MacroeconomicTheory

TheEconomicEquilibrium
ClassicalTheory
1.ProductMarket
2.FactorMarket
3.MoneyMarket

KeynesianTheory

Longrun

EconomicGrowth

ISLMModel
(Hicks&
Hansen)

Shortrun

BusinessCycles

Output,Price,EmploymentandInterestRateDetermination

DidYouKnowThat...
TheCuriousCaseofthe5CentCoke
The price of a 6.5 Oz bottle of CocaCola remained unchanged at 5 cents from
18861959?
GreatDepression,Prohibition,twoWorldWars,andseveralrecessions
occurred.
Priceofsugartripled.
Structureandtechnologychangedinindustry.
Why???
Originallyclaimedtobeapatentmedicinesoldassingleservings.
Theabilityforconsumerstobuyasingleserving.
DanielLevyandAndrewT.Youngarguethreefactorsaccountforpricerigidity.
From1899to1921,CocaColawasobligatedbylongtermcontractswith
Syrupat$0.92pergallon.After1921,thesyruppricefluctuated.
Technologyofvendingmachinescouldonlyacceptasinglecoin.
FirmfeltitwasimportantthatconsumerscouldbuyaCokewithasingle
coin.
Pricesformanyfirmstypicallyfullyadjustwithinayearortwo.
Shortrunshiftsindemandandsupplymayresultinmultiplepricechanges,butin
longruncometoequilibriumpoint.

Macroeconomics in Long-Run

The Classical Theory

TheoryofOutput(Y)andEmployment(E)

TheClassicalMacroeconomicTheory
Classical economists: Adam Smith, J.B. Say, David Ricardo,
John Stuart Mill, Thomas Malthus, A.C. Pigou, and others
wrote from 1770s to 1930s.
MainQuestion:
HowtoincreasetheOutput(meansRealGDP)ofanationsin
theLongRun??????
Output

Economic Growth with Stability

LongRun
Whypricesdidntchangeoveraperiodoftime?

TheClassicalMacroeconomicTheory
Classical Assumptions/Postulates
a. The Economy is characterized by Capitalist Economy.
b. Perfectly Competitive Markets, Invisible hands, Lassizfair Policy, Division of
Labor and Free Market Economy
a. Economy is always in equilibrium. The problems in the macro economy will be
temporary and the market will correct itself.
b. Factor Market: Always Full Employment: Labor is the only variable factor of
production, so there is always full employment in the economy. In long run as
people are motivated by self interest.
c. Capital Market:
No Role of Money: Money is used only for transaction purpose
No Money Illusion: People cannot be fooled my money illusion
d.

Flexibles Prices (P) and Wages (W): An increase or decrease in it ensure that the
economy operates at full employment and restore equilibrium. Prices are stable.

e.

No Role of Government

f.

Long run Output: Says Law.

The Classical Macroeconomic Theory:

The Foundation
ClassicalSaysLaw(J.BSay17761832):
AdictumofeconomistJ.B.SayisthatSupplycreatesits
owndemandbothin
bartereconomy
monetizedeconomy

Producinggoodsandservicesgeneratestheincomeand
thewillingnesstopurchaseothergoodsandservices.
So,AggregateSupply=AggregateDemand
Nogeneralunderproduction
Nogeneraloverproduction
NoUnemployment
Onlyvoluntaryandfrictionalunemploymentisthere

Says Law and the Circular Flow

Values of Total Production(piqi)=Cost of Production

Cost of Production= rent+wages+interest+profit
Rent+wages+interest+profit= Factors Income
Factor Income=Total Expenditure
Total Expenditure=Values of Total Production
Total Demand=Total Supply

The Classical Theory of Output and Employment

TheClassicalTheoryfirstattemptedtoexplain
a) NationalLevelsofOutput(RealGDP)andPriceLevel:
(ThroughGoodsMarketEquilibrium)
determinantsoftheOutputandPricelevelwithASandAD
b)NationalLevelsofEmployment(E)
(ThroughLaborMarketEquilibrium)
determinantsofEmploymentandRealWageratewithDLandSL
DeterminantsofNationalLevelofY,PandE(wagerate)
c) NationalLevelofInterestRates
(ThroughMoneyMarketEquilibrium)
NationalConsumption(C),Saving(S)andInvestment(I)
DeterminatesofInterestrates(SandI)

The Classical Theory of Output and Employment

A. The Goods Markets
Question: How national output is produced and
price is determined?
Answers:
Output is produced through various factors
of production
Price is determined through interaction
between aggregate demand and
aggregate supply
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A. Aggregate Supply of Output(National Output):

The Production Function:
Aggregate Production or Supply Function
Y = F(K ,L)
Relate output to factors of production
Technology constant
_
K= K (capital Fixed)
L = N (amount of homogeneous
labor)

A. Aggregate Supply of Output(National Output):

The Total and MP ( of L)

Y
output

F (K , L )
1

MPL
As more labor is
added, MPL

MPL
1

MPL

Slope of the production

function equals MPL

labor

A. Aggregate Supply of Output(National Output):

ShapeoftheAggSupplyCurve:LRASCisVertical
An aggregate supply curve:
Shows the relationship between real
output and price level.
is vertical at the fullemployment level of
real output (production) indicating that the
quantity of aggregate production is
independent of the price level.
In the classical model,
unemployment is impossible.

