Transcript Intermediate Macroeconomics

Classical
Macroeconomics
Intermediate Macroeconomics
ECON-305 Spring 2013
Professor Dalton
Boise State University
Who are the Classicalists?

History of Economic Thought
Smith to Marginal Revolution
 Growth theory to Allocation theory


Keynes


All those (contemporaneous and prior to
Keynes) who viewed the market system as
a self-coordinating mechanism.
A Classical Model?

Monetary theory; Business cycle theory
A “Classical” Model
Underlying Assumptions
1.
2.
Agents are maximizers (firms-profits,
households-utility)
Markets are perfectly competitive



Perfect knowledge
Trading occurs at market-clearing prices
Agents have stable expectations
Markets always clear.
Three Components
1. “Classical” theory of
Employment and Output
2. Say’s Law of Markets
3. Quantity Theory of Money
“The Classical Dichotomy”
A Classical Model
of Output and
Employment
Output and Employment


Short-run Production Function
Y = A F(K,L)

1.
2.
3.
A – index of total factor productivity
(technology and other growth
influences)
Positive relationship between L and Y,
given A and K
Diminishing returns
Increases in A or K increase Y for a given L
Y
Positive relationship
between L and Y
Y1
Y0
a
L0
b
L1
Y= A F(K,L)
L
W/P, MPL
L
(as labor input
increases from L0 to
L1, movement from a
to b on the
production function,
output grows from
Y0 to Y1).
Y
Y1
Y0
a
L0
Y= A F(K,L)
b
L1
L
W/P, MPL
MPLa
MPLb
Diminishing returns
occurs; MPL falls as
labor input expands
(MPLa > MPLb).
a
b
MPL
L0
L1
L
Y
Y*= A* F(K,L)
c
Y1
Y= A F(K,L)
Y0
a
L0
L
W/P, MPL
c
MPLc
MPLa
a
MPL*
MPL
L0
L
Increases in A or K
increase Y for a
given L (movement
from a to c).
Y
Y*= A* F(K,L)
c
Y1
Y0
a
L0
Y= A F(K,L)
b
L1
L
W/P, MPL
(W/P)a=MPLa
(W/P)b=MPLb
a
b
MPL*
MPL
L0
(as labor input
increases from L0 to
L1, movement from a
to b on the
production function,
output grows from
Y0 to Y1).
Diminishing returns
occurs; MPL falls as
labor input expands
(MPLa > MPLb).
c
MPLc
Positive relationship
between L and Y
L1
L
Increases in A or K
increase Y for a
given L (movement
from a to c).
Demand for Labor






Profit-maximization occurs where
MRi = MCi
In a perfectly competitive market: Pi = MRi
Therefore:
Pi = MCi
Pi∆Qi = Wi∆Li
Which is equivalent to: ∆Qi/∆Li = Wi/Pi
A profit-maximizing firm hires labor until
the marginal product of labor equals the
real wage rate.
Y
When the real wage
is (W/P)a…
Y1
Y0
a
Y= A F(K,L)
b
L
W/P, MPL
then L0 labor is hired.
As a result Y0 output
is produced.
If the real wage falls
to (W/P)b, then at L0,
the MPL exceeds the
real wage…
the firm reacts by
hiring more L until
(W/P)a=MPLa
(W/P)b=MPLb
(W/P)b = MPLb …
(W/P)a
a
b
and output expands
to Y1.
(W/P)b
DL
L0
L1
L
Changes in the Real Wage

What causes a fall in the real wage and
an increase in employment?
An increase in the price of output
 A fall in the nominal wage rate


What causes a rise in the real wage
and a reduction in employment?
A decrease in the price of output
 An increase in the nominal wage rate

