

I

w/P

N

Nd

Cet. Par., investment demand by firms rises as interest rates fall. The investment curve slopes downward.

Cet. Par., labor demand by firms rises as real wages fall. Labor demand slopes downward.

Labor SupplyLabor Supply

Workers have a plan for things they wish to buy. Workers exchange their labor to buy the goods. In a monetary economy, workers exchange their

labor for money and use the money to buy the goods, but it is not the money they want. It is the goods.

That is, households trade “reals for reals”, labor for goods, to achieve the consumption they desire to maximize their utility.

Households OptimizeHouseholds Optimize

Households maximize utility by maximizing consumption. This requires income.

So, within normal operating ranges, households supply labor at an increasing rate with increasing wage rates.

Saving increases with rising interest rates.

That is, ∆Ns/ ∆(w/P) > 0 and ∆S/ ∆y > 0

or (w/P)↑⇒ Ns↑ and (S)↑⇒ r↑

Micro Analysis of Labor SupplyMicro Analysis of Labor Supply

hours of leisure

24

W/P

2

3

4

181615

W/P

2

3

4

86 9

hours of work

Ns

U1

U2

U3

ImplicationsImplications

S, I

r S

w/P

N

Ns

Cet. Par., saving by households increases as interest rates rise. The saving curve slopes upward.

Cet. Par., labor supply by households rise as real wages rise. Labor supply slopes upward.

Abstinence TheoryAbstinence Theory

William Nassau Senior argued that, all else equal, people would prefer to consume now rather than later.

But people are induced by interest rates to forego current consumption and save in anticipation of being able to consume more in the future.

Therefore the higher the interest rate, the more people will be inclined to forego current consumption (abstinence from consumption) in favor of the return which promises higher consumption in the future.

This means that the higher the interest rate, the higher the saving rate.

Saving makes the buying power available to firms and other borrowers who will spend it, so buying power is never lost. Ultimately all current income is spent in the current period.

Factor Markets are ResolvedFactor Markets are Resolved

S, I

r

S*, I*

r*

I

S

S*, I*, r*, K*

w/P

NN*

(w/P)*

Nd

Ns

(w/P)*, N*

Each market has supply and demand related to a single variable. The two factor markets can achieve stable equilibrium.

Effect of an Increase in Labor ProductivityEffect of an Increase in Labor Productivity

w/p

NN1

(w/p)1

Nd1

Ns

Nd2

N2

(w/p)2

1. Labor is more productive.

2. Firms increase demand for labor.

3. Employment increasese and wages are bid upward.

Income Tax CutIncome Tax Cut

w/p

NN1

(w/p)2

Nd

Ns2

N2

(w/p)1

1. The same real wage is more attractive to workers.

2. Labor supply increases.

3. Employment increases and wages fall.

4. Unemployment Rate falls.

Ns1

ProductionProduction

Land (L)

Labor (N)

Capital (K)ProductionAF(K,L,N) Output (Y)

Factors of Production(Inputs)

Production (2)Production (2)

A simplified form of the Production Function is Y = AF(K,N)where

Y = real output per period of timeA = total factor productivityK = capital stockN = labor (number of workers or labor hours usedF = function relating the amount of output produced from the capital and labor used

Production (3)Production (3) Y = AF(K,N) is a mathematical expression

that computes how much output will be produced with a certain technology (A) from inputs K and N.

Example: Cobb-Douglas Production Function: Y = AKαN1-α, 0 < α < 1.Typical values are Y = AK0.3N0.7.

The Shape of ProductionThe Shape of Production

The production function slopes upward from left to right--more capital stock results in more output. (∆Y/∆K > 0)

The production function becomes flatter as capital increases--more capital results in more output, but at a diminishing rate. (You get less increase in output from adding the second unit of capital than you did from adding the first.)

This is referred to as diminishing marginal returns to capital.

Production FunctionProduction Function

K

Y Y=F(N*,K)

K2

Y2

The level of employment has alreadybeen established in the labor market.

Y1

Y3

K1 K3

Production Function: MPKProduction Function: MPK

K

Y

Y=F(N*,K)

K2

Y2

Y1

Y3

K1 K3

B

A The slope of the tangent at point A is the MPK at point A. The slope of the tangent at point B is the MPK at point B.

Production Function: MPNProduction Function: MPN

N

YY=F(N,K*)

N2

Y2

Y1

Y3

N1 N3

B

A

The slope of the tangent at point A is the MPN at point A. The slope of the tangent at point B is the MPN at point B.

Capital ChangeCapital Change

N

Y

Y=F(N,K2)Y2

Y1

N1

Y=F(N,K1)

Technology ChangeTechnology Change

N

Y

Y2

Y1

N1

Y=A1F(N,K*)

Y=A2F(N,K*)

Classical Real SectorClassical Real Sector

N

YY=F(N*,K*)

N*

Y*

S, I

r

S*, I*

r*

I

S

S*, I*, r*, K*

w/P

NN*

(w/P)*

Nd

Ns

(w/P)*, N*

YY*

P

1

2

3

4

LRAS

Increase in Labor ProductivityIncrease in Labor Productivity

w/P

N

Y

P

S

I

S,I

r

r*

S*,I*

Ns

Nd2

LRAS1

Y=F(N,K)Nd

1

LRAS2

+

+

+

Determinants of Output & EmploymentDeterminants of Output & Employment

Only real variables affect output and employment. Money is irrelevant.

Only supply/production factors affect output and employment. Demand factors are irrelevant.

Only changes in labor supply, labor productivity, capital formation, or improvements in production technology can increase output.

Note that taxes, to the extent that they affect the supply of labor or the cost of capital formation, can affect output. (How they affect demand is irrelevant.)

Supply-side Tax CutSupply-side Tax Cut

w/P

N

YS

I

S,I

r

r*

S*,I*

Ns1

Ns2

LRAS1

Y=F(N,K)Nd

LRAS2

-

+

+

P

Say’s LawSay’s Law

Jean Baptiste Say argued that widespread, prolonged over-production of goods was impossible.

This implies that prolonged, widespread unemployment is also impossible.

He argued that “supply creates its own demand.” The production process creates the incomes to buy the goods produced.

Recessions and depressions can’t happen?

Walras’ LawWalras’ Law

If there are n markets in the economy, and n-1 of them are in equilibrium, then the nth one must also be in equilibrium.

Equivalently, it is impossible to have only on market in disequilibrium.

NeutralityNeutrality

We say that money is long-run neutral if the level of the money supply is irrelevant to the real-sector outcomes (output and employment) in the long-run.

We say that money is short-run neutral if the level of the money supply is irrelevant to the real-sector outcomes (output and employment) in the short-run.

Neutrality implies that we still need to consider the money supply to compute the real-sector equilibrium, but ultimately the money supply doesn’t change the real sector equilibrium.

DichotomyDichotomy

We say a model is dichotomous, or that there is a dichotomy of money, if it is possible to solve a model for all the real sector variables without ever using the monetary sector equations.

That is, we can separate the model into real sector equations and monetary sector equations, and solve the two halves of the model independently.

The classical model is dichotomous.