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ECON2020: Macroeconomic Theory
Lecture 5:
Agg. Supply 1 – The Classical Model
(Or the LRAS curve)
Dr Terence Yeo
School of Economics
University of Queensland
Introduction:
2 Schools of Macroeconomic Thought
• Modern macroeconomics centres around 2 schools of thought (not actually)
1. Neo-Classical school
• Markets are perfectly competitive (or almost so)
• Markets always clear (prices adjust instantly to external shocks. No excess demand or supply)
• Real Output depends only on availability of factors of production and technology.
• Think back to Long-Run growth theory (Lecture 2: ECON1020)
• Implications
• Business cycles result of rational economic agents making optimal decisions when faced with shocks.
• Even recessions are optimal and efficient outcomes to external shocks
• No role for Government in managing economy
• Monetary and Fiscal policy ineffective in influencing real output.
• If all markets always clear – then unemployment is always voluntary (wages too low to work)
• Afterall, Involuntary employment only occurs if excess supply of labor in labor markets
Introduction:
2 Schools of Macroeconomic Thought
• Modern Macroeconomics centres around 2 schools of thought
2. New-Keynesian school
• Many markets are NOT perfectly competitive due to
• Product diversification -> Monopolistic competition
• Economies of Scale -> Monopolies and Oligopolies
• Regulatory Capture -> Market power due to political influence and power imbalances
• Imperfect Information etc.
• See this link – recent inflation in Australia seems to be correlated with increases in firm profits
• Markets do not always clear instantly
• due to price stickiness, wage rigidities etc.
• Implication:
• Recessions and Expansions maybe OVER-reactions to external shocks.
• Significant role for monetary and fiscal policies in managing Real Output.
Introduction
• Neo-classical Models – More appropriate for Long-run analysis
• Over the Long-run:
• Sufficient time for firms to update prices in-spite of price stickiness
• Hence given sufficient times, prices eventual reach equilibrium levels.
• On average over the long run
• Business cycles “average out”
• Employment at Full Employment on average
• Output at potential GDP/Full employment Output on average
• Potential GDP determined by changes in availability of factors of production such as labor,
natural resources, capital
• Hence Neo-classical models better at analysing changes in the economy
over the long run
• Focus of this lecture deriving the Long-Run Agg. Supply Curve (LRAS).
Lecture Outline
1. The Theory of the Firm and Labour Demand
2. Labour Supply
3. Labour Market Equilibrium
4. Tech Change and Labour Market
5. Equilibrium Output in the Classical Model
6. The Classical Aggregate Supply Curve (LRAS)
7. General Equilibrium in the Classical Model
8. Policy in the Classical Model
Our Neo-Classical Model
Some Basic Assumptions:
• 2 Economic Agents
• Many Firms – modelled as one representative firm
• Many Households – modelled as one representative household
• Government – in charge of exogenous monetary and fiscal policy
• 2 Markets
• Labour Market – Households supply and Firms demand Labour
• Goods Market – Firms supply and Household demand goods
• Many firms and households – so many buyers and sellers in both markets
• Hence both markets are perfectly competitive.
• And Firms and Households are price takers.
Theory of the Firm
• At the heart of the Neo-Classical Model is the classical Theory of the Firm.
• Firms use a production technology () to process inputs of
• Labor ()
• Capital ()
• Into real output () of goods
= (,)
• I.e. one can think of the production process as a function () that returns a result
– Output (): given the quantities of inputs (, ) fed into the process.
• Reasonable to assume that
• Output increases with both inputs
Δ
Δ
> 0 &
Δ
Δ
> 0
Theory of the Firm
• At the heart of the Neo-Classical Model is the
Classical Theory of the Firm.
• Firms are perfectly competitive
• Hence price-takers – take as given prices such as
• : (Nominal) Wage rate (Price of Labor)
• : (Nominal) Capital Rental rate (Price of Capital)
• : Price Level (Price of Output/Goods)
• Firm’s decision:
• To maximise profits (Π)
• By choosing production inputs (,) (which also determines output )
• While taking as given prices (, , )
Theory of the Firm
• In mathematics, firm’s decision problem
max
,
Π , = ⋅ , − ( + )
Where
• ⋅ , = ⋅ is total revenue
• is cost of labor
• is cost of capital
• To solve this problem
• (if you recall from ECON1050, or as you’ll see from Lecture 7 of ECON2010)
• Need to take derivatives of the profit function Π(,) w.r.t. control variables and , and
set both to 0
Π
= ⋅ − = 0 ℎ ≔
≈
Δ
Δ
()
Π
= ⋅ − = 0 ℎ ≔
≈
Δ
Δ
()
Theory of the Firm
• The solution
⋅ = 5.4
⋅ = (5.5)
• Intuition? Recall that ≈
Δ
Δ
⇒ Δ ≈ × Δ
• And that
ΔΠ = ⋅ Δ − ( ⋅ Δ + ⋅ Δ)
• Since firms take , as given (fixed).
• What happens to profits if we
increase labor by > 0, while leaving capital unchanged? Δ = 0
• Watch the lecture recording for the rest. ☺
Labour Demand
• In the very long run (e.g. decades), firms can adjust both capital and labor
• Suppose our definition of the long run (e.g. 1 or 2 year) is too short for firms to
significantly change the quantity of capital they use
• Buying and installing new capital (e.g. building new production lines, buying machinery) takes too
long in our definition of the long-run.
• For example, Intel states that it takes ~3years to set up a chip fabrication facility (Link)
• So (in our very simple classical model)
we treat capital employed as fixed
= ഥ
• Hence we only need to consider Demand for Labour which stems from marginal
productivity of Labor
⋅ =
Labour Demand
• We consider only Labor demand from
⋅ = (5.5)
• While in higher level macro courses, we can get a lot from 5.5 alone
• We lack the mathematical tools to do so at the level of ECON2020.
