the classical model how classical is it? gardner ackley macroeconomic theory 1961
TRANSCRIPT
THE CLASSICAL MODELTHE CLASSICAL MODEL
How Classical is it?How Classical is it?
Gardner AckleyGardner AckleyMacroeconomic TheoryMacroeconomic Theory
19611961
Gardner AckleyGardner AckleyAdam SmithAdam Smith
A 1770s
A 1770s
kind o
f guy.
kind o
f guy.
A 1960s
A 1960s
kind of guy.
kind of guy.
CLASSICAL ECONOMNICS
Adam Smith (1723 – 1790)The Wealth of Nations, 1776
David Ricardo (1772 – 1823)On the Principles of Political Economy and Taxation, 1817
John Stuart Mill (1806 – 1873)Principles of Political Economy, 1848
TEXTBOOK CLASSICISM
Gardner Ackley (1915 – 1998)Macroeconomic Theory, 1961
Chairman of the Council of Economic Advisorsduring the Johnson Administration (1964 – 1968)
TEXTBOOK CLASSICISM
Refers to all economists up to but not including Keynes.
Takes a (mostly) short-run view.
Treats capital as parametric and doesn’t deal with growth.
Assumes that markets work “perfectly.”
Assumes away all problems of pervasive unemployment.
Allows for changes in the functional distribution of income.
Separates monetary issues from relative-price issues.
CLASSICAL ECONOMICS
Refers to the writings of Adam Smith through J. S. Mill.
Takes a long-run view.
Focuses on capital accumulation and economic growth.
Illuminates the nature of market forces.
Treats pervasive unemployment as a temporary problem.
Is concerned with the functional distribution of income.
Separates monetary issues from relative-price issues.
TEXTBOOK CLASSICISM
Refers to all economists up to but not including Keynes.
Takes a (mostly) short-run view.
Treats capital as parametric and doesn’t deal with growth.
Assumes that markets work “perfectly.”
Assumes away all problems of pervasive unemployment.
Allows for changes in the functional distribution of income.
Separates monetary issues from relative-price issues.
CLASSICAL ECONOMICS
Refers to the writings of Adam Smith through J. S. Mill.
Takes a long-run view.
Focuses on capital accumulation and economic growth.
Illuminates the nature of market forces.
Treats pervasive unemployment as a temporary problem.
Is concerned with the functional distribution of income.
Separates monetary issues from relative-price issues.
Gardner Ackley was “a believer in the Government's ability to manage the economy through fiscal and monetary fine-tuning---a belief disputed by classical economic theorists….”
From the NYT obituary, August 20, 1998
LABORINPUT
OUTPUT
Production is the central focus of the classical model. Inputs in the forms of labor and capital are combined to produce output.
K = K0
THE PRODUCTION FUNCTION
The labor input (in worker-hours) is measured along the horizontal axis; output (the economy’s real GDP) is measured along the vertical axis.
The given capital input determines the shape and location of the production function.
The production function shows how much output can be produced by any specific level of labor input.
Up to a point, an increase in labor input results in an increase in output.
The slope of the production function, i.e., the increase in output divided by the increase in the labor input, is (by definition) the marginal productivity of labor, the MPL.
At some level of labor input, the MPL is zero, and beyond that level, it goes negative.
The upward-sloping supply curve reflects the workers’ preferred tradeoff between labor and leisure.
LABORINPUT
REALWAGERATE S
D
Worker-hours are bought and sold in a competitive market in which the workers and employers alike base their labor-market decisions on the real wage rate―the wage rate measured in terms of its purchasing power.
The downward-sloping demand is a derived demand. It reflects labor’s declining marginal productivity, as gauged by the employers.
The equilibrium real wage rate established by market forces ensures a fully employed economy.
THE LABOR MARKET
At some real wage rate, the supply curve steepens, if only because the potential work force is limited by the population.
And it is possible that a still higher real wage rate, the supply curve is backward-bending as high-income workers prefer more leisure time to spend their incomes to still more income to spend.
LABORINPUT
REALWAGERATE S
D
But in virtually all macroeconomic frameworks, the market-clearing real wage rate is assumed to occur in the upward-sloping segment of the labor supply curve.
THE LABOR MARKET
Note that when the demand curve is extended to the horizontal axis (at which point the demand price of labor is zero), the marginal productivity of labor is also zero.
LABORINPUT
REALWAGERATE S
D
LABORINPUT
OUTPUT
With supply and demand determining the level of labor input, the production function indicates the corresponding level of output.
The output of the economy, which includes both consumer goods and producer goods, is sold at competitive prices, generating the revenue to pay the incomes of both laborers and capitalists. Those incomes, then, are precisely enough to buy the economy’s output.
