CLASSICAL MODEL OF INCOME AND EMPLOYMENT 9.1. Simple Classical Model The classical model of version of the ideas of clas Ricardo and also the ideas income and employment is a formalised ssical economists like Adam Smith, David 1 of neo-classical economists like Marshall, Edgeworth, Pigou etc. According to Keynes those economists who ig believe in Say’s law of markets are classical economists. Say’s law states that supply creates its own demand and there is no Possibility of general over production. The classical economists believe that in a competitive capitalist €conomy there exists an automatic mechanism which brings about full employment of labour. This automatic mechanism is known as the ‘invisible hand’. Asin the Keynesian model of income and employment in the classical modelalso the economy is divided into four markets :the labour market, the money market the commodity market and the bond market. 4 However following Walras law the commodity market is topped arid equilibrium conditions in three markets are considered.-Mreach market there exists one demand’ Tunctio » one supply function and one equilibrium condition. In this way the classical model canbe Tepresented with the help of certain equations. We first consider the labour m: that there exists an aggregate the level of output is a functi capital stock : ‘Y= 9(N, K,)....(1) where -¥ is output, N is employment and Kis the given stock of capital:We assume that shemarginal productivity. Sieur i postive, Put diminishing asthe volume of employment increases ie * > 0 and oY <0. The aggregate production function ‘ dN’ rs 1S upward rising but concave from below. We assume that there is Perfect competition in the labour market and entrepreneurs try to Maximise total profits. Total profit will be maximised where the value. of the marginal productivity of labour is equal to the money wage rate. arket of the economy. It is assumed Production function which states that ‘ion of the level of employment, given the 237 | ae238 MACROECONUONS | ay } imisi iti written as W=P, —— The profit maximising condition can be : iN hey | e rate and P is the price level. Or, Po dy s Wis the money wag P WN i wage rate should be equal tothe marginal physi (2) i.e the real Pe lot the real wage rate on the Vert ;vity of labour. If we pl u ‘ aii Jevel of employment on the horizontal axis the marging physical productivity of labour curve will be the labour demand curve It will give us the amount of labour demanded at different real wag, rates. As the real wage rate decreases, the demand for labour increaseg and vice-versa. The classical labour demand function is therefore g function of real wage rate while the Keynesian labour demand function is a function of money wage rate. Consider now the supply side of the labour market. It is assumed | that money wages and prices are perfectly flexible both in the upward and in the downward direction. The supply of labour is assumed to be a function of the real wage rate such that as the real wage rate increases the supply of labour also increases. The main difference between the Keynesian labour supply function and the classical labour supply function is that in the Keynesian model labour supply is assumed to be a function of the money wage rate while in the classical model labour supply is assumed to be a function of the real wage rate. Again, in the Keynesian model money wages ate assumed to be rigid in the downward direction but in the classical model money wages are assumed to be flexible. In the Keynesian model the labour supply curve has a horizontal portion and an upward rising portion. The horizontal portion represents the minimum wage rate at which there exists a perfectly elastic supply | of labour. But in the classical model the labour supply curve is assumed | to be upward rising.. It has no horizontal portion. The classical labour supply function can be written as : N=N(W/P) (3) such that —2N__ 5 0, ‘Thus in the labour mati a(W/P we get the following three ewe D “(1 Y =4(N, Ky) ay (2) 55> WP (3) N=N(W/P) From these three equations we can solve for three unknowns!”CLASSICAL MODEL OF INCOME AND EMPLOYMENT. 