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## THE CLASSICAL MODEL

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**THE CLASSICAL MODEL**Gardner Ackley Macroeconomic Theory 1961 How Classical is it?**A 1960s**kind of guy. A 1770s kind of guy. Adam Smith Gardner Ackley**CLASSICAL ECONOMNICS**Adam Smith (1723 – 1790) The Wealth of Nations, 1776 David Ricardo (1772 – 1823) On the Principles of Political Economy and Taxation, 1817 John Stuart Mill (1806 – 1873) Principles of Political Economy, 1848 TEXTBOOK CLASSICISM Gardner Ackley (1915 – 1998) Macroeconomic Theory, 1961 Chairman of the Council of Economic Advisors during the Johnson Administration (1964 – 1968)**CLASSICAL ECONOMICS**Refers to the writings of Adam Smith through J. S. Mill. Takes a long-run view. Focuses on capital accumulation and economic growth. Illuminates the nature of market forces. Treats pervasive unemployment as a temporary problem. Is concerned with the functional distribution of income. Separates monetary issues from relative-price issues. TEXTBOOK CLASSICISM Refers to all economists up to but not including Keynes. Takes a (mostly) short-run view. Treats capital as parametric and doesn’t deal with growth. Assumes that markets work “perfectly.” Assumes away all problems of pervasive unemployment. Allows for changes in the functional distribution of income. Separates monetary issues from relative-price issues.**CLASSICAL ECONOMICS**Refers to the writings of Adam Smith through J. S. Mill. Takes a long-run view. Focuses on capital accumulation and economic growth. Illuminates the nature of market forces. Treats pervasive unemployment as a temporary problem. Is concerned with the functional distribution of income. Separates monetary issues from relative-price issues. TEXTBOOK CLASSICISM Refers to all economists up to but not including Keynes. Takes a (mostly) short-run view. Treats capital as parametric and doesn’t deal with growth. Assumes that markets work “perfectly.” Assumes away all problems of pervasive unemployment. Allows for changes in the functional distribution of income. Separates monetary issues from relative-price issues. Gardner Ackley was “a believer in the Government's ability to manage the economy through fiscal and monetary fine-tuning---a belief disputed by classical economic theorists….” From the NYT obituary, August 20, 1998**OUTPUT**THE PRODUCTION FUNCTION The given capital input determines the shape and location of the production function. K = K0 The production function shows how much output can be produced by any specific level of labor input. Up to a point, an increase in labor input results in an increase in output. LABOR INPUT Production is the central focus of the classical model. Inputs in the forms of labor and capital are combined to produce output. The slope of the production function, i.e., the increase in output divided by the increase in the labor input, is (by definition) the marginal productivity of labor, the MPL. The labor input (in worker-hours) is measured along the horizontal axis; output (the economy’s real GDP) is measured along the vertical axis. At some level of labor input, the MPL is zero, and beyond that level, it goes negative.**THE LABOR MARKET**Worker-hours are bought and sold in a competitive market in which the workers and employers alike base their labor-market decisions on the real wage rate―the wage rate measured in terms of its purchasing power. The upward-sloping supply curve reflects the workers’ preferred tradeoff between labor and leisure. REAL WAGE RATE S The downward-sloping demand is a derived demand. It reflects labor’s declining marginal productivity, as gauged by the employers. D The equilibrium real wage rate established by market forces ensures a fully employed economy. LABOR INPUT**THE LABOR MARKET**At some real wage rate, the supply curve steepens, if only because the potential work force is limited by the population. And it is possible that a still higher real wage rate, the supply curve is backward-bending as high-income workers prefer more leisure time to spend their incomes to still more income to spend. REAL WAGE RATE S But in virtually all macroeconomic frameworks, the market-clearing real wage rate is assumed to occur in the upward-sloping segment of the labor supply curve. D LABOR