Download The Classical Model and Macroeconomic Policy

The Classical Model and
Macroeconomic Policy
"the greatness of America has grown out of a political and social
system and a method of control of economic forces distinctly its own our American system - which has carried this great experiment in
human welfare further than ever before in all history. We are nearer
today to the ideal of the abolition of poverty and fear from the lives of
men and women than ever before in any land."
Overview
What do you do as president if you are faced with a stock market crash that produced headlines like
"STOCK PRICES SLUMP $14,000,000,000 IN NATION-WIDE STAMPEDE TO UNLOAD," banks
closing their doors all across the country, double digit declines in output and prices, an unemployment rate
approaching 25%, and protesters taking to the streets? This was America in the 1930s – a very difficult
time that required decisive action by President Hoover, but given the prevailing ideological preference for
the market's Invisible Hand over the government’s Visible Hand, aggressive government intervention was
not in the cards.i
In retrospect the solutions seem obvious; the government could help by printing money and / or by
increasing its spending – a solution at least hundreds of former students have suggested over the years
when confronted with the situation. If these solutions are obvious to even novices, why were theorists and
policy makers so averse to any active fiscal and monetary responses? The answer was that policy makers,
including President Hoover and Federal Reserve Chair Eugene Meyer, were guided in their thinking by the
prevailing views on how the macroeconomy operates. For President Hoover, it was the American system.
the greatness of America has grown out of a political and social system and a method of control of
economic forces distinctly its own - our American system - which has carried this great
experiment in human welfare further than ever before in all history. We are nearer today to the
ideal of the abolition of poverty and fear from the lives of men and women than ever before in any
land.
And his policies were grounded in this view. To both Hoover and Meyer there was a logic in their policies:
markets would take care of all problems, and in this unit we'll outline the basics of the Classical model that
dominated economic thinking and policy at the time and provided the theoretical justification for those
policies.
We begin with the national income identity version of equilibrium - AS = AD. If there is to be full
employment, then all of the output produced in the economy (AS) needs to be purchased (AD).
Y=C+I+G+X–M
With a little bit of algebra, this equation can be transformed into the following form.
(I - S) + (X - M) = (T - G)
Although both equations contain the same information, the second formulation provides the basis for our
discussion of the Classical model. The first term in parentheses (I-S) represents the balance in the financial
/ capital market. Investment Spending (I) represents business' demand for funds to build factories and buy
machines, while Savings (S) represents households' supply of funds to the market as they put money in
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savings accounts, stocks, or bonds. This supply and demand for funds provides the basic structure of one of
the key markets in the circular flow - the domestic capital market.
The second term in parentheses (X-M) represents the balance in the foreign currency market because all
international transactions - exports and imports - require the use of foreign currency. For the US, Exports
(X) represent the demand for $s to buy currently produced goods and services produced in the US, while
Imports (M) represents the supply of $s needed to be sold to buy currently produced foreign goods and
services.
The third term (T-G) is simply the government budget surplus - the difference between how much the
government collects in Tax revenue (T) and the level of Government spending (G). If the government is
spending more than it is bringing in, it is running a budget deficit and (T - G <0). A balanced budget,
meanwhile, happen if (T - G = 0).
So far so good, but now we need to look at the implications this has for policy makers confronted with a
deepening depression in the US in the 1930s. The fundamental question facing those policy makers is: does
the market system have an adequate self-correction mechanism that produces a level of output that fully
employs the nation's resources? Will there be adequate demand to buy all that has been produced? If AD
was less than AS, workers would be laid off as producers cut back on production (AS), and this would
increase unemployment and the economy would contract.
To answer this question we will look closely at the individual pieces of the second equation [(I - S) + (X M) = (T - G)]. Remember, when this equality exists then we know that AS =AD and there will be adequate
demand. We start with the domestic capital market to see if there is any reason to believe there is a natural
tendency in the market system to produce a domestic balance [I=S]. We then look to see if we should
expect an international balance [X=M]. If a balance is automatically created by the market system in both
markets, which is what the Classical economists believed, then the implication is very straightforward: the
government must balance its budget [T=G]. In this world, fiscal policy in the form of an increase in
government spending financed by borrowing would simply "crowd-out" business and household borrowers
and leave the economy unchanged. This helps explain the reaction on the part of Hoover to raise taxes and
cut spending when faced with mounting budget deficits at the onset of the Depression. Now let's try to fill
in the details by returning to the national income identity and looking more closely at the domestic capital
and international capital market balances.