THE REAL ECONOMYOUTPUT
REALINCOME
Q = f(K, N)
LABORINPUT
REALWAGERATE S
D
LABORINPUT
OUTPUT
REALINCOME
K = K0
Y/P = Q
Q is the economy’s real output.
Y is nominal income.
P is the price level.
Y/P is real income.
N is the variable labor input.
K is the given capital input.
W is the nominal wage rate.
W/P is the real wage rate.
(Y/P)N is real labor income.
Y/P − (Y/P)N is capitalist income.N
N
W/P
(Y/P)N
THE REAL ECONOMY
Suppose that, for some reason or other, the real wage rate was stuck above the market-clearing level. K = K0
S
D
Y/P = Q
N
N
W/P
A REAL WAGE RATE STUCK TOO HIGH
The labor input would be demand- constrained; total income to labor may rise, fall, or remain unchanged, depending on the demand elasticity. The resulting unemployment is measured by the discrepancy between the labor supply and labor demand at the excessively high real wage rate.
The economy’s real output, which is the same as the real income paid to all the factors of production (labor and capital), declines.
unemployment
(Y/P)N
(Y/P
) N
Suppose that people’s preferred labor-leisure tradeoff changes in the direction of less leisure, causing the supply of labor to shift rightward.
K = K0
S
D
Y/P = Q
N
N
W/P
A CHANGE IN THE LABOR-LEISURE TRADEOFF
The number of worker-hours supplied and demanded increases, and the real wage rate is bid down.
The real income paid to the work force rises, falls, or remains unchanged, depending upon the elasticity of the demand for labor.
The economy’s real output, which is the same as the real income paid to all the factors of production (labor and capital), unambiguously rises.(Y/P)N(Y/P)N
S
D
K = K0
K = K1Y/P = Q
N
N
W/P
N
N
A LABOR-NEUTRAL INCREASE IN CAPTIAL
Consider an increase in the capital input (K increases from K0 to K1) that does not change the MPL, as indicated by the unchanged slope of the production function.
Notice that the production function now has a positive vertical intercept, which implies some automation. This automation, however, works only to increase output and not to displace labor or to employ more of it.
The unchanged MPL implies an unshifted demand for labor.
But with a greater capital input, the economy’s real output and hence real income rise.
(Y/P)N
S
D
K = K0
K = K1
Y/P = Q
N
N
W/P
AN INCREASE IN LABOR-USING CAPTIAL
Consider an increase in capital of the labor-using variety. The MPL (the slope) is greater at each and every level of labor input.
At the margin, the complementarity between labor and capital has been strengthened, such that the level of labor input at which MPL = 0 has increased. Accordingly, the demand for labor shifts rightward.
And with both the real wage rate and the level of employment increasing, the income received by labor increases dramatically.
The economy’s output and real income rise, but less dramatically.
(Y/P)N
S
D
K = K0K = K1
Y/P = Q
N
N
W/P
A RESTRUCTURING WITH LABOR-SAVING CAPTIAL
Consider a restructuring of capital with more of the labor-saving variety. The MPL is lessened at each and every level of labor input.
At the margin, the complementarity between labor and capital has been weakened, such that the level of labor input at which MPL = 0 has decreased. Accordingly, the demand for labor shifts leftward.
And with both the real wage rate and the level of employment decreasing, the income received by labor decreases dramatically.
But the economy’s output and hence real income rise.
(Y/P)N(Y/P)N
Q
P
CLASSICAL MONETARY THEORY
Pre-dating even Adam Smith was an understanding of the relationship between the economy’s output and the general level of prices.
The equation of exchange MV = PQ can illuminate this relationship. If the quantity of money (M) is given, and if the velocity of money (V) tends not to change, then the general level of prices (P) and the economy’s output (Q) are inversely related.
PQ = MV
If the product of two variables (PQ) is equal to a constant (MV), the graphical rendition of the relationship is an equilateral hyperbola.
A rectangle inscribed between the axes and the equilateral hyperbola has an area of MV.
With MV constant, all such rectangles have the same area.
Light up all the areas and it’s sort of pretty.
MV
P
K = K0
Y/P = Q
N
N
Making an explicit appearance in the classical model, either as a variable or a parameter are eight magnitudes, namely: K, M, N, P, Q, V, W, and Y.
W/P
Q
S
D
(Y/P)N
(MV)0
THE CLASSICAL MODEL
The nominal wage rate (W) does not make a solo appearance on an axis. But an auxiliary diagram can easily be created to keep track of W.
