The Classical Macro Model

Intermediate Macroeconomics
The Classical Macro Model
The Simple Classical Model

The Classical Assumptions

 Classical economics stressed the role of real as opposed
to nominal factors in determining real output. Money
was only important as a medium of exchange.
 Classical economics stressed the self-adjusting nature
of the economy. Government policies to insure full
employment were unnecessary and generally harmful.
Classical economists assumed:
– Perfectly flexible wages and prices.
– Perfect information.
A Classical Model of Output
Determination
 The Starting point is the Production Function
 Y = F(K, N) where
– Y = National output
– K = Capital
– N = labour
– And F is a functional notation
 Assume K is constant in the short run so that Y varies
directly with N. So to determine output, we need to
know what determines employment, N. Employment
is determined from the labour market.
 In the labour market, we have the demand and the
supply sides.
Properties of the Production Function
 With K given, output varies directly with the level of N
 From the production function, we can compute the
following:
 Marginal product of labour can be derived from the
production function using calculus.
 FN=MPN=dF/dN=dY/dN>0
 FNN=d2F/dN2<0 i.e. the economy is subject to the law of
diminishing returns.
 Does the following production function exhibit these
properties?
 Y=K0.5N0.5, K=1
The Demand for labour
Curve
 Producers are willing to hire up to
the point where the real wage
(W/P) = MPN.
 Notice that in the range of
diminishing returns, the demand
curve for labour is downward
sloping.
 The demand for labour can be
expressed in both real and nominal
terms.
Figure1: Production Function and

Marginal Product of labour Curve
The Labour Market
 Note: Firms demand labour services and households
supply labour services.
 The labour market comprises
 a) The Demand for labour side
 b) The Supply of Labour side
 : Assumptions
 1. Firms are profit maximizers
 2. Households maximize their utility
 3. Firms take the price level and money Wage as given;
households take the money wage as constant
 The labour market is ALWAYS in equilibrium.
Demand for Labour
 Firms employ labour to maximise profits and the
condition hat must be must is:
 P.MPN=W (1) where;
 P= the price level of output
 MPN=marginal product of labour
 W= money/nominal wage.
 (1) can be rewritten in a familiar form:
 MPN= W/P (2).
 So for the firm to maximize profit, equations (1) and (2)
must hold. In fact, the two equations are the same but
their use depends on the question under consideration.
Demand for Labour Cont’d
 From equation 2, MPN= W/P, for the firm to maximize
profit in hiring labour, it must employ labour at the
point where the marginal product of the last worker
equals the fixed money wage.
 Because of diminishing returns, we consider the falling
segment (the downward sloping portion) of the MPN
curve.
 The profit maximising level of labour demand can be
graphically determined using equations 1 or 2 as shown
in diagrams below.
Real vs. Nominal
 The demand for labour
can be expressed in real
terms, i.e., Figure 2a
(Top)
Figure 2a labour Demand for a Firm in real Terms
 Firms maximize profits
where W/P = MPN.
 Or, alternatively, firms
maximize profits where
W = MPN x P. Labour
demand can be expressed
in nominal terms, as in
Figure 2b (Bottom)
 We will use both,
Figure 2b The Demand for labour in Nominal Terms depending on the
situation.
Determinants of the Demand for labour
Demand
 We conclude from the two diagrams that labour demand is
a negative function of the real wage meaning as the real
wage increases, labour demand decreases and vice versa:
 Nd = f (W/P) (-)
 That is, the demand for labour is a negative function of the
real wage, i.e., the higher the real wage, the lower the
demand for labour.
 Can you use economic intuition to explain this?


 or,
Deriving the Labour Demand Function
Labour Supply
 Classical economists assumed that individuals
maximize their utility or satisfaction. Utility was
generated by real income earned through the disutility
of work that could then be used to purchase marketable
goods and services as well as leisure. There is therefore
a trade-off between real income resulting from working
and the pleasures or utility of leisure, doing your own
thing.
 U=f(Consumption, Leisure) with the following
constraint:
 W+L=H, H=24 hours
Labour Supply
 Ns = g (W/P) (+)
 or, the supply of labour is a positive function of the real
wage, i.e., the higher the real wage, the higher the
supply of labour.
 Classicals believed that the substitution effect of a
money wage change outweighed the income effect.
 So when plotted against the real wage, the labour
supply curve is upward sloping.
Equilibrium Output and Employment
 To determine what the equilibrium output and level of

employment will be in an economy, according to the
Classical model, the supply and the demand for labour
must be equal i.e.
Ns = Nd where
 Y = F (K*, N)
 Nd = f (W/P)
 Ns = g (W/P)

