Classical Approach of Macroeconomics

After reading this chapter, you will be conversant with: The Classical Aggregate Supply Model The Keynesian Aggregate Supply Model The Classical Analysis of Income Determination

Macroeconomics

INTRODUCTION
Earlier we have seen the role of aggregate demand in determining output and employment at a given price level. We have simply kept aside supply side and its role in the determination of output and employment. As we have seen, the aggregate demand function represents the total quantity of output willingly bought at a given price level, given the values of exogenous or autonomous components like government spending, nominal money stock and the tax rate and behavioral parameters such as the marginal propensity to consume (MPC), marginal propensity to import (MPI), etc. The variation in the price level was of a purely hypothetical situation. Whatever amount of goods was demanded would be supplied at the existing price level. We now turn to a complete model of determination of aggregate output and the price level. To start with, we analyze the conditions determining aggregate supply in both Classical and Keynesian macroeconomic frameworks. Later on we integrate both aggregate supply and aggregate demand functions to have a complete model of income determination and price level, with the help of both Classical and Keynesian analyses. The aggregate supply curve describes the combinations of output and the price level at which firms are willing, at the given price level, to supply the given quantity of output. The amount of output that business firms are willing to supply depends on the prices they receive for their goods and the amount they have to pay for labor and other factors of production. Accordingly, the aggregate supply curve shows conditions in the factor markets, especially, the labor market, as well as the goods market. In this section we concentrate on two special cases in discussing aggregate supply function, i.e. Classical and Keynesian. From a historical standpoint it is very important to compare and contrast the views expressed by the classical economists and J.M. Keynes. The main reason is that the analysis have different implications regarding a market economys tendency to adjust to full employment and the relative effectiveness of monetary and fiscal measures.

THE CLASSICAL AGGREGATE SUPPLY MODEL

To develop an aggregate supply model, we have to consider a number of relationships: the production function, the demand for labor function and the supply of labor function. From these relationships, we derive an aggregate supply function, a relationship between output and the price level. The first step in the derivation of the supply curve is the production function.

The Production Function

This is a technological relation between the rates of input of productive resources and the maximum rate of output that can be had from those inputs, given the technology of production. For example, suppose it takes two units of capital and three units of labor (in fixed proportion) to produce a particular product. This functional relationship between inputs and outputs is an example of a production function. The measure of quantity of aggregate output is national product or GDP(Y). Generally, economists are concerned with production functions in a microeconomic context, i.e. production function of a single firm or an industry. For our purpose, we must consider an aggregate production function. For the economy as a whole we postulate the following relationship. Given the nations land, natural resources, and technology, the economys output is a function of the economys capital stock and the amount of labor employed. In equation form, the relationship is Y = f(K, N) 148 .... (8.1)

Aggregate Supply, Price Level and Employment: Macroeconomic Equilibrium in the Classical Model

where Y represents the economys output or income, K the economys capital stock, and N the amount of labor employed. Output is assumed to be positively related to the capital stock and the amount of labor employed. Diminishing returns are also assumed with regard to the factors of production so that an increase in employment (the capital stock), with the capital stock (employment) constant, increases output but at a diminishing rate. Since the theory of income determination presented in this chapter is a short run theory, both the capital stock and technology (as well as the nations land and natural resources) are assumed constant. If the capital stock is assumed constant, output in the short run depends only on quantity of labor input: Y = f(N) ....(8.2) and may be plotted as in Figure 8.1. In Figure 8.1, output is measured on the vertical axis and employment on the horizontal. The relationship Y = f(N) suggests that output increases as employment increases but at a diminishing rate. For example, if employment is N0, output is Y0. As employment increases to N1 and then to N2, output increases, but the increases in output become smaller. Figure 8.1: The Production Function