INPUT**OUTPUT**OUTPUT REAL INCOME THE REAL ECONOMY With supply and demand determining the level of labor input, the production function indicates the corresponding level of output. Note that when the demand curve is extended to the horizontal axis (at which point the demand price of labor is zero), the marginal productivity of labor is also zero. LABOR INPUT REAL WAGE RATE The output of the economy, which includes both consumer goods and producer goods, is sold at competitive prices, generating the revenue to pay the incomes of both laborers and capitalists. Those incomes, then, are precisely enough to buy the economy’s output. S D LABOR INPUT**OUTPUT**REAL INCOME THE REAL ECONOMY Y/P = Q Q =f(K, N) K = K0 Q is the economy’s real output. Y is nominal income. P is the price level. Y/P is real income. N is the variable labor input. K is the given capital input. W is the nominal wage rate. W/P is the real wage rate. (Y/P)N is real labor income. Y/P − (Y/P)N is capitalist income. N LABOR INPUT REAL WAGE RATE W/P S D (Y/P)N N LABOR INPUT**A REAL WAGE RATE STUCK TOO HIGH**Y/P = Q Suppose that, for some reason or other, the real wage rate was stuck above the market-clearing level. K = K0 The labor input would be demand- constrained; total income to labor may rise, fall, or remain unchanged, depending on the demand elasticity. N The resulting unemployment is measured by the discrepancy between the labor supply and labor demand at the excessively high real wage rate. W/P unemployment S D The economy’s real output, which is the same as the real income paid to all the factors of production (labor and capital), declines. (Y/P)N (Y/P)N N**A CHANGE IN THE LABOR-LEISURE TRADEOFF**Y/P = Q Suppose that people’s preferred labor-leisure tradeoff changes in the direction of less leisure, causing the supply of labor to shift rightward. K = K0 The number of worker-hours supplied and demanded increases, and the real wage rate is bid down. N The real income paid to the work force rises, falls, or remains unchanged, depending upon the elasticity of the demand for labor. W/P S The economy’s real output, which is the same as the real income paid to all the factors of production (labor and capital), unambiguously rises. D (Y/P)N (Y/P)N N**A LABOR-NEUTRAL INCREASE IN CAPTIAL**Y/P = Q K = K1 Consider an increase in the capital input (K increases from K0 to K1) that does not change the MPL, as indicated by the unchanged slope of the production function. K = K0 Notice that the production function now has a positive vertical intercept, which implies some automation. This automation, however, works only to increase output and not to displace labor or to employ more of it. N N W/P S The unchanged MPL implies an unshifted demand for labor. D But with a greater capital input, the economy’s real output and hence real income rise. (Y/P)N N N**AN INCREASE IN LABOR-USING CAPTIAL**Y/P = Q K = K1 Consider an increase in capital of the labor-using variety. The MPL (the slope) is greater at each and every level of labor input. K = K0 At the margin, the complementarity between labor and capital has been strengthened, such that the level of labor input at which MPL = 0 has increased. N Accordingly, the demand for labor shifts rightward. W/P S And with both the real wage rate and the level of employment increasing, the income received by labor increases dramatically. D (Y/P)N The economy’s output and real income rise, but less dramatically. N**A RESTRUCTURING WITH LABOR-SAVING CAPTIAL**Y/P = Q Consider a restructuring of capital with more of the labor-saving variety. The MPL is lessened at each and every level of labor input. K = K0 K = K1 At the margin, the complementarity between labor and capital has been weakened, such that the level of labor input at which MPL = 0 has decreased. N Accordingly, the demand for labor shifts leftward. W/P S And with both the real wage rate and the level of employment decreasing, the income received by labor decreases dramatically. D (Y/P)N (Y/P)N But the economy’s output and hence real income rise. N**CLASSICAL MONETARY THEORY**Q Pre-dating even Adam Smith was an understanding of the relationship between the economy’s output and the general level of prices. PQ = MV MV The equation of exchange MV = PQ can illuminate this relationship. If the quantity of money (M) is given, and if the velocity of money (V) tends not to change, then the general level of prices (P) and the economy’s output (Q) are inversely related. P A rectangle inscribed between the axes and the equilateral hyperbola has an area of MV. With MV constant, all such rectangles have the same area. If the product of two variables (PQ) is equal to a constant (MV), the graphical rendition of the relationship is an equilateral hyperbola. Light up all the areas and it’s sort of pretty.