• So let’s introduce a concrete production function to serve as pedagogical example. Let
= ഥ, = ഥ −
2
2
, (5.6)
• Where is a parameter representing the level of technology or productivity
• To obtain ≔
, take derivative with respect to to obtain
= ഥ − 5.7
• This should be somewhat familiar
• Increase in technology or capital (per worker) increases the productivity of each additional worker.
• But an increase in the labour force () reduces the productivity of each additional worker .
Labour Demand
• Substitute (5.7) into (5.5) to obtain
ഥ − =
⇒ = ഥ −
(5.8)
• Recall that Labor Demand is the relationship between
• Quantity of Labour demanded () And price of labor
- here we use the real wages (since in classical theory, only real variables matter – as prices are fixed)
• We can see that firms’ demand for labour depends on
• Level of Technology ()
• Level of capital stock employed (ഥ)
• And that as real wages
increase, Quantity of Labour Demanded () falls.
• Labor Demand curve is downward sloping (as with most regular demand curves)
Labour Demand
Lecture Outline
1. The Theory of the Firm and Labour Demand
2. Labour Supply
3. Labour Market Equilibrium
4. Tech Change and Labour Market
5. Equilibrium Output in the Classical Model
6. The Classical Aggregate Supply Curve (LRAS)
7. General Equilibrium in the Classical Model
8. Policy in the Classical Model
Households’ Decision Problem
• Classical Theory of labour supply comes from Households’ decisions.
• The representative Household’s (HH) utility (“happiness”) depends on
• Consumption ()
• Quantity of Labor supplied ()
• HH’s enjoy both consumption and leisure time.
• More time spent working (supplying labour means less leisure time (lowers utility)
• Suppose the HH’s utility function is
, = −
1
2
2 5.9
• is a parameter that measures the disutility (or unpleasantness ) of work
• The lower the value of – the more labour supplied lowers utility.
Households’ Decision Problem
• The HH’s decision problem is to maximize utility
• By choosing levels of ,
• Subject to it’s budget constraint ⋅ = ⋅ or equivalently:
= ⋅
(5.10)
• Consumption expenditure ( ⋅ ) equals Labor income ( ⋅ )
• Taking prices , as given
• HH solve
max
,
, . . =
⋅ (5.11)
Labor Supply
• Substituting (5.9) and 5.10 sequentially into (5.11), the problem becomes
max
,
−
1
2
2 . . =
⇒ max
−
1
2
2 (5.12)
• Easily solved (by taking derivative of (5.12) and setting it to 0) and shown that the solution is
=
(5.13)
• Recall that Labor Supply is the relationship between quantity of labor supplied
and real price of labor
• Clearly Labor Supply is upward sloping
Δ
Δ
> 0
• And increases in shifts the Labor Supply to the Right (if work is more pleasant, then labor supply increases)
Labour Supply
Lecture Outline
1. The Theory of the Firm and Labour Demand
2. Labour Supply
3. Labour Market Equilibrium
4. Tech Change and Labour Market
5. Equilibrium Output in the Classical Model
6. The Classical Aggregate Supply Curve (LRAS)
7. General Equilibrium in the Classical Model
8. Policy in the Classical Model
Labour Market Equilibrium
• In the Labour Market
• Many sellers (Households) and Many buyers (Firms)
• Perfect Information (level of real wages is know to everyone)
• Hence Labour Market is perfectly competitive.
• Labour Market Equilibrium where demand meets supply
• I.e. at the level of real wages at which
= . . (5.14)
• Given our demand (5.8) and supply curves (5.13), this implies
= ഥ −
Labour Market Equilibrium
= ഥ −
• Solving for equilibrium real wage rate
∗
=
ഥ
1 +
. . (5.15)
• Sub back into Labour Demand or Supply to obtain
equilibrium. Labour hours worked (∗)
∗ =
∗ = ∗ =
1 +
ഥ . (5.16)
Labour Market Equilibrium
Lecture Outline
1. The Theory of the Firm and Labour Demand
2. Labour Supply
3. Labour Market Equilibrium
4. Tech Change and Labour Market
5. Equilibrium Output in the Classical Model
6. The Classical Aggregate Supply Curve (LRAS)
7. General Equilibrium in the Classical Model
8. Policy in the Classical Model
Technological Change,
Investment into Capital Stock and Labour Market
• Suppose either that
• There is technological advances (Δ > 0)
• Or an increase in capital stock Δഥ > 0
• What happens in the labor market?
• Let’s consider Δഥ > 0 (the analysis for Δ is identical, given the
specification of the production function).
• From the labour demand equation (5.7)
↑= ഥ ↑ −
• An increase in ഥ increases the horizontal intercept (the constant term ഥ)
hence shifts the labor demand curve to the right.
• I.e. Holding
constant, an increase in ഥ
increases quantity of labour demanded
Technological Change,
Investment into Capital Stock and Labour Market
Impact of
Δ > 0
Or
Δഥ > 0
ഥ ഥ ′
Technological Change,
Investment into Capital Stock and Labour Market
• From the Labour market diagram, we see that Δഥ > 0 results in
• Increases in both eqm. real wages and labour hours employed.
• We can see the same result from analysis of equations for equilibrium real wages
(5.15) and labour hours employed (5.16).
∗
=
ഥ
1 +
⇒ Δ
∗
=
1
1 +
Δ ⋅ ഥ + Δഥ ⋅
∗ =
1 +
ഥ ⇒ Δ∗ =
1 +
Δ ⋅ ഥ + Δഥ ⋅
• Clearly, Δ > 0 or Δഥ > 0 will cause Δ
∗
> 0 and Δ∗ > 0.
• Takeaway: Technological Improvement ( > ) and increases in capital stock
(ഥ > ) will increase both real wages and employment in the economy.