The Demand for Labor Function

If we assume a given capital stock and pure competition, the demand for labor curve consists of the marginal product of labor curve, which can be derived from the production function. Under pure competition a profit maximizing firm hires workers until the (average) money wage, W, is equal to the general price level, P, multiplied by the marginal product of labor, MPL. In equation form the relationship is W = P . MPL ....(8.3) The money wage represents the actual wage paid to labor. In the above relationship, W represents the cost of hiring an additional worker, and P . MPL represents the revenue associated with the employment of an additional worker. So long as the cost of hiring an additional worker is less than the revenue gained, firms will demand additional workers. As firms hire additional workers, the marginal product of labor declines. Consequently, employment will increase until the money wage, W, equals the general price level, P, multiplied by the marginal product of labor, MPL. Firms have no incentive to hire additional labor since the cost of hiring an additional worker exceeds the revenue gained. If both sides of equation (8.3) are divided by the general price level, P, one gets the following relationship. W P = MPL ....(8.4)

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The wage-price ratio on the left side of equation (8.4) is usually referred to as the real wage. It is the money wage deflated by the general price level. Consequently, with the capital stock constant and with pure competition, the real wage, W/P, equals the marginal product of labor, MPL. To obtain the demand for labor curve, a relationship between the real wage and the amount of labor demanded, we use the relationship W/P = MPL and determine the marginal product of labor from the production function. As defined, the marginal product of labor is the change in output per unit change in the quantity of labor employed. If the change in output is N and the change in employment is N, the marginal product of labor is the change in output, Y, divided by the change in employment, N, or Y/N. Consequently, the marginal product of labor, Y/N, is the slope of the production function. In Figure 8.2.A the marginal product of labor at employment level N0 is ( Y/N )0, the slope of the production function at that level of employment. The relationship slopes downward and to the right because diminishing returns to labor have been assumed. The demand for labor function, a relationship between real wage (W/P) and the amount of labor demanded, is shown in Figure 8.2.B. Once the real wage is specified the amount of labor demanded is determined. The amount of labor demanded depends on the real wage. At real wage (W/P)0 in Figure 8.2.B the amount of labor demanded is N0. If the real wage declines, the amount of labor demanded increases. For example, if the real wage declines to (W/P) 1, the amount of labor demanded increases to N1 because, with the lower real wage, business firms have an incentive to employ additional workers. Since the amount of labor demanded is a function of the real wage, we specify the demand for labor function as ND = f ( W P ) and dN
D

d(W/P)

<0

..... (8.5)

Figure 8.2: The Production and Demand for Labor Functions

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where ND is the amount of labor demanded and W/P is the real wage. The amount of labor demanded is inversely related to the real wage. Therefore, a decrease in the real wage increases the amount of labor demand. Since the marginal product of labor curve is derived from the production function, it shifts if the production function shifts. For example, if the capital stock increases, the production function shifts upward and the demand for labor curve shifts to the right, indicating an increase in the demand for labor.

The Supply of Labor Function

As in the case of the demand for labor function, the real wage plays a key role in the supply of labor function. The classical model assumes that the supply of labor depends upon the real wage (W/P). In equation form, the supply of labor function is written as s dN S S N = f(W/P), and W < 0 where N is the amount of labor supplied and W/P d( ) P is the real wage. The amount of labor supplied is assumed to be positively related to the real wage so that an increase in the real wage results in an increase in the amount of labor supplied. Graphically, the supply of labor function is depicted in Figure 8.3. At real wage (W/P)0, the amount of labor supplied is N0. If the real wage increases to (W/P)1 the amount of labor supplied increases to N1. Figure 8.3: The Supply of Labor Function

Let us summarize our arguments so far: i. ii. iii. iv. Production is entirely a function of the quantity of labor: Y = f(N) Amount of labor supplied depends only on real wage and increases with real wage: NS = f(W/P) Amount of labor demanded also depends only on real wage and decreases with it: ND= f(W/P) According to the classical economists, the real wage is perfectly flexible. Therefore, the view which underlies the classical theory is one which believes that the economy is made up of efficiently operating markets that are very flexible and with rapidly adjusting prices. Indeed the modern classical theory is often referred to as being a flex price (which also includes labor wage) model. If all markets are in equilibrium, then it means that the labor market must be in equilibrium also: ND = NS = N From the above, it can be inferred that given the labor force N quantity supplied will be Y = f(N) , irrespective of the price level. In the classical model (which is 151

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based on Says law of markets i.e. supply creates its own demand), aggregate output (y) is solely determined in the labor market, aggregate demand is required only to determine the price level. Figure 8.4: The Derivation of Aggregate Supply Curve (with money wages flexible)

