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Classical Macroeconomics Intermediate Macroeconomics ECON-305 Spring 2013 Professor Dalton Boise State University Who are the Classicalists? History of Economic Thought Smith to Marginal Revolution Growth theory to Allocation theory Keynes All those (contemporaneous and prior to Keynes) who viewed the market system as a self-coordinating mechanism. A Classical Model? Monetary theory; Business cycle theory A “Classical” Model Underlying Assumptions 1. 2. Agents are maximizers (firms-profits, households-utility) Markets are perfectly competitive Perfect knowledge Trading occurs at market-clearing prices Agents have stable expectations Markets always clear. Three Components 1. “Classical” theory of Employment and Output 2. Say’s Law of Markets 3. Quantity Theory of Money “The Classical Dichotomy” A Classical Model of Output and Employment Output and Employment Short-run Production Function Y = A F(K,L) 1. 2. 3. A – index of total factor productivity (technology and other growth influences) Positive relationship between L and Y, given A and K Diminishing returns Increases in A or K increase Y for a given L Y Positive relationship between L and Y Y1 Y0 a L0 b L1 Y= A F(K,L) L W/P, MPL L (as labor input increases from L0 to L1, movement from a to b on the production function, output grows from Y0 to Y1). Y Y1 Y0 a L0 Y= A F(K,L) b L1 L W/P, MPL MPLa MPLb Diminishing returns occurs; MPL falls as labor input expands (MPLa > MPLb). a b MPL L0 L1 L Y Y*= A* F(K,L) c Y1 Y= A F(K,L) Y0 a L0 L W/P, MPL c MPLc MPLa a MPL* MPL L0 L Increases in A or K increase Y for a given L (movement from a to c). Y Y*= A* F(K,L) c Y1 Y0 a L0 Y= A F(K,L) b L1 L W/P, MPL (W/P)a=MPLa (W/P)b=MPLb a b MPL* MPL L0 (as labor input increases from L0 to L1, movement from a to b on the production function, output grows from Y0 to Y1). Diminishing returns occurs; MPL falls as labor input expands (MPLa > MPLb). c MPLc Positive relationship between L and Y L1 L Increases in A or K increase Y for a given L (movement from a to c). Demand for Labor Profit-maximization occurs where MRi = MCi In a perfectly competitive market: Pi = MRi Therefore: Pi = MCi Pi∆Qi = Wi∆Li Which is equivalent to: ∆Qi/∆Li = Wi/Pi A profit-maximizing firm hires labor until the marginal product of labor equals the real wage rate. Y When the real wage is (W/P)a… Y1 Y0 a Y= A F(K,L) b L W/P, MPL then L0 labor is hired. As a result Y0 output is produced. If the real wage falls to (W/P)b, then at L0, the MPL exceeds the real wage… the firm reacts by hiring more L until (W/P)a=MPLa (W/P)b=MPLb (W/P)b = MPLb … (W/P)a a b and output expands to Y1. (W/P)b DL L0 L1 L Changes in the Real Wage What causes a fall in the real wage and an increase in employment? An increase in the price of output A fall in the nominal wage rate What causes a rise in the real wage and a reduction in employment? A decrease in the price of output An increase in the nominal wage rate Y Y*= A* F(K,L) d Y2 c Y0 Y= A F(K,L) a L At current employment L0, the MPL exceeds the current wage (W/P)a… W/P, MPL c MPLc (W/P)a=MPLa d and the firm reacts by hiring more labor until (W/P)a = MPLa … (W/P)a a DL* DL L0 An increase the quantity of capital or an increase in total factor productivity will shift the production function and increase the marginal product of labor… L2 L and output expands to Y2. Aggregate Labor Demand In each market MPLi = DLi = DLi(Wi/Pi) Aggregating across markets DL = DL(W/P) In the short run, the demand for labor is an inverse function of the real wage Lower nominal wage increases QDL and increases Y Higher price level reduces the real wage, increasing the QDL and increasing Y Supply of Labor Aggregate supply of labor SL = SL(W/P) Labor force participation LT = LT(W/P) Higher real wages increase labor force participation and the labor supply, given preferences and population of workers Substitution effect dominates income effect Y Y= A F(K,L) L W/P, MPL SL LT DL L Given worker preferences, there is a real supply curve of labor and a labor force participation curve. Given technology and the quantity of capital there is a real demand curve for labor. If the real wage is at (W/P)a… Y then the QDL < QSL… Y= A F(K,L) Y0 a Firms employ where (W/P)a = MPLa… employment is at L0 L and output is Y0. An excess supply of labor exists. W/P, MPL