Lecture Outline
1. The Theory of the Firm and Labour Demand
2. Labour Supply
3. Labour Market Equilibrium
4. Tech Change and Labour Market
5. Equilibrium Output in the Classical Model
6. The Classical Aggregate Supply Curve (LRAS)
7. General Equilibrium in the Classical Model
8. Policy in the Classical Model
Equilibrium Output in the Classical Model
• We previously:
• Assumed capital employed in production is fixed ഥ
• Solved for the Equilibrium level of Labour hours employed (∗)
∗ =
1 +
ഥ (5.16)
• We can now obtain the equilibrium level of output ∗ in the classical model
• Substitute Eqm. Labour (5.16) into production function 5.6: = ഥ −
2
2
∗ = ഥ∗ −
∗ 2
2
⇒ ∗ = ഥ
1 +
ഥ −
1 +
ഥ
2
2
• Solving, we get
∗ =
2 +
2 1 + 2
2 ഥ2 . 5.22
Equilibrium Output in the Classical Model
• In the classical model (given the equations used for production function, and household utility),
Equilibrium output is:
∗ =
2 +
2 1 + 2
2 ഥ2 . 5.22
• Notice that equilibrium in the classical model is derived
• With No reference to goods market considerations (IS-curve)
• such as nominal prices ,, , only real price of labour
• Or Planned Expenditures:
Consumption, Planned Investment or Government expenditures , ,
• With No reference to money market considerations (LM-Curve)
• Such as money supply or liquidity demand.
• So this equilibrium output in the Classical Model is independent of factors that determines equilibrium
output in the IS-LM model.
• Takeaway: Short-run considerations are different from long-run factors for the macroeconomy.
Equilibrium Output in the Classical Model
• Thus, in the Classical model: equilibrium output is determined only
by factor markets (labor market) and factor availability ഥ and the
production () technology.
• From equation (5.22), only the parameters of
• labour supply (),
• capital stock (ഥ),
• and the production technology (A), play any role in equilibrium output.
• Hence in this model, both fiscal and monetary policy are completely
irrelevant to the determination of output!
• Consistent with our previous discussion that one implication of
Neo-Classical Theory is that monetary and fiscal policy is ineffective.
Lecture Outline
1. The Theory of the Firm and Labour Demand
2. Labour Supply
3. Labour Market Equilibrium
4. Tech Change and Labour Market
5. Equilibrium Output in the Classical Model
6. The Classical Aggregate Supply Curve (LRAS)
7. General Equilibrium in the Classical Model
8. Policy in the Classical Model
The Classical Aggregate Supply Curve
• The Classical Aggregate Supply curve should be familiar to us as the Long Run Aggregate Supply
(LRAS) in our discussion of the AD-AS model from ECON1020 (or any introductory Macro course).
• Let us now derive the LRAS from our little classical model.
• Recall that the Aggregate Supply curve tells us the relationship between:
• Price Level in the economy (of goods and services produced in the economy)
• Real Output supplied in the economy
• The Classical Agg. Supply Curve or LRAS is determined by the equilibrium output
from our classical model!
• Because output from our classical model is determined solely by Supply-side factors such as labour employed
∗ , capital stock ഥ and level of technology when they are fully employed.
• And because the Classical Model is best used for LR analysis – as previously discussed.
• In fact, we can think of the classical model equilibrium output as
potential GDP / Productive Capacity / Full-employment Output
The Classical Aggregate Supply Curve
• Looking at the classical model equilibrium output equation
∗ =
2+
2 1+ 2
2 ഥ2 . 5.22
• It should be immediately apparent that output supplied is unaffected by
changes to price levels in the economy
• Price level does not appear in (5.22) – hence the level of output supplied ∗ is
always the same, at all possible price levels.
• Hence, the Classical Agg. Supply Curve (LRAS) is a vertical line!
• However, (5.22) also shows that changes to , ഥ will shift the LRAS to
the left or right
• I.e. changes to the parameters , , ഥ will change potential GDP (∗)
=
= (ഥ,)
∗
∗
∗
∗
Labour Market
Production FunctionFlip Vertical Axis to Horizontal Axis
∗
∗
AD-AS Diagram
∗
=
= (ഥ,)
∗
∗
∗
∗
Labour Market
Production FunctionFlip Vertical Axis to Horizontal Axis
∗
∗
AD-AS Diagram
∗
ഥ >
Or
>
=
= (ഥ,)
∗
∗
∗
∗
Labour Market
Production FunctionFlip Vertical Axis to Horizontal Axis
∗
∗
AD-AS Diagram
∗
>
Work becomes
less unpleasant
Lecture Outline
1. The Theory of the Firm and Labour Demand
2. Labour Supply
3. Labour Market Equilibrium
4. Tech Change and Labour Market
5. Equilibrium Output in the Classical Model
6. The Classical Aggregate Supply Curve (LRAS)
7. General Equilibrium in the Classical Model
8. Policy in the Classical Model
General Equilibrium in the Classical Model
• We’ve obtained the Aggregate Supply curve from the classical model
• A vertical line at the level of equilibrium output from the classical model
• We are interested in the General Equilibrium in the economy
• The equilibrium level of prices and output in the overall economy
• Taking into consideration both
• Aggregate Supply determined by factors of production and technology
• Aggregate Demand ()– determined by IS-LM model
• Determined by demand from Goods market and influences from money market.
• We’ve covered the derivation of the AD curve from the IS-LM Model
• I.e. take equilibrium from IS-LM model, but allow price level to vary.
General Equilibrium in Classical Model
∗
∗
General Equilibrium in Classical Model
To understand the mechanics of these effects, it is useful to note the structure of this economy:
Different markets determine different variables.
• Aggregate Demand () is determined by factors that affect markets important in the IS-LM model:
• Financial Markets: Money Supply ഥ and Liquidity Demand ((, )
• Demand in Goods Markets: Exogenous government purchases ( ҧ), Investment Demand , , and consumption
demand = ҧ + − ത
• Long-Run Aggregate Supply determines LR equilibrium output ∗
Is affected only by the ability of firms to supply goods and services, which in turn in determined by
• ∗: labour market equilibrium labour force
• : level of production technology
• ഥ: capital stock available in the economy
• Any factors (such as monetary or fiscal policy) that only affects AD only changes price levels
– but will NOT affect long-run output (∗)
How to use these diagrams?