239 Nand W/P i.e. the level of income, the Nand W/P sn rel of acon, hs evel of con ade Siagrams we shall get a labour demand curve whichis downward sloping and a labour supply curve which is upward rising. At the intersection int of the labour demand curve and the labour supply curve the equilibrium real wage rate and the equilibrium level ares 10} ca will pe desermninet pare we know the equilibrium level of. eat we can get the equilibrium level of ji q we ocion po of income from the aggregate This is shown in figure-9.1. The equilibrium level of employment is N; the equilibrium real wage rate is (W/P), and the equilibrium level of output is Y, One important’ characteristic of this equilibrium is that it isa fuflemployment equilibrium, At the real wage rate (W/P),, those who are willing to work are getting jobs. Thus full employment equilibrium is the only possible equilibrium in the classical model. If the real < 3s we OL wage rate is greater than a Nf Fig. 9.1 8 ¥),, labour supply will be | greater than labour demand at that real wage rate and unemployment will prevail. This is no problem in the classical model where money “wages are flexible. So long there is unemployment money wages will fall because of competition among labourers. As money wages fall, the employment of labour becomes more profitable. More labour is demanded and more employment takes place. As a result the supply of output increases. To dispose of the additional supply, ie Must fall. Thus if the price level decreases in the ® ie Wage rate will remain the same and the incent'V" t bour will be absent. Hence the logic of the classical m' ee wie Pice level should fallinlower proportion ian heme Wilf other words so long there is unemployment, y of labour will all, the demand for labour will increase and the ar Fached. AS until the position of full employmmenee « é Rachel lexibility of money wages and prices, Se eae a oe coe een Siocon eae top Saree poco tat a a Crees ese i see conn ys ueeome na fm" wie daca ea cee in 2s demand for money, ¥ is real output, Pis price lev and k isa monsy faction. On the supply side it is assumed that the Supply of renee, Even and constant at thelevel,M, ie. Mi, M,, Equilibrium cates M, = My The equilibrium condition in the money market can stone (d ne ek Y (4). But we already keow at fron equations (1)—(3). Hence we e ai : JCAL MODEL OF INCOME AND EMPLOYMENT zag ciass! Forthis we should conn in bendinatke of the economy rest. For the simple version of the classical theo inter dint ry that Whatever same nt and whatever is borrowed is invested. Houscholds sare faved 1M ngsto purchase bonds A\ y sd se the ns. Firms finance their issued PY by sellings bonds to the ignestme. Thus saving is connected rousetimsdemand for bonds while with the Ss connected with the Prey imesimet ponds. Since the rate of M y of termined by the demand ise oe the supply af loans it for lotn as the loanable funds theory igure of interest determination, © a fecording to the classical economists the rte ofintetat dete ea (Fie equainy of saving and investmens. hie ase tunction of the rate of interest such that astherateof saving also increases. S=S (r).... (5) such that $* (r) >0 itis also assumed that investment is af such that as the rate of interest ine 1 (r) ...(6) such that I° #1... (7). ied that saving is interest increases ‘unction of the rate of interest eases, investment decreases, ai; fate of interest is determined by equations (5)-(7). Note that the determination of the determination Of the eq system, The compl equations YY=¢onKy ay OX wep (7) <0. Equilibrium requires that § Tate of interest is in no way linked with the luilibrium values of the other variables in the ete classical model therefore contains the following 9 |242 MACROECONOMIC THEORY There are also 9 variables in the model: Y, N, W, P, My, M, | I, r. Hence the system is determinate. Note that the system S| decomposable. We can solve equations (1)-(3) for 3 variables; = W/P. Once ¥ isknown the equations (4) to (6) determine P, Equati of interest independently. Graphically e (7)-(9) determine the rate complete model can be represented as follows. (figure 9.3) In part A we have drawn the labour demand curve and the la| on curve. In part B we have drawn the rectangular hyperbola a " lo 2 * and in part D we have drawn a straight line through the origin with slope (W/P),. The equilibrium real wage rate and the equilibrium Mnf) ° St Su ~ anaes Fig. 9.3 ager saraa seiemaned in part A of the diagram. Part Bdeter™ ee cl of output. Given the level of output. PC ‘ lermines the equilibrium price level and part D determines peCLASSICAL MODEL OF INCOME AND EMPLOYMENT aay money wage rate. In part E the equilibrium rate of interest is determined. It should be noted that parts A, B, C and D are linked with one another but part E is not linked with them.. This shows that inthe present model the determination of the equilibrium rate of interest js not connected with the determination of the equilibrium values of other variables. This means that any shift of the saving function or the investment function will affect only the rate of interest. It will not affect the values of the other variables. For example if the investment function shifts in the upward direction the saving function remaining, the same, then the equilibrium rate of interest will increase. But it will have no impact on real income, employment, real wage rate, moncy wage rate and the price level. We can divide our system into two parts. Equations (1)—(3) are called the real part of the system and equations (4)—(6) are called the monetary part of the system. Thus the real variables like the real wage rate, the level of output and level of employment are determined in the real sector while the monetary variables like the price level and the money wage rate are determined in the monetary part of the system. 