LRASC

Price Levels

Price Level

longterm

Says law, coupled with flexible interest

prices, wages and interest rates would
tend to keep workers fully employed.
Qty of Output
( Real GDP)
Output

A. Aggregate Demand of Output(National Output):

Demand for Product comes from the general public(all
economic agent) and since supply creates its own demand,
demand curve slopes downward from left to right according
to law of demand.
Y=C + I + G +Nx

Price Level

P1
Prices

P2
AD

AD
Y1

Y2

Qty of output
(GDP)

Equilibrium:
Aggregate Demand and Aggregate Supply

Classical
economists
believed that Says law,
flexible interest rates,
prices,
and
wages
would always lead to
full employment at real
GDP (Ex. at12 trillion)

A change in aggregate demand will cause a change in the price level, which is temporary.

The Classical Theory of Output and Employment

B.FactorMarket: TheLaborMarket
Question
Wouldunemploymentbeaproblemintheclassicalmodel?
Whatsthefullemploymentlevelofoutput?
Howwagerateisdetermined?
Answer
No unemployment,thereisalwaysfullemployment,ifatall
onlynaturalrateofunemployment.
classicaleconomistsassumedwageswouldalwaysadjustto
thefullemploymentlevel.

B. Labor Market: Supply of Labor

Ns=f(w),
Where w is real wage rate, Ns is labor supply
So, Real Wage rate, w= W/P
w

Ns=f(w)

Labour (N)

B. Labor Market: Demand for Labor

Demand for labor depends upon Marginal Revenue Productivity
of Labor(MRPL)
What is MRPL?????????
Firms employ labor till MRPL=Wage rate
Lets define Profit = Revenue - Cost
So Profit = Revenue - Cost
= (P x MPL) W
Hire labor until Profit = 0
i.e. P x MPL = W
i.e. MPL = W/P

w=W/P

So, Nd=f (MRPL ): where Nd is Demand for Labor

MPL =f(w)
where, w is real wage rate, W is nominal wage rate

B. Labor Market: Demand for Labor

MPL and the demand for labor(DL)
Units of
output,
Y

Each firm hires labor

up to the point where MPL
= W/P

Real
wage,
w=
W/P

MPL, Labor
demand
Units of labor, L
Quantity of labor
demanded, L*

P is flexible is classical model

Real wage, w =W/P

Equilibrium: in the Labor Market

Equilibrium Between Product and Factor Market

(Goods and Labor Market):

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Determination of Equilibrium
Output, Prices and Employment
SL
Real
Wage
rate w

E
DL

Price
Level

N*
F (K , L )

Y*
Real
Output

Employment

LRASC

P**
P*

AD2
AD1
N*

Y*

Y**Real output

The Classical Theory of Output and Employment

C. The Money & Credit Market: Equilibrium through S & I
Savings(S):
Whenincomeissaved,itis
notreflectedinproduct
demand
Itisatypeofleakage fromthe
circularflowofincomeand
output,becausesaving
withdrawsfundsfromthe
incomestream.

Investment(I)
Classicaleconomistscontended
eachdollarsavedwouldbe
matchedbybusinessinvestment.
Leakageswouldthusequalto
injections.
Atequilibrium,theprice of
credittheinterestrate
ensuresthattheamountof
creditdemandedequalsthe
amountsupplied.

So,S=YC
SupplyofFunds:Savings

DemandforFunds:Investment

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C.TheMoney&CreditMarket:EquilibriumthroughS&I
EquatingDesiredSavingandInvestmentintheClassicalModel

Collapse of Classical Economics

PrevailedUntilGreatDepression(1930)
Classicaleconomistassumesthatthereisperfectcompetition
inbothlaborandoutputmarketswhichisunrealistic.
Sayslawi.e.supplycreatesitsowndemand.Thispostulates
failedduringgreatdepression
Laboristheonlyfactorofproductioninclassicaleconomists.
Howeverotherfactorofproductionsarealsoimportant.
Classicaltalkedaboutlongrun.
EmergenceofKeynesianEconomics

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Classical and Keynesian Economics

KeynesianEconomics:
ClassicalEconomics
Classicaleconomistassumesthat Theperfectcompetitioninbothlabor
andoutputmarketsisunrealistic.
thereisperfectcompetitionin
bothlaborandoutputmarkets. ThePostulatesofSayslawfailed
duringgreatdepression..ASnotequal
Sayslawi.e.supplycreatesits
toADalways.InfactfallinADleadto
owndemand,Nofluctuationsis
Businesscycle(fluctuationinOutput)
output.AS=AD.
ProblemofAS
Laboristheonlyvaraiblefactor
ofproduction

ProblemofAD
ApartfromLaborotherfactorof
productionsarealsoimportant.

Pricesandwagesareflexible.
ClassicallongrunAnalysis.
LRASisVertical
NoroleofGovt.
NoRoleofMoney

PricesandWagesareSticky.
Everythingisinshortrun.
SRASisUpwardsloping
ActiveRoleofGovt.
ActiveRoleofMoney.

References
Ch 5. Classical Theory of Employment and Output in
Macroeconomic Theory and Policy by D N Dwivedi
Ch3. National Income where it come from and where it
goes in Macroeconomics by N Gregory Mankiw,7th edition

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ThankYouAll

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