Goods and Money Market shocks
(e.g. Δ
ഥ
, Δ)
• Shifts IS or LM curves
• In turn shifts AD curve.
• Affects only ∗
• But not ∗ since ∗ is only affected by
supply side factors – i.e. factors that shift
AS curve.
Supply Side Shocks (e.g. Δ, Δഥ)
• Shifts labor market demand
• Changing equilibrium labor employment
• In turn affecting supply of eqm. Output
• Shifting AS curve
• Affects both ∗ and ∗
Please watch lecture recording if you have
not already done so.
=
= (ഥ,)
∗
∗
∗
∗
Labour Market
Production FunctionFlip Vertical Axis to Horizontal Axis
∗
∗
AD-AS Diagram
∗
∗
IS-LM Diagram
∗
∗
When the economy is in general equilibrium,
all markets must be in equilibrium
– including Goods and Financial markets.
Hence general equilibrium output (∗) must be
At intersection of IS-LM curves.
Lecture Outline
1. The Theory of the Firm and Labour Demand
2. Labour Supply
3. Labour Market Equilibrium
4. Tech Change and Labour Market
5. Equilibrium Output in the Classical Model
6. The Classical Aggregate Supply Curve (LRAS)
7. General Equilibrium in the Classical Model
8. Policy in the Classical Model
Government Policy in the Classical Model
• In this section, we’ll discuss why one implication of neo-classical models is that Fiscal and
Monetary policies are ineffective in changing real output
• LR equilibrium output (∗)
• Determined only by n, A and ഥ
• Not by Fiscal policy instruments i.e. changes in govt. expenditure ҧ or net taxes ത
• Nor Monetary policy instruments such as nominal money supply ഥ
• Hence multipliers for govt. policies in this model is 0
(govt. policies have no impact on real output).
• Not surprising, since real output is determined only by supply side factors in neo-classical models.
Δ∗
Δ ҧ
=
Δ∗
Δത
=
Δ∗
Δ ഥ
= 0
Changes in Fiscal Policy in the Classical Model
(Δ ҧ > 0)
• Let’s first examine in detail the impact of an expansionary fiscal policy in the context of the
classical model
• E.g. an increase in government expenditure Δ ҧ > 0
• Let the initial equilibrium be at
∗
, ∗, ∗ ∗, ∗,∗ (in the diagram on the next slide)
• As in Lecture 4, an increase in government expenditure causes the
curve to shift Right (from to ′)
• Holding price level unchanged at ∗,
The new IS-LM equilibrium demand for output increases from ∗ 1
• Recall that IS-LM determines quantity demanded of real output (i.e. aggregate quantity demanded)
• Hence the AD curve shifts Right from to ′
=
= (ഥ,)
∗
∗
∗
∗
Labour Market
Production FunctionFlip Vertical Axis to Horizontal Axis
∗
∗
AD-AS Diagram
∗
∗
IS-LM Diagram
′
′
′
∗
∗′
1
′
∗
∗′
1
2
1
3
4
Changes in Fiscal Policy in the Classical Model
(Δ ҧ > 0)
• At ∗, now there is excess aggregate demand
• Aggregate quantity demanded is 1 but aggregate quantity supplied remains at
∗ - since there were no changes in supply side factors
(∗, ഥ )
• Excess aggregate demand drives up price levels from ∗ to ∗′.
• Increase in price levels causes real money supply to fall in the money market (from
ഥ
∗
to
ഥ
∗
′, with
ഥ
∗
<
ഥ
∗
′)
• Since real output/income remains unchanged at ∗, liquidity demand stays constant.
• LM-Curve shifts to the LEFT
• Left ward shift of LM curve continues drives up interest rates to ∗
′
(decreasing planned investment) until equilibrium demand for
output in IS-LM returns to ∗ (until quantity of aggregate demanded returns to quantity of aggregate output supplied – at which
point here is no longer any upward pressure on price levels.)
• End result – no change in ∗,
W
P
∗
, N∗, but an increase in ∗ and ∗
• the increase in ҧ is matched by an equal decrease in planned investment (complete crowd out)
• End result of the expansionary fiscal policy is only inflation (Δ∗ > 0)
Changes in Monetary Policy
in the Classical Model (Δ ഥ > 0)
• Let’s next examine in detail the impact of expansionary monetary policy in the context
of the classical model
• E.g. an increase in nominal money supply Δ ഥ > 0
• Let the initial equilibrium be at
∗
0
∗ ,
∗, ∗ 0
∗, 0
∗ ,∗ (in the diagram on the next slide)
• Holding price level unchanged at 0
∗ and income unchanged at ∗, the increase in
nominal money supply (0 1) initially increase real money supply (
0
∗
to
1
∗
) which
shifts the LM curve to the left.
• The new IS-LM equilibrium implies demand for output increases from (∗ 1)
• Hence the AD curve shifts Right from to ′
=
= (ഥ,)
∗
∗
∗
∗
Labour Market
Production FunctionFlip Vertical Axis to Horizontal Axis
∗
∗
AD-AS Diagram
∗
∗
IS-LM Diagram
0
1
′
0
∗
1
∗
1
′
0
1
∗
1
1
2
Changes in Monetary Policy
in the Classical Model (Δ ഥ > 0)
• At ∗, now there is excess aggregate demand
• Aggregate quantity demanded is 1 but aggregate quantity supplied remains at
∗ - since there were no changes in supply
side factors (∗, ഥ )
• Excess aggregate demand drives up price levels from 0
∗ to 1
∗.
• Increase in price levels causes real money supply to fall in the money market (from
ഥ
0
∗ to
ഥ
1
∗ , with
ഥ
0
∗ >
ഥ
1
∗)
• Since real output/income remains unchanged at ∗, liquidity demand stays constant.