Y
Y*= A* F(K,L)
d
Y2
c
Y0
Y= A F(K,L)
a
L
At current
employment L0, the
MPL exceeds the
current wage
(W/P)a…
W/P, MPL
c
MPLc
(W/P)a=MPLa
d
and the firm reacts
by hiring more labor
until (W/P)a = MPLa …
(W/P)a
a
DL*
DL
L0
An increase the
quantity of capital or
an increase in total
factor productivity
will shift the
production function
and increase the
marginal product of
labor…
L2
L
and output expands
to Y2.
Aggregate Labor Demand



In each market MPLi = DLi = DLi(Wi/Pi)
Aggregating across markets
DL = DL(W/P)
In the short run, the demand for labor
is an inverse function of the real wage
Lower nominal wage increases QDL and
increases Y
 Higher price level reduces the real wage,
increasing the QDL and increasing Y

Supply of Labor



Aggregate supply of labor
SL = SL(W/P)
Labor force participation
LT = LT(W/P)
Higher real wages increase labor force
participation and the labor supply,
given preferences and population of
workers

Substitution effect dominates income
effect
Y
Y= A F(K,L)
L
W/P, MPL
SL
LT
DL
L
Given worker
preferences, there is
a real supply curve
of labor and a labor
force participation
curve.
Given technology
and the quantity of
capital there is a real
demand curve for
labor.
If the real wage is at
(W/P)a…
Y
then the QDL < QSL…
Y= A F(K,L)
Y0
a
Firms employ where
(W/P)a = MPLa…
employment is at L0
L
and output is Y0.
An excess supply of
labor exists.
W/P, MPL
U
SL
(W/P)a=MPLa
Unemployment
equals LT1 – L0.
LT
(LT1 – LS) is
voluntarily
unemployed…
(W/P)a
a
DL
L0
LS LT1
L
(LS – L0) is
involuntarily
unemployed.
Y
With an excess supply
of labor, nominal
wages are bid down.
Ye
Y0
Y= A F(K,L)
e
L
W/P, MPL
(W/P)a=MPL
(W/P)e=MPL
e
Firms employ where
(W/P)e = MPLe…
employment is at Le
U
a
As the nominal wage
falls, the excess
supply of labor
shrinks until QDL =
QSL.
SL
and output is Ye.
LT
Unemployment equals
LTe – Le.
(W/P)a
U
L0 Le LTe
DL
L
All unemployment is
voluntary. Full
employment exists.
Output and Employment



Output and employment are
determined by technology, total factor
productivity, the quantity of capital,
labor preferences and population.
The real wage adjusts through
nominal wage adjustments to bring
about labor market equilibrium.
Changes in L and Y are due to shifts in
DL and SL.
Will aggregate
demand be sufficient
to purchase full
employment output?
Say’s Law
Say’s Law

Conventional version:
“Classical economists believed in Say’s
Law and therefore could not explain
prolonged massive unemployment.
Keynes rejected Say’s Law and was
able to lay the foundations for modern
macroeconomics.”
What is Say’s Law?
Jean-Baptiste Say
“It is worthwhile to remark, that 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… When the producer
has put the finishing hand to his product, he is
most anxious to sell… Nor is he less anxious to
dispose of the money he may get for it… the
mere circumstance of the creation of one
product immediately opens a vent for other
products.”
- Book I, Chapter XV, Treatise on Political Economy,
(1821)
Snowdon and Vane




“Supply creates its own demand” captures
the essence of Say’s Law…
“…there could be no impediment to full
employment caused by a deficiency of
aggregate demand.”
“Say’s Law was originally set forth in the
context of a barter economy…”
“…aggregate demand and aggregate supply
are always guaranteed equality…”
Two Versions of “Say’s Law”1


Weak version – each act of production
and supply creates an equivalent
demand for output in general; true at
all output levels – no guarantee of full
employment.
Strong version – in a competitive
market economy there are automatic
tendencies for full employment to be
established.
1Trevithick
(1992)
From Say’s Law to the
Loanable Funds Market