THE CLASSICAL MODEL
The real wage rate is conventionally symbolized by a script ω. Hence, we can write: ω = W/P.
P
W
Solving for W, we can write: W = ωP, where ω is the slope of the ray that relates W to P.
ω
ω’
1
1
For a given real wage, W and P move in direct proportion to each other.
If the real wage falls (because of a rightward shift in the labor supply or a leftward shift in labor demand), the ray (W = ωP) rotates clockwise, indicating, a lower real wage rate, a lesser slope.
Making an explicit appearance in the classical model, either as a variable or a parameter are eight magnitudes, namely: K, M, N, P, Q, V, W, and Y.
P
K = K0
Y/P = Q
N
N
W/P
Q
S
D
(Y/P)N
(MV)0
THE CLASSICAL MODEL
P
W
ω
ω =
1
P
K = K0
Y/P = Q
N
N
Making an explicit appearance in the classical model, either as a variable or a parameter are eight magnitudes, namely: K, M, N, P, Q, V, W, and Y.
W/P
Q
S
D
(Y/P)N
(MV)0
THE CLASSICAL MODEL
Conspicuous by its absence is the interest rate, a key variable in the analysis of both secular and cyclical movements in the economy’s output.
ω =
ω = The interest rate governs resource allocation within the output magnitude by dividing output (Q) into its temporally related components of investment (I) and consumption (C).
P
K = K0
Y/P = Q
N
N
W/P
Q
S
D
(Y/P)N
(MV)0
THE CLASSICAL MODEL
An increase in saving (decrease in consumption), lowers the interest rate, allowing the business community to finance more investment activities.
RA
TE
OF
IN
TE
RE
ST
SAVIING (S) INVESTMENT (D)
D
S
ω = The interest rate governs resource allocation within the output magnitude by dividing output (Q) into its temporally related components of investment (I) and consumption (C).
P
K = K0
Y/P = Q
N
N
W/P
Q
S
D
(Y/P)N
(MV)0
RA
TE
OF
IN
TE
RE
ST
SAVIING (S) INVESTMENT (D)
D
S
THE CLASSICAL MODEL
An increase in saving (decrease in consumption), lowers the interest rate, allowing the business community to finance more investment activities.
ω = The interest rate governs resource allocation within the output magnitude by dividing output (Q) into its temporally related components of investment (I) and consumption (C).
P
K = K0
Y/P = Q
N
N
W/P
Q
S
D
(Y/P)N
(MV)0
THE CLASSICAL MODEL
An increase in saving (decrease in consumption), lowers the interest rate, allowing the business community to finance more investment activities.
P
K = K0
Y/P = Q
N
N
The underlying assumption (or vision) entails a unfailing market mechanism that allocates resources within the output aggregate, keeping investment in line with saving.
W/P
Q
S
D
(Y/P)N
(MV)0
THE CLASSICAL MODEL
This mechanism, which relies on equilibrating movements in interest rate, is acknowledged by--but is not integral to--the classical model.
ω =
K = K0
S
D
With money and the price level now in play, observe the real and monetary consequences of an increase in the supply of labor.
Y/P = Q
N
N
W/P
P
Q
THE CLASSICAL MODEL
(Y/P)N
(MV)0
ω =
K = K0
S
D
With money and the price level now in play, observe the real and monetary consequences of an increase in the supply of labor.
This time, we’ll keep track of the nominal wage rate, too.
Y/P = Q
N
N
W/P
P
Q
THE CLASSICAL MODEL
(Y/P)N
(MV)0
P
W
ω
ω’
1
1
ω =
K = K0
S
D
K = K1Y/P = Q
N
N
W/P
N
N
P
Q
THE CLASSICAL MODEL
(Y/P)N
(MV)0
(MV)0
Observe the real and monetary consequences of a labor-neutral increase in capital.
ω =
S
D
K = K0
K = K1
Y/P = Q
N
N
W/P
P
Q
THE CLASSICAL MODEL
Observe the real and monetary consequences of an increase in capital of the labor-using variety.
(Y/P)N
(Y/P)N
(MV)0
(MV)0
ω =
Observe the real and monetary consequences of an increase in capital of the labor-using variety.
And we’ll keep track of the nominal wage rage.
S
D
K = K0
K = K1
Y/P = Q
N
N
W/P
P
Q
THE CLASSICAL MODEL
(Y/P)N
(Y/P)N
(MV)0
(MV)0
P
W
ω
ω’
1
1ω =
S
D
K = K0K = K1
Y/P = Q
N
N
W/P
P
Q
THE CLASSICAL MODEL
(Y/P)N(Y/P)N
(MV)0
(MV)0
Observe the real and monetary consequences of a restructuring with capital of a labor-saving variety.