The classical view of aggregate supply curve is shown in Figure 8.4. The top part of the figure shows the equilibrium conditions in labor market i.e. ND = NS = N . The equilibrium real wage is (W/P) and the equilibrium level of employment is N . The middle section of Figure 8.4 shows aggregate production function for the whole economy. As shown in figure, the production function is not a straight line, but is curved. This demonstrates diminishing returns to fixed factor, capital. The level of output that corresponds to full employment equilibrium in the labor market ( N ) is Y . For example, if the price level rises, the nominal wage rate (W) will adjust after a change in the price level in order to keep the real wage constant at the equilibrium level i.e. (W/P) . Thus, according to classicals, the economy will always be at its full employment level of output Y .

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At the full employment level of output, any employment which might exist is voluntary and is referred to as the natural rate of unemployment, because output cannot be raised above its current level even if the price level rises. There is no more labor available to produce any extra output. Thus, the aggregate supply curve will be vertical (i.e. perfectly price-inelastic aggregate supply curve) at a level of output corresponding to full employment of the labor force, Y as shown in the bottom part of Figure 8.4. The aggregate supply curve which relates the aggregate supply of output to the general price level should not be confused with the supply of labor curve, NS, which relates the amount of labor supplied to the real wage (W/P).

THE KEYNESIAN AGGREGATE SUPPLY MODEL

This classical approach to analyzing economic behavior came under severe criticism due to its unrealistic assumptions of wage-price flexibility and the existence of voluntary unemployment. In real world, all unemployment is certainly not voluntary. There are many who wish to work but cannot find work implying the existence of involuntary unemployment. J. M. Keynes and Keynesian economists disputed the classical assumptions and pointed out that a perfectly efficient wage-price flexibility is far from real world. Different prices adjust at different speeds. Some adjust very rapidly while others are slow to change. For example, interest rates and exchange rates tend to change quickly but wage rates do not. Therefore the Keynesian aggregate supply curve is based on the assumption that the wage does not change much or change at all when there is unemployment, and thus the unemployment can continue for sometime. As shown below this difference of views with regard to the labor supply behavior leads to a totally different result. The aggregate production function is the same as (8.2) with declining marginal product of labor (MPL). The demand for labor is also the same as a decreasing function of the real wage. The difference is in the description of labor supply behavior. Let us summarize the Keynesian assumptions. i. The nominal wage (W) is an exogenous variable in the short run: W = W. A milder version would be that money wage adjustment is extremely sluggish. But this does not mean that money wages do not adjust. Rather it means that they adjust slowly, relative to the general price level. It is not a rapid flexible adjustment as happens in the classical model. ii. The labor market is not always in equilibrium and this implies the existence of less-than full employment situation. Figure 8.5 illustrates the working of the Keynesian model. We will start with the three segmented aggregate supply curves made up of AB, BC and CD. The segment along AB, prices are completely inflexible, output and employment change without any change in the price level. Along BC, money wages do not adjust as quickly as the price level. Therefore the business firms can adjust by producing more output and hiring more labor. The segment along CD is the full capacity or full employment aggregate supply curve. Now let us see the aggregate demand and aggregate supply together.

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Figure 8.5: The Derivation of Aggregate Supply Curve (with money wages rigid)

For example, there is an increase in investment spending. This in turn increases expenditure and demand in the economy, so the aggregate demand curve moves from AD0 to AD1. As aggregate demand increases, firms produce more output to meet this extra demand and also employ more labor force. Corresponding to the increase in aggregate demand, output rises from Y0 to Y1. But price level will also keep rising, as the extra demand in the economy puts pressure on to markets and prices are bid upwards. The rise in price level is shown as the move from P0 to P1. However if the price level rises faster than money wages, then the real wage will fall and firms will employ more labor force. Thus, an increase of aggregate demand over the segment BC will result in both an increase in output and an increase in price level. But when we compare this situation with a shift in aggregate demand from AD 2 to AD3 over the range AB of the aggregate supply curve, whatever increase there is in demand comes through output only i.e. Y2 to Y3. Because, as shown in figure 8.5, prices are completely inflexible over the range AB. This is in contrast to the full employment (Y) segment, CD. Because, at the output level Y, economy has reached its physical capacity constraint i.e., it cannot increase output beyond the level Y where all the resources are fully employed. There is no more labor available to produce any extra output. Thus, the aggregate supply curve will be vertical at a level of output corresponding to full-employment of the labor force i.e. Y. All of the extra demand, from AD 4 to AD5, in the economy puts pressure on the markets and price level increases from P4 to P5. Therefore, the important contribution of the Keynesian aggregate supply model is that different prices, including money wages, adjust at different speeds implying a much broader range of supply response. This is evident from the different segments of the aggregate supply curve. If you are interested in what happens to the economy following a change in aggregate demand, it is essential to know where the economy is in equilibrium on different segments of the aggregate supply curve.