The quote that Snowdon and Vane use to
exemplify Say’s Law seems to line up best
with the “weak version”.
Immediately turn to the classical theory of
Saving, Investment and Interest to justify
the “strong version”.
Isn’t it reasonable to conclude that
Say’s Law is not sufficient for full
employment?
Say’s Principle
Say’s Principle




Clower and Leijonhufvud
Not the mnemonic “supply creates its
own demand.”
Rather, “the net value of an
individual’s planned trades is
identically zero.”
Distinguishes transactors (economic
behavior) from thieves and
philanthropists

Steven Keen
Say’s Principle

SP defines set of theoretically
admissible budgets
pxdx + pydy – sm,0 ≡ 0
Extensions
(1) hold money for future use
pxdx + pydy + (dm–sm,0) ≡ 0
(2) supplier of non-money commodities
px(dx–sx,0) + py(dy–sy,0) + (dm – sm,0) ≡ 0
Say’s Principle
(3) large number of commodities (m)
p1(d1–s1,0) + p2(d2–s2,0) + …
+ pm-1(dm-1–sm-1,0) + (dm – sm,0) ≡ 0
(4) simplify, defining EDi ≡ xi ≡ di–si
p1x1 + p2x2 + … + pm-1xm-1 + xm ≡ 0
(5) large number of transactors (k)
Say’s Principle
p1x1,1 + p2x2,1 +
p1x1,2 + p2x2,2 +
… + pm-1xm-1,1 + xm,1 ≡ 0
… + pm-1xm-1,2 + xm,2 ≡ 0
p1x1,k-1 + p2x2,k-1 + … + pm-1xm-1,k-1 + xm,k-1 ≡ 0
p1x1,k + p2x2,k + … + pm-1xm-1,k + xm,k ≡ 0
p 1 X 1 + p 2 X2
+ … + pm-1Xm-1
+ Xm
≡0
where Xi =∑xi,j for all i, j
Aggregate Say’s Principle
Aggregate Version SP:
“The net value of the sum of all
aggregate EDs is identically zero.”
1.
2.
3.
Valid for any set of prices
No statement can be directly made
about value of sum of subset of EDs
SP refers to plans not outcomes
Interpretations


“A general glut is impossible.”
“Supply creates its own demand.”




“Supply of a commodity at a price
gives rise to an equal demand at
that price.”
“No one plans to supply without also
planning for the use of the
proceeds.
“Given prices, planned supplies
must equal planned demands.”
“Given prices, planned sales
create means to finance planned
buys.”
True
False
True
True
False
General Equilibrium and SP




General equilibrium exists when price
vector exists such that Xi = 0 for all i
“All planned transactions are
executed.”
Is GE consistent with SP?
Yes
Does SP imply GE will exist?
No
Disequilibrium and SP


Take a typical macro model existing of
money (M), bonds (b), labor (L), and goods
(G).
By SP, M + pBB + pGG + pLL ≡ 0
Suppose ESL exists. What does that imply?
∑EDM,B,G = ESL
It also tells us the price adjustments that are
necessary to reach GE.
Does NOT tell us that the adjustments will
occur!

National Income Theory and SP
“…aggregate demand and aggregate supply
are always guaranteed equality…” (Snowdon
and Vane)
True or False?
True, if AD and AS refers to all commodities
(including the monetary commodity).
In modern macro theory, AD and AS refers to
final goods and services , a subset of all
commodities. So, False; SP does not imply
AD ≡ AS.
Classical Theory of
Saving, Investment
and Interest Rates
Theory of Loanable Funds






E =Y
E = C(r) + I(r)
Y – C(r) = S(r) dC/dr < 0; dS/dr > 0
→ S(r) = I(r)
Flow of saving = Supply of loanable
funds
Flow of investment expenditure =
Demand for loanable funds
Theory of Loanable Funds