Domestic Balance (I - S)
To see how market forces might produce domestic balance and equate savings and investment we need to
look at the factors that influence the level of savings by households and the level of investment spending by
firms. Classical economists focused attention on one factor - interest rates. Savings and interest rates are
assumed to be positively related; an increase in interest rates makes savings more attractive and it thus
increases the level of savings Investment spending is also assumed to be dependent on interest rates. As
interest rates rise, monthly payments on loans to buy new machinery and build new factories and offices
will rise and business will reduce spending on these investments, just as you might decide not to buy the
car or the home.
This is it, so all we need to do is put these ideas into a graph of the capital market with interest rates (price)
on the vertical axis and quantity of funds (savings and investment) on the horizontal axis. The positively
sloped Savings (S) curve captures the positive relationship between household savings and interest rates,
while the Investment (I) curve slopes downward to reflect the negative relationship between investment
spending and interest rates. Equilibrium in the market occurs where the two curves intersect. At the interest
rate (r*) Investment = Savings so the demand for credit (I) equals the supply of credit (S).
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Diagram 1
Capital Market in the Classical Model
But can we expect the economy to automatically move to this interest rate? Classical economists believed
the answer was yes, that domestic balance would be achieved because the interest rate would adjust to
create the balance. If there was an excess supply of funds because the savings of people exceeded the
investment demand of businesses for these funds, which happens when the interest rate was above r*, then
banks would have a "sale." Just as T-shirt shops cut their prices to unload unsold inventory, so would
banks. They would lower the price of funds (interest rates), which would reduce the surplus as the quantity
of savings declined and the quantity of investment demand increased. Similarly, if there was an excess
demand for funds, which would happen if the interest rate were below r*, banks would raise interest rates
to attract additional funds and eliminate the shortage. If the interest rate were free to move, we could expect
that it would settle at r* where we would have I = S.
For Classical economists, the belief in the ability of markets to “clear” meant that the market system has a
natural tendency to create domestic balance and equate I and S. In this world, we expect to see (I - S) = 0
without the need for any government intervention.
Now we'll look at of international balance.
International Balance (X - M)
Will the market system equate the international flow of goods and services and create balance in the foreign
exchange market? This will be a little more difficult to 'prove,' but we can outline the nature of the process
known as the specie-flow mechanism. The specie-flow mechanism has five features.
1. Link between currency and gold
Each country that accepts the “rules” of the gold standard sets a price for its currency in terms of gold. For
example, let's assume for the sake of simplicity that the price of an ounce of gold was set at 20 US $'s and
10 English £s. In this case it would take twice as many US $s as English £s to buy an ounce of gold so the
exchange rate between the two currencies would thus be set at $2 per £.
2. Link between international trade and gold
There is a link between a trade imbalance and the gold supply that can be seen in the table below. A shirt in
the US costs $20, costs 1 ounce of gold, while in England a 15 £ shirt costs 1.5 ounce of gold. At these
prices you are likely to see Americans and British consumers buying American shirts because it costs them
less gold to buy the shirt. This would create a trade surplus by lowering US imports (M) and raising US
exports (X).
UK
US
price of ounce of gold
10 £
$20
price of shirt in terms of currency
15 £
$20
price of shirt in term of gold
1.5 ounce
1 ounce
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For example, assume the US trade surplus with England is $60, which means 30£s are coming into the US
(remember the 2-1 exchange rate). People in the US will go to the Fed and exchange the 30£s they get from
selling US exports to England for US $s. The 30£s the Fed gets will be shipped back to England where the
Bank of England exchanges them for 3 ounces of gold. The 3 ounces of gold will then be returned to the
Fed. The link between the trade surplus and gold is now complete - a trade surplus creates an inflow of
gold, while a trade deficit creates an outflow of gold.ii
3. Link between gold and money supply
A nation's money supply is directly related to the central banks' holdings of gold. If the amount of gold
increases in a country as a result of an inflow of gold, then the central bank will issue more money, while
an outflow of gold will reduce a country's money supply. In the US, the central bank is the Federal Reserve
(Fed) and under the gold standard the Fed holds assets, including gold, that support its liabilities - those
Federal Reserve Notes (the $ bills in your pockets) we use as money. The value of the notes the Fed issues
is based upon the value of the assets it holds; if the Fed were to increase its holdings of gold, then it would
issue new Federal Reserve Notes, which means the money supply increases.
4. Link between money supply and prices (AS curve)
There is a link between the money supply and prices known as the Quantity Theory of Money. In the
Classical world, money was simply a medium of exchange because it had no intrinsic value. You could not
eat it or wear it, so if you had it, you spent it. This relationship can be represented with a simple equation.
