Classical Macroeconomics

1. Classical Macroeconomics Intermediate Macroeconomics ECON-305 Spring 2013 Professor Dalton Boise State University

2. 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

3. A “Classical” Model

4. Underlying Assumptions • 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.

5. Three Components 1. “Classical” theory of Employment and Output 2. Say’s Law of Markets 3. Quantity Theory of Money “The Classical Dichotomy”

6. A Classical Model of Output and Employment

7. Output and Employment • Short-run Production Function • Y = A F(K,L) • 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

8. Y Positive relationship between L and Y (as labor input increases from L0 to L1, movement from a to b on the production function, output grows from Y0 to Y1). Y1 Y= A F(K,L) b Y0 a L0 L1 L W/P, MPL L

9. Y Diminishing returns occurs; MPL falls as labor input expands (MPLa > MPLb). Y1 Y= A F(K,L) b Y0 a L0 L1 L W/P, MPL MPLa a MPLb b MPL L L0 L1

10. Y Increases in A or K increase Y for a given L (movement from a to c). 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 L L0

11. Y Positive relationship between L and Y (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). Increases in A or K increase Y for a given L (movement from a to c). Y*= A* F(K,L) c Y1 Y= A F(K,L) b Y0 a L0 L1 L W/P, MPL c MPLc (W/P)a=MPLa a (W/P)b=MPLb b MPL* MPL L L0 L1

12. 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.

13. Y When the real wage is (W/P)a… 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)b = MPLb … and output expands to Y1. Y1 Y= A F(K,L) b Y0 a L W/P, MPL (W/P)a=MPLa (W/P)a a b (W/P)b=MPLb (W/P)b DL L L0 L1

14. 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

15. 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… At current employment L0, the MPL exceeds the current wage (W/P)a… and the firm reacts by hiring more labor until (W/P)a = MPLa … and output expands to Y2. Y Y*= A* F(K,L) d Y2 c Y= A F(K,L) Y0 a L W/P, MPL c MPLc d (W/P)a=MPLa (W/P)a a DL* DL L L0 L2

16. 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

17. 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

18. Y 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. Y= A F(K,L) L W/P, MPL SL LT DL L

19. If the real wage is at (W/P)a… then the QDL < QSL… Firms employ where (W/P)a = MPLa… employment is at L0 and output is Y0. An excess supply of labor exists. Unemployment equals LT1 – L0. (LT1 – LS) is voluntarily unemployed… (LS – L0) is involuntarily unemployed. Y Y= A F(K,L) Y0 a L W/P, MPL SL LT U (W/P)a=MPLa (W/P)a a DL L L0 LS LT1

20. Y With an excess supply of labor, nominal wages are bid down. As the nominal wage falls, the excess supply of labor shrinks until QDL = QSL. Firms employ where (W/P)e = MPLe… employment is at Le and output is Ye. Unemployment equals LTe – Le. All unemployment is voluntary. Full employment exists. Ye Y= A F(K,L) e Y0 L W/P, MPL SL LT U (W/P)a=MPLa (W/P)a (W/P)e=MPLe DL U L L0 Le LTe

21. 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.

22. Will aggregate demand be sufficient to purchase full employment output?

23. Say’s Law

24. 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?

25. 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)

26. 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…”

27. 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)

28. 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?

29. Say’s Principle

30. 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

31. 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

32. 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)

33. Say’s Principle p1x1,1 + p2x2,1 + … + pm-1xm-1,1 + xm,1≡ 0 p1x1,2 + p2x2,2 + … + 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 p1X1 + p2X2 + … + pm-1Xm-1 + Xm ≡ 0 where Xi =∑xi,j for all i, j

34. Aggregate Say’s Principle Aggregate Version SP: “The net value of the sum of all aggregate EDs is identically zero.” • 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

35. Interpretations True False True True False • “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.”

36. 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

37. 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!

38. 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.

39. Classical Theory of Saving, Investment and Interest Rates

40. 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

41. 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

42. r SLF = S DLF = I S, I If r is flexible, the classical model assures that E = Y at full employment. Why?

43. SLF = S Let Ye be full employment output; then E0 is AD that equals Ye. E0 = C0 + I0 At r0, I0 = S0 → C0 = E0 – I0 Suppose increase in desired saving. r falls, I and S rise, and C falls by (E0 – I1) ∆C = ∆I → Ye = E0 = C0 + I0 = E1 = C1 + I1 r SLF1= S1 r0 r1 DLF = I I0 I1 E0 = E1 S, I, E C1 C0 Ye E = Y Y

44. 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?

45. Quantity Theory of Money

46. Quantity Theory of Money Two versions Cambridge cash-balances approach Marshall, Pigou Fisher’s equation of exchange

47. Cambridge QTM Md – transactions demand for money - demand to hold - positive relationship with level of money expenditures

48. 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

49. 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

50. Fisher’s Equation of Exchange MV ≡ PY Quantity of money expenditures on final goods is identicalto 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