THE CLASSICAL MODEL

Gardner Ackley
Macroeconomic Theory
1961
How Classical is it?
Adam Smith Gardner Ackley
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 Advisors
during the Johnson Administration (1964 – 1968)
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.

TEXTBOOK CLASSICISM
Refers to all economists up to but not including Keynes.
Gardner
Takes Ackley
a (mostly) was “aview.
short-run believer in the Government's
ability to manage the economy through fiscal and
Treats capital as parametric and doesn’t deal with growth.
monetary fine-tuning---a belief disputed by classical
Assumes that markets
economic work “perfectly.”
theorists….”
Assumes away all problems of pervasive unemployment.
From the NYT obituary, August 20, 1998
Allows for changes in the functional distribution of income.
Separates monetary issues from relative-price issues.
OUTPUT THE PRODUCTION FUNCTION
K = K0
LABOR
INPUT
Production is the central focus of
the classical model. Inputs in the
forms of labor and capital are
combined to produce output.
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 LABOR MARKET

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 upward-sloping supply curve
reflects the workers’ preferred
REAL
WAGE
tradeoff between labor and leisure.
RATE
S The downward-sloping demand is a
derived demand. It reflects labor’s
declining marginal productivity, as
D gauged by the employers.
The equilibrium real wage rate
LABOR
established by market forces ensures
INPUT 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
REAL
WAGE income to spend.
RATE
S But in virtually all macroeconomic
frameworks, the market-clearing real
wage rate is assumed to occur in the
D upward-sloping segment of the labor
supply curve.

LABOR
INPUT
OUTPUT THE REAL ECONOMY
REAL
INCOME With supply and demand determining
the level of labor input, the production
function indicates the corresponding
level of output.
Note that when the demand curve is
extended to the horizontal axis (at
which point the demand price of labor
LABOR is zero), the marginal productivity of
INPUT
labor is also zero.
REAL
WAGE The output of the economy, which
RATE
S includes both consumer goods and
producer goods, is sold at
competitive prices, generating the
D revenue to pay the incomes of both
laborers and capitalists. Those
incomes, then, are precisely enough
LABOR to buy the economy’s output.
INPUT
 OUTPUT THE REAL ECONOMY
Y/P = Q
REAL
INCOME Q = f(K, N)

K = K0

Q is the economy’s real output.

Y is nominal income.
P is the price level.
N
LABOR Y/P is real income.
INPUT
REAL N is the variable labor input.
W/P
WAGE
RATE K is the given capital input.
S
W is the nominal wage rate.

D W/P is the real wage rate.

(Y/P)N is real labor income.
(Y/P)N
Y/P − (Y/P)N is capitalist income.
N
LABOR
INPUT
 A REAL WAGE RATE STUCK TOO HIGH
Y/P = Q
Suppose that, for some reason or
other, the real wage rate was stuck
K = K0 above the market-clearing level.
The labor input would be demand-
constrained; total income to labor
may rise, fall, or remain unchanged,
depending on the demand elasticity.
N
The resulting unemployment is
measured by the discrepancy
W/P unemployment
between the labor supply and labor
S demand at the excessively high real
wage rate.
(Y/P)N

D The economy’s real output, which is

the same as the real income paid to
(Y/P)N all the factors of production (labor
and capital), declines.
N
 A CHANGE IN THE LABOR-LEISURE TRADEOFF
Y/P = Q
Suppose that people’s preferred
labor-leisure tradeoff changes in the
K = K0 direction of less leisure, causing the
supply of labor to shift rightward.
The number of worker-hours
supplied and demanded increases,
and the real wage rate is bid down.
N
The real income paid to the work
force rises, falls, or remains
W/P unchanged, depending upon the
S elasticity of the demand for labor.
The economy’s real output, which is
D the same as the real income paid to
all the factors of production (labor
(Y/P)
(Y/P)NN and capital), unambiguously rises.

N
 A LABOR-NEUTRAL INCREASE IN CAPTIAL

Y/P = Q K = K1
Consider an increase in the capital
input (K increases from K0 to K1)
K = K0 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,
N which implies some automation. This
automation, however, works only to
W/P increase output and not to displace
labor or to employ more of it.
S
The unchanged MPL implies an
unshifted demand for labor.
D
But with a greater capital input, the
(Y/P)N economy’s real output and hence
real income rise.
N
 AN INCREASE IN LABOR-USING CAPTIAL

Y/P = Q
K = K1
Consider an increase in capital of the
labor-using variety. The MPL (the
K = K0 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
N labor input at which MPL = 0 has
increased.
W/P Accordingly, the demand for labor
S shifts rightward.
And with both the real wage rate and
the level of employment increasing,
D the income received by labor
(Y/P)N increases dramatically.
The economy’s output and real
N
income rise, but less dramatically.
 A RESTRUCTURING WITH LABOR-SAVING CAPTIAL

