Macroeconomic Theory

Macroeconomic Theory
The Economic Equilibrium

Classical Theory Keynesian Theory

IS-LM Model
1. Product Market √ √
(Hicks &
2. Factor Market √ √ Hansen)
3. Financial Market √ √

Long-run Short-run

Economic Growth Business Cycles

Output, Price, Employment and Interest Rate Determination

 Did You Know That...
The Curious Case of the 5-Cent Coke

The price of a 6.5 Oz bottle of Coca-Cola remained

unchanged at 5 cents from 1886–1959?
• Great Depression, Prohibition, two World Wars,
and several recessions occurred.
• Price of sugar tripled.
• Structure and technology changed in industry.

Why???
 Did You Know That...
The Curious Case of the 5-Cent Coke

• Originally claimed as “patent medicine” sold as single servings.

• The ability for consumers to buy a single serving.
• Daniel Levy and Andrew T. Young argues 3 factors account for price
rigidity.
• From 1899 to 1921, Coca-Cola was obligated by long-term contracts
with Syrup at $0.92 per gallon. After 1921, the syrup price
fluctuated.
• Technology of vending machines could only accept a single coin.
• Firm felt it was important that consumers could buy a Coke with a
single coin.

• Prices for many firms typically fully adjust within a year or two.
• Short-run shifts in demand and supply may result in multiple price
changes, but in long run come to equilibrium point.
 The Classical Theory

Theory of Output(Y) and Employment (E)

 The Classical Macroeconomic Theory

• Classical economists: Adam Smith, J.B. Say, David Ricardo, John

Stuart Mill, Thomas Malthus, A.C. Pigou, and others—wrote
from 1770s to 1930s.

• The first attempt to explain inflation, output, income,

employment, consumption, saving and investment.
• Main Question:
– How to increase the Output (means Real GDP) in the Long
Run??????
• Output
Economic Growth with Stability
• Long Run
– Why prices didn’t change over a period of time?
 The Classical Macroeconomic Theory
Classical Assumptions/Postulates
a. The Economy is characterized by Capitalist Economy.
b. Perfectly(Pure) Competitive Markets, Invisible hands, Lassiz-fair Policy, Division
of Labor and Free Market Economy
a. Product Market: Economy is always in equilibrium. Problems in the economy
are temporary and will correct themselves.
b. Factor Market: Always Full Employment: Labor is the only variable factor of
production, so there is always full employment in the economy. In long run as
people are motivated by self interest.
c. Capital Market:
▪ No Role of Money: Money is used only for transaction purpose
▪ No Money Illusion: People cannot be fooled my money illusion. they
understand nominal vs. real value.
c. Flexibles Prices (P), Wages (W) and Interest Rates(i):. All Prices are stable.
d. No Role of Government
Say’s law
e. Long run Output: Say’s Law. AS=AD
 The Classical Macroeconomic Theory:
The Foundation
Classical Say’s Law (J.B Say 1776-1832):
– A dictum of economist J.B. Say is that Supply creates its
own demand” both in
• barter economy
• monetized economy
– Producing goods and services generates the income and the
willingness to purchase other goods and services.
– Desired expenditures equal actual expenditures.
So, Aggregate Supply = Aggregate Demand
• No general underproduction
• No general over production
• No Unemployment
– Only voluntary and frictional unemployment is there
 The Classical Theory of Output and Employment
The Classical Theory first attempted to explain

a) National Levels of Output (Real GDP) and Price Level:

(Through Goods Market Equilibrium)
– > determinants of the Output and Price level with AS and AD
b) National Levels of Employment (E)
(Through Labor Market Equilibrium)
– > determinants of Employment and Real Wage rate with DL and SL
– >Determinants of National Level of Y, P and E ( w=wage rate)
c) National Level of Interest rates
(Through Money Market Equilibrium)
– National Consumption(C), Saving (S) and Investment (I)
– Determinates of Interest rates (S and I)
The Classical Theory of Output and Employment

A. The Goods Markets

Question: How national output is produced and
price is determined?