**THE CLASSICAL MODEL**Y/P = Q Q K = K0 (MV)0 N P Making an explicit appearance in the classical model, either as a variable or a parameter are eight magnitudes, namely: K, M, N, P, Q, V, W, and Y. W/P S D The nominal wage rate (W) does not make a solo appearance on an axis. But an auxiliary diagram can easily be created to keep track of W. (Y/P)N N**THE CLASSICAL MODEL**For a given real wage, W and P move in direct proportion to each other. The real wage rate is conventionally symbolized by a script ω. Hence, we can write: ω = W/P. Solving for W, we can write: W = ωP, whereωis the slope of the ray that relates W to P. W If the real wage falls (because of a rightward shift in the labor supply or a leftward shift in labor demand), the ray (W = ωP) rotates clockwise, indicating, a lower real wage rate, a lesser slope. ω 1 ω’ 1 P**THE CLASSICAL MODEL**Y/P = Q Q K = K0 (MV)0 N P Making an explicit appearance in the classical model, either as a variable or a parameter are eight magnitudes, namely: K, M, N, P, Q, V, W, and Y. ω = W/P W S ω 1 D (Y/P)N P N**THE CLASSICAL MODEL**Y/P = Q Q K = K0 (MV)0 N P Making an explicit appearance in the classical model, either as a variable or a parameter are eight magnitudes, namely: K, M, N, P, Q, V, W, and Y. ω = W/P S D Conspicuous by its absence is the interest rate, a key variable in the analysis of both secular and cyclical movements in the economy’s output. (Y/P)N N**THE CLASSICAL MODEL**Y/P = Q Q K = K0 (MV)0 S N P RATE OF INTEREST The interest rate governs resource allocation within the output magnitude by dividing output (Q) into its temporally related components of investment (I) and consumption (C). ω = W/P S D D SAVIING (S) INVESTMENT (D) An increase in saving (decrease in consumption), lowers the interest rate, allowing the business community to finance more investment activities. (Y/P)N N**THE CLASSICAL MODEL**Y/P = Q Q K = K0 (MV)0 S N P RATE OF INTEREST The interest rate governs resource allocation within the output magnitude by dividing output (Q) into its temporally related components of investment (I) and consumption (C). ω = W/P S D D SAVIING (S) INVESTMENT (D) An increase in saving (decrease in consumption), lowers the interest rate, allowing the business community to finance more investment activities. (Y/P)N N**THE CLASSICAL MODEL**Y/P = Q Q K = K0 (MV)0 N P The interest rate governs resource allocation within the output magnitude by dividing output (Q) into its temporally related components of investment (I) and consumption (C). ω = W/P S D An increase in saving (decrease in consumption), lowers the interest rate, allowing the business community to finance more investment activities. (Y/P)N N**THE CLASSICAL MODEL**Y/P = Q Q K = K0 (MV)0 N P The underlying assumption (or vision) entails a unfailing market mechanism that allocates resources within the output aggregate, keeping investment in line with saving. ω = W/P S D This mechanism, which relies on equilibrating movements in interest rate, is acknowledged by--but is not integral to--the classical model. (Y/P)N N**THE CLASSICAL MODEL**Y/P = Q Q K = K0 (MV)0 N P With money and the price level now in play, observe the real and monetary consequences of an increase in the supply of labor. ω = W/P S D (Y/P)N N**THE CLASSICAL MODEL**Y/P = Q Q K = K0 (MV)0 N P With money and the price level now in play, observe the real and monetary consequences of an increase in the supply of labor. This time, we’ll keep track of the nominal wage rate, too. ω = W/P W S ω 1 ω’ D 1 (Y/P)N P N**THE CLASSICAL MODEL**Y/P = Q Q K = K1 K = K0 (MV)0 (MV)0 N N P Observe the real and monetary consequences of a labor-neutral increase in capital. ω = W/P S D (Y/P)N N N**THE CLASSICAL MODEL**Y/P = Q Q K = K1 K = K0 (MV)0 (MV)0 N P Observe the real and monetary consequences of an increase in