• LM-curve shifts Left
• Leftward shift of LM curve continues) until equilibrium demand for output in IS-LM returns to ∗
(until the LM curve returns to its original position)
• End result – no change in ∗,
W
P
∗
, N∗ or i∗, but an increase in ∗
• End result of the expansionary monetary policy is only inflation (Δ∗ > 0) in the classical model
Monetary Policy in the Classical Model
%Δ∗ = %ΔഥM
• In the Classical Model, the growth rate of the price level will exactly equal the growth rate of the
money supply.
• That is, in absence of any other changes in exogenous variables,
• for example, a 10% growth rate in the money supply
• will lead to an inflation rate of exactly 10%.
%Δ
ഥ
= % ഥ −%∗ = 0
• Any changes in nominal money supply ( ഥ) will leave real money supply
ഥ
∗
unchanged.
• We see this from the IS-LM diagram, because the LM curve returns to its original position
• Since there is no change in liquidity demand (real output remains unchanged at ∗)
• When the LM curve returns to its original position (0), it must be because real money supply returned to its original value.
• In the Classical model, then, the central bank is powerless to affect the value of the real money
supply (at least in the Long-run)
• For this reason, monetary policy is “neutral” in the Classical model
Investment into Capital Stock in Classical
Model (Δഥ > 0)
• Finally, let’s consider the impact of an increase in capital (Δഥ > 0)
• Holding
unchanged, Δഥ > 0
• Increases marginal productivity of labour () and hence demand for labour
↑= ഥ ↑ −
• Labour demand curve shifts right
• Also shifts the production function up – i.e. holding unchanged,
output increases as ഥ increases (. . ഥ′, > (ഥ′, ) if ′ > )
• Equilibrium labour employed increases from ∗ to ∗
′
• Equilibrium output increases from ∗ to ∗
′
• Shifting the AS curve to the right – to ′
Investment into Capital Stock in Classical
Model (Δഥ > 0)
• Rightward shift of AS curve causes price level to fall from ∗ to ∗′
• Holding income constant, fall in price level causes real money supply to shrink
(
ഥ
∗
>
ഥ
∗
′ as
∗ > ∗
′
)
• In turn causing the LM curve to shift right – i.e. at the same income and hence liquidity demand,
equilibrium interest rates fall.
• LM curve continues to shift right until equilibrium output quantity demanded (or equivalently,
aggregate quantity demanded) equals the new aggregate quantity supplied ∗′ - restoring general
equilibrium in the economy.
• Overall impact:
• Increase in real wages, Increase in equilibrium output, Fall in interest rate (that increases investment)
Conclusion
• The Classical model puts aggregate supply, through factor markets,
in the central role as driving the economy.
• Fiscal and monetary policy, and aggregate demand management
more generally, have no effect on output or employment, or real
wages.
• The key drivers for improving living conditions, in the Classical model,
are the capital stock and technological improvements.
• The missing piece of the puzzle, though, is unemployment (excess
supply of labor), which appears nowhere in this model.
Looking Ahead: Lecture 6 – Keynesian Model
• The Keynesian Labour Market
• The Keynesian Aggregate Supply Curve
• General Equilibrium in the Keynesian Model
• Policy in the Keynesian Model
• CML 2 released next week.
• Opens 1pm, 27 March
• Closes 1 pm, 3 April
• Covers Topic 3-4 (IS-LM and IS-LM Policy)
Lecture 5:
Agg. Supply 1 – The Classical Model
(Or the LRAS curve)
Dr Terence Yeo
School of Economics
University of Queensland
Introduction:
2 Schools of Macroeconomic Thought
• Modern macroeconomics centres around 2 schools of thought (not actually)
1. Neo-Classical school
• Markets are perfectly competitive (or almost so)
• Markets always clear (prices adjust instantly to external shocks. No excess demand or supply)
• Real Output depends only on availability of factors of production and technology.
• Think back to Long-Run growth theory (Lecture 2: ECON1020)
• Implications
• Business cycles result of rational economic agents making optimal decisions when faced with shocks.
• Even recessions are optimal and efficient outcomes to external shocks
• No role for Government in managing economy
• Monetary and Fiscal policy ineffective in influencing real output.
• If all markets always clear – then unemployment is always voluntary (wages too low to work)
• Afterall, Involuntary employment only occurs if excess supply of labor in labor markets
Introduction:
2 Schools of Macroeconomic Thought
• Modern Macroeconomics centres around 2 schools of thought
2. New-Keynesian school
• Many markets are NOT perfectly competitive due to
• Product diversification -> Monopolistic competition
• Economies of Scale -> Monopolies and Oligopolies
• Regulatory Capture -> Market power due to political influence and power imbalances
• Imperfect Information etc.
• See this link – recent inflation in Australia seems to be correlated with increases in firm profits
• Markets do not always clear instantly
• due to price stickiness, wage rigidities etc.
• Implication:
• Recessions and Expansions maybe OVER-reactions to external shocks.
• Significant role for monetary and fiscal policies in managing Real Output.
Introduction
• Neo-classical Models – More appropriate for Long-run analysis
• Over the Long-run:
• Sufficient time for firms to update prices in-spite of price stickiness
• Hence given sufficient times, prices eventual reach equilibrium levels.
• On average over the long run
• Business cycles “average out”
• Employment at Full Employment on average
• Output at potential GDP/Full employment Output on average
• Potential GDP determined by changes in availability of factors of production such as labor,
natural resources, capital
• Hence Neo-classical models better at analysing changes in the economy
over the long run
• Focus of this lecture deriving the Long-Run Agg. Supply Curve (LRAS).
