MACROEconomics

Created:2007-2013 by Jim

Luke.This work is licensed

under the Creative Commons Attribution-

NonCommercial License

Unit 8: Classical Theory

The moment that government appears at market, the principles of the market will be subverted.

- Edmund Burke

MACROEconomics

Slide 2

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

MACROEconomics

Classical theory evolved in 1800’s to explain business cycle and justify free-market policies.

MACROEconomics

Slide 4

Why Classical Theory?

Context Agricultural Productivity

Improved Industrial Revolution Evolution of war Rapid but erratic growth Periodic inflations/deflations Frequent financial

panics/depressions

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The Classical Theory Using AD-AS Model

MACROEconomics

Slide 6

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?

MACROEconomicsClassical Theory Assumptions

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

MACROEconomicsCircular Flow - Classical Economy.

Balanced Budget: G =T. What ever is

taken away from consumers as taxes gets spent anyway

as G.There is no govt

borrowing.

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..

Ignore ROW.It’s a closed

economy model.

MACROEconomicsClassical Model Assumptions:

Implications

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)

MACROEconomics

Created:Jan 2008

by Jim Luke.This work is licensed

under the Creative Commons Attribution-

NonCommercial License

Recessionary Gap: High unemployment

PPrice Level(price index)

Real GDP@start

Price Index @start

start

LRASSR-AS

AD

Real GDPif we had full employment

Gap represents amount of

unemployment

MACROEconomics

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 GDPreturn to full employment.

PPrice Level

(price index)

Real GDP@start

Price Index

after

start

LRASSR-ASinitial

AD

Real GDPfull employment

SR-ASafter

after

MACROEconomics

Created:Jan 2008

by Jim Luke.This work is licensed

under the Creative Commons Attribution-

NonCommercial License

Expansionary Gap:- Shortages of workers/resources- Dropping inventories

PPrice Level

Real GDP@start

start

LRAS

SR-AS

AD

Inflationary pressure

MACROEconomics

Created:Jan 2008

by Jim Luke.This work is licensed

under the Creative Commons Attribution-

NonCommercial License

Expansionary Gap:Classical Adjustment

Firms bid up resource pricesFirms raise product prices to replace inventory

Result: one-time increase in price level (inflation)decrease in Real GDPreturn to full employment.Shortages end.

PPrice Level

Real GDP@start

start

LRAS

SR-ASintial

AD

after

SR-ASafter

Full Emp.GDP

MACROEconomics

Created:Jan 2008

by Jim Luke.This work is licensed

under the Creative Commons Attribution-

NonCommercial License

In Classical theory Contractionary Gaps are caused by Supply Shocks.

Price Index @start

PPrice Level

Full Emp. Real GDP

start

LRAS

SR-AS

AD

LRAS supply shock

SRAS supply shock

MACROEconomics

Slide 15

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)

MACROEconomics

Slide 16

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 pricesMarket economies are stable & tend to equilibriumPersistent 'glut' impossibleLong-run Growth from technology & capital accumulation

MACROEconomics

Slide 17

Classical History

Reasonable approximation of much: 19th & early 20th century experience Better explanation than alternative at the time

High-growth & rising living standards