U SL (W/P)a=MPLa Unemployment equals LT1 – L0. LT (LT1 – LS) is voluntarily unemployed… (W/P)a a DL L0 LS LT1 L (LS – L0) is involuntarily unemployed. Y With an excess supply of labor, nominal wages are bid down. Ye Y0 Y= A F(K,L) e L W/P, MPL (W/P)a=MPL (W/P)e=MPL e Firms employ where (W/P)e = MPLe… employment is at Le U a As the nominal wage falls, the excess supply of labor shrinks until QDL = QSL. SL and output is Ye. LT Unemployment equals LTe – Le. (W/P)a U L0 Le LTe DL L All unemployment is voluntary. Full employment exists. Output and Employment Output and employment are determined by technology, total factor productivity, the quantity of capital, labor preferences and population. The real wage adjusts through nominal wage adjustments to bring about labor market equilibrium. Changes in L and Y are due to shifts in DL and SL. Will aggregate demand be sufficient to purchase full employment output? Say’s Law Say’s Law Conventional version: “Classical economists believed in Say’s Law and therefore could not explain prolonged massive unemployment. Keynes rejected Say’s Law and was able to lay the foundations for modern macroeconomics.” What is Say’s Law? Jean-Baptiste Say “It is worthwhile to remark, that a product is no sooner created, than it, from that instant, affords a market for other products to the full extent of its own value… When the producer has put the finishing hand to his product, he is most anxious to sell… Nor is he less anxious to dispose of the money he may get for it… the mere circumstance of the creation of one product immediately opens a vent for other products.” - Book I, Chapter XV, Treatise on Political Economy, (1821) Snowdon and Vane “Supply creates its own demand” captures the essence of Say’s Law… “…there could be no impediment to full employment caused by a deficiency of aggregate demand.” “Say’s Law was originally set forth in the context of a barter economy…” “…aggregate demand and aggregate supply are always guaranteed equality…” Two Versions of “Say’s Law”1 Weak version – each act of production and supply creates an equivalent demand for output in general; true at all output levels – no guarantee of full employment. Strong version – in a competitive market economy there are automatic tendencies for full employment to be established. 1Trevithick (1992) From Say’s Law to the Loanable Funds Market The quote that Snowdon and Vane use to exemplify Say’s Law seems to line up best with the “weak version”. Immediately turn to the classical theory of Saving, Investment and Interest to justify the “strong version”. Isn’t it reasonable to conclude that Say’s Law is not sufficient for full employment? Say’s Principle Say’s Principle Clower and Leijonhufvud Not the mnemonic “supply creates its own demand.” Rather, “the net value of an individual’s planned trades is identically zero.” Distinguishes transactors (economic behavior) from thieves and philanthropists Steven Keen Say’s Principle SP defines set of theoretically admissible budgets pxdx + pydy – sm,0 ≡ 0 Extensions (1) hold money for future use pxdx + pydy + (dm–sm,0) ≡ 0 (2) supplier of non-money commodities px(dx–sx,0) + py(dy–sy,0) + (dm – sm,0) ≡ 0 Say’s Principle (3) large number of commodities (m) p1(d1–s1,0) + p2(d2–s2,0) + … + pm-1(dm-1–sm-1,0) + (dm – sm,0) ≡ 0 (4) simplify, defining EDi ≡ xi ≡ di–si p1x1 + p2x2 + … + pm-1xm-1 + xm ≡ 0 (5) large number of transactors (k) Say’s Principle p1x1,1 + p2x2,1 + p1x1,2 + p2x2,2 + … + pm-1xm-1,1 + xm,1 ≡ 0 … + pm-1xm-1,2 + xm,2 ≡ 0 p1x1,k-1 + p2x2,k-1 + … + pm-1xm-1,k-1 + xm,k-1 ≡ 0 p1x1,k + p2x2,k + … + pm-1xm-1,k + xm,k ≡ 0 p 1 X 1 + p 2 X2 + … + pm-1Xm-1 + Xm ≡0 where Xi =∑xi,j for all i, j Aggregate Say’s Principle Aggregate Version SP: “The net value of the sum of all aggregate EDs is identically zero.” 1. 2. 