ω =
K = K0
Y/P = Q
N
N
W/P
S
D
(Y/P)N
MV0
Q
P
MV1
THE CLASSICAL MODEL
Observe the real and monetary consequences, assuming a given money supply, of an increase in the velocity of money (V).
ω =
ω = Observe the real and monetary consequences, assuming a given velocity of money, of an increase in the money supply (M).
Does it matter that the increase in money supply (M) also caused the rate of interest to be lower than it otherwise would have been?
Can the allocation within the output magnitude proceed without being distorted by a monetary expansion?
K = K0
Y/P = Q
N
N
W/P
S
D
(Y/P)N
M0V
Q
P
M1V
THE CLASSICAL MODEL
RA
TE
OF
IN
TE
RE
ST
SAVIING (S) INVESTMENT (D)
D
S
ω = Does it matter that the increase in money supply (M) also caused the rate of interest to be lower than it otherwise would have been?
Can the allocation within the output magnitude proceed without being distorted by a monetary expansion?
K = K0
Y/P = Q
N
N
W/P
S
D
(Y/P)N
Q
P
M1V
THE CLASSICAL MODEL
RA
TE
OF
IN
TE
RE
ST
SAVIING (S) INVESTMENT (D)
D
S+ΔM
Does it matter that the stabilization policy (the increase in M to match the increase in Q) also caused the rate of interest to be lower than it otherwise would have been?
Can the allocation within the output magnitude proceed without being distorted by a policy-infected rate of interest?
S
D
K = K0
K = K1
Y/P = Q
N
N
W/P
P
Q
THE CLASSICAL MODEL
Now suppose the central bank is committed to a policy of price-level stabilization.
How does this policy affect the real and/or monetary consequences of an increase in capital of the labor-using variety?(Y/P)N
(Y/P)N
M0V
M1V
ω =
What are the consequences?
K = K0
S
D
Y/P = Q
N
N
W/P
Suppose that the central bank blunders mightily by allowing the money supply to collapse. Fortunately, prices and wage rates, being sufficiently flexible and not impeded by policymakers, adjust downward quickly and in direct proportion to the shrinkage of the money supply. (Y/P)N
M0V0
Q
P
M1V
1
THE CLASSICAL MODEL
ω =
What are the consequences?
K = K0
S
D
Y/P = Q
N
N
W/P
Suppose that the central bank blunders mightily by allowing the money supply to collapse. Confidence is shaken and the velocity of money falls, too. Then, policy-makers step in and try to keep prices and wage rates from falling. Deflation sets in anyway, but with prices falling more than wage rates.(Y/P)N
(Y/P
) N
unemployment
M0V0
Q
P
M1V
1
THE CLASSICAL MODEL
ω =
THE CLASSICAL MODELTHE CLASSICAL MODEL
See Roger LeRoy Miller and David D. VanHooseSee Roger LeRoy Miller and David D. VanHooseMacroeconomics: Theories, Policies, and International ApplicationsMacroeconomics: Theories, Policies, and International Applications
Chapters 3 - 5Chapters 3 - 5
Gardner AckleyGardner AckleyMacroeconomic TheoryMacroeconomic Theory
19611961
This slide is the solutionto the study problem:
LARAMIE CLEAN AIR ACT
which is available as a .pdf fileon the course website.
Now suppose that the Federal Reserve attempts to soften the act’s effect on output by expanding the money supply.
Any factory whose emissions result in air less pure than that found in Laramie, Wyoming will be subject to a ceremonial dismantling on Earth Day.
S
D
K = K0
K = K1
Y/P = Q
N
N
W/P
P
Q
CONSEQUENCES of the
LARAMIE CLEAN AIR ACT
(Y/P)N(Y/P)N
(MV)0
(MV)0
What are the consequences?
M1V
This slide is the solutionto the study problem:
LARAMIE CLEAN AIR ACT
which is available as a .pdf fileon the course website.
S
D
K = K0
Y/P = Q
N
N
W/P
THE CLASSICAL MODELdepicting
A KEYNESIAN-STYLE COLLAPSEINTO DEPRESSION
(Y/P)N(Y/P)N
Observe the real and monetary and real consequences of a waning of the animal spirits in a fixed-price/fixed-wage setting.
As money is hoarded rather than spent, the economy spirals downward. Labor demand falls, and capital in underutilized.
ω =
M0V0
Q
M0V1
P
The so-called “classical” frameworktogether with the Keynesian treatment
of prices, the wage rate, and interest rates can depict an economic collapse brought about by a waning of the “animal spirits.”