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The%20classical%20model%20of%20macroeconomics

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The CLASSICAL model of macroeconomics is the polar opposite of the extreme ... AS1. A beneficial supply shock raises. potential output by shifting AS0 to ... – PowerPoint PPT presentation

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Title: The%20classical%20model%20of%20macroeconomics


1
The 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.

2
The 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.

3
The 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.

4
The 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.

5
The 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.

6
Aggregate 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

7
The 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

8
The 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
9
The 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.

10
Equilibrium inflation
AS
Inflation
At A, the goods, money and labour markets are all
in equilibrium.
Y
Output
11
Equilibrium 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
12
Equilibrium 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
13
The 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.

14
Supply-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.

15
Adjustment 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
16
Short-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.

17
The 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
18
The 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.

19
A 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
20
A temporary supply shocke.g. an increase in the
price of oil
SAS
Inflation
?
E
MDS
Y
Output
21
Tradeoffs 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.

22
Tradeoffs 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
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