3. Valid for any set of prices No statement can be directly made about value of sum of subset of EDs SP refers to plans not outcomes Interpretations “A general glut is impossible.” “Supply creates its own demand.” “Supply of a commodity at a price gives rise to an equal demand at that price.” “No one plans to supply without also planning for the use of the proceeds. “Given prices, planned supplies must equal planned demands.” “Given prices, planned sales create means to finance planned buys.” True False True True False General Equilibrium and SP General equilibrium exists when price vector exists such that Xi = 0 for all i “All planned transactions are executed.” Is GE consistent with SP? Yes Does SP imply GE will exist? No Disequilibrium and SP Take a typical macro model existing of money (M), bonds (b), labor (L), and goods (G). By SP, M + pBB + pGG + pLL ≡ 0 Suppose ESL exists. What does that imply? ∑EDM,B,G = ESL It also tells us the price adjustments that are necessary to reach GE. Does NOT tell us that the adjustments will occur! National Income Theory and SP “…aggregate demand and aggregate supply are always guaranteed equality…” (Snowdon and Vane) True or False? True, if AD and AS refers to all commodities (including the monetary commodity). In modern macro theory, AD and AS refers to final goods and services , a subset of all commodities. So, False; SP does not imply AD ≡ AS. Classical Theory of Saving, Investment and Interest Rates Theory of Loanable Funds E =Y E = C(r) + I(r) Y – C(r) = S(r) dC/dr < 0; dS/dr > 0 → S(r) = I(r) Flow of saving = Supply of loanable funds Flow of investment expenditure = Demand for loanable funds Theory of Loanable Funds Higher interest rates increase the cost of funds to purchase capital goods and therefore reduce capital purchases → dI/dr < 0 Real interest rate equilibrates the supply and demand for loanable funds r SLF = S DLF = I S, I If r is flexible, the classical model assures that E = Y at full employment. Why? SLF = S r SLF1 = S1 r0 Let Ye be full employment output; then E0 is AD that equals Ye. E0 = C0 + I0 r1 At r0, I0 = S0 → C0 = E0 – I0 DLF = I I0 I1 E0 = E1 S, I, E C1 Suppose increase in desired saving. r falls, I and S rise, and C falls by (E0 – I1) C0 ∆C = ∆I → Ye = E0 = C0 + I0 = E1 = C1 + I1 Ye Y E=Y Loanable Funds and Aggregate Demand The real interest rate changes to reconcile desired saving and desired investment and maintain real expenditures. The real sector of the economy consists of the labor and loanable funds market; together they determine real Y, L, E, S, I, C, w and r. What determines the price level and nominal values? Quantity Theory of Money Quantity Theory of Money Two versions Cambridge Marshall, Fisher’s cash-balances approach Pigou equation of exchange Cambridge QTM Md – transactions demand for money - demand to hold - positive relationship with level of money expenditures Cambridge QTM Md = k(PY) k: fraction of money income desired to be held for transactions k can vary in both the short and long runs, but to begin with consider it constant Cambridge QTM In equilibrium, Ms = Md MS = k(PY) Y is determined by production function and operation of the labor market k fixed → ∆MS = ∆P Changes in the money supply lead to proportionate changes in the price level Fisher’s Equation of Exchange MV ≡ PY Quantity of money expenditures on final goods is identical to the money income from sale of final goods V is income velocity of circulation Average number of times a monetary unit used to conduct final transactions Constant in short run due to technology of exchange Fisher’s Equation of Exchange M = (1/V)(PY) Y determined by operation of labor market and production function V fixed → ∆M = ∆P Changes in the money supply lead to proportionate changes in the price level Monetary Equilibrium Theory Return to 4-commodity model (B,G, M, L) In GE, EDM = 0; Md = Ms Suppose an increase in MS Creates an ESM By SP, corresponding ED created What markets are likely to have direct ED? Bond market and Goods market Increase in PB (fall in r) and PG Aggregate Demand, Aggregate Supply, and Price Level Determination Classical Aggregate Demand Money is the one commodity traded for all other commodities. Aggregate demand is simply aggregate money expenditures. AD = MV With M and V, AD shows all combinations of P and Y that yield same level of money expenditures. AD is negatively sloped (rectangular hyperbola) W2 The southwest quadrant shows the demand and supply of labor for given real wages. P W0 W1 AD W/P Y The southeast quadrant shows the production function for given A and K. The northeast quadrant represents AD and AS. Where’s AS? SL DL L Y = A F(K,L) The northwest quadrant shows the relationship between the real wage and the price level for given nominal wages. W2 P W0 W1 AS0 Begin in the labor market –the real wage w0 equilibrates the market and yields employment of L0. P0 AD