9.2. Effect of change in Money Supply We can also consider the effect of an increase in the quantity of money in this classical system. Equations (1)—(3) will remain unaffected when money supply increases. Hence the level of income, the level of employment and the real wage rate will remain unaffected as a result of changes fn money supply. The equilibrium rate of interest as determined from equations (7)—(9) will also remain unaffected. Equations (4)—(6) will only be affected a money supply increases. Equations (4)—(6) can be condensed into a single equation M, = kPY. In this equation k is assumed to be constant. Moreover Y remains the same. Hence to maintain equilibrium if M, increases P must also increase. P will increase in the same proportion in which money supply increases. Since the real wage rate Temains the same, it means that the money wage rate will also increase in the same proportion in which the price level increases. Thus when the supply of money changes the Teal variables of the system will remain unaffected while the monetary Variables will change proportionately. In this case money is said to be Neutral. Thus in the classical model money is neutral, though it is not Neutral in the Keynesian model. Suppose the money supply is doubled from M, to 2M,, Then in fi igure244 MACROECONOMIC THEORY 9.3 the rectangular hyperbola of part (C) will shift to the right et My 2M, new position = = PY. The equilibrium output level remains the sam, \e at Y, but the equili ium price level is doubled to 2P,. Since the wage rate of part A remains the same, the real wage line of pity remains unaffected. From this line we can get the moncy wage Tate given the price level. From this line it is seen that when the price Jeye becomes 2P,, the money wage rate becomes 2W,. Thus an increase in the quantity of money affects only parts C and D of our diagram, But it has no impact on parts A, B, E of the diagram. Similarly if money supply decreases the rectangular hyperbola of part C will shift to the left and price and money wages will reduce in the same proportion. ‘Thus according to the classical model money is a ‘veil’ which only covers the real variables of the system. Hence any change in the supply of money cannot affect the real variables of the system. 9.3 Shift of labour supply curve Proceeding in the same way we can also obtain the effects of a rightward shift of the labour supply curve in the classical model. We assume that the supply of money remains the same when labour supply Fig. 9.4 increases. The effects can be analysed with the help of the above diagram. Sce figure 9.4. Lgl ee alllCLASSICAL MODEL OF INCOME AND EMPLOYMENT 245 ° In part A of figure 9.4 the labour supply curve has shifted from N,(W/P) ON, (W/P). As a result the equilibrium level of employment has increased from N, to N, and the equilibrium real wage rate has decreased from (W/P), to (W/P),. In part B we sce that when the Jevel of einployment has increased, the level of output has also increased from Y, to Y;. In part Citis found that when the level of output increases from Y, to Y, the equilibrium price level decreases from P, to P,. Since the real wage rate has decreased the real wage line (W/P), has lower slope than the real wage line (W/P),. From the real wage line (W/P), it is seen that the wage rate is lower at W,, when the price level is lower at P,. Thus the effects of an increase in the supply of labour can be summarised as follows : a lower real wage, a larger employment, a larger output, a lower price level and a lower money wage. The rate of interest will remain unaffected. Note that a change in the real variable affects the monetary part as well. 9.4. Shift of the production function We can also analyse the effects of an upward shift of the production function in the classical model. The upward shift implies an increase Fig 9.5 m both the average and marginal products of labour. As the marginal Product of labour increases, the labour demand curve of part (A) shifts ‘o the right. This is shown in figure (9.5) lh dct cs.2 246 MACROECONOMIC THEORY In part B when the production function shifts from Y to Y!, ve a new marginal product curve MPL,, in part A. The equilibrium, es wage rate increases from (W/P), to (W/P), and the Cquilibrium toy, of employment increases