Lecture Outline
1. The Theory of the Firm and Labour Demand
2. Labour Supply
3. Labour Market Equilibrium
4. Tech Change and Labour Market
5. Equilibrium Output in the Classical Model
6. The Classical Aggregate Supply Curve (LRAS)
7. General Equilibrium in the Classical Model
8. Policy in the Classical Model
Our Neo-Classical Model
Some Basic Assumptions:
• 2 Economic Agents
• Many Firms – modelled as one representative firm
• Many Households – modelled as one representative household
• Government – in charge of exogenous monetary and fiscal policy
• 2 Markets
• Labour Market – Households supply and Firms demand Labour
• Goods Market – Firms supply and Household demand goods
• Many firms and households – so many buyers and sellers in both markets
• Hence both markets are perfectly competitive.
• And Firms and Households are price takers.
Theory of the Firm
• At the heart of the Neo-Classical Model is the classical Theory of the Firm.
• Firms use a production technology () to process inputs of
• Labor ()
• Capital ()
• Into real output () of goods
= (,)
• I.e. one can think of the production process as a function () that returns a result
– Output (): given the quantities of inputs (, ) fed into the process.
• Reasonable to assume that
• Output increases with both inputs
Δ
Δ
> 0 &
Δ
Δ
> 0
Theory of the Firm
• At the heart of the Neo-Classical Model is the
Classical Theory of the Firm.
• Firms are perfectly competitive
• Hence price-takers – take as given prices such as
• : (Nominal) Wage rate (Price of Labor)
• : (Nominal) Capital Rental rate (Price of Capital)
• : Price Level (Price of Output/Goods)
• Firm’s decision:
• To maximise profits (Π)
• By choosing production inputs (,) (which also determines output )
• While taking as given prices (, , )
Theory of the Firm
• In mathematics, firm’s decision problem
max
,
Π , = ⋅ , − ( + )
Where
• ⋅ , = ⋅ is total revenue
• is cost of labor
• is cost of capital
• To solve this problem
• (if you recall from ECON1050, or as you’ll see from Lecture 7 of ECON2010)
• Need to take derivatives of the profit function Π(,) w.r.t. control variables and , and
set both to 0
Π
= ⋅ − = 0 ℎ ≔
≈
Δ
Δ
()
Π
= ⋅ − = 0 ℎ ≔
≈
Δ
Δ
()
Theory of the Firm
• The solution
⋅ = 5.4
⋅ = (5.5)
• Intuition? Recall that ≈
Δ
Δ
⇒ Δ ≈ × Δ
• And that
ΔΠ = ⋅ Δ − ( ⋅ Δ + ⋅ Δ)
• Since firms take , as given (fixed).
• What happens to profits if we
increase labor by > 0, while leaving capital unchanged? Δ = 0
• Watch the lecture recording for the rest. ☺
Labour Demand
• In the very long run (e.g. decades), firms can adjust both capital and labor
• Suppose our definition of the long run (e.g. 1 or 2 year) is too short for firms to
significantly change the quantity of capital they use
• Buying and installing new capital (e.g. building new production lines, buying machinery) takes too
long in our definition of the long-run.
• For example, Intel states that it takes ~3years to set up a chip fabrication facility (Link)
• So (in our very simple classical model)
we treat capital employed as fixed
= ഥ
• Hence we only need to consider Demand for Labour which stems from marginal
productivity of Labor
⋅ =
Labour Demand
• We consider only Labor demand from
⋅ = (5.5)
• While in higher level macro courses, we can get a lot from 5.5 alone
• We lack the mathematical tools to do so at the level of ECON2020.
• So let’s introduce a concrete production function to serve as pedagogical example. Let
= ഥ, = ഥ −
2
2
, (5.6)
• Where is a parameter representing the level of technology or productivity
• To obtain ≔
, take derivative with respect to to obtain
= ഥ − 5.7
• This should be somewhat familiar
• Increase in technology or capital (per worker) increases the productivity of each additional worker.
• But an increase in the labour force () reduces the productivity of each additional worker .
Labour Demand
• Substitute (5.7) into (5.5) to obtain
ഥ − =
⇒ = ഥ −
(5.8)
• Recall that Labor Demand is the relationship between
• Quantity of Labour demanded () And price of labor
- here we use the real wages (since in classical theory, only real variables matter – as prices are fixed)
• We can see that firms’ demand for labour depends on
• Level of Technology ()
• Level of capital stock employed (ഥ)
• And that as real wages
increase, Quantity of Labour Demanded () falls.
• Labor Demand curve is downward sloping (as with most regular demand curves)
Labour Demand
Lecture Outline
1. The Theory of the Firm and Labour Demand
2. Labour Supply
3. Labour Market Equilibrium
4. Tech Change and Labour Market
5. Equilibrium Output in the Classical Model
6. The Classical Aggregate Supply Curve (LRAS)
7. General Equilibrium in the Classical Model
8. Policy in the Classical Model
Households’ Decision Problem
• Classical Theory of labour supply comes from Households’ decisions.
• The representative Household’s (HH) utility (“happiness”) depends on
• Consumption ()
• Quantity of Labor supplied ()
• HH’s enjoy both consumption and leisure time.
• More time spent working (supplying labour means less leisure time (lowers utility)
• Suppose the HH’s utility function is
, = −
1
2
2 5.9
• is a parameter that measures the disutility (or unpleasantness ) of work
• The lower the value of – the more labour supplied lowers utility.
Households’ Decision Problem
• The HH’s decision problem is to maximize utility
• By choosing levels of ,
• Subject to it’s budget constraint ⋅ = ⋅ or equivalently:
= ⋅
(5.10)
• Consumption expenditure ( ⋅ ) equals Labor income ( ⋅ )
• Taking prices , as given
• HH solve
max
,
, . . =
⋅ (5.11)
Labor Supply
• Substituting (5.9) and 5.10 sequentially into (5.11), the problem becomes
max
,
−
1
2
2 . . =
⇒ max
−
1
2
2 (5.12)
• Easily solved (by taking derivative of (5.12) and setting it to 0) and shown that the solution is
=
(5.13)
• Recall that Labor Supply is the relationship between quantity of labor supplied
and real price of labor
• Clearly Labor Supply is upward sloping
Δ
Δ
> 0
• And increases in shifts the Labor Supply to the Right (if work is more pleasant, then labor supply increases)
Labour Supply
Lecture Outline
1. The Theory of the Firm and Labour Demand
2. Labour Supply
3. Labour Market Equilibrium
4. Tech Change and Labour Market
5. Equilibrium Output in the Classical Model
6. The Classical Aggregate Supply Curve (LRAS)
7. General Equilibrium in the Classical Model
8. Policy in the Classical Model
Labour Market Equilibrium
• In the Labour Market
• Many sellers (Households) and Many buyers (Firms)
• Perfect Information (level of real wages is know to everyone)
• Hence Labour Market is perfectly competitive.