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Unemployment in the Keynesian model is caused by demand deficiency. In the figure 8.5 if aggregate demand is AD0, then the level of output is Y0 and employment is N0 which is below the full employment level, N . Unemployment is to the extent of N to N0. It could be reduced if the aggregate demand increases and touch the segment, CD. Therefore the Keynesian theory of unemployment suggests that governments can play an active role in the economy by adjusting the level of aggregate demand through its fiscal and monetary instruments.

THE CLASSICAL ANALYSIS OF INCOME DETERMINATION

According to the orthodox doctrine, as we have seen in the previous section, the operation of market forces would automatically result in the full employment level of equilibrium. To refresh the readers memory, it was argued that if the wage rates and prices were sufficiently flexible there should be no reason for unemployment. As shown there, a reduction in wage rate would cure any temporary unemployment. The possibility of general glut (i.e. oversupply of output) was also ruled out by classical analysis of income determination. One of the propositions of classical analysis was Says Law of Markets which stated that supply creates its own demand. The obvious implication of Says law is that any increase in output and employment (or supply) will by itself generate an equivalent increase in income expenditure (or demand). The working of Says law is based on a simple concept that the exchange between two parties involves both a purchase and a sale. Say extended this interdependency of supply and demand from the barter economy where every sale involves a demand of equal value and no excess demand or supply can exist and no commodity will be produced without a corresponding level of demand for its consumption to a general theory of markets. Therefore, the very act of production constitutes the demand for other goods, a demand equivalent to the value of the surplus goods each economic unit produces. Under these conditions, as argued by J.B. Say, there can never be a general overproduction of goods and hence aggregate demand (AD) equals aggregate supply (AS) in the economy. However, total output may surpass total demand, because at some point, an individual may prefer leisure rather than employment, but such unemployment will be purely voluntary rather than involuntary unemployment. Further, prices are assumed to be such that the value of commodities produced is just equal to the value of expenditure on commodities as a whole. The essence of the argument was accepted and clarified by David Ricardo and J.S. Mill, major practitioners of classical ideas. This formulation of Says law quite explicitly admits that temporary imbalances in specific lines of production might arise because individuals may not correctly direct their production in accordance with wants and requirements of others. This maladjustment of relative outputs is merely temporary and is viewed as an essentially short-term phenomenon. Because it is felt that a supply in excess of demand of one commodity is more or less exactly balanced by a supply below demand of another class of goods, which in turn implies that on the whole there is no overproduction or a general glut of commodities. Further, in the long run the market mechanism works in such a fashion that it would tend to adjust or rectify whatever internal imbalances exist in the short run in some sectors of the economy. Therefore, the basic argument of Says law applies to an economy using money without making any fundamental changes. David Ricardo and his followers believed that the law is also applicable for an economy which is monetized, perhaps under the impression that, apart from the occasional eccentric miser people do not desire money for its own sake. This implied that if they sold this output or services for money, the money so earned would in turn be promptly spent on other goods and services. Therefore, in the classical system of income determination money is regarded merely as a convenient medium of exchange, 155

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introduced essentially with a view to replace barter economy which is inconvenient and far from the real world. Thus, the basic premise on which the entire classical system is based is on Says law of markets. And it shows that under conditions of general equilibrium the economy operates at the full employment level of output. The classical formulation of macroeconomic system is presented with the help of a graphical apparatus to explain the determination of income and employment and price level.

