Title: The%20classical%20model%20of%20macroeconomics
1The classical model of macroeconomics
- The CLASSICAL model of macroeconomics is the
polar opposite of the extreme Keynesian model. - It analyses the economy when wages and prices are
fully flexible. - In this model, the economy is always at its
potential level.
2The classical model of macroeconomics (2)
- Excess demand or supply are rapidly eliminated by
wage or price changes so that potential output is
quickly restored. - Monetary and fiscal policy affect prices but have
no impact on output. - In the short-run before wages and prices have
adjusted, the Keynesian position is relevant
whilst the classical model is relevant to the
long-run.
3The Taylor Rule again
- Previously it was assumed that prices were fixed
and so we talked in terms of a simple Taylor Rule
where interest rates responded to the output part
of the rule. - Here, we allow prices to vary and think in terms
of the Taylor Rule where interest rates respond
to both output and inflation. - In this case, higher inflation leads to the bank
raising the interest rate, thus reducing
aggregate demand and output.
4The macroeconomic demand schedule
- The macroeconomic demand schedule (MDS) shows the
combinations of inflation and output for which
aggregate demand equals output when the interest
rate is set by a Taylor Rule. - Higher inflation is associated with lower
aggregate demand and lower output.
5The macroeconomic demand schedule (2)
- The slope of the schedule is determined by
- the reaction of interest rate decisions to
inflation - and the responsiveness of aggregate demand to
interest rate changes - Consequently
- It will be flat when
- interest rate decisions respond a lot to
inflation - and aggregate demand is highly responsive to
interest rate changes. - It will be steep when
- interest rate decisions do not respond much to
inflation - and aggregate demand responds little to interest
rate changes.
6Aggregate supply and potential output
- Potential output depends upon
- the level of technology
- the quantities of labour demanded and supplied in
the long-run, when the labour market is fully
adjusted - When wages and prices are fully flexible, output
is always at the potential level - In the short-run we can treat potential output as
given
7The classical aggregate supply schedule
- The classical model has an aggregate supply curve
which is vertical at potential output - This means that equilibrium output can be reached
at different levels of inflation - In the classical model, people do not suffer from
money illusion - Consequently, only changes in real variables
influence other real variables
8The classical aggregate supply schedule (2)
This schedule shows the output firms wish to
supply at each inflation rate.
AS
Inflation
When wages and prices are flexible, output is
always at its potential level (Y).
Potential output is the economys
long-run equilibrium output.
Y
Output
9The classical aggregate supply schedule (3)
- Better technology will shift AS to the right and
hence increase potential output. - Increased employment will also shift AS to the
right and increase potential output - as will the use of more capital.
- In the short-run, we can treat potential output
as given.
10Equilibrium inflation
AS
Inflation
At A, the goods, money and labour markets are all
in equilibrium.
Y
Output
11Equilibrium inflation a supply shock
AS0
If the central bank pursues its target of ?0
when the economy is at potential output, it
must respond by reducing its target real interest
rate.
A
?
?0
Inflation
MDS0
Y0
Output
12Equilibrium inflation a demand shock
AS0
A
?
?0
Inflation
Since potential output is the same at B, the bank
must tighten its monetary policy in order to hit
its target of ?0 .
MDS0
Y0
Output
13The speed of adjustment
- Adjustment in the Classical world is rapid, so
the economy is always at potential output (full
employment). - If wages and prices are sluggish, then output may
deviate from the potential level. - A Keynesian world of fixed wages and prices may
describe the short run period before adjustment
is complete.
14Supply-side economics
- The pursuit of policies aimed not at increasing
aggregate demand, but at increasing aggregate
supply. - A way of influencing potential output, seen as
critical in the classical view of the economy.
15Adjustment in the labour market
Medium run (1 year)
Long-run (4-6 years)
Short-run (3 months)
Clearing the labour market
Largely given
Beginning to adjust
WAGES
Demand- determined
Normal work week
HOURS
Hours/ employment mix adjusting
Full employment
Largely given
EMPLOYMENT
16Short-run aggregate supply
- If adjustment is not instantaneous, output may
diverge from Yp in the short run. - Firms may vary labour input
- via hours of work (overtime or layoffs).
- Wages may be sluggish in falling to restore full
employment in response to a fall in aggregate
demand. - The short-run aggregate supply schedule shows the
prices charged by firms at each output level,
given the wages they pay.
17The short-run aggregate supply schedule
Suppose the economy is initially at Y in
full- employment equilibrium at A, with inflation
?0
SAS
Inflation
A
? 0
Y
Y
Output
18The adjustment process
- When SAS and MDS are combined, changes in MDS
lead mainly to a change in output in the
short-run. - Over time, deviations from full employment
gradually change wage growth and short-run
aggregate supply. - The economy, therefore, gradually works its way
back to potential output.
19A lower inflation target
Starting from long-run equilibrium at E
AS
SAS
E
Inflation
?
With inflation at ? ' but wages unchanged, the
real wage rises bringing involuntary
unemployment.
MDS
Y
Output
20A temporary supply shocke.g. an increase in the
price of oil
SAS
Inflation
?
E
MDS
Y
Output
21Tradeoffs in monetary objectives
- Inflation targeting works well when all shocks
are demand shocks. - When shocks are supply shocks, stabilising
inflation may lead to highly variable output. - Conversely, a policy of stabilising output may
lead to highly variable inflation.
22Tradeoffs in monetary objectives (2)
- One way round this is to to steer a middle course
by using a Taylor Rule, i.e. a rule that takes
into account deviations of both inflation and
output from their long-run levels. - Another is to allow flexible inflation targeting
- because the inflation target is a medium-run one,
this allows some discretion for reducing
variability in output