• Labour Market Equilibrium where demand meets supply
• I.e. at the level of real wages at which
= . . (5.14)
• Given our demand (5.8) and supply curves (5.13), this implies
= ഥ −
Labour Market Equilibrium
= ഥ −
• Solving for equilibrium real wage rate
∗
=
ഥ
1 +
. . (5.15)
• Sub back into Labour Demand or Supply to obtain
equilibrium. Labour hours worked (∗)
∗ =
∗ = ∗ =
1 +
ഥ . (5.16)
Labour Market Equilibrium
Lecture Outline
1. The Theory of the Firm and Labour Demand
2. Labour Supply
3. Labour Market Equilibrium
4. Tech Change and Labour Market
5. Equilibrium Output in the Classical Model
6. The Classical Aggregate Supply Curve (LRAS)
7. General Equilibrium in the Classical Model
8. Policy in the Classical Model
Technological Change,
Investment into Capital Stock and Labour Market
• Suppose either that
• There is technological advances (Δ > 0)
• Or an increase in capital stock Δഥ > 0
• What happens in the labor market?
• Let’s consider Δഥ > 0 (the analysis for Δ is identical, given the
specification of the production function).
• From the labour demand equation (5.7)
↑= ഥ ↑ −
• An increase in ഥ increases the horizontal intercept (the constant term ഥ)
hence shifts the labor demand curve to the right.
• I.e. Holding
constant, an increase in ഥ
increases quantity of labour demanded
Technological Change,
Investment into Capital Stock and Labour Market
Impact of
Δ > 0
Or
Δഥ > 0
ഥ ഥ ′
Technological Change,
Investment into Capital Stock and Labour Market
• From the Labour market diagram, we see that Δഥ > 0 results in
• Increases in both eqm. real wages and labour hours employed.
• We can see the same result from analysis of equations for equilibrium real wages
(5.15) and labour hours employed (5.16).
∗
=
ഥ
1 +
⇒ Δ
∗
=
1
1 +
Δ ⋅ ഥ + Δഥ ⋅
∗ =
1 +
ഥ ⇒ Δ∗ =
1 +
Δ ⋅ ഥ + Δഥ ⋅
• Clearly, Δ > 0 or Δഥ > 0 will cause Δ
∗
> 0 and Δ∗ > 0.
• Takeaway: Technological Improvement ( > ) and increases in capital stock
(ഥ > ) will increase both real wages and employment in the economy.
Lecture Outline
1. The Theory of the Firm and Labour Demand
2. Labour Supply
3. Labour Market Equilibrium
4. Tech Change and Labour Market
5. Equilibrium Output in the Classical Model
6. The Classical Aggregate Supply Curve (LRAS)
7. General Equilibrium in the Classical Model
8. Policy in the Classical Model
Equilibrium Output in the Classical Model
• We previously:
• Assumed capital employed in production is fixed ഥ
• Solved for the Equilibrium level of Labour hours employed (∗)
∗ =
1 +
ഥ (5.16)
• We can now obtain the equilibrium level of output ∗ in the classical model
• Substitute Eqm. Labour (5.16) into production function 5.6: = ഥ −
2
2
∗ = ഥ∗ −
∗ 2
2
⇒ ∗ = ഥ
1 +
ഥ −
1 +
ഥ
2
2
• Solving, we get
∗ =
2 +
2 1 + 2
2 ഥ2 . 5.22
Equilibrium Output in the Classical Model
• In the classical model (given the equations used for production function, and household utility),
Equilibrium output is:
∗ =
2 +
2 1 + 2
2 ഥ2 . 5.22
• Notice that equilibrium in the classical model is derived
• With No reference to goods market considerations (IS-curve)
• such as nominal prices ,, , only real price of labour
• Or Planned Expenditures:
Consumption, Planned Investment or Government expenditures , ,
• With No reference to money market considerations (LM-Curve)
• Such as money supply or liquidity demand.
• So this equilibrium output in the Classical Model is independent of factors that determines equilibrium
output in the IS-LM model.
• Takeaway: Short-run considerations are different from long-run factors for the macroeconomy.
Equilibrium Output in the Classical Model
• Thus, in the Classical model: equilibrium output is determined only
by factor markets (labor market) and factor availability ഥ and the
production () technology.
• From equation (5.22), only the parameters of
• labour supply (),
• capital stock (ഥ),
• and the production technology (A), play any role in equilibrium output.
• Hence in this model, both fiscal and monetary policy are completely
irrelevant to the determination of output!
• Consistent with our previous discussion that one implication of
Neo-Classical Theory is that monetary and fiscal policy is ineffective.
Lecture Outline
1. The Theory of the Firm and Labour Demand
2. Labour Supply
3. Labour Market Equilibrium
4. Tech Change and Labour Market
5. Equilibrium Output in the Classical Model
6. The Classical Aggregate Supply Curve (LRAS)
7. General Equilibrium in the Classical Model
8. Policy in the Classical Model
The Classical Aggregate Supply Curve
• The Classical Aggregate Supply curve should be familiar to us as the Long Run Aggregate Supply
(LRAS) in our discussion of the AD-AS model from ECON1020 (or any introductory Macro course).
• Let us now derive the LRAS from our little classical model.