Equilibrium in the Classical Model

According to the traditional classical formulation, the economy consists of three markets, namely, labor market, goods market and money market. In each of these markets, the operation of the forces of supply and demand would finally result in full employment level of output. The classical system can be represented by the following set of equations. Labor Market: Y dY = f(N) W/P f(W/P) f(W/P) N
S

..... (8.6) ..... (8.7) ..... (8.8) .... (8.9) .... (8.10)

= dN ND = N N Where Y N W P = = = =
S D

= =

real output or income employment money wage rate general price level ..... (8.11) quantity of money real output or income general price level fraction of income that is deemed to be held in cash balances ..... (8.12) ..... (8.13) ..... (8.14)

Money Market: M = KPY Where M Y P K = = = =

Goods Market: S = f(r) I = f(r) S=I Where S I R = = = savings investment rate of interest

The classical macroeconomic analysis explains the determination of equilibrium levels of aggregate employment and output, real wage, saving and investment, rate of interest and price level and money wage. It is shown in the set of equations above. Equation (8.6) is the aggregate production of the economy which is a functional relationship between employment and output. Output increases with an increase in 156

Aggregate Supply, Price Level and Employment: Macroeconomic Equilibrium in the Classical Model

employment. However, the rate of increase in output decreases as employment increases because of the operation of the law of diminishing returns. Equation (8.7) expresses the profit maximization condition which states that under a competitive system real wages equal the marginal product of labor. Equation (8.8) shows the demand for labor as a function of the real wage rate. More and more employment is offered only as the real wage rate is lowered. This is so because the marginal product of labor decreases as output increases with the increase in employment. The demand function for labor is the slope of the production function embodied in Equation (8.6). Equation (8.9) treats the supply of labor as an increasing function of the real wage rate because the marginal disutility of work rises as the amount of work done increases. Equation (8.10) specifies the equilibrium conditions for the labor market. Equation (8.11) represents the quantity theory of money. Equation (8.12) expresses savings as an increasing function of the interest rate, given the full employment level of output. Equation (8.13) treats investment as a decreasing function of the interest rate. Both savings and investment are defined in real terms. Equation (8.14) shows the equilibrium condition in the goods market. As shown above, it is easy to see how these equations constitute a self-contained system. Equations (8.8), (8.9) and (8.10) show the equilibrium conditions in the labor market i.e. both the equilibrium quantity of labor employed and the corresponding equilibrium level of real wage rate. Then automatically, we can derive from equation (8.6) the total output that will be produced at that level of employment. This, in turn, represents the full employment level of output consistent with the given equilibrium level of real wage rate. From equation (8.11), given the money stock we can find out the amount of money income that would correspond to the full employment level of output. As the full employment level of output is already known, the level of price can be determined easily from the same equation. Equation (8.12) treats savings as an increasing function of the interest rate, given the full employment level of output. Equation (8.13) shows investment as a decreasing function of interest rate. Equation (8.14) represents the equilibrium conditions in the goods market. Figure 8.6 Determination of Aggregate Output and the Price Level in the Classical System

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Figure 8.6 shows the determination of aggregate output and the price level in the classical model. Figure 8.6(a) shows the aggregate production function subject to diminishing returns. For each level of labor input there is a corresponding total output. Figure 8.6(b) represents the intersection of supply and demand curves for labor. The demand for labor N here is taken as precisely reflecting the Marginal Productivity of labor, (MPL) from the aggregate (production) function. A change in the height of the production (Pn) function, with no change in its slope at any level of employment, would leave the Marginal Productivity curve unchanged. But any change in the slope of the production function curve will alter the Marginal Productivity i.e. labor demand curve. The intersection of two curves defines the point of full employment, N and the real wage ( W /P) which corresponds to full employment. If the real wage is less than ( W /P)0, the result would be a labor shortage and vice versa. In Figure 8.6 (c) the straight line through the origin, KPY (whose slope is 1/k), shows the amount of money required for each level of money income. If the actual stock of money is M 0, then money income must equal (P Y ). Since Y is known from diagram (b), P 0 can be derived. Part (d) shows the necessary level of money wage. Any real wage is a ratio of price to money wage. Therefore, corresponding to each real wage are numerous possible combinations of price level and wage rates, all of which fall on a straight line throughout the origin whose slope measures the W/P. As we have seen, an aggregate supply curve may be derived on the basis of equations (8.6) to (8.10) and is shown as AS0 in Figure 8.7. Since the classical economists assumed that money wages are flexible, the aggregate supply curve is perfectly inelastic at the full employment level of output, Y0 = Y . If aggregate demand is AD0 and aggregate supply is AS0, in Figure 8.7, the equilibrium price level, money wage, real wage, employment and output levels are P0, W0, (W/P) 0, N0 and Y0 respectively. Figure 8.7: Aggregate Supply and Demand in the Classical Model