capital of the labor-using variety. ω = W/P S D (Y/P)N (Y/P)N N**THE CLASSICAL MODEL**Y/P = Q Q K = K1 K = K0 (MV)0 (MV)0 N P ω’ Observe the real and monetary consequences of an increase in capital of the labor-using variety. And we’ll keep track of the nominal wage rage. ω = W/P W 1 S ω 1 D (Y/P)N (Y/P)N P N**THE CLASSICAL MODEL**Y/P = Q Q K = K0 K = K1 (MV)0 (MV)0 N P Observe the real and monetary consequences of a restructuring with capital of a labor-saving variety. ω = W/P S D (Y/P)N (Y/P)N N**THE CLASSICAL MODEL**Y/P = Q Q K = K0 MV0 MV1 N P Observe the real and monetary consequences, assuming a given money supply, of an increase in the velocity of money (V). ω = W/P S D (Y/P)N N**THE CLASSICAL MODEL**Y/P = Q Q K = K0 M0V M1V S N P RATE OF INTEREST Observe the real and monetary consequences, assuming a given velocity of money, of an increase in the money supply (M). Does it matter that the increase in money supply (M) also caused the rate of interest to be lower than it otherwise would have been? Can the allocation within the output magnitude proceed without being distorted by a monetary expansion? ω = W/P S D D SAVIING (S) INVESTMENT (D) (Y/P)N N**THE CLASSICAL MODEL**Y/P = Q Q K = K0 M1V S +ΔM N P RATE OF INTEREST Does it matter that the increase in money supply (M) also caused the rate of interest to be lower than it otherwise would have been? Can the allocation within the output magnitude proceed without being distorted by a monetary expansion? ω = W/P S D D SAVIING (S) INVESTMENT (D) (Y/P)N N**THE CLASSICAL MODEL**Y/P = Q Q K = K1 K = K0 M1V M0V N P Does it matter that the stabilization policy (the increase in M to match the increase in Q) also caused the rate of interest to be lower than it otherwise would have been? Can the allocation within the output magnitude proceed without being distorted by a policy-infected rate of interest? Now suppose the central bank is committed to a policy of price-level stabilization. How does this policy affect the real and/or monetary consequences of an increase in capital of the labor-using variety? ω = W/P S D (Y/P)N (Y/P)N N**THE CLASSICAL MODEL**Y/P = Q Q K = K0 M1V1 M0V0 N P Suppose that the central bank blunders mightily by allowing the money supply to collapse. Fortunately, prices and wage rates, being sufficiently flexible and not impeded by policymakers, adjust downward quickly and in direct proportion to the shrinkage of the money supply. ω = W/P S D (Y/P)N What are the consequences? N**THE CLASSICAL MODEL**Y/P = Q Q K = K0 M0V0 M1V1 N P Suppose that the central bank blunders mightily by allowing the money supply to collapse. Confidence is shaken and the velocity of money falls, too. Then, policy-makers step in and try to keep prices and wage rates from falling. Deflation sets in anyway, but with prices falling more than wage rates. ω = W/P unemployment S D (Y/P)N (Y/P)N What are the consequences? N**THE CLASSICAL MODEL**Gardner Ackley Macroeconomic Theory 1961 See Roger LeRoy Miller and David D. VanHoose Macroeconomics: Theories, Policies, and International Applications Chapters 3 - 5**CONSEQUENCES**of the LARAMIE CLEAN AIR ACT Y/P = Q Q This slide is the solution to the study problem: LARAMIE CLEAN AIR ACT which is available as a .pdf file on the course website. This slide is the solution to the study problem: LARAMIE CLEAN AIR ACT which is available as a .pdf file on the course website. K = K0 (MV)0 (MV)0 M1V K = K1 N P Any factory whose emissions result in air less pure than that found in Laramie, Wyoming will be subject to a ceremonial dismantling on Earth Day. Now suppose that the Federal Reserve attempts to soften the act’s effect on output by expanding the money supply. W/P S D What are the consequences? (Y/P)N (Y/P)N N**THE CLASSICAL MODEL**depicting A KEYNESIAN-STYLE COLLAPSE INTO DEPRESSION Y/P = Q Q The so-called “classical” framework together with the Keynesian treatment of prices, the wage rate, and interest rates can depict an economic collapse brought about by a waning of the “animal spirits.” K = K0 M0V0 M0V1 N P Observe the real and monetary and real consequences of a waning of the animal spirits in a fixed-price/fixed-wage setting. As money is hoarded rather than spent, the economy spirals downward. Labor demand falls, and capital in underutilized. ω = W/P S D (Y/P)N (Y/P)N N