from N, to N,. Output increases frat Y, to Y, both because of higher production function and because of larger employment. When money supply remains the same, the Bric, level falls from P, to P, in part C. Since the real wage rises the fi wage line rotates in the upward direction from (W/P), to (wp) As seen in the diagram, when the price level falls money wage the also falls to W,. However, depending on the slopes of the Various functions, the new money wage might also be higher than the old, Bu the real wage will definitely be higher. The Money wage, may also remain the same. i 9.5. A Generalised Classical Model of Income and Employment Let us consider a classical model which is different from the simple classical model in several respects. In the simple classical model we assume that the determination of the rate of the interest is independent of the determination of the level of income. The rate of interest is determined by saving and investment which depend on the rate of interest. Let us now suppose that saving and investment depend not only on the level of income but also on the rate of interest. We then have the following more general saving and investment functions: 8s 8S = t?>o pad S=S(r,Y) “_ and 5. >0 a 1=1(r,Y that ~<0and—>0 I(r, Y) such demand for money depends not only on the level of. income but a on the rate of interest. In other words let us introduce the speculati A JeC 2 23=3 St CLASSICAL MODEL OF INCOME AND EMPLOYMENT 247 demand for money into the classical model. Let us write the money 5 4 My 1 gemand function as follows: = = L(r,Y) where is the demand for real money balances or demand for money in real terms. This is the same as the liquidity preference schedule of Keynes which states that the demand for money is a function of both the rate of interest and the level of income. As in the Keynesian model it is assumed that P 5 (M,/P) SMU?) and 7 > 0. This means that the demand for real nod balances is inversely related to the rate of interest and directly related to the level of income. Let us now assume that money wages and prices are: perfectly flexible and perfect competition prevails in all markets. Entrepreneurs try to maximise total profit. Total capital stock is given and constant. The volume of output depends on the level of employment, given the capital stock. The aggregate production function can therefore be written as Y=$(N, Ky) ‘Where N is employment, K, is given capital stock. We assume that the supply of labour is a function of real wage rate such that as real wage rate increases the supply of labour also increases. The demand for labour curve is identical with the marginal physical productivity of labour curve. The generalised classical model can therefore be represented with the help of the following equations: (1) ¥= ¢ (N, Ky) dY 2)—= msn wr (3) N=N (W/P) a) > =L(r,Y) (5) M, = My (6) My=™, ()S=8(,¥), (8)1=1(r,¥) ()S=1 7 In this model also we have 9 equations and 9 unknowns: Y, N,W, + M,, M,, r,S, and I. Hence the system is determinate. Consider now | prirsihs of the system. Equations (1)—(3) determine the values of | unknowns : Y, N and W/P. This equilibrium is a full employment boMACROECONOMIC THEORY i flexibility of libri the assumption of perfect Tn employment level of income is automat; wages ai 3). Consider equations (7 )—(9) Sin. achieved from equations (1)— (3) the saving function _ r S(r,¥) has three unknown, we can get a relationshy sevf) between S and r that Y is constant at a certa, level.For one level of incom, a we shall get one sa function. Similarly we ca, also get one investmen irXf) function relating I and r for one level of income. We can get the saving function Fig. 9.6 corresponding to the level of incone Y, and the investment function corresponding to the level of income Y,. At their point of intersection the equilibrium rate of interes, is determined. This is shown in figure(9.6) In this figure I(r, Y,) is the investment function corresponding to the full employment level of income and S (r, Y;) is the saving functioe corresponding to the full employment level of income. They intersect at the rate of interest r,. Hence r, is the equilibrium rate of interest At this rate of interest saving at full employment is equal to investment at full employment. Let us now consider the equations of the money market i.e. equations (4) to (6). They can be condensed into a single equation : M, . p 7 LBY), of, M, = PL(r.Y). But ris already known. Y is also known. So there is onl one unknow? P tobe determined from this equation. This determines the equilbriu= Price level. Thus we get the result i demand for mons is a function of the rate of i ae cned 248 ° $1 SiCLASSICAL MODEL OF INCOME AND EMPLOYMEN 249 full employment is automatically achieved in the labour