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LECTURE NOTES ON MACROECONOMICS
ECO306
FALL 2011
GHASSAN DIBEH
Chapter 2 The Classical Model


With the advent of capitalism markets for labor, capital, land,
commodities and all domains and resources were established and
a very important question that wasn’t asked before arise: will the
economic system now left to the workings of the market, generate
full employment of resources?
In the 18th and 19th century Karl Marx invented the name
“classical economists” to include Ricardo, James Mill and other
economists of the 18th and 19th century that answered by “yes”
The three pillars of the Classical Model
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Say’s law  there is a logical impossibility of supply
exceeding demand in the economy
Output and employment are determined by the supply side of
the economy and in particular in the labor market
The quantity theory of money  Neutrality of money or
equivalence of a money economy with a moneyless one.
Says Law
Supply creates its own Demand
The law states that to supply more of the final commodity firms
will necessarily hire more of the factors of production whose
revenues from their services will be the same in value as the
commodities they produce.
Assuming there are only two economic agents: the firms and the
households. Consumers provide labor and capital to the firms.
Firms use the capital and labor to produce both consumption and
capital goods. Firms pay consumers for their capital and labor
services interest and wages respectively. Households use their
income to buy consumption (C) and capital goods (I).
Says Law

The relation can be described as follows
Firms
C, I
Y
r,W
K, L
HH
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Thus since the value of goods produced is equal to the value of
incomes generated then supply creates its own demand and
there can be no overproduction in the economy.
I. Says Law
Says Law can be written as:
However David Ricardo stated that production is either sold or
consumed and every sale is used to buy and consume some other
commodity. This can be translated into
Savings (S) = Investment (I)
For the Classicals the economy cannot experience generalized
gluts, overproduction crises or cyclical recessions as result of
deficiency of demand.
Output and employment determination
Since according to the Says Law aggregate demand is
irrelevant to output determination thus the supply is the
determinant of production
The Classical Production Function

It can be presented as
K=capital stock, L=labor hours, and A= technology

Later in the 20th century the Cobb-Douglas function was
introduced
With 0<α<1
Labor demand in the economy


Assuming we are working in a short run situation (K=constant)
and that all firms maximize their profits we obtain the
aggregate profit maximizing condition:
or:
The profit maximizing condition is thus:
or:
II. Employment determination

1.
2.
The workings of the labor market are
Labor demand MPL
Labor supply: it is given by workers’ maximization of a utility
function that balances the real wage vs. the disutility of
labor.
. The labor supply function is then a
function of the real wage or
3.
The money wage w that is flexible
Employment determination

The labor market can be represented graphically

The full employment is L* at a wage of
Employment determination

The production would thus be

Or graphically
The Great Depression
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
An industrial production drop of 50% and unemployment
reaching 25%. How can that happen?
The Great Depression was associated with a deflation
The decline in the general price level led to an increase in real
wages. Nominal wage rigidity can lead to such results
The Great Depression


A drop in the general price level will shift the marginal
revenue product of labor to the left
If wages are flexible, the nominal wage will drop until the
equilibrium employment reaches full employment again L* at
the same real wage but at a lower nominal one.
The Saving-Investment in the Classical Model
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


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Financial markets are made of the market for loanable funds
The supply is the savings of households in the economy
The demand is the investment in the economy
The determinant of savings and investments is the interest rate
dS
>0
So S  S (r )
with
dr
dI
And I  I (r )
with
>0
dr
The Saving-Investment in the classical model


if there is a negative investment shock in the economy, the
investors turned pessimistic. The initial drop in investment leads
to lower savings and a compensating increase in in consumption.
Output will remain at full employment but its composition
between the production of consumption goods and the
production of capital goods
Fiscal policy in the Classical model


Government intervention in the economy is not necessary to
cure recessions because the capitalist economy has internal
mechanisms that ensure the return to full employment.
The government budget can be defined as
where T = taxes and G=government expenditures
This budget is either a surplus (B>0), a balance (B=0) or a
deficit (B<0). Thus we now have two saving agents: the
households and the government. The savings function becomes:
S total  S p  S pub  S p  (T  G )
where S p  private savings; Spub  public savings
Fiscal policy in the Classical model
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
Given that total savings in the economy must still equal to
investment at equilibrium then we have
The only mechanism that determines the market for loanable
funds is still the interest rate
Fiscal policy in the Classical model

The flow diagram becomes:
Firms
G
G
Y
r, w
C, I
K, L
G
T
HH
Fiscal policy in the Classical Model
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
We can derive the equilibrium condition from the expenditure
side
Rearranging it and using S total  I we obtain:
 Stotal  (Y  C  T )  (T  G)

The equilibrium condition in the presence of the government
becomes:
Y  C  T  (T  G )  I (r )
Government expenditures increase



If the government increases expenditures from G to G’ total
savings will decrease shifting the curve to the left.
The result is that interest rates increase, reducing investment in
the economy and increasing private savings
Hence, the increase in government expenditures has no effect
on output
III. The Quantity Theory of Money

It is represented by the following equation:
where M= stock of money
V= income velocity of money
P= the price level
Y= real output

The velocity of money measures the number of times a unit of
money (say $1) exchanges hands in a given period.
The Quantity Theory of Money
This equation in essence is a tautology i.e. it is true by
definition, however, the classicals transformed it into a theory
(QTM) when they made two assumptions:
1) Y is determined by real factors from equilibrium in the labor
market 
2) Velocity of money is constant.
 The Cambridge equation for money demand is:

Where 0<k<1 and constant
The Quantity Theory of Money


In the classical system the only reason for holding money is for
transactions. Imposing the equilibrium condition that money
supply and money demand should be equal then
Comparing this to the Quantity theory of money equation

constant
The Quantity Theory of Money

We have:
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But the assumptions of the model imply that

And thus

This implies that the price level is determined solely by the
money available in the economy
The classical aggregate demand

We can define a relationship between the price level and output

Which can be graphically represented as
The classical aggregate demand

If we add to the graph above the classical aggregate supply
determined by
) which is vertical at full
employment output
then
The classical Dichotomy

In the classical model, money has no effect on real factors
(Y,S,I…) but it determines the price level