Higher interest rates increase the cost
of funds to purchase capital goods
and therefore reduce capital purchases
→ dI/dr < 0
Real interest rate equilibrates the
supply and demand for loanable funds
r
SLF = S
DLF = I
S, I
If r is flexible, the classical model assures that E = Y at full
employment. Why?
SLF = S
r
SLF1 = S1
r0
Let Ye be full
employment output;
then E0 is AD that
equals Ye.
E0 = C0 + I0
r1
At r0, I0 = S0
→ C0 = E0 – I0
DLF = I
I0 I1
E0 = E1 S, I, E
C1
Suppose increase in
desired saving.
r falls, I and S rise,
and C falls by (E0 – I1)
C0
∆C = ∆I
→ Ye = E0 = C0 + I0
= E1 = C1 + I1
Ye
Y
E=Y
Loanable Funds and
Aggregate Demand



The real interest rate changes to reconcile
desired saving and desired investment and
maintain real expenditures.
The real sector of the economy consists of
the labor and loanable funds market;
together they determine real Y, L, E, S, I, C,
w and r.
What determines the price level and nominal
values?
Quantity Theory of
Money
Quantity Theory of Money

Two versions
 Cambridge
 Marshall,
 Fisher’s
cash-balances approach
Pigou
equation of exchange
Cambridge QTM

Md – transactions demand for
money
- demand to hold
- positive relationship with
level of money expenditures
Cambridge QTM
Md = k(PY)
k: fraction of money income
desired to be held for transactions
 k can vary in both the short and
long runs, but to begin with
consider it constant

Cambridge QTM


In equilibrium, Ms = Md
MS = k(PY)
Y is determined by production function
and operation of the labor market
 k fixed


→ ∆MS = ∆P

Changes in the money supply lead to
proportionate changes in the price level
Fisher’s Equation of Exchange

MV ≡ PY
Quantity of money expenditures on final
goods is identical to the money income
from sale of final goods
 V is income velocity of circulation

Average number of times a monetary unit
used to conduct final transactions
 Constant in short run due to technology of
exchange

Fisher’s Equation of Exchange

M = (1/V)(PY)
Y determined by operation of labor
market and production function
 V fixed


→ ∆M = ∆P

Changes in the money supply lead to
proportionate changes in the price level
Monetary Equilibrium Theory



Return to 4-commodity model (B,G, M,
L)
In GE, EDM = 0; Md = Ms
Suppose an increase in MS
Creates an ESM
 By SP, corresponding ED created
 What markets are likely to have direct ED?
 Bond market and Goods market
 Increase in PB (fall in r) and PG

Aggregate
Demand,
Aggregate Supply,
and Price Level
Determination
Classical Aggregate Demand


Money is the one commodity traded
for all other commodities. Aggregate
demand is simply aggregate money
expenditures.
AD = MV
With M and V, AD shows all combinations
of P and Y that yield same level of money
expenditures.
 AD is negatively sloped (rectangular
hyperbola)

W2
The southwest
quadrant shows
the demand and
supply of labor for
given real wages.
P
W0
W1
AD
W/P
Y
The southeast
quadrant shows
the production
function for given
A and K.
The northeast
quadrant
represents AD and
AS.
Where’s AS?
SL
DL
L
Y = A F(K,L)
The northwest
quadrant shows
the relationship
between the real
wage and the price
level for given
nominal wages.
W2
P
W0
W1
AS0
Begin in the labor
market –the real
wage w0
equilibrates the
market and yields
employment of L0.
P0
AD
W/P
w0
Y0
Y
Employment of L0
yields an output of
Y0…
which determines
the AS curve, AS0.
AS and AD
determine the
price level P0.
L0
SL
DL
L
Y = A F(K,L)
The only nominal
wage consistent
with the price level
P0 and the real
wage w0 is the
nominal wage W 0.
W2
W0
P
Suppose an increase
in the money supply.
AD increases to AD1.
AS0
P1
AD1
P0
AD
W/P
w0
w1
Y0
ED
SL
DL
Y
L0
L
At the current price
level, P0, ED for
goods appears,
increasing prices to
P1.
At P1 and W0, the real
wage falls to w1,
creating an ED for
labor.
The nominal wage
rises to W 2 in order to
restore labor market
equilibrium.
At w0, employment of
L0 yields an output of
Y0…
Y = A F(K,L)
Consistent with
goods market
equilibrium.
Monetary Neutrality