Equilibrium in the
labour Market
 Equilibrium in the labour
market yields the market
real wage (W/P)0 and the
level of employment (N0).
 Given the (N0) level of
employment, the level of
income is determined at
(Y0).
 The economy automatically
adjusts to full employment
Figure 3 Classical Output and at (N0).
Employment Theory
Effect of a Change in
Price
 Price level change has no
effect on real variables.
 As P , W  in the same
proportion, so that (W/P)
and N are unchanged.
 Effect can be shown to be
the same: no matter
whether we use real wage
(W/P) as in part a, or
nominal wage (W) as in
part b, price level changes
have no real effect in the
Figure 4 labour Market Equilibrium and the Money
Wage classical system.
The Aggregate Supply
Curve
 If we plot various levels of
prices (the absolute price
level) and their respective
level of Y, we plot out a
vertical aggregate supply
curve.
 The level of real output is
not affected by nominal
variables.
 Real output is affected only
by real variables.
Figure 5 Classical Determination of Aggregate
Supply
Shifts in the Aggregate

Supply Curve
 A change in the level of capital
stock is a change in a real factor.
 As K, the production function
shifts up, which shifts the labour
demand curve, i.e., the MPN or Nd
.
 The real wage (W/P) and the real
level of employment (N).
 The level of real output is only
affected by real variables.
Figure 6 The Effect on Output, the
 Real output is not affected by
Real Wage, and Employment of an nominal variables.
Increase in the Capital Stock in the
Classical System
The Classical Macro Model
Money in the Classical System

Classical Aggregate Demand
 Classical economics is supply-side economics.
 Real output on the supply side is determined by the real factors
of production—land, labor, capital, and entrepreneurial ability.
Y=F(K,N) is real!
 All variables that are supply side determined are real variables
—Y, N, MPN, W/P, S, I, C, r.
 Autonomous variables, such as G and T are real.
 The demand side is important only in determining the nominal
variables—W, P, MPNxP.
 The money supply, M, is a nominal variable.
 The classical aggregate demand curve is an implicit aggregate
demand.
 What is the role of money in determining aggregate demand?
Determination of Price in the classical
model
 To classical economists, the quantity of money
determines the price level. That is, P=f(Ms). To
determine the direction and the extent to which price
depends on money supply, we need a theory: The
Quantity Theory of Money of which two versions will
be used discussed – the Fisherien and the Cambridge
Versions.
The Cambridge Approach to the Quantity
Theory
 In the version, we move away from the mechanical
nature of the version of the QTM by Fisher. As
championed by A. Marshall & A.C. Pigou , the QTM is
put in the context of demand for money where the
average money holdings is a constant fraction of
nominal income:
 Md=k(Py), k>0 and 0<k<1
The Cambridge Approach to the
Quantity Theory Cont’d
 We can move from the equation of exchange to
money demand:
 k= 1/v
 From the money market equilibrium, an increase
in Ms results in excess supply of money and
excess spending and given the fixed output
supply, prices will go up. This is the economics
behind this version of the QT: So the level price is
determined by MS.
Classical Aggregate Demand
 The Classical aggregate Figure 4-1 The Classical
Aggregate Demand Curve
demand curve plots
combinations of price level
(P) and real output (Y)
consistent with the equation
of exchange, MV = PY, for
a given money supply (M)
and a fixed velocity (V).
 Assume M = 300 and V = 4.
 Points such as P = 12.0 and Y = 100 or P = 6.0 and Y = 200
(PY = 1200 = MV in each case) lie along the aggregate
demand curve.
 An increase in the money supply to M = 400 shifts the
aggregate demand curve to the right.
Effects of a Change in the Money
Supply in the Classical System
 Successive increases Figure 4.2 Aggregate Supply
and Aggregate Demand in
in the money supply, the Classical System
from M1 to M2 and
then to M3, shift the
aggregate demand
curve to the right,
from Yd(M1) to
Yd(M2) to Yd(M3).
 The price level rises from P1 to P2 to P3.
 Output, which is supply-determined, is unchanged (Y1 = Y2 =
Y3).
The Classical Theory of the Interest Rate
 In the classical system, the equilibrium interest rate
was the rate which the amount of funds individuals &
firms desired to hold was just equal to the amount of
funds others desired to borrow.
 The market is the Loanable funds or the bonds market
which has to two sides: the demand and supply sides
 Household, firms and government constitute the
demand side of the loanable funds market
 Household, firms and government also constitute the
supply side of the loanable funds market
The Classical Theory of the