• Recall that the Aggregate Supply curve tells us the relationship between:
• Price Level in the economy (of goods and services produced in the economy)
• Real Output supplied in the economy
• The Classical Agg. Supply Curve or LRAS is determined by the equilibrium output
from our classical model!
• Because output from our classical model is determined solely by Supply-side factors such as labour employed
∗ , capital stock ഥ and level of technology when they are fully employed.
• And because the Classical Model is best used for LR analysis – as previously discussed.
• In fact, we can think of the classical model equilibrium output as
potential GDP / Productive Capacity / Full-employment Output
The Classical Aggregate Supply Curve
• Looking at the classical model equilibrium output equation
∗ =
2+
2 1+ 2
2 ഥ2 . 5.22
• It should be immediately apparent that output supplied is unaffected by
changes to price levels in the economy
• Price level does not appear in (5.22) – hence the level of output supplied ∗ is
always the same, at all possible price levels.
• Hence, the Classical Agg. Supply Curve (LRAS) is a vertical line!
• However, (5.22) also shows that changes to , ഥ will shift the LRAS to
the left or right
• I.e. changes to the parameters , , ഥ will change potential GDP (∗)
=
= (ഥ,)
∗
∗
∗
∗
Labour Market
Production FunctionFlip Vertical Axis to Horizontal Axis
∗
∗
AD-AS Diagram
∗
=
= (ഥ,)
∗
∗
∗
∗
Labour Market
Production FunctionFlip Vertical Axis to Horizontal Axis
∗
∗
AD-AS Diagram
∗
ഥ >
Or
>
=
= (ഥ,)
∗
∗
∗
∗
Labour Market
Production FunctionFlip Vertical Axis to Horizontal Axis
∗
∗
AD-AS Diagram
∗
>
Work becomes
less unpleasant
Lecture Outline
1. The Theory of the Firm and Labour Demand
2. Labour Supply
3. Labour Market Equilibrium
4. Tech Change and Labour Market
5. Equilibrium Output in the Classical Model
6. The Classical Aggregate Supply Curve (LRAS)
7. General Equilibrium in the Classical Model
8. Policy in the Classical Model
General Equilibrium in the Classical Model
• We’ve obtained the Aggregate Supply curve from the classical model
• A vertical line at the level of equilibrium output from the classical model
• We are interested in the General Equilibrium in the economy
• The equilibrium level of prices and output in the overall economy
• Taking into consideration both
• Aggregate Supply determined by factors of production and technology
• Aggregate Demand ()– determined by IS-LM model
• Determined by demand from Goods market and influences from money market.
• We’ve covered the derivation of the AD curve from the IS-LM Model
• I.e. take equilibrium from IS-LM model, but allow price level to vary.
General Equilibrium in Classical Model
∗
∗
General Equilibrium in Classical Model
To understand the mechanics of these effects, it is useful to note the structure of this economy:
Different markets determine different variables.
• Aggregate Demand () is determined by factors that affect markets important in the IS-LM model:
• Financial Markets: Money Supply ഥ and Liquidity Demand ((, )
• Demand in Goods Markets: Exogenous government purchases ( ҧ), Investment Demand , , and consumption
demand = ҧ + − ത
• Long-Run Aggregate Supply determines LR equilibrium output ∗
Is affected only by the ability of firms to supply goods and services, which in turn in determined by
• ∗: labour market equilibrium labour force
• : level of production technology
• ഥ: capital stock available in the economy
• Any factors (such as monetary or fiscal policy) that only affects AD only changes price levels
– but will NOT affect long-run output (∗)
How to use these diagrams?
Goods and Money Market shocks
(e.g. Δ
ഥ
, Δ)
• Shifts IS or LM curves
• In turn shifts AD curve.
• Affects only ∗
• But not ∗ since ∗ is only affected by
supply side factors – i.e. factors that shift
AS curve.
Supply Side Shocks (e.g. Δ, Δഥ)
• Shifts labor market demand
• Changing equilibrium labor employment
• In turn affecting supply of eqm. Output
• Shifting AS curve
• Affects both ∗ and ∗
Please watch lecture recording if you have
not already done so.
=
= (ഥ,)
∗
∗
∗
∗
Labour Market
Production FunctionFlip Vertical Axis to Horizontal Axis
∗
∗
AD-AS Diagram
∗
∗
IS-LM Diagram
∗
∗
When the economy is in general equilibrium,
all markets must be in equilibrium
– including Goods and Financial markets.
Hence general equilibrium output (∗) must be
At intersection of IS-LM curves.
Lecture Outline
1. The Theory of the Firm and Labour Demand
2. Labour Supply
3. Labour Market Equilibrium
4. Tech Change and Labour Market
5. Equilibrium Output in the Classical Model
6. The Classical Aggregate Supply Curve (LRAS)
7. General Equilibrium in the Classical Model
8. Policy in the Classical Model
Government Policy in the Classical Model
• In this section, we’ll discuss why one implication of neo-classical models is that Fiscal and
Monetary policies are ineffective in changing real output
• LR equilibrium output (∗)
• Determined only by n, A and ഥ
• Not by Fiscal policy instruments i.e. changes in govt. expenditure ҧ or net taxes ത
• Nor Monetary policy instruments such as nominal money supply ഥ
• Hence multipliers for govt. policies in this model is 0
(govt. policies have no impact on real output).
• Not surprising, since real output is determined only by supply side factors in neo-classical models.
Δ∗
Δ ҧ
=
Δ∗
Δത
=
Δ∗
Δ ഥ
= 0
Changes in Fiscal Policy in the Classical Model
(Δ ҧ > 0)
• Let’s first examine in detail the impact of an expansionary fiscal policy in the context of the
classical model
• E.g. an increase in government expenditure Δ ҧ > 0
• Let the initial equilibrium be at
∗
, ∗, ∗ ∗, ∗,∗ (in the diagram on the next slide)
• As in Lecture 4, an increase in government expenditure causes the
curve to shift Right (from to ′)
• Holding price level unchanged at ∗,
The new IS-LM equilibrium