market and it is the only possible equilibrium situation. Underemployment equilibrium is also not possible. Further, like the classical model the rate of interest is determined by the saving and investment functions (though saving and investment depend on the level of income) and the price level is determined from the money market (though money demand function is dependent on the rate of interest). Consider the effects of an increase in the supply of money in model. Equations (1)—(3) will remain unaffected when money supply increases. Hence equilibrium levels of income and employment will remain unaffected as money supply increases. As the level of income remains unaffected, the saving and investment functions will remain unaffected and the equilibrium rate of interest will also remain unaffected. Only the equilibrium, condition of the money market will be affected as the supply of money increases. The equilibrium condition of the money market can be written as M, = P.L (r,Y). Butr and Y will remain unaffected. Hence as money supply increases price level also increases in the same proportion. This result is also the same as in the simple classical model. In this model therefore money is neutral. Thus we see that even if we admit of a few modifications of the simple classical model the properties of the classical model will remain unaltered as long as we retain (3) i.e. as long as we assume perfect flexibility of. equations (1)—' (1)—(3) may be called the heart of the wages and prices. Equations classical model. So long they », remain. intact the classical conclusions will follow. However in this modified version of the classical model there aretwo situations where full employment cannot be achieved even if money wages and prices Q are perfectly flexible. Consider first the situation where the rf shapes and positions of the saving s(rvf) and investment functions are such that they intersect to produce @ Fig. 9.7 ‘ negative rate of interest. This is shown in the above diagram (figure—9.7) ~ The saving function at full employment intersects the investmentLe Wee sa ioe es gt ee 250 MACROECONOMIC THEORY function at full employment to produce a negative rate of interest r, In other words, here a negative rate of interest is required to maintain the equality between saving and investment at full employment. Since the rate of interest cannot be negative, the full employment position cannot be achieved in this situation. Here at all positive rates of interest saving at full employment is greater than investment at ful] employement. The peculiar shapes of saving and investment functions are responsible for not getting full employment in this situation. In other words interest inclasticity of saving and investment functions cannot give us full employement in this case. There is another situation where the speculative demand for money schedule may act as an obstacle to the achievement of full employment. We know that there is a lower limit below which the rate of interest cannot fall. This lower limit is set by the liquidity trap where the speculative demand for money curve becomes horizontal. Now if the rate of interest required to maintain full employment is less than the rate of interest permitted by the liquidity trap, then full employment » cannot be achieved. This is shown in the following figure (figure 9.8) , r Q lz 0 : Fg 98 The rate of interest required to maintain full employment is t)- But the minimum rate of interest permitted by liquidity trap is r,. Here r,. is less than r,. Since the rate of interest cannot fall bellow r,, the full employmem situation cannot be achieved. In this case the speculative demand for money function is responsible for not getting full employment. Apart from these two special cases full employment will be automatically achieved in the model. Hence the model can better be described as a classical model.CLASSICAL MODEL OF INCOME AND EMPLOYMENT 251 9.6. Wicksell’s Formulation of the Classical Model Inthe classical model we know that full employment is automatically chieved and as the supply of money increases the price level also increases in the same proportion. Most of the classical economists admitted that as money supply increases, price level also increases proportionately. But they did not analyse the manner in which an increase in the quantity of money will lead to an increase in the price level. Most of the classical economists argued mechanically with the help of the quantity equation M, = kPY where equlibrium in money market requires that price level should increase proportionately. It was Wicksell who first gave a systematic analysis of how change in the quantity of money affects the price level assuming that full employment is maintained. Let us now see how Wicksell