ECM-32023

ADVANCED MACRO ECONOMICS

SOUTH EASTERN UNIVERSITY OF SRI LANKA

DEPARTMENT OF SOCIAL SCIENCE

CLASSICAL MACRO ECONOMICS

What is macro economics?

History of the Classical theory of macroeconomics.

Developers of the classical economics.

Concepts of the classical economists.

Criticism of the classical economists.

Conclusion.

What is macro economics?

Macroeconomics is a branch of economics dealing with the performance, structure,Behavior and decision-making of the whole economy. This includes a national, regional or global economy. With microeconomics, macroeconomics is one of the twoMost general fields in economics.

Classical theory of economicsA theory of economics especially directed toward macroeconomics,

based on the unrestricted working of markets and the pursuit of individual self interests.Classical economics relies on three key assumptions- flexible prices, say’s law, and saving investment equality-in the analysis of macroeconomics.

Classical economics can trace its roots to Adam Smith in 1776. in the wealth of nationAdam smith presented a comprehensive analysis of economic phenomena based on the notions of free markets and actions guided by individual self interests in a Laissez fair environment.

Classical economics came of age during after industrialization.

Developers of the classical economics

Adam Smith( Scottish philosopher)

Alfred Marshall(British economist)

Arthur Cecil Pigou (British economist)

David Ricardo (British economist)

Harriet Martineau (British author)

John Elliott Cairns (British economist)

Nassau William senior (British economist)

Robert Torrens (British economist and politician)

CONCEPT OF CLASSICAL ECONOMISTS

Once upon a time in a land far, far away…….

There were a group of people called the classical economists.In classical land, they believed,

•Full employment is the norm.

•Laissez-fair “let it be”

•Vertical aggregate supply curve.

•Stable aggregate demand.•Real output depends upon

I. Say’s lawII. Responsive, flexible, prices and wages.

Say’s Law:According to say’s law, when an economy produces a certain level of real GDP,It also generates the income needed to purchase that level of real GDP.In other words, the economy is always capable of demanding all of the outputThat its workers and firms choose to produce. Hence, the economy Is alwaysCapable of achieving the natural level of real GDP.

David Ricardo:The market is perfect and self sustaining.Government intervention can only be a detriment to the economy.The market automatically adjust to “booms” and busts.

Classical economists’ view of these following titles

Macro is aggregated Micro:

Classical economists conceived of the macroeconomic as no more than aggregated microeconomics. Thus, what we now conceive of as aggregate supply was simply the sum of each firm’s production decision.  Similarly, aggregate demand was the sum of all individual demand curves.Gerard Debreu, in his 1957 book, Theory of Value proved the existence of a general

competitive equilibrium.  That is, if all markets are perfectly competitive, all firms maximize profits, and all individuals maximize utility, there is a set of prices at which all markets will be in equilibrium. 

Focus on the Supply Side:

Classical economics focused on the supply side of the economy. Specifically, Jean Baptiste Say’s Law dominated classical economic thought: Supply creates its own demand.  Say meant that production creates income that provides enough purchasing power to purchase all the goods being produced, no more and no less.

The Labor Market:

The classical view of the economy begins with the labor market.  Profit maximizing firms hire labor up to the point where the marginal revenue product, or the additional revenue gained from one extra unit of labor, equals the wage rate.  (In real terms, the real demand for labor is its marginal productivity.  The real demand equals the real wage, that is, the nominal wage divided by the price level.)

The Product Market:

Equilibrium employment thus served as the source of aggregate supply. Given the equilibrium level of employment, the aggregate production function determines the equilibrium left of output.

Thrift & Enterprise determine the Composition of GDP:Thrift can be thought of as economic agents’ propensity to save, and is based on their willingness to defer present for future consumption.  Enterprise can be thought of as their propensity to invest, which is dependent on the availability of investment opportunities or the rate of return on capital. Thrift and enterprise are fixed in the short run; changes in either and have no effect on the level of GDP, only on its composition.

The Classical Dichotomy Segments the Economy into Real & Financial Sides:

The Classical analysis of the macro-economy led to what is now known as the classical dichotomy. The economy has two sides, real and financial. The real side includes the real variables in the economy, including output and employment, while the financial side includes all nominal factors of the economy, such as the aggregate price level and nominal interest rates.  The notion of a dichotomy means that nominal factors only influence financial side of the economy, never the real side.  As we noted above, real variables are determined entirely on the supply side of the economy: employment is determined in the labor market, and output is determined by the aggregate production function.

Quantity Theory of Money:

The Classical view of aggregate demand was the Quantity Theory of Money.  The Quantity Theory is, based on the equation of exchange: MV = PQ, where M is the supply of money, V is the velocity of money (the average number of times a dollar is spent in a year), P is the aggregate price level and Q is real GDP.  The equation of exchange is an identity, but the Classical reinterpreted it as a behavioral relationship as follows:  Let M represent money demand (MD).  Then MD=(1/V)PQ or MD=kPQ where k=1/V.

This means that the demand for money, MD is proportional to nominal GDP (PxQ) or income. An increase in real income (Q) means that people spend more, so they need to hold more money, which means the demand for money increases. Also, if the price level increases the demand for money similarly increases, because people must carry more cash to have equivalent purchasing power.

Economy-wide Unemployment isn’t likely:

In classical thought, the labor market determines employment. At the equilibrium wage rate, everyone who wants a job will have one. Unemployment was believed to be caused by people choosing not to work for low wages. Unemployment occurring in one sector of the economy was the result of a change in consumer demand away from that sector’s products towards another sector’s products.  The result should be lower wages in the former sector and rising wages in the latter.  Over time, labor should migrate from the former to the latter.  Unemployment then is a sector problem and exists when people choose not to work for low wages or when they choose not to migrate.

Widespread unemployment simply should not occur, according to classical theory.  If it did, the cause must be “sticky” wages—wages that don’t adjust downward, due to market imperfections such as unions.   Labor unions interfere with the economy’s movement towards full employment because they push up wages and make workers less willing to relocate for new work.  Over time though, unemployment should disappear.

Classical Views on Fiscal Policy:

Classical economists conceived of fiscal policy in much more limited terms than it is viewed today. The notion of discretionary policy was not widely accepted, since the only responsible fiscal policy was a balanced budget.  Thus, expansionary fiscal policy, for example increasing government spending without increasing taxes to stimulate the economy, was not generally considered by policy makers. 

According to the above sub-title of the economics, classical economists’ view visible.

Criticism of classical economistsClassical economists Keynesian concept

Wages and prices are fully flexible in order to clear markets rapidly.

Economy operates at full employment most of the time.

Aggregate supply curve is vertical.

Minimal government intervention reflecting distrust of government and belief in its inefficiency.

Prices and wages downwardly inflexible.

Laissez fair is subject to recession and widespread unemployment.

Horizontal aggregate supply curve to full employment.

Active government policy is needed to stabilize the economy.

Conclusions

The Classical school was the primary school of thought in economics until the 1930's and the time of the Great Depression.

The shortcomings of the Classical school became extremely evident when its practitioners were unable to explain the extraordinary decline in economic activity and increase in unemployment during the 1930s.

The Classical were mostly criticized for being unable to see the importance of the short-run changes that were taking place.

Their models which held many variables fixed and focused on the supply side of the economy could not give a viable answer for what was happening. This brought about a great deal of criticism from many analysts and cast the entire economics discipline in a bad light, much like what happened after the Great Recession of 2007-09.