Ch.

1
Classical Macroeconomics: Output and Employment

1. The Starting Point

 Great Depression: “The General Theory of Employment, Interest and Money” by John Maynard
Keynes, in 1936 → Revolution against Classical.
 Classical thought even taken by the Keynesians as scrape but actually it proves to be base for
counter attack on Keynesians by Monetarist, New Classical and real business cycle theorists.
 Keynes considered all economists before 1936 as Classical but there also existed two broad
categories: Classical; Adam Smith, David Ricardo, John Stuart Mill; &&&: Neoclassical; Alfred
Marshal and A.C. Pigou.
 Classical Focus: Full employment (a point where actual output is just equal to potential output)
and Equilibrium.
2. The Classical Revolution
 Classical itself is a revolution against Mercantilist (16 th & 17th Century)
 Principles of Mercantilist: Bullionism and State Action
 Bullionism: Collect gold through export orientation, export of gold was prohibited, colonialism
 Principles of Classical: Real factors (money as means of exchange) and Free Market Economy (Self
adjusting tendencies)
 Classical thought are presented for explanation in the long-run, however, short run thinking could
be extracted
 Mercantilist viewed money as a source of demand but Classical termed this role as dangerous
 Mercantilist emphasized
3. Production
 Y =F ( Ḱ , N )
 Table: 1
 Figure: 1
4. Employment
 Assumptions: Market works well, optimizing behavior, perfect information, flexible wages, market
clear
Labour Demand
 Individual firm i.e. ith firm, perfect competition, profit maximization, output depends upon labour
hence choosing output is the basic decision for profit maximization
 Profit maximization decision of the ith firm is MC = MR
 MR = P
 MC of the firm is the marginal labour cost because labour is the only input & MCi = W/MPNi
 P = MCi ⇒ P = W/MPNi ⇒ MPNi =W/P
 Figure: 2
 Downward sloping curve due to the law of diminishing returns
 MPN curve is the demand curve for labour: inverse relationship
 Demand for labour is the aggregation of demands of all individual
 Nd = f(W/P) : Negative relationship
Labor Supply
 Individual Workers: Utility maximization
 Indifference curve analysis is helpful to understand Figure: 3
  Ns = g(W/P) : Positive relationship
 Two important features of labour supply curve:
Real wage
Positive Slope (Income Effect, and Substitution Effect, Backward Bending labour suppy curve)
 Figure: 3

5. Equilibrium Output and Employment

 Ch. 2
Classical Macroeconomics: Money, Prices and Interest

Aggregate Price Level- the Demand Side of the Economy

1. The Quantity Theory of Money

 Quantity of money determines aggregate demand which in turn determines price level
The Equation of Exchange
 An identity relating volume of transactions ( T ) at current prices ( PT ) to the supply of money
( M ) times the turnover rate ( V T )
 Turnover Rate: Average number of time each dollar is used in transactions during a certain time
PT T
period is called velocity of money i.e. VT=
M
 The identity given by Irving Fisher is M V T =PT T [on the basis of definition of velocity of
money]
3600
 Example: VT= =12
300
 This expression of exchange includes transactions of commodities produced in current time period
as well as transactions related to goods produced in previous time period
 Another version of equation of exchange, which consider income ( Y ) and velocity of income
( V ) as the variables of equation, does not include goods and services produced in previous time
period and includes only current output: V=PY/M ⇒ M V =PY
 This identity could be converted into equation if factors explaining velocity of money could be
explained

2.