Download Classical Economics Part I: The Classical Economic System Why

Part I: The Classical
Economic System
• The centerpiece of classical economics
is Say’s law
Classical Economics
– Say’s law states, “Supply creates its own
demand”
– This means that somehow, what we
produce – supply – all gets sold
Chapter 11
Copyright ©2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Why Does Anybody Work?
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Consumer Goods and Investment Goods
• People work because they want money to
buy things
• Think of production as consisting of
two products: consumer goods and
invest-ment goods (for now, we’re
ignoring government goods)
• The money spent on consumer goods
is designated by the letter C
• The money spent on investment goods
is designated by the letter I
– People who produce things are paid. They
spend this money on what other people
produce
– As long as everyone spends everything that he
or she earns, the economy is OK
• But, the economy begins to have problems when
people save part of their incomes
– People do save, and saving is crucial to
economic growth
• Without saving, we could not have investment – the
production of plant, equipment, and inventory
Copyright ©2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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Consumer Goods and
Investment Goods
Consumer Goods and
Investment Goods
If we think of GDP as total spending, then
If we think of GDP as total spending, then
GDP would be C + I
GDP would be C + I
If we think of GDP as income received, then
If we think of GDP as income received, then
GDP would be C + S
GDP would be C + S
GDP = C + I
GDP = C + S
Copyright ©2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-7
Consumer Goods and
Investment Goods
Copyright ©2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-8
Consumer Goods and
Investment Goods
GDP = C + I
GDP = C + I
GDP = C + S
GDP = C + S
And since things equal to the same thing are equal to
each other, we have
C+I=C+S
Things equal to the same thing are equal to each other
C+I=C+S
Next, we can subtract the same thing from both sides
of the equation. In this case we subtract C
I=S
Copyright ©2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-9
Copyright ©2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-10
2
Say’s Law Revisited
Say’s Law Revisited
S=0.5 They save the rest
Households
Households
Households
Households
The economy produces a supply of
consumer goods and investment
goods (Aggregate Supply = AS)
7.0 AS
Firms
AS=7.0
C=6.5
Firms
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11-11
The people who produce
these goods (Households)
spend part of their incomes
on consumer goods
I=0.5
Copyright ©2002 by The McGraw-Hill Companies, Inc.
Their savings are
borrowed by investors
who spend this money on
investment goods
11-12
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Supply and Demand
Revisited
Say’s Law Revisited
S=0.5
Households
Households
AS=7.0
The curves cross at a
price of $7.30 and a
quantity of 6
GDP = C + I
GDP = 6.5 + 0.5
GDP = 7.0
C=6.5
10
S
9
8
7
I=S
Firms
D
6
I=0.5
2
4
GDP = 7.0 = Aggregate Demand (AD)
6
8
Quantity
10
12
14
We can see that Say’s law holds up, at least in accordance with classical analysis.
Supply does create its own demand. Everything produced is sold. (AS = GDP=AD)
Copyright ©2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-13
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11-14
3
Supply and Demand Revisited
The Loanable Funds Market
The demand and
supply curves cross at
an interest rate of 15
percent
Supply and Demand
Revisited
If the quantity supplied is
greater than the quantity
demanded at a certain price
(in this case $8), the price
will fall to the equilibrium
level ($6), at which quantity
demanded is equal to
quantity supplied.
Supply of
savings
20
15
10
Market for Hypothetical Product
14
S
12
10
8
6
4
5
Demand for
investment
funds
D
2
0
Quantity of loanable funds
0
Quantity
11-15
Copyright ©2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Supply and Demand Revisited
Hypothetical Labor Market
If the wage rate is set too high
($9 an hour),the quantity of
labor supplied exceeds the
quantity of labor demanded.
The wage rate falls to the
equilibrium level of $7; at
that wage rate, the quantity of
labor demanded equals the
quantity supplied
20
Supply of
labor
18
16
14
12
10
8
6
4
Demand
for labor
2
0
Quantity of labor
Copyright ©2002 by The McGraw-Hill Companies, Inc. All rights reserved.
11-17
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11-16
The Classical Equilibrium: Aggregate
Demand Equals Aggregate Supply
• On the micro level, when quantity demanded
equals quantity supplied, we’re at equilibrium
• On the macro level, when aggregate demand
equals aggregate supply, we’re at equilibrium
• The classical economist believed our
economy was either at, or tending toward , full
employment
• So at classical equilibrium – the GDP at which
aggregate demand was equal to aggregate
supply – we were at full employment
Copyright ©2002 by The McGraw-Hill Companies, Inc. All rights reserved.
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