Answers:
• Output is produced through various factors
of production

•Price is determined through interaction

between aggregate demand and
aggregate supply
10
A. Aggregate Supply of Output(National Output):

The Production Function:

• Aggregate Production or Supply Function

Y = F(K ,L)
• Relate output to factors of production
Technology constant
_
K= K (capital Fixed)
L = N (amount of homogeneous
labor)
A. Aggregate Supply of Output(National Output):

Shape of the Agg Supply Curve: LRASC is Vertical

An aggregate supply curve:
LRASC
• relationship between real output and the Price Levels
price level.
• is vertical at the full-employment level of
real output (production) indicating that the
quantity of aggregate production is Price Level
independent of 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.
Qty of Output
( Real GDP)
Output
A. Aggregate Demand of Output(National Output):
• Demand for Product comes from the general public(all
economic agent) and since supply creates its own demand,
demand curve slopes downward from left to right according
to law of demand.

Price Level Y=C + I + G +Nx

P1
Prices
P2

AD
AD

Y1 Y2 Qty of Output
(Real GDP)
 Equilibrium:
Aggregate Demand and Aggregate Supply

Classical theorists
believed that Say’s law,
flexible interest rates,
prices, and wages
would always lead to
full employment at real
GDP (Ex. at12 trillion)

A change in aggregate demand will cause a change in the price level, which is temporary.
The Classical Theory of Output and Employment

B. Factor Market: The Labor Market

• Question
– Would unemployment be a problem in the classical model?
– What’s the full employment level of output?
– How wage rate is determined?
• Answer
– No unemployment, there is always full employment,
if at all there, only natural rate of unemployment is there.
– classical economists assumed wages would always adjust to
the full employment level.
 B. Labor Market: Supply of Labor

• Ns=f(w),
Where w is real wage rate, Ns is labor supply
Real Wage rate, w= W/P

w
Ns=f(w)

Labour (N)
 B. Labor Market: Demand for Labor

Demand for labor depends upon Marginal Revenue Productivity

of Labor(MRPL)

What is MRPL?????????

• Firms employ labor till MRPL=Wage rate

• Let’s define Profit = Revenue - Cost

• So Profit = Revenue - Cost
= (P x MPL) – W
Hire labor until Profit = 0
i.e. P x MPL = W w=W/P
i.e. MPL = W/P

So, Nd=f (MRPL ): where Nd is Demand for Labor

MPL =f(w)
where, w is real wage rate, W is nominal wage rate
 B. Labor Market: Demand for Labor
MPL and the demand for labor(DL)

Units of
output,
Each firm hires labor
Y
up to the point where MPL
= W/P
Real
wage,
w=
W/P
MPL, Labor
demand

Units of labor, L
Quantity of labor
demanded, L* P is flexible is classical model
Real wage, w =W/P
 Equilibrium: in the Labor Market
In the classical model if
w= real Unemployment
SL there is unemployment,
wage beyond the natural rate,
rate wage rates should fall to
E the point where
w Equilibrium unemployed workers
DL will be attractive to hire.

N* N= Labour Therefore, in the

classical model people
(Factor or Labor Market Equilibrium) will not be
unemployed for very
long and the model
tends towards “ full
employment.”
 Determination of Equilibrium
Output, Prices and Employment

SL
Real
Wage
rate w
E
w
DL Price LRASC
Level

N*
P**
F (K , L ) Employment
Y* P*
Real R
Output
AD2
AD1

N* Y* Y**Real output
The Classical Theory of Output and Employment
C. The Money & Credit Market: Equilibrium through S & I
Savings(S): Investment (I)

– When people save (S) money – Classical economists argued that

there is a leakage in the circular
flow and planned consumption
can fall short of real GDP.
– It is a type of leakage from the
circular flow of income and
output, because saving
withdraws funds from the
income stream.
– So, S= Y-C
Supply of Funds: Savings
each dollar saved will be matched
by business investment equally.
– Leakages would thus equal to
injections.
– At equilibrium, the price of
credit—the interest rate—
ensures that the amount of
credit demanded equals the
amount supplied.
Demand for Funds: Investment
C. The Money & Credit Market: Equilibrium through S & I
Equating Desired Saving and Investment in the Classical Model

The price of Credit

(interest rate)
ensures that the
demand and supply
of credit are equal
 Collapse of Classical Economics

Prevailed Until Great Depression (1930)

• Classical economist assumes that there is perfect competition

in both labor and output markets which is unrealistic.

• Says’ law i.e. supply creates it’s own demand . This postulates
failed during great depression

• Labor is the only factor of production in classical economists.

However other factor of productions are also important.

• Classical talked about long run.

• Emergence of Keynesian Economics

 References
• Ch3. National Income where it come from and
where it goes in Macroeconomics by N
Gregory Mankiw,7th edition
Thank You All