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Since money wages and prices are assumed to be flexible, real wages, employment, and output are at their full employment levels. The general price level and output are determined by the interaction of aggregate demand and supply. Investment, saving, and the interest rate are determined by the interaction of investment and saving. Like Keynes, the classical economists assumed that investment is inversely related to the interest rate. The investment function is plotted in Figure 8.8. Unlike Keynes, the classical economists assumed that saving depends on the interest rate. In particular, they assumed that it is directly related to the interest rate. The savings function is also plotted in Figure 8.8. Figure 8.8: Investment, Saving and the Interest Rate in the Classical Model

For the interest rate to be at its equilibrium level, investment must equal saving. Thus, the equilibrium condition is I=S According to the equilibrium condition, the equilibrium interest rate in Figure 8.8 is i0. If the interest rate is less than i0, investment exceeds saving and the interest rate increases. Conversely, if it is greater than i0, savings exceed investment and it decreases. If interest rate is i0, the equilibrium levels of investment and savings are I0 and S0, respectively. The equilibrium level of consumption can be determined by subtracting investment I0 (or saving S0) from income Y0. Thus, in the classical model, the division of output into consumption and investment is determined by the investment and savings functions. Should society decide to invest (save), more or less, investment, savings, and the interest rate will be altered. However, aggregate output and the general price level will remain unchanged. To illustrate, suppose the investment function of Figure 8.8 were to shift to the right. Investment, savings, and the interest rate would increase. Since the aggregate demand and supply curves of Figure 8.7 are unaltered, output and the price level are constant. The increase in the interest rate reduces consumption. In fact, the reduction in consumption offsets the increase in investment so as to leave output unchanged. Having discussed the classical system of macroeconomic equilibrium, let us consider one of the basic propositions of the model: changes in the nominal money supply will result in proportional changes in money wages and prices, with no change in real wage, employment and output. This is shown below. Change in Money Supply In the classical analysis, change in the aggregate money supply will not affect the real wage, employment and output. The change in money supply will affect only the price level and the money wage. For example, suppose the nominal money supply doubles. This will cause an upward shift in the product of P and Y . With the increase in money supply, as shown in Figure 8.7 aggregate demand increases to AD1. As a result the price level and the money wage rate increases to P 1 and W1 159

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respectively. Since no one in the economy will hold idle money, an increase in the total money supply will mean an effective increase in the aggregate money supply P Y with no increase in the aggregate supply. Now the previous output, Y , will sell at a higher price, P1. If money wage is not increased, real wage would fall. Therefore real wages, employment and output are unchanged. As we have seen in the traditional classical formulation, the determination of the equilibrium level of saving and investment is independent of the determination of the output, employment and price level. The equations relating from (8.6) to (8.11) can be solved independently of the system of equations (8.12) to (8.14). Thus the latter system only determines the distribution of aggregate output and income between investment spending and consumption spending. Further, the classical system led to a dichotomized analysis of the economy, with real variables determined by real factors, and monetary variables determined by monetary factors. The classical formulation of Quantity Theory of Money asserts that changes in money supply affect only the absolute price level and not the relative prices which are determined in the goods market by the real forces of demand for and supply of goods. The implication of this is that money is neutral and can have no effect on the real magnitudes like output or employment. The real wage (W/P) and levels of employment (N) and output (Y) are determined by real factors alone i.e. MPL and marginal disutility of labor. Money wages and prices are determined solely by monetary factors i.e. changes in the money supply. Changes on the real side can affect prices and wages, but changes on the monetary side have no effect on the real magnitudes. This presumably justifies the classical tradition of developing the theory of output and employment entirely in real terms (Says Law).

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