Y/P = Q
Consider a restructuring of capital
with more of the labor-saving
K = K0 variety. The MPL is lessened at
K = K1
each and every level of labor input.
At the margin, the complementarity
between labor and capital has been
weakened, such that the level of
N labor input at which MPL = 0 has
decreased.
W/P Accordingly, the demand for labor
S shifts leftward.
And with both the real wage rate
and the level of employment
D decreasing, the income received by
(Y/P)
(Y/P)
N
labor decreases dramatically.
N
But the economy’s output and
N
hence real income rise.
CLASSICAL MONETARY THEORY Q

Pre-dating even Adam Smith was an

understanding of the relationship

MV
PQ = MV
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 P
the velocity of money (V) tends not to
A rectangle inscribed between
change, then the general level of
the axes and the equilateral
prices (P) and the economy’s output
hyperbola has an area of MV.
(Q) are inversely related.
With MV constant, all such
If the product of two variables (PQ) is
rectangles have the same area.
equal to a constant (MV), the
graphical rendition of the relationship Light up all the areas and it’s sort
is an equilateral hyperbola. of pretty.
 THE CLASSICAL MODEL

Y/P = Q Q

K = K0

(MV)0

N P

Making an explicit appearance in the

W/P
classical model, either as a variable
S or a parameter are eight magnitudes,
namely: K, M, N, P, Q, V, W, and Y.
D The nominal wage rate (W) does not
make a solo appearance on an axis.
(Y/P)N But an auxiliary diagram can easily
be created to keep track of W.
N
 THE CLASSICAL MODEL

For a given real wage, W and P

move in direct proportion to each
other.
The real wage rate is conventionally
symbolized by a script ω. Hence, we
can write: ω = W/P.

Solving for W, we can write: W = ωP,

where ω is the slope of the ray that
relates W to P.
W
If the real wage falls (because of a
rightward shift in the labor supply or a ω
leftward shift in labor demand), the
1
ray (W = ωP) rotates clockwise, ω’
indicating, a lower real wage rate, a 1
lesser slope.

P
 THE CLASSICAL MODEL

Y/P = Q Q

K = K0

(MV)0

N P

Making an explicit appearance in the

ω = W/P W
classical model, either as a variable
S or a parameter are eightωmagnitudes,
namely: K, M, N, P, Q, V, W, and Y.
1
D
(Y/P)N

N P
 THE CLASSICAL MODEL

Y/P = Q Q

K = K0

(MV)0

N P

Making an explicit appearance in the

ω = W/P
classical model, either as a variable
S or a parameter are eight magnitudes,
namely: K, M, N, P, Q, V, W, and Y.
D Conspicuous by its absence is the
interest rate, a key variable in the
(Y/P)N analysis of both secular and cyclical
movements in the economy’s output.
N
 THE CLASSICAL MODEL

Y/P = Q Q

K = K0

(MV)0
RATE OF INTEREST

S
N P

The interest rate governs resource

ω = W/P
allocation within the output magnitude
S D by dividing output (Q) into its
temporally related components of
investment (I) and consumption (C).
D
SAVIING (S)
INVESTMENT (D) An increase in saving (decrease in
(Y/P)N consumption), lowers the interest rate,
allowing the business community to
N
finance more investment activities.
 THE CLASSICAL MODEL

Y/P = Q Q

K = K0

(MV)0
RATE OF INTEREST

S
N P

The interest rate governs resource

ω = W/P
allocation within the output magnitude
S D by dividing output (Q) into its
temporally related components of
investment (I) and consumption (C).
D
SAVIING (S)
INVESTMENT (D) An increase in saving (decrease in
(Y/P)N consumption), lowers the interest rate,
allowing the business community to
N
finance more investment activities.
 THE CLASSICAL MODEL

Y/P = Q Q

K = K0

(MV)0

N P

The interest rate governs resource

ω = W/P
allocation within the output magnitude
S by dividing output (Q) into its
temporally related components of
investment (I) and consumption (C).
D
An increase in saving (decrease in
(Y/P)N consumption), lowers the interest rate,
allowing the business community to
N
finance more investment activities.
 THE CLASSICAL MODEL

Y/P = Q Q

K = K0

(MV)0

N P

The underlying assumption (or vision)

ω = W/P
entails a unfailing market mechanism
S that allocates resources within the
output aggregate, keeping investment
in line with saving.
D
This mechanism, which relies on
(Y/P)N equilibrating movements in interest
rate, is acknowledged by--but is not
N
integral to--the classical model.
 THE CLASSICAL MODEL

Y/P = Q Q

K = K0

(MV)0

N P

With money and the price level now

ω = W/P
in play, observe the real and
S monetary consequences of an
increase in the supply of labor.
D
(Y/P)N

N
 THE CLASSICAL MODEL

Y/P = Q Q

K = K0

(MV)0

N P

With money and the price level now

ω = W/P W
in play, observe the real and
S monetary consequences ω of an
increase in the supply of labor.
1
ω’
D This time, we’ll keep track of the
nominal wage rate,1too.
(Y/P)N

N P
 THE CLASSICAL MODEL

Y/P = Q K = K1 Q

K = K0

(MV)0
(MV)0

N P

Observe the real and monetary

ω = W/P
consequences of a labor-neutral
S increase in capital.

D
(Y/P)N

N
 THE CLASSICAL MODEL

Y/P = Q Q
K = K1

K = K0

(MV)0
(MV)0

N P

Observe the real and monetary

ω = W/P
consequences of an increase in
S capital of the labor-using variety.

(Y/P)N
D
(Y/P)N

N
 THE CLASSICAL MODEL

Y/P = Q Q
K = K1

K = K0

(MV)0
(MV)0

N P

Observe the real and ω’monetary

ω = W/P W
consequences of 1an increase in
S ω variety.
capital of the labor-using
And we’ll keep track
1 of the nominal

(Y/P)N
D wage rage.

(Y/P)N

N P
 THE CLASSICAL MODEL

Y/P = Q Q

K = K1 K = K0

(MV)0
(MV)0

N P

Observe the real and monetary

ω = W/P
consequences of a restructuring with
S capital of a labor-saving variety.

D
(Y/P)
(Y/P)
N
N

N
 THE CLASSICAL MODEL

Y/P = Q Q

K = K0

MV0 MV1

N P

Observe the real and monetary

ω = W/P
consequences, assuming a given
S money supply, of an increase in the
velocity of money (V).
D
(Y/P)N

N
 THE CLASSICAL MODEL

Y/P = Q Q

K = K0

M0V M1V
RATE OF INTEREST

S
N P

Does it matter
Observe the real
thatand
themonetary
increase in
ω = W/P
consequences,
money supply (M)assuming
also caused
a given
the
S D velocity
rate of interest
of money,
to be
of lower
an increase
than it in
the moneywould
otherwise supplyhave
(M).been?
D
SAVIING (S) Can the allocation within the output
INVESTMENT (D) magnitude proceed without being
(Y/P)N distorted by a monetary expansion?
N
 THE CLASSICAL MODEL

Y/P = Q Q

K = K0

M1V
RATE OF INTEREST

S
+ΔM
N P

Does it matter that the increase in

ω = W/P
money supply (M) also caused the
S D rate of interest to be lower than it
otherwise would have been?
D
SAVIING (S) Can the allocation within the output
INVESTMENT (D) magnitude proceed without being
(Y/P)N distorted by a monetary expansion?
N
 THE CLASSICAL MODEL

Y/P = Q Q
K = K1

K = K0

M1V
M0V

N P

Now suppose
Does it matter the
thatcentral
the stabilization
bank is
ω = W/P
policy (the increase
committed to a policyinof
Mprice-level
to match
S the increase in Q) also caused the
stabilization.
rate of interest to be lower than it
How does this policy affect the real
otherwise would have been?
(Y/P)N
D and/or monetary consequences of
Canincrease
an the allocation
in capital
within
of the
thelabor-
output
(Y/P)N magnitude
using variety?
proceed without being
distorted by a policy-infected rate of
N
interest?
 THE CLASSICAL MODEL

Y/P = Q Q

K = K0

M1V1
M0V0

N P
Suppose that the central bank blunders
ω = W/P mightily by allowing the money supply
to collapse. Fortunately, prices and
S wage rates, being sufficiently flexible
and not impeded by policymakers,
D adjust downward quickly and in direct
proportion to the shrinkage of the
(Y/P)N money supply.

N What are the consequences?

 THE CLASSICAL MODEL

Y/P = Q Q

K = K0

M1V1
M0V0

N P
Suppose that the central bank blunders
ω = W/P unemployment
mightily by allowing the money supply
to collapse. Confidence is shaken and
S the velocity of money falls, too. Then,
policy-makers step in and try to keep
(Y/P)N

D prices and wage rates from falling.

Deflation sets in anyway, but with
(Y/P)N prices falling more than wage rates.

N What are the consequences?

 THE CLASSICAL MODEL
Gardner Ackley
Macroeconomic Theory
1961
See Roger LeRoy Miller and David D. VanHoose
Macroeconomics: Theories, Policies, and International Applications
Chapters 3 - 5
 CONSEQUENCES
of the
LARAMIE CLEAN AIR ACT
Y/P = Q Q

This slide is the solution

to the study Kproblem:
= K0

LARAMIE CLEAN AIR ACT

(MV)0
which is available as a .pdf file
(MV)0 M1V
on the course website.
K = K1

N P

Any factory
Now suppose whose
that the
emissions
Federal
W/P
Reserve
result in air
attempts
less pure
to soften
than that
the
S act’s effect
found on output
in Laramie, by
Wyoming will
expanding
be subject to thea money
ceremonial
supply.
dismantling on Earth Day.
D
What are the consequences?
(Y/P)
(Y/P)NN

N
 THE CLASSICAL MODEL
depicting
A KEYNESIAN-STYLE COLLAPSE
Y/P = Q Q
INTO DEPRESSION

The so-called “classical”

K = K0 framework
together with the Keynesian treatment
of prices, the wage rate, and interest rates
can depict an economic collapse brought
M0V0
about by a waning of the “animal spirits.”
M0V1

N P

Observe the real and monetary and real

ω = W/P
consequences of a waning of the animal
S spirits in a fixed-price/fixed-wage setting.
As money is hoarded rather than spent, the
D economy spirals downward. Labor demand
falls, and capital in underutilized.
(Y/P)
(Y/P)
N
N