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The classical model of economics

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Economics 122aFall 2012

Agenda for next two classes:

1. The classical macro model 2. How economists measure

output/income

Some announcements• Course is limited to those on course list on web page plus

juniors (appeals are under consideration and should be decided early next week).

• There will be an optional section on logs and math review next Friday.

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The great chasm of macroeconomics

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Classical macro:- perfect markets

-rational individuals

- flexible wages and prices

- full employment

Keynesian macro:- imperfect competition

-bounded rationality

- sticky wages and prices

- unemployment

This is our topic for today:

classical approach

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Basics of Static Classical Model: Production Theory

Classical production model. The basic model is simplest

representation of the classical approach. When dynamized,

it becomes the neoclassical growth model.

Factor markets: capital and labor inputs (K and L)

One sector for output (Y).

Aggregate production function (for real GDP, Y)

What is a production function? Recipe for combining

inputs into outputs for given technology.

(1) Y = F( K, L)

Standard assumptions: positive marginal product (PMP),

diminishing returns (DR), constant returns to scale (CRTS):

CRTS: mY = F( mK, mL)

PMP: ∂Y/∂K>0; ∂Y/∂L>0

DR: ∂2Y/∂K2<0; ∂2Y/∂L2<0

Production function for popovers

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Courtesy of Florence Kling Harding , Twentieth Century Cookbook, 1921

Potential Output

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Potential output. With exogenous labor force (LF), inherited capital (K) , unemployment at the NAIRU (u*), this gives potential output (Yp):(2) Yp = F[K, (1-u*)LF]

Potential output critical for unemployment theory and growth theory and for medium and long-run forecasts.

u* = Jones “long-run or natural rate of unemployment” = non-accelerating inflation rate of unemployment

(NAIRU) = unemployment rate at which inflation neither rises

or falls = lowest sustainable rate of unemployment = around 5-6 percent today

Real GDP over the cycle

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12,000

12,500

13,000

13,500

14,000

14,500

15,000

2004 2005 2006 2007 2008 2009 2010 2011 2012

Real GDP (Actual)Real Potential GDP

Re

al G

DP

(b

illio

ns

of

20

05

$)

Large GDP “gap”

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Example: Cobb-Douglas production function

Very important production function: Cobb-Douglas (log linear)F( K, L) = AKαL1-α

Properties:MPL = ∂[AKαL1-α]/∂L=(1-α)AKαL1-α /L = (1-α)Y/L = (1-α) x APL(and similarly for MPK)

F( K, L) = 1.5L1-.5

L YMPL (discrete)

MPL (continuous/ derivative)

0.00 0.00 na1.00

1.00 1.00 0.500.41

2.00 1.41 0.350.32

3.00 1.73 0.290.27

4.00 2.00 0.25

0.00.20.40.60.81.01.21.41.61.82.0

0 0.5 1 1.5

Y, M

PL

Labor inputs (L)

Y

MPL

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Factor Markets

Factor markets: capital and labor inputs (K and L):- Capital inherited from past investments- Labor inputs exogenous (from biology, health, customs,

pharma)Real wage rate: = W/P = MPL = ∂Y/∂L = ∂[F( K, L)]/∂L (see Fig.

1)

Real rental rate on capital (like apartment rental as $ per month):

= R/P = MPK = ∂Y/∂K = ∂[F( K, L)]/∂KNational income = labor income + capital income = WL + RK

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Distribution with the Cobb-Douglas production function

National incomeY = MPL x L + MPK x K = L[(1-α)Y/L] +K[αY/K ] = Y (exhaustion of product theorem)

Shares of capital and labor:share of K = RK/Y = (αY/K ) x (K/Y) = constant = α

Why do economists like Cobb-Douglas? See next slides on historical data on factor shares.

Incomes in the National Income Accounts

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Share, 2001

National income 93.9 13,359

Compensation of employees 51.1 8,295 62.1%Proprietors' income 14.1 1,157 8.7%Rental income of persons 6.2 410 3.1% Corporate profits after tax 9.3 1,448 10.8%Net interest and misc 4.6 527 3.9%Taxes on production and imports 6.8 1,098 8.2%

2011

Table 1.12. National Income by Type of Income[Billions of dollars]Bureau of Economic AnalysisLast Revised on: August 29, 2012

1929

Source: U.S. Bureau of Economic Analysis (www.bea.gov)

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Near-constancy of labor’s share of national income

0%

10%

20%

30%

40%

50%

60%

70%

80%

1929 1939 1949 1959 1969 1979 1989 1999 2009

Share of compensation

Share of wages

?

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Other sources of national income

-5%

0%

5%

10%

15%

20%

1929

1932

1935

1938

1941

1944

1947

1950

1953

1956

1959

1962

1965

1968

1971

1974

1977

1980

1983

1986

1989

1992

1995

1998

2001

2004

2007

2010

Interest Proprietors Rental Corporate profits

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Applications of static neoclassical model

Impact of immigration: problem setImpact of foreign investment:

• Assume that foreign firms build a factory in US. What is effect in simple neoclassical model?

• Answer: Same as immigration, but reverse the factors.Impact of government debt: later in course

• What is the effect of a growing government debt?• Slightly more complicated, but might crowd out capital

stock. This then reduces output. Note effects on wages and rentals.

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What are the macroeconomic effects of

immigration?

Alfred Stieglitz

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L

W/P

MPL

Real wages and MPL: graphics

L*

(W/P)*

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L

W/P

MPL

Effect of immigration

L*

(W/P)1

(W/P)2

E1

E2

Assume immigrants are perfect substitutes for L

Results:1. Wage rate falls.2. Output and national

income rise.3. Capital income rises.4. More generally, income of

substitutes fall and complements rise.

5. Empirical studies suggest that low-skilled and Hispanic workers are hurt by Mexican immigration.

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National Academy of Sciences study (The New Americans)

“Immigration over the 1980s increased the labor supply of all workers by about 4 percent. On the basis of evidence from the literature on labor demand, this increase could have reduced the wages of all competing native-born workers by about 1 or 2 percent. Meanwhile, noncompeting native-born workers would have seen their wages increase…”

“Based on previous estimates of responses of wages to changes in supply, the supply increase due to immigration lowered the wages of high school dropouts by about 5 percent…”

What we missed at the end of last lecture…

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International macro

In a world of rapid globalization, international macro becomes increasingly important.

Role of exchange rates, international trade, currencies.

The biggest issues today are:

8. What are “global imbalances?” Why does the US have such a huge current trade deficit while China has such a large surplus? How will these resolve? 9. What is the reason for the Euro crisis? Will the Eurozone fall apart, or evolve closer to a standard fiscal union? Is disaster waiting around the corner?

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So this leads to the biggest question of them all…

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Why study macroeconomics?

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Because you may be the next Ben Bernanke – in charge of rescuing the world economy from the wreckage of some future depression!

A puzzler for the next class

Assume there are two goods (computers and shoes)

Period 1PShoes = Pcomputers = $1

Qshoes = Qcomputers = 1

Nominal GDP = $2

Period 2Pshoes = 1; Pcomputers = $0.01

Qshoes = 1; Qcomputers = 100

Nominal GDP = $2

What is the growth of real GDP from period 1 to period 2?

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