Classical Assumptions and the Market Result

1
Classical Assumptions and the Market Result

• KEY ASSUMPTIONS OF THE CLASSICAL SCHOOL
• Firms and workers have perfect information
  about relevant prices.
• All prices and wages are perfectly flexible.
• Firms are all perfect competitors in product
  and input markets.
• MAIN ASSUMTION RESULTING FROM THESE ASSUMPTIONS
• All markets clear. That is, prices and wages
  adjust to the levels
• where demand and supply are equal.

2
Endogenous Exogenous Classical Variables

• ENDOGENOUS VARIABLES IN THE CLASSICAL MODEL
• Y (national output)
• N (employment)
• w/p (the real wage)
• r (the interest rate)
• EXOGENOUS VARIABLES IN THE CLASSICAL MODEL
• Exogenous to the Classical model is any non-price
  variable which shifts labor
• supply and/or labor demand curves, and/or the
  aggregate production
• function. The most relevant exogenous variables
  are
• technology
• the aggregate capital stock
• population
• preferences over labor-vs-leisure

3
The Aggregate Production Function
Y
Y F( K , N )
Y1
N
N1
4
NS and ND as Functions of the Nominal Wage
NS(P2)
w
NS(P1)
w2
ND2 MPNP2
w1
ND1 MPNP1
N
N1
5
NS and ND as Functions of the Nominal Wage
w
NS(P1)
NS(P3)
w1
w3
ND1
ND3
N
N1
6
Aggregate Supply in the Classical System
Ys
P
P2
P1
P3
Y1
Y
7
The Quantity Theory of Money

• This classical theory states that the price
  level is proportional to
• the quantity of money. Mathematically,
• MV PY , where V income velocity of money
• P (V/Y)M
• The classical aggregate demand curve plots the
  combinations of
• price level (P) and real output (Y)
  consistent with the quantity
• theory equation above.
• Assuming that V and Y are fixed, the quantity
  of money determines
• the price level. Graphically, a change in M
  is the only factor that
• shifts the Classical aggregate demand curve

8
Aggregate Supply and Demand in the Classical
System
Ys
P
Yd(M3)
Yd(M2)
Yd(M1)
Y
9
The Classical Theory of the Interest Rate
r
Sl
r0
i0 (g - t)
r1
i1 (g - t)
l loans
l0
l1
The components of aggregate demand - C, I, and G
- play their explicit role in the determination
of r. It is r that guarantees that
exogenous changes in the particular components of
demand do not affect the aggregate level of
demand.
10
Policy Implications of the Classical Model

• The quantity of money does not affect the
  equilibrium values
• of the real variables in the system - output,
  employment, and
• the interest rate.
• Changes in government spending or tax levels
  have no effects on
• aggregate demand because of interest rate
  adjustment and
• crowding out effects.
• Changes in marginal income tax rates, however,
  would have
• supply side effects. A reduction in the
  marginal income tax rate
• stimulates labor supply and therefore leads
  to an increase in
• employment and output.

11
The Classical School Answers

• How much and in what ways do supply- /
  demand-side
• forces cause fluctuations in Y, N, and P?
• Supply-side forces account for 100 of
  fluctuations
• Y and N.
• Demand-side forces do not affect Y and N.
• Both supply- and demand- side forces affect P.
  

12
The Classical School Answers (cont)

• How do the roles of supply- and demand- side
  forces change
• in comparing the short-run and long-run time
  periods?
• Supply is fixed in the short-run. In the
  long-run, supply
• shifts according to how changes in technology,
  capital,
• and population affect employment.
• Demand can shift around in the short-run, as
  well as in
• the long run, according to changes in the
  money supply.
• Prices increase or decrease accordingly.