W/P w0 Y0 Y Employment of L0 yields an output of Y0… which determines the AS curve, AS0. AS and AD determine the price level P0. L0 SL DL L Y = A F(K,L) The only nominal wage consistent with the price level P0 and the real wage w0 is the nominal wage W 0. W2 W0 P Suppose an increase in the money supply. AD increases to AD1. AS0 P1 AD1 P0 AD W/P w0 w1 Y0 ED SL DL Y L0 L At the current price level, P0, ED for goods appears, increasing prices to P1. At P1 and W0, the real wage falls to w1, creating an ED for labor. The nominal wage rises to W 2 in order to restore labor market equilibrium. At w0, employment of L0 yields an output of Y0… Y = A F(K,L) Consistent with goods market equilibrium. Monetary Neutrality A change in the money supply produces changes in nominal values but not real values Example previous page Increase money supply increased nominal wage rate and (nominal) price level Did not change any real values (real wage, employment, output) What about real interest rate? The Fisher Effect Real interest rate determines I0 and S0 and equilibrates loanable funds market Nominal v. real interest rates i = r + (∆P/P) Dynamic equation of exchange (∆M/M) + (∆V/V) = (∆P/P) + (∆Y/Y) (∆M/M) = (∆P/P) (∆M/M) ∆i , but not r SLF = S’ i SLF = S i1 i0 DLF = I’ DLF = I S 0 = I0 S, I An increase in the money supply increases the inflation rate. As suppliers and demanders adjust to the higher inflation rate, suppliers will require a higher nominal interest rate to compensate for lost purchasing power, but demanders will be willing to pay a higher interest rate because inflation has increased nominal profits. Once both demanders and suppliers have fully adjusted, all that has changed is the nominal interest rate but the real interest rate stays the same. An Alternative interpretation of classical theory P AS1 Begin in equilibrium, at real wage w0, determining employment L0 and output Y0. Given the money supply, MV = AD0, so the price level is P0. AS0 P2 P1 Suppose an increase in AD1 the money supply. The ESM creates an EDY, and prices rise. P0 AD0 w0 w1 Y0 W/P ED Y L0 L1 SL DL L Y = A F(K,L) As prices rise, profits rise. Higher profits cause firms to increase their output and quantity demanded for labor at the current nominal wage. An ED exists for labor at the new real wage. Workers increase their nominal wage demands, raising the costs of supplying output and the AS curve shifts to the left. Wages and prices adjust until the new equilibrium is reached. Cycle as Adjustment The “short-run” AS curve is positively sloped. Changes in AD can lead to changes in overall output levels as nominal wages adjust to new nominal AD levels. Still not does not capture the full flavor of classical economics. Say’s Law, Say’s Principle, and Walras’s Law Demand Failure v. Coordination Failure While the Alternative Model captures the notion that output can change in the short run due to monetary changes, it fails to capture the importance of Say’s Law in classical reasoning. For classicalists, demand failure could not be the cause of recessions. A general glut was impossible! Demand Failure v. Coordination Failure Partial gluts - due to the wrong goods being produced – could lead to secondary ramifications that caused “general” recessions. The cause of recessions in classical analysis was coordination failure, not demand failure. Coordination failure means that capital and labor are misallocated – unemployment in recessions is primarily a structural problem. Profits and Employment Coordination failures reveal themselves in losses for some products (those in ES) and higher than normal profits for other products (those in ED). Firms react to these profit differentials to correct the coordination failure. Moving capital and retraining labor takes time! “Classical” Macroeconomic Policy Fiscal and Monetary Policy Since the problem is not aggregate demand, government spending can’t solve the problem. Partial gluts may spread into uncertainty and increased demands for money; central banks need to stand ready to provide credit to the banking system at high rates of interest. (Assists the Gold Standard!) Structural Policy Government must not intervene to counteract adjustments to revealed coordination failures. Government must not attempt to interfere with the price adjustments that will occur. Government can assist the unemployed.