MV = PY
The equation states the obvious - the value of nominal GDP (PY) equals the product of the money supply
(M) and velocity (V), which is defined as the number of times a piece of currency is spent in a year. For
example, if there were ten $1 bills in circulation (M), and each dollar is spent an average of twenty times in
a year, velocity (V) would be 20 and this money supply would support spending (PY) valued at $200.
Now, if you accept this equation, then with a little it of algebra you can get the following dynamic version
of the relationship. The equation states the growth rate in the value of nominal GDP equals equal the
growth rate in output (y) plus the growth rate in prices (p), and this equals the growth rate in money product
(m) plus the growth rate in velocity (v).
m+v =p+y
To see how it works, let's assume you have no reason to believe that there will be any change in velocity (v
= 0) and that we increase the money supply by 4%. In this case nominal GDP will grow by 4% (y+p=4),
but the key question is: how much of this 4% shows up in higher prices (p) and how much of it shows up in
higher output (y).
For the Classical economists, the answer was in their view of the labor market. The belief in flexible prices
and well functioning markets is reflected in the assumption the economy will always operate at full
employment. If there is unemployment then the labor market should operate like any other market in which
there is a surplus. Unemployment is a signal, just like rising inventories in a retail outlet, that the problem is
simply that the price is too high. Unemployment exists because wages are too high, and the labor market
would eliminate the surplus by driving down wages. In the face of unemployment, workers would bid
down wages until equilibrium was established. In this simple world, there is no long-term unemployment.
Returning to the initial question of how the increase in money would be allocated between higher prices
and output, the answer would be higher prices since the economy would always be at full employment and
thus any increase in buying power would show up at higher prices.iii In this world individuals would show
up with their extra money that had been printed, and businesses would have a choice; they could respond to
the higher demand by placing more orders for extra goods or they could raise the price to squeeze out some
potential buyers. Because of full employment, the businesses would not be able to get the additional
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product so they would be forced to simply raise the price. In this case the only impact of the increase in the
money supply would be higher prices – what you would her in the press as higher inflation.
If we were to look at the Classical model in terms of the AS-AD model, the implication of the Classical
assumptions is the vertical AS curve at full employment in Diagram 2. A change in the price level will not
change aggregate supply since it will not change the level of equilibrium employment in the labor market.
More importantly, the level of income/output in the economy is determined exclusively by the supply-side
of the economy, which is why Classical economists focused their attention on the supply-side and ignored
the demand-side of the economy. If they build it, someone will buy it — an economic version of the Field
of Dreams concept known in the profession as Say’s Law. This will not be the last time the supply-side of
the economy dominates thinking about the macroeconomy. We will see it again in the policies of Ronald
Reagan and George Bush II. First, though, let's look at the implications for fiscal and monetary policy.
Diagram 2
The Classical AS - AD Model
5. Link between prices and trade balance
There is a link between prices and trade flows. In the first three columns of the table below you see a repeat
of the earlier table – the three "Before price change" columns. Before the war price of shirts was lower in
the US, gold flowed into the US, which increased the money supply and US prices. There are also three
new "After price change" column. In the new columns the prices for gold are unchanged so there have been
no devaluations, but the prices of the shirt in terms of the domestic currencies have changed. In the “after
price change” scenario, the shirt that originally cost $20 in the US now costs $40, while the shirt in England
that used to cost 15 £s still costs 15 £s. At the existing exchange rates, the shirt costs 1.5 ounces of gold in
England and 2 ounces of gold in the US.
UK
US
price of ounce
of gold
10 £s
$20
Before price change
price of shirt in
price of shirt in
terms of currency term of gold
15 £s
1.5 ounce
$20
1 ounce
price of
ounce of gold
10 £s
$20
After price change
price of shirt in
price of shirt in
terms of currency
term of gold
15 £s
1.5 ounce
$40
2 ounce
Buyers will now reconsider their purchases. US consumers will now find foreign goods cheaper and switch
to foreign goods, raising US imports, while in England US goods will look more expensive and you can
expect a decline in English demand for US goods. The result is an increase in US imports and a decline in
US exports, which will eliminate the original trade surplus.
Now you have all of the pieces of the specie-flow mechanism. The self-correcting nature of the
international balance is summarized in Diagram 3 below.
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Diagram 3
Foreign Exchange Market with Gold Standard
There are natural market forces creating equilibrium (X - M = 0) in the foreign capital market; any trade
imbalance will be corrected by changes prices driven by international flows of gold. We now have a market
economy that will achieve domestic and foreign balance without government intervention.