A change in the money supply
produces changes in nominal values
but not real values

Example previous page
Increase money supply increased nominal
wage rate and (nominal) price level
 Did not change any real values (real wage,
employment, output)
 What about real interest rate?

The Fisher Effect


Real interest rate determines I0 and S0
and equilibrates loanable funds
market
Nominal v. real interest rates
i = r + (∆P/P)
 Dynamic equation of exchange

(∆M/M) + (∆V/V) = (∆P/P) + (∆Y/Y)
 (∆M/M) = (∆P/P)


(∆M/M)
∆i , but not r
SLF = S’
i
SLF = S
i1
i0
DLF = I’
DLF = I
S 0 = I0
S, I
An increase in the money supply increases the inflation rate. As suppliers
and demanders adjust to the higher inflation rate, suppliers will require a
higher nominal interest rate to compensate for lost purchasing power, but
demanders will be willing to pay a higher interest rate because inflation has
increased nominal profits. Once both demanders and suppliers have fully
adjusted, all that has changed is the nominal interest rate but the real
interest rate stays the same.
An Alternative
interpretation of
classical theory
P
AS1
Begin in equilibrium, at
real wage w0,
determining employment
L0 and output Y0.
Given the money supply,
MV = AD0, so the price
level is P0.
AS0
P2
P1
Suppose an increase in
AD1 the money supply. The
ESM creates an EDY, and
prices rise.
P0
AD0
w0
w1
Y0
W/P
ED
Y
L0
L1
SL
DL
L
Y = A F(K,L)
As prices rise, profits
rise. Higher profits cause
firms to increase their
output and quantity
demanded for labor at
the current nominal
wage.
An ED exists for labor at
the new real wage.
Workers increase their
nominal wage demands,
raising the costs of
supplying output and
the AS curve shifts to the
left. Wages and prices
adjust until the new
equilibrium is reached.
Cycle as Adjustment


The “short-run” AS curve is positively
sloped. Changes in AD can lead to
changes in overall output levels as
nominal wages adjust to new nominal
AD levels.
Still not does not capture the full
flavor of classical economics.
Say’s Law,
Say’s Principle,
and
Walras’s Law
Demand Failure v.
Coordination Failure



While the Alternative Model captures
the notion that output can change in
the short run due to monetary
changes, it fails to capture the
importance of Say’s Law in classical
reasoning.
For classicalists, demand failure could
not be the cause of recessions.
A general glut was impossible!
Demand Failure v.
Coordination Failure


Partial gluts - due to the wrong goods being
produced – could lead to secondary
ramifications that caused “general”
recessions.
The cause of recessions in classical
analysis was coordination failure, not
demand failure. Coordination failure means
that capital and labor are misallocated –
unemployment in recessions is primarily a
structural problem.
Profits and Employment


Coordination failures reveal
themselves in losses for some
products (those in ES) and higher than
normal profits for other products
(those in ED).
Firms react to these profit differentials
to correct the coordination failure.
Moving capital and retraining labor
takes time!
“Classical”
Macroeconomic
Policy
Fiscal and Monetary Policy


Since the problem is not aggregate
demand, government spending can’t
solve the problem.
Partial gluts may spread into
uncertainty and increased demands
for money; central banks need to
stand ready to provide credit to the
banking system at high rates of
interest. (Assists the Gold Standard!)
Structural Policy



Government must not intervene to
counteract adjustments to revealed
coordination failures.
Government must not attempt to
interfere with the price adjustments
that will occur.
Government can assist the
unemployed.