Interest Rate Cont’d
The SSLF may also be called the saving function or
the demand for bonds
 Similarly, the DDLF may also be called the
Investment function or the supply of bonds
 Classical economists assume that the LF market is
always in equilibrium, i.e. SSLF=DDLF and that the
interest rate is perfectly flexible. With excess demand
for funds, the interest rate increases and with excess
supply the interest rate decreases. This flexibility in
the interest rate guarantees that exogenous changes in
the particular components of AD do not affect the
level of AD
The SSLF and DDLF Schedules
 At higher interest rate, people are enticed to save
more so this gives an upward sloping SSLF schedule.
 For the demand for Loanable funds curve, at higher
interest rate, the cost of borrowing increases so
demand for loanable funds will reduce so we
postulate a downward sloping DDLF curve.
 At a given interest rate, an increase in the budget
deficit which is bond-financed will increase the total
demand for loanable funds and will thus shift the
DDLF curve to the right.
The Loanable Funds Theory of
Interest Rates
 The equilibrium interest
rate (ro) is the rate that
equates:
 The supply of loanable
funds, which consists of
new saving (S),
 With the demand for
loanable funds, which
consists of investment (I)
plus the bond-financed
government deficit (G -T). Figure 4-3 Interest Rate Determination in the Classical System
NOTE: The Loanable Funds Theory is a real theory of interest rates.

Intermediate
Changes inMacroeconomics
Autonomous
Spending
 An autonomous decline in
investment shifts the
investment schedule to the
left from I0 to I1—the
distance I.
 The equilibrium interest
rate declines from r0 to r1.
 As the interest rate falls,
there is an interest-rate-
induced increase in
investment—distance B.
Figure 4.4 Autonomous Decline in Investment Demand
Intermediate
Changes inMacroeconomics
Autonomous
Spending
 There is also an interest-
rated-induced decline in
saving, which is an equal
increase in consumption—
distance A.
 The interest-rate-induced
increases in consumption
and investment just balance
the autonomous decline in
investment.
 There is no change in real
output.
Figure 4.4 Autonomous Decline in Investment Demand
NOTE: A change in autonomous spending changes only the

composition of output!
Effect of Increase in Government
Spending in the Classical Model
 At point E, the
equilibrium
interest rate r0
equates the
supply of
loanable funds,
S, with the
demand for
loanable funds, I.
Figure 4.5 Effect of Increase in Government Spending in Classical Model
 Adding government deficit spending, (G - T)1 shifts the

demand for loanable funds to the right to point F. The interest
rate rises from r0 to r1.
Effect of Increase in Government
Spending in the Classical Model
 The increase in the
interest rate causes a
decline in the quantity
of investment from I0
to I1, a distance B, and
an increase in saving,
which is an equal
decline in
consumption, from S0
to Sl, a distance A. Figure 4.5 Effect of Increase in Government Spending in Classical Model
 The decline in investment and consumption just balances the

increase in government deficit spending, (G - T)1.
Crowding Out
 We have a name for what happened when the
government increased the deficit.
 It is called crowding out—100% crowding out or
complete or total crowding out in the Classical case.
 It crowds out private spending, partly from investors
(less I) and partly from consumers (less C, that is to
say, more S)
 The level of output (Y) does not change.
 The only change is in the composition of output.
 Is that change real or nominal?
 So we have seen that a bond-financed increase in G
has no effect on output and employment!
Policy Implication of the classical
Equilibrium Model
 Monetary policy Effects:
 Will monetary policy have real effects? That is, will it
cause employment and output to change? The answer is
no because the resultant change in price will not affect
the real wage because the money wage will increase in
proportion to the price level. So N, Y are not affected.
Expansionary Monetary Policy Effects in
the classical equilibrium model
 Increases in the Figure 4.2 Aggregate Supply