So, lets pull the three pieces together. The market system will create a balance in the domestic capital
market through flexible interest rates that assure that (I-S =0), and this will be at full employment because
any unemployment would push down wages and eliminate the surplus. The gold standard, meanwhile, will
assure that there will be external balance (X-M=0), and the implication for the government of this is are
very clear in the equation we began with. Since (I-S) = (X-M) = 0, the government MUST balance its
budget (G - T = 0).
(I - S) + (X - M) = (T - G)
The Policy Implications
The implication of the vertical aggregate supply curve should be obvious. Policy makers could enact
macroeconomic policies to shift aggregate demand, but they would have no impact on output and
employment.
Fiscal policy
On the fiscal policy side, the Classical model implies that any efforts to expand public sector spending
through borrowing would prove futile. If the government decides to increase its spending (#G) by running a
deficit, this would increase demand for funds in the capital market. If you believe in well-functioning
markets, you know this increase in demand will raise the price of funds - an increase in interest rates (#r).
Faced with higher interest rates, businesses will reduce their investment spending ($I) – they buy fewer
machines and build fewer factories and offices because of the higher expenses - and households will reduce
their consumption spending ($C) – they buy fewer cars and appliances. The net change in aggregate
demand is thus zero. The increase in government spending would be just offset by decreases in private
consumption and investment spending. The implication for fiscal policy is simple and direct: balance the
budget. Any efforts to expand the economy with higher government spending and / or lower taxes will
"crowd-out" the private sector and will have no net effect on the economy's short run performance. Fiscal
policy is ineffective and cannot be considered a stabilization tool.iv
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Monetary policy
What if the government financed the increased spending by printing more money? Is monetary policy an
option for stabilization of the macro economy? The answer to these questions, or at least the answer at that
time, was no. Any increase in the money supply (#M) must end up as higher prices (#P), higher output
(#Y), or lower velocity ($V). If you accept the Classical assumptions that velocity is constant and there is
full employment in the labor market, then output does not change and there is a direct link between money
supply growth and inflation. In fact the inability of monetary policy to have an impact on the real economy
has a name - the "neutrality of money." The growth in the money supply will increase aggregate demand as
individuals attempt to buy goods and services with the additional money, but because the economy is
already at capacity, output will not increase and the additional demand will manifest itself in higher prices.
The implications of this analysis are very clear - government should stay out of the business of managing
the economy. Any attempts to stimulate the economy, either with fiscal or monetary policy, will prove to
be ineffective at best - the victim of crowding out. These ideas were not lost on officials at the Fed who,
when faced with the UK's abandonment of the gold standard and mounting unemployment lines, refused to
aggressively expand the money supply. They were joined by the President and Congress who refused to
aggressively cut taxes or increase spending to counter the decline in private spending.
The logic of the model was impeccable, but it provided no guidance for policy makers dealing with the
Great Depression. This opened the door for John Maynard Keynes and his 'new' theory of how the
economy operated that we will now examine.
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1920s Classical Model
i
To make matters worse, on September 21, 1931 the United Kingdom, the world's superpower, announced it would
abandon the gold standard. This presented US policy makers with the need to choose an appropriate response.
ii
This simple example shows how the Fed's presses print money, and it would be the same procedure if the gold were
being mined and $50 million in gold was presented to the Treasury to be minted into coins If you wanted some dollars
and had some gold, you would simply present the gold to the Treasury or Fed and you would receive US $s at the
exchange rate. The actual exchange rate at that time was $23.22 US dollars per ounces of gold.
iii
At full employment, when the money supply increased and people tried to use the 'new' money to buy more stuff,
there were no free resources that sellers could tap into to raise production. Producers would offer wage increases to
attract more workers, but they would have to raise their prices to cover the higher costs. Workers, meanwhile, would
see the higher prices and demand higher wages just to keep up. Where once workers worked for $5 an hour when the
price level was 1, we would now find that workers received $10 an hour when the price level was 2. Prices rise and
wages rise, but we would get no more employment and real wages would stay unchanged.
iv
The logic of crowding-out can be seen by returning to the equation (I - S) + (X - M) = (T - G). Because of the belief
in a natural tendency for equilibrium (I = S) and (X = M), the government is left with the job of balancing its budget (G
= T). Furthermore, if the government runs a deficit (G>T), then the balance will only be restored if there is an
imbalance in one of the other two terms if imports exceed exports (M > X) and / or savings exceeds investment (S > I)
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