The Classical Model

Classical economists Adam Smith, J.B. Say, David Ricardo, John Stuart Mill, Thomas Malthus, A.C. Pigou, and others wrote from the 1770s to the 1930s. They assumed wages and prices were flexible, and that competitive markets existed throughout the economy.

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The Classical Model

The classical model was the first attempt to explain
Determinants of the price level National levels of real GDP Employment Consumption Saving Investment
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The Classical Model (cont'd)

Say s Law
A dictum of economist J.B. Say that supply creates its own demand Producing goods and services generates the means and the willingness to purchase other goods and services. Supply creates its own demand; hence it follows that desired expenditures will equal actual expenditures.

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Say s Law and the Circular Flow

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The Classical Model (cont'd)

Assumptions of the classical model
Pure competition exists. Wages and prices are flexible. People are motivated by self-interest. People cannot be fooled by money illusion.

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The Classical Model (cont'd)

Money Illusion
Reacting to changes in money prices rather than relative prices If a worker whose wages double when the price level also doubles thinks he or she is better off, that worker is suffering from money illusion.

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The Classical Model (cont'd)

Consequences of the assumptions
If the role of government in the economy is minimal, If pure competition prevails, and all prices and wages are flexible, If people are self-interested, and do not experience money illusion, Then problems in the macroeconomy will be temporary and the market will correct itself.

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Classical Theory
Classical economics believed that prices, wages and interest rates are flexible. Say s law says when economy produces a certain level of real GDP, it also generates the income needed to purchase that level of real GDP.) hence, always capable of achieving the natural level of GDP. Fallacy here: no guarantee that the income received will be used to purchase g & s.----some will be saved.
But theory would be redeemed, if the savings goes into equal needed amounts of investment.

Interest Rate Flexibility

 For Say s law to be valid, amount of money saved must = amount of money invested.  Why? Because of interest rate flexibility.  More money into savings, more available for investment. This would force interest rates go down.  Says believes if C decreases the same percentage increase will be seen in I

Three States of the Economy

1. 2. 3. Real GDP is less than Natural Real GDP (recessionary gap) Real GDP is more than Natural Real GDP (inflationary gap) Real GDP is equal to Natural Real GDP.

Key: Wage rates and prices will adjust quickly to surplus or shortage
In recession- unemployment rate higher than natural rate. Surplus exists in labor market Drives down wage rate In inflationary gap, unemployment lower than natural rate Shortage exists in labor market Drives up the wage rate

The Classical Model (cont'd)

Equilibrium in the credit market
When income is saved, it is not reflected in product demand. It is a type of leakage from the circular flow of income and output, because saving withdraws funds from the income stream.

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The Classical Model (cont'd)

Equilibrium in the credit market
Classical economists contended each dollar saved would be matched by business investment. Leakages would thus equal injections. At equilibrium, the price of credit the interest rate ensures that the amount of credit demanded equals the amount supplied.

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The Classical View of the Credit Market

In classical theory, the interest rate is flexible and adjusts so that saving equals investment. If saving increases and the saving curve shifts rightward the increase in saving eventually puts pressure on the interest rate and moves it downward. A new equilibrium is established where once again the amount households save equals the amount firms invest.

Long-run Equilibrium
The condition where the Real GDP the economy is producing is equal to the Natural Real GDP and the unemployment rate is equal to the natural unemployment rate.

Recessionary (Contractionary) Gap

The condition where the Real GDP the economy is producing is less than the Natural Real GDP and the unemployment rate is greater than the natural unemployment rate.

Inflationary (Expansionary) Gap

The condition where the Real GDP the economy is producing is greater than the Natural Real GDP and the unemployment rate is less than the natural unemployment rate.

Inflationary (Expansionary) Gap

The economy is currently in short-run equilibrium at a Real GDP level of Q1. QN is Natural Real GDP or the potential output of the economy. Notice that Q1>QN. When this condition (Q1>QN) exists, the economy is said to be in an inflationary gap.

Economy and Labor Market

Equating Desired Saving and Investment in the Classical Model

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Equating Desired Saving and Investment in the Classical Model

Summary
Changes in saving and investment create a surplus or shortage in the short run. In the long run, this is offset by changes in the interest rate. This interest rate adjustment returns the market to equilibrium where S = I.

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Equilibrium in the Labor Market

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The Relationship Between Employment and Real GDP

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Classical Theory, Vertical Aggregate Supply, and the Price Level

In the classical model, long-term unemployment is impossible. Say s law, coupled with flexible interest rates, prices, and wages would tend to keep workers fully employed. The LRAS curve is vertical. A change in aggregate demand will cause a change in the price level.
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Classical Theory and Increases in Aggregate Demand

Classical theorists believed that Says law, flexible interest rates, prices, and wages would always lead to full employment at real GDP of $12 trillion

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Effect of a Decrease in Aggregate Demand in the Classical Model

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