© The McGraw-Hill Companies, 2002 0 The classical model of macroeconomics The CLASSICAL model of...

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The classical model of macroeconomics

• The CLASSICAL model of macroeconomics is the polar opposite of the extreme Keynesian model.

• It analyses the economy when wages and prices are fully flexible.

• In this model, the economy is always at its potential level.

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• Excess demand or supply are rapidly eliminated by wage or price changes so that potential output is quickly restored.

• Monetary and fiscal policy affect prices but have no impact on output.

• In the short-run before wages and prices have adjusted, the Keynesian position is relevant whilst the classical model is relevant to the long-run.

The classical model of macroeconomics (2)

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The Taylor Rule again

• Previously it was assumed that prices were fixed and so we talked in terms of a simple Taylor Rule where interest rates responded to the output part of the rule.

• Here, we allow prices to vary and think in terms of the Taylor Rule where interest rates respond to both output and inflation.– In this case, higher inflation leads to the bank

raising the interest rate, thus reducing aggregate demand and output.

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The macroeconomic demand schedule

Output

Inflation

MDS

• The macroeconomic demand schedule (MDS) shows the combinations of inflation and output for which aggregate demand equals output when the interest rate is set by a Taylor Rule.

• Higher inflation is associated with lower aggregate demand and lower output.

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• The slope of the schedule is determined by:– the reaction of interest rate decisions to inflation– and the responsiveness of aggregate demand to interest

rate changes

• Consequently:– It will be flat when

• interest rate decisions respond a lot to inflation• and aggregate demand is highly responsive to interest rate

changes.

– It will be steep when• interest rate decisions do not respond much to inflation• and aggregate demand responds little to interest rate

changes.

The macroeconomic demand schedule (2)

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Aggregate supply and potential output

• Potential output depends upon:– the level of technology– the quantities of labour demanded and

supplied in the long-run, when the labour market is fully adjusted

– When wages and prices are fully flexible, output is always at the potential level

• In the short-run we can treat potential output as given

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The classical aggregate supply schedule

• The classical model has an aggregate supply curve which is vertical at potential output

• This means that equilibrium output can be reached at different levels of inflation

• In the classical model, people do not suffer from money illusion

• Consequently, only changes in real variables influence other real variables

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The classical aggregate supply schedule (2)

Output

Inflation

Potential output is theeconomy’s long-runequilibrium output.

This schedule shows theoutput firms wish to supply ateach inflation rate.

AS

Y*

When wages and prices areflexible, output is always at itspotential level (Y*).

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The classical aggregate supply schedule (3)

• Better technology will shift AS to the right and hence increase potential output.

• Increased employment will also shift AS to the right and increase potential output

• as will the use of more capital.• In the short-run, we can treat potential

output as given.

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Equilibrium inflation

Output

Inflation

AS

Y*

Overall equilibrium isshown where MDS = ASat the potential outputlevel Y* and inflation level *.

MDS

* A

At A, the goods, money and labour markets are all in equilibrium.

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AS1

A beneficial supply shock raisespotential output by shifting AS0 to

AS1and lowers inflation to 2* at D.

D2*

Y1*

Equilibrium inflation: a supply shock

Output

Inflation

MDS0

0*

Y0*

A

AS0

If the central bank pursues itstarget of 0* when the economy

is at potential output, it mustrespond by reducing its targetreal interest rate.This will lead to an increasedamount of money being demanded:to achieve, money marketequilibrium at this interest rate,the bank must supply more money.

MDS1

C

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Equilibrium inflation: a demand shock

Output

Inflation

MDS0

0*

Y0*

A

AS0

Since potential output is the sameat B, the bank must tighten itsmonetary policy in order to hit itstarget of 0* .

Beginning at A, an increase inaggregate demand broughtby an increase in investmentsay, would shift MDS0 to MDS1

moving us to a new equilibriumB. At B, potential output is thesame but is higher at 1*

MDS1

B1*

Since the bank follows a Taylorrule, it will increase the target realinterest rate and thereby reversethe increase in MDS.

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The speed of adjustment

• Adjustment in the Classical world is rapid, so the economy is always at potential output (full employment).

• If wages and prices are sluggish, then output may deviate from the potential level.

• A Keynesian world of fixed wages and prices may describe the short run period before adjustment is complete.

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Supply-side economics

• The pursuit of policies aimed not at increasing aggregate demand, but at increasing aggregate supply.

• A way of influencing potential output, seen as critical in the classical view of the economy.

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Adjustment in the labour market

Short-run(3 months)

Medium run(1 year)

Long-run(4-6 years)

WAGES

HOURS

EMPLOYMENT

Largelygiven

Demand-determined

Largelygiven

Beginningto adjust

Hours/employment

mixadjusting

Clearingthe labour

market

Normal work week

Fullemployment

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Short-run aggregate supply

• If adjustment is not instantaneous, output may diverge from Yp in the short run.

• Firms may vary labour input – via hours of work (overtime or layoffs).

• Wages may be sluggish in falling to restore full employment in response to a fall in aggregate demand.

• The short-run aggregate supply schedule shows the prices charged by firms at each output level, given the wages they pay.

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The short-run aggregate supply schedule

Output

Inflation

Y*

SAS

0 SAS1

SAS2In time, the firm is able tonegotiate lower wages,and the SAS shifts to SAS1 and then to SAS2,

A

A2

2

until equilibrium is restored at A2.

Suppose the economy is initially at Y* in full-employment equilibrium at A, with inflation 0

B

In response to a fall in aggregate demand, firms in the short runvary labour input, thus moving along SAS to B.

Y

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The adjustment process

• When SAS and MDS are combined, changes in MDS lead mainly to a change in output in the short-run.

• Over time, deviations from full employment gradually change wage growth and short-run aggregate supply.

• The economy, therefore, gradually works its way back to potential output.

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MDS'

the inflation target is cutfrom * to 3*: the raising of

interest rates to achieve thisshifts MDS to MDS'.

Output

Inflation

Y*

SAS

*E

MDS

AS

A lower inflation targetStarting from long-runequilibrium at E:

E'1*Given wage levels, firms adjust to E' in the short run.With inflation at ' but wagesunchanged, the real wagerises bringing involuntary unemployment.

3

SAS3

E3

Equilibrium is eventually reached at E3, back at Y*.

SAS'

As the labour market (wage)adjusts SAS shifts e.g. toSAS’.

2*E2

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A temporary supply shocke.g. an increase in the price of oil

Y*

MDS

Output

SAS

E

SAS'

Higher oil prices force firms to charge more for their output, so SAS shifts to SAS’.

Y'

Higher prices cause a movealong MDS and output falls toY’.

'E'

Equilibrium moves from E to E’.

If the bank maintains theinflation target of *, in time,unemployment reduceswages and SAS gradually shifts back to SAS', so Y*is restored.

Inflation

*

*''E''

If the bank had accommodated the supply shock by relaxing its target, the economy could have moved straight back to Y*, at E’’.

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Tradeoffs in monetary objectives

• Inflation targeting works well when all shocks are demand shocks.

• When shocks are supply shocks, stabilising inflation may lead to highly variable output.

• Conversely, a policy of stabilising output may lead to highly variable inflation.

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Tradeoffs in monetary objectives (2)

• One way round this is to to steer a middle course by using a Taylor Rule, i.e. a rule that takes into account deviations of both inflation and output from their long-run levels.

• Another is to allow flexible inflation targeting– because the inflation target is a medium-run

one, this allows some discretion for reducing variability in output