analysed the effects of an increase in the supply of money on the aggregate demand for commodities. According to Wicksell there are two rates of interest: the natural rate of interest and the market rate of interest. The natural rate of interest is determined at the intersection of saving and investment functions. It is the only equilibrium rate of interest. Market rate of interest or the loan rate of interest is determined by the supply of and the demand for loans. This theory of determining the market rate of interest is known as the loanable funds theory of interest. The market rate of interest can only temporarily differ from the natural rate of interest. If the market rate of interest is less than the natural rate of interest there will be an excess demand in the commodity market and this will lead to a rise in the price level. This situation will continue so long as the market rate remains below the natural rate. Suppose that initially the market rate of interest is equal to the natural rate of interest. We assume that whatever is saved is lent and whatever is borrowed is invested. Then the saving schedule will be identical with the supply of loan schedule and the investment schedule will be identical with the demand for loan schedule. Hence the equality of saving and investment also gives the équality betwen lending and borrowing. The market rate of interest is therefore the same as the Natural rate of interest. Now suppose that the supply of money increases and that the new money is diverted into the loan market. The supply of loans will now be greater than the supply of saving by A M where A M is the new Money supplied. This will be the case where the commercial banksoS give loans by creating bank money. Here the market rate of ; . will be less than the natural rate of interest as the supply of Ton tt increases. This is shown in the side diagram (figure 9,9), Initial, "y saving and investment schedules intersect at point Aand T, is the n; rate of interest. It is also the market rate of interest. Now sy, that money supply increases by AM and the extra Money is lent, supply of loan schedule is S + A M which lies to the right of the Saving schedule. The demand for loan schedule ramains the same. : unchanged rate of interest r, there is an excess supply equal to AR in the loan market. As a result the v loan rate (market rate) will fall. The demand for loans is equal to the supply of loans when the market rate of interest falls to r,,. But at r,,, there is an excess of investment over saving by the ™ amount CD. Assuming that there Tm! Cc is full employment, an excess of investment over saving will mean an inflationary gap in the commodity market. In other © SI words, when investment is Fig. 9.9 greater than saving, aggregate demand will be greater than aggregate supply. Assuming that there is full employment an excess demand in the commodity market will lead to a rise in the price level. The Price rise will continue so long as the excess demand remains present in the commodity market and the excess demand will remain present so long as the market rate of interest remains below the natural rate of interest. It is only when the supply of new money stops that the market Tate of interest will again be equal to the natural rate of interest and the price rise will Stop. In this way Wicksell analysed how 4 increase in the quantity of money leads to an increase in the price level. The price level must increase in the same proportion for otherwise there will be surplus money at the disposal of the publc which will push up the price level, : The analysis of Wicksell can be summarised with the help of tt following equations: ‘ (Y=¢(N,K,) dy 2) — = (2) wP 252 MACROECONOMIC THEORY le ‘aturay S+aM,| CLASSICAL MODEL OF INCOME AND EMPLOYMENT 253 (3) N=N (W/P) (4) S=S (r) (5)1=1 (rt) (6)1=S+ 4M + DH (7) DH = M - kPY. DH means dishoarding. We assume that the supply of money (M) is given and that the supply of new money. (A M) is also given. We thenhave 7 equations and 8 unknowns: Y,N,W,P, 1,1,S and DH. Hence the system is not determinate. We have two ways to make the system determinate. Either we can assume that (8) S =I or we can assume that (8) DH = 0 ie. M = kPY. This means that A M = 0 = DH. For ifS=1, then A M + DH = 0 or, AM= _DH ice. hoarding must be equal to new money creation. Now if hoarding is not equal to zero, this means that AM is not equal to zero. This implies that the supply of money is not constant. For the supply of money to remain constant, 4M must be equal to zero. If A M = -DH = 0, then M = kPY which 'sthe quantity equation.We can therefore say that Wicksell’s analysis differs from the simple quantity theory only in the process in which , ‘heresults are obtained and not in the results. “i —