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MACRO
Economics
Unit 8: Classical Theory
The moment that government appears at market, the principles
of the market will be subverted.
- Edmund Burke
Created:
2007-2013 by Jim Luke.
This work is licensed under
the Creative Commons
Attribution-NonCommercial
License
MACRO
Economics
Evolution of Macro Economic Theories
Classical Theory
 Is a market-system stable?
 What role does a government play in a market system?
 How to react to “supply shocks” (war, industrial revolution,
population growth)
 Explain periodic inflation/deflation
Keynesian Theory
 Explain Great Depression
 Role of government in industrialized economy
 Can government “manage’ industrial economy?
Modern Issues




Explain role of fiat money & banking
Persistent inflation & govt deficits
Effects of expectations
Global/open economies
Slide 2
MACRO
Economics
Classical theory evolved in 1800’s to
explain business cycle and
justify free-market policies.
MACRO
Economics
Why Classical Theory?
Context
 Agricultural Productivity Improved
 Industrial Revolution
 Evolution of war
 Rapid but erratic growth
 Periodic inflations/deflations
 Frequent financial
panics/depressions
Slide 4
MACRO
Economics
The Classical Theory
Using AD-AS Model
MACRO
Economics
Major Concerns of Classical Economists

‘Persistent glut' possible?
 Rapid Growth
 Industrial Revolution
 Agricultural Productivity Improved



Will technology make unemployment inevitable?
Why inflation?
Can government:
 improve welfare?
 “manage” economy?
Slide 6
MACRO
Classical Theory Assumptions
Economics

All markets are competitive
 Goods, resource, financial markets
 Equilibrium prices in all markets:

no shortages or surpluses

Government balanced budget: G=T
Households spend all income
 unless high interest rates “bribe” them to save.
Firms borrow to finance I.
Financial markets make sure S = I.
No R.O.W.

Say's Law --> improved supply drives economy




MACRO
Circular Flow - Classical Economy.
Economics
Balanced Budget:
G =T. What ever is
taken away from
consumers as taxes
gets spent anyway
as G.
There is no govt
borrowing.
Ignore ROW.
It’s a closed
economy model.
Competitive financial markets
cause S = Firm Borrowing..
Firms borrow to finance I. So,
S=I. In effect, whatever
households save gets spent
eventually as I anyway..
MACRO
Classical Model Assumptions:
Implications
Economics
Real GDP (real output) depends on
Firms’ production plans
 SRAS and LRAS drive everything
 AD doesn’t change much
Say’s Law : Supply Creates Demand
(people will spend all of their income)
MACRO
Recessionary Gap:
High unemployment
Economics
LRAS
P
Price Level
(price index)
SR-AS
Gap represents
amount of
unemployment
Price
Index
start
@start
AD
Created:
Jan 2008
by Jim Luke.
This work is licensed under
the Creative Commons
Attribution-NonCommercial
License
Real
GDP
Real
GDP
@start
if we had
full
employme
nt
MACRO
Economics
Recessionary Gap:
Classical Adjustment
As wages and resource prices
drop, the profitability of
production improves.
SRAS shifts right.
As firms hire more workers, firms
produce more. Newly hired
households spend more.
Result:
one-time drop in price level (deflation)
increase in Real GDP
return to full employment.
LRAS
P
Price Level
(price
index)
SR-ASinitial
SR-ASafter
start
after
Price
Index
AD
after
Real
GDP
Real
GDP
@start
full
employmen
t
MACRO
Expansionary Gap:
- Shortages of workers/resources
- Dropping inventories
Economics
P
Price Level
LRAS
SR-AS
Inflationary
pressure
start
AD
Created:
Jan 2008
by Jim Luke.
This work is licensed under
the Creative Commons
Attribution-NonCommercial
License
Real
GDP
@start
MACRO
Expansionary Gap:
Classical Adjustment
Economics
Firms bid up resource
prices
Firms raise product
prices to replace
inventory
Result:
one-time increase in
price level (inflation)
decrease in Real GDP
return to full
employment.
Shortages end.
Created:
Jan 2008
by Jim Luke.
This work is licensed under
the Creative Commons
Attribution-NonCommercial
License
SR-ASafter
P
Price Level
LRAS
SR-ASintial
after
start
AD
Full
Em
p.
GD
P
Real
GDP
@start
MACRO
In Classical theory
Contractionary Gaps are caused by
Supply Shocks.
Economics
LRAS
P
Price Level
LRAS supply shock
SR-AS
Price Index
SRAS supply shock
start
@start
AD
Created:
Jan 2008
by Jim Luke.
This work is licensed under
the Creative Commons
Attribution-NonCommercial
License
Full Emp.
Real GDP
MACRO
Economics
Classical Policy Rx
Market Economy will
 Return to Full-Employment Equilibrium
 BY ITSELF!
 No government intervention needed
Laissez-Faire Policies
 Small government
 Promote markets & capitalism
 Balanced budget

Taxes = G
(C+I reduced by G)
Slide 15
MACRO
Economics
Classical Model Predictions
‘Supply Shocks' Determine Real GDP & Business Cycle
 Recessionary gaps

temporary then deflation
 'Inflationary' gaps

temporary then inflation
Gold standard or “hard money” stabilizes prices
Market economies are stable & tend to equilibrium
Persistent 'glut' impossible
Long-run Growth from technology & capital accumulation
Slide 16
MACRO
Economics
Classical History
Reasonable approximation of much:
 19th & early 20th century experience
 Better explanation than alternative at the time
High-growth & rising living standards
Slide 17