Macroeconomics Models

The Classical Model

The Classical View
A classical macroeconomist believes that the economy is self-regulating and always
at full employment.
The classical model assumes free competition in markets
The term “classical” derives from the name of the founding school of economics that
includes Adam Smith, David Ricardo, and John Stuart Mill
This leads to two major classical economic conclusions:
1. The price level is fully flexible; real GDP is determined independent from the price
level ("money is neutral").
2. The economy will operate at a full- (or natural) employment level(principle
Laissez-faire).

The Keynesian Model.

A Keynesian macroeconomist believes that left alone, the economy would rarely
operate at full employment and that to achieve and maintain full employment, active
help from fiscal policy and monetary policy is required.
The term “Keynesian” derives from the name of one of the twentieth century’s most
famous economists, John Maynard Keynes.
He observed that a stagnant equilibrium below full employment was possible because
of a unique combination of factors: Very low interest rates removed the incentive to
save (low savings supply), while negative business prospects kept firms from investing
(low investment demand). Under these conditions, Keynes noted that stimulation of
aggregate demand was critical to move the economy to the full-employment GDP
level.
There are three major assumptions in the Keynesian model:
1. Firms do not change product prices in the (very) short run because of such things
as menu costs (the costs of relabeling, redesigning contracts, and so on), and
factor costs may also be rigid because of long-term contracts (e.g., wages and
factor input purchases). This means that the aggregate price level is fixed and that
firms will sell the amount that is demanded, implying that GDP is determined by
aggregate expenditures. The horizontal or "flat" aggregate supply curve at
relatively low GDP and fixed price level is called the Keynesian segment of the
supply curve.

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2. Aggregate expenditures—the sum of consumption expenditures, investment,
government purchases, and exports minus imports—equals national income.
Therefore, there is a direct relationship between aggregate demand and aggregate
income.
3. GDP and aggregate expenditures have a special two-way influence: An increase in
real GDP increases aggregate expenditures, and an increase in aggregate
expenditures increases real GDP. For example, if consumption, as a part of
aggregate expenditures, goes up, it will increase income, but consumption will go up
even further because of the (positive) propensity to consume at higher income
levels (consumption function).
Consumption and Saving function
The consumption function is the relationship between consumption expenditure and
disposable income (see Fig.). The slope of the consumption function is the marginal
propensity to consume (MPC), or, the change in consumption expenditure resulting
from a change in disposable income:
Marginal propensity to consume (MPC) = ΔC/ΔYD
- where ΔC = change in consumption (Δ stands for change)
- ΔYD = change in disposable income
- YD = disposable income = total income - taxes = Y- T
The amount of consumption when disposable income is zero is called autonomous.
This is equal to the intercept (y axis), or CAUT in Fig.. Above this amount, consumption
is called induced consumption.
The consumption function will shift as a result of changes in the real interest rate,
wealth, or expected future income. Because a change in real GDP changes disposable
income, it will change consumption expenditure.

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The saving function is the relationship between saving and disposable income. The
marginal propensity to save (MPS) is the change in savings that results from a change
in disposable income, or
Marginal propensity to save (MPS)=ΔS/ΔYD
- where ΔS = change in saving (Δ stands for change) ΔYD = change in disposable
income
- Households' disposable income is either used to consume or to save, so the
consumption expenditure plus saving equals disposable income, which implies.
- Marginal propensity to consume + marginal propensity to save= 1
- When consumption expenditure exceeds disposable income, saving is negative
(dissaving).
- When consumption expenditure is less than disposable income, there is saving.

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The Multiplier Process
The two-way relationship between real GDP and aggregate expenditures is caused by
the multiplier process. In this section, we show an example of this process.
The spending (or expenditure) multiplier is the amount by which a change in
autonomous expenditure (e.g., government expenditure to stimulate demand) is mul-
tiplied to determine the change in the equilibrium values of expenditures and GDP. The
multiplier is larger than 1 because a change in autonomous expenditure also changes
the induced expenditures.
In a simple economy (one without taxes or imports),
Spending multipliers 1/MPS= 1/(1 - MPC)
- For example, a $1 million increase in the total amount of investment in an economy
will set off a chain reaction of increases in expenditures.
- Initially, $1 million is added as income. If 80 percent of that additional income is
spent, a total of $800,000 will be added to incomes. This means that total income
has now been raised by $1 million (the initial expenditure) plus $800,000, or $1.8
million. In turn, the extra income of $800,000 causes 80 percent of $800,000 to be
expended and added to incomes, and so on. The process continues, and, ultimately,
the initial investment times the factor 1/(1-80%) is added to income, or 5x$l million =
$5 million.
- An important assumption of the multiplier process is that either the supply of
money or the velocity of money will increase to allow the extra spending to occur.

The Business Cycle

The up-and-down pattern of GDP growth over time, consisting of recessions and
expansions, is called the business cycle.
The business cycle is the fluctuating pattern of GDP growth over time, consisting of
expansions (recovery) and contractions (recessions); see Fig.

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The Business Cycle in the AS-AD Model
The business cycle occurs because aggregate demand and the short-run aggregate
supply fluctuate, but the money wage does not change rapidly enough to keep real
GDP at potential GDP.
- An above full-employment equilibrium is an equilibrium in which real GDP exceeds
potential GDP.
- A full-employment equilibrium is an equilibrium in which real GDP equals potential
GDP.
- A below full-employment equilibrium is an equilibrium in which potential GDP
exceeds real GDP.

Figures 27.9(a) and (d)

illustrate above full-
employment equilibrium.
The amount by which real GDP
exceeds potential GDP is called
an inflationary gap.
Figures 27.9(b) and (d)
illustrate full-employment
equilibrium.

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Figures 27.9(c) and (d)
illustrate below full-
employment equilibrium.
The amount by which real
GDP is less than potential GDP
is called a recessionary gap.
Figure 27.9(d) shows how, as
the economy moves from one
type of short-run equilibrium
to another, real GDP
fluctuates around potential
GDP in a business cycle.

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