J.A.SACCO CH. 11- Classical and Keynesian Macroanalysis

J.A.SACCO

CH. 11- Classical and Keynesian Macroanalysis

Classical and Keynesian Macroanalysis

Section 4A was a “cliffhanger” for section 4B.In Section 4A we examined what happens

after an aggregate demand or supply shockWhat we didn’t analyze is the effect of those

shocks on the determination of equilibrium output, employment and the price level (inflation).

Classical AnalysisKeynesian AnalysisTwo different methods of explaining the macroeconomy and the flexible nature of prices. Helps to explain equilibrium levels of GDP and employment.

The Classical Model

1770’s- First attempt to explain the determinants of the price level and the national levels of output, income, employment, consumption, saving, and investment.

Adam Smith J.B.Say David Ricardo Thomas Malthus

The Classical Model

Beliefs:I. All wages and prices are flexible and that

competitive markets exist throughout the economy (supply/demand)

II. Economy is self-regulating– economy always capable of achieving the natural rate of real GDP output and full employment (LRAS)

III. The price level of products and input costs change by the same percentage, that is proportionally, in order to maintain full employment level of output

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The Classical Interpretation

Say’s Law Supply creates its own demand Producing goods and services generates the

means and the willingness to purchase other goods and services

Example- Economy produces 7 trillion GDP (final goods/services) simultaneously produces the income with which these goods/services can be demanded.Actual Aggregate Income = Actual Aggregate Expenditure

Total National Supply Equals its own Demand

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Say’s Law and the Circular Flow

7

The Classical Model

Assumptions of the Classical Model*In order to study the classical model must accept

the following assumptions1) Pure competition exists- no single buyer or

seller of a good or service can influence price

2) Wages and prices are flexible- All prices and wages are determined by supply/demand. Buyers/sellers cause prices to rise and fall to equilibrium levels

The Classical Model

3) People are motivated by self-interest- Businesses want to maximize profit. Households want to maximize standard of living.

4) People cannot be fooled by money illusion- Buyers and sellers recognize the change in relative prices, that is they understand inflation and lost purchasing power.

8% rise in wages/ 8% rise in price level (inflation) You are not better off!!!

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The Classical Model

Consequences of the Assumptions1) Minimize the role of government in the

economy2) If disequilibrium (unemployment/inflation)

occurs it will be temporary3) The power of market forces will keep the

economy at full-employment in the long-run

Roll of Government is minimal!

Houston, We May Have a Problem!

What is the problem with the assumption that all income will be spent to purchase all goods and services produced by an economy?

Saving

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The Problem of Saving

The Problem of Saving While it is true that the income obtained from

producing a certain level of real GDP must be sufficient to purchase that level of real GDP, there is no guarantee that all of this income will be spent. Some of this income might be saved

Saving is a type of leakage in the circular flow of income and output

Therefore aggregate demand will be less than aggregate supply.

This goes against the economy achieving the natural level of real GDP .

Full employment/No savings

Below full employment, because of savings

The Problem of Saving

Leakage

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The Classical Model

Question If saving increases won’t AD fall as

consumption is reduced?Classical Answer

No, because Saving (S) = Investment (I) Remember, investment (I) is a component of

GDP. So any income saved would be invested by

businesses so that the leakage of saving (less “C”) would be matched by the injection of business investment (more “I”).

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Equating Desired Saving and Investment in the Classical Model

Question How does the market adjust to changes in

investment? In other words, what happens when

demands of aggregate investment (a right shift) is greater then the supply of all savings in the economy?

CREDIT MARKET

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Investment2

Saving

Investment1


Investment and Saving per Year($ billions)

600 700 800 9000

2

4

6

8

10

12

14

Inte

rest

Rate

(p

erc

en

t)

At 10% interest rate, anincrease in investmentcreates a shortage (gap), Investment>Savings.The increase in interest rate returnsthe market toequilibrium

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Summary Changes in saving and investment create a

surplus or shortage in the short-run. In the long-run this is offset by changes in

the interest rate. This interest rate adjustment returns the

market to equilibrium where S = I.

*The credit market is entirely flexible based on supply and demand.

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Equilibrium in the Labor Market

Flexibility of the wage rate also keeps the labor market in equilibrium.

If supply of workers > Demand for workers

Then wage rate decreases to reach “full employment”

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D

S


Employment (millions or workers)105 115 125 135

0

2

4

6

8

10

12

14

Hou

rly

Wag

e R

ate

($)

Full-employmentequilibrium

145 155

16 UnemploymentSupply of labor

Demand of labor

19Changes in the demand for Labor Market

Question How does the market adjust to changes

( left shift) in the demand for labor?

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D2

D1

S


Employment (millions or workers)105 115 125 135

0

2

4

6

8

10

12

14

Hou

rly

Wag

e R

ate

($)

145 155

16Unemployment

Wages adjust to eliminate theunemployment


If unemployed (surplus labor) accept lower wage than all workers can be put back to work (equilibrium reached)

Classical economists believe that any unemployment that occurs in the labor market or any other resource market is “voluntary unemployment”.

Once again, just as with the credit market , the labor market is also flexible.

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Classical Price Level and Output Determination

Long term involuntary unemployment is impossible

Say’s Law- Flexible interest rates, prices, wages will keep all markets in equilibrium

The LRAS (vertical) is the only aggregate supply curve that exists in equilibrium

Any shift of AD will soon cause a change in the price level

Any AD shock will cause only “temporary” disequilibrium.

Real GDP per Year

Pri

ce L

eve

l

Q0

LRAS

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Classical Theory and Increases in Aggregate Demand

Real GDP per Year

Pri

ce L

eve

l

Q0

LRAS

AD1

Observations Initial equilibrium at

P=100 and Q0

100E1

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Classical Theory and Increases in Aggregate Demand

Real GDP per Year

Pri

ce L

eve

l

Q0

LRAS

AD1

AD2

Observations At PL 100, an

increase in AD creates disequilibrium

At PL 100- greater than full employment exists (shortage)

AD (Q1) > AS (Q0)

100A1

E1

Q1

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Classical Theory and anIncrease in Aggregate Demand

Real GDP per Year

Pri

ce L

eve

l

Q0

LRAS

AD1

AD2

Observations Classical theory believes

the economy adjusts back to equilibrium. WHY?

Wages/resources are bidded up. Price level increases to E2 returning the economy to equilibrium P = 110, Real GDP = Q0

Only the price level changes

Real GDP supply is determined

100

110

A1

Q1

E1

E2

Classical Theory and anIncrease in Aggregate Demand

Long-Run Macroeconomic Equilibrium

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Effect of a Decrease in Aggregate Demand in the Classical Model

Graph a decrease in aggregate demand.

Figure 19.5 Short-Run Versus Long-Run Effects of a Negative Demand ShockRay and Anderson: Krugman’s Macroeconomics for AP, First EditionCopyright © 2011 by Worth Publishers

Long-Run Macroeconomic Equilibrium

Classical Price Level and Output Determination

Conclusions In the long run, everything adjusts so fast that the

economy is essentially always on or quickly moving back to equilibrium.

Economy is at or soon to be at full employment/equilibrium.

In the classical model, equilibrium level of real GDP is supply determined by the LRAS.

Changes in AD only effect the price level. It does not effect the output of real goods and services.

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J.A.SACCO CH. 11- Classical and Keynesian Macroanalysis