and Aggregate Demand in
money supply from the Classical System
M1 to M2 and then to
M3, shift the
aggregate demand
curve to the right,
from Yd(M1) to
Yd(M2) to Yd(M3).
 The price level rises from P1 to P2 to P3.
 Output, which is supply-determined, is unchanged (Y1 = Y2 =
Y3).
Fiscal Policy in the classical system
 Assume G goes up. We have to know how it is
financed. There are 3 ways of raising the money:
 1. Borrowing (increase in demand for loanable funds)
– a bond-financed increase in G
 2. Increase in Taxes (A Tax-financed increase in G)
 3. Increase in money supply (Money-financed
increase in G)
 For option 3, we already know the effect. Only
prices will change but N, Y, Real wage, Interest rate
will all not change. The AD curve will shift to the
right on the vertical AS curve.
A bond-financed increase in G
 For a bond-financed increase in G, DDLF curve will
shift to the right and at initial interest rate, there will
be excess demand for funds so the interest rate
increases.
 The increase in the interest rate has two effects on AD.
 1. There is an interest rate induced fall in investment
 2. With the interest rate increasing, saving will
increase which is mirrored by an equal reduction in
consumption (a component of AD)
AIntermediate
bond-financed increase in G
Macroeconomics
 Cont’dbelieved that the
Because classical economists
loanable funds market is always in equilibrium, the
rise in the interest rate will cause reductions in
consumption and investment whose magnitude will
be equal to the initial increase in G. So on net there
will be no change in AD; only that its components
will change, consumption and Investment have
reduced but G has increased.
A bond-financed increase in
G as no real effect!
A bond-financed Increase in
Government Spending in the
Classical Model
 The increase in the
interest rate causes a
decline in the quantity
of investment from I0
to I1, a distance B, and
an increase in saving,
which is an equal
decline in
consumption, from S0
to Sl, a distance A. Figure 4.5 Effect of Increase in Government Spending in Classical Model
 The decline in investment and consumption just balances the

increase in government deficit spending, (G - T)1.
Tax Policy
There are two types of tax policies: A lump-sum tax
Change (To) & a Change in the marginal tax rate
(t) Demand -Side Effects
1. T=To+ tY, 0<t<1.
Assume To (Lump-sum taxes) are reduced – this is
expansionary fiscal policy.
The resultant budget deficit (the revenue lost by the tax
cut) can again be bond-financed or money financed
and the effects have already been analysed – it has no
real effects.
Tax Policy Cont’d
 Assume the government reduces the tax rate. This
policy will have real effects as the after tax real wage
will increase so labour supply will increase and
employment will increase so through the production
function, output will increase at a given price level.
Thus, the AS curve shifts to the right on a constant
AD curve so output increases and prices decline.
Supply-Side Effect
 In part a, a reduction in the
marginal tax rate (from
0.40 to 0.20) increases the
after-tax real wage for a
given pretax real wage.
 The labor supply curve
shifts to the right, moving
from A to B.
 Employment and output
increase, as shown in part
b of the graph, moving
from A to B on the
production function.
Figure 4.6 The Supply-Side Effects of an Income Tax Cut
Figure 4.6c The Supply-Side Effects of an
Income Tax Cut
This increase in output is represented by the shift to the

right in the vertical aggregate supply curve in part c, from A
to B. Income  from Y0 to Y1, while price  from P0 to P1.
An Alternate Version of Figure 4-6

The Classical Macro Model

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The Classical Macro Model

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Intermediate Macroeconomics

The Classical Macro Model

The Simple Classical Model

The Classical Assumptions

Figure1: Production Function and

 To determine what the equilibrium output and level of

Shifts in the Aggregate

The Classical Macro Model

Money in the Classical System

NOTE: The Loanable Funds Theory is a real theory of interest rates.

NOTE: A change in autonomous spending changes only the

 Adding government deficit spending, (G - T)1 shifts the

 The decline in investment and consumption just balances the

 Increases in the Figure 4.2 Aggregate Supply

 The decline in investment and consumption just balances the

This increase in output is represented by the shift to the

An Alternate Version of Figure 4-6

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