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The following version of the Classical and Keynesian models as well as the analysis behind them
is primarily from the seminal work of Sargent. This is a macroeconomic text that is used by
graduate students all over the country. Thomas Sargent is one of the best recognized and most
respected names in macroeconomics and is currently at Stanford University. In the mid-80s, he
wrote another nastier book (“Dynamic Macroeconomic Theory”) that ensured the doom of any
graduate student who had been brave enough to wade through “Macroeconomic Theory” even
though solutions to the problems in these books are available.
Note: for notation/definitions, look at the description at the end of this document.
Classical Model
The Classical model can be represented by a set of simultaneous equations, each equation either a
market clearing condition or behavioral relationship. Remember that a system of n equations
allows us to solve for at most n unknowns. The mechanics of setting this economic model are
beyond simply counting variables and equations since the question of whether to make a
particular variable endogenous or exogenous is an important issue.
Wage Equation
W/P = FN(K, N)
Real Wage = Marginal Product of Labor (Partial derivative of the production function with
respect to labor/employment).
Consumption Function
C = C((Y, T, δK, ((M + B)/p)π, I), i – π) C1 > 0, C2 < 0 1
1
C1 is the partial derivative of the consumption function with respect to its first argument – perceived
disposable income. Similarly, C2 is the partial derivative with respect to the second argument – the real
interest rate.
This can be rewritten as C = C(YD, i – π) where YD is perceived disposable income2. In the
classical model, disposable income is defined as “the rate at which households can consume
while expecting that their real wealth is being left intact”.
Perceived disposable income varies positively with output (Y) and Investment (I)
Perceived disposable income varies negatively with taxes (T), th amount of output used to
replace depreciated capital (δK), deficit of the Government financed by money creation (M)
and sale of bonds (B) whose real value will be [(M+B)/P]π.
Overall, consumption increases if perceived disposable income (YD) increases (i.e., C1 < 0).
Consumption depends negatively on the real interest rate (i.e., C2 < 0).
Investment function
dK F − (i + δ − π )
≡ I = I K or I = I(q(K, N, i – π, δ)), I′ > 0
dt i −π
We assume the real interest rate (r – π) is always positive. Then, I will be positive (i.e., the
time derivative or the growth rate of K will be positive) if FK (the marginal product of capital)
exceeds the real cost of capital (i + δ – π) which includes the cost of borrowing (i – π) as well
as the cost of replacing depreciated capital.
The ratio that is the argument of the Investment function may be seen as a relative price (the
ratio of the benefit of procuring capital to letting funds remain idle in some interest bearing
account that represents the opportunity cost). It is important to note that this is a Keynesian
investment function since the original classical model was equipped with an unrealistic
condition that the second-hand capital goods market is continuously cleared (i.e., no excess
demand or supply exists). The Investment function is redefined as q which, in turn, is a
function of K, N, i – π and δ. Finally, note that q depends on K and N only because of the
presence of FK which is the marginal product of capital (which depends on K and N).
2
Obviously, YD = YD(Y, T, δK, ((M + B)/p)π, I)
Money Market Equilibrium
M/P = m(i, Y) mi < 0, mY > 0
Money supply (M/P) = money demand (m(i, Y)). The money demand function (m) is shown to
have a speculative motive (mi < 0) and a transactions motive (mY > 0).
Keynesian Model
There is no discussion of arguments/equations/functions since they are essentially similar to the
Classical model.
Wage Equation
W/P = FN
Consumption Function
C = C(Y – T – δK – ((M + B)/P)π, i – π )
This is a simpler version of the consumption function in the Classical model. There is a
discussion below.
Investment Function
I = I(q(K, N, i – π, δ))
Solution method
The entire set of equations is first ‘totally differentiated’ (an example is provided in a
technical appendix towards the end of this handout). This means that the variables in the
equations will now be dW or dP or dY instead of W or P or Y (respectively).
The fully differentiated equations are then solved as a system of equations.
Relationships between endogenous variables and other endogenous and exogenous variables
are examined from the solution. Thus, from solutions, expressions (comparative statics) are
obtained which tell us about behavioral relationships within the economy.
Notation/Definitions
W = nominal wage
P = aggregate price level
Pi = price set by firm i
Pi/P = relative price of firm i (relative to other prices)
N = employment/employed workforce
K = stock of capital
Y = aggregate output
NS = Supply of labor
F = aggregate production function
δ = rate of depreciation of capital stock (given exogenously)
C = consumption
I = Investment (net of replacement of depreciated capital)
M = money stock
B = stock of bonds
π = inflation (no distinction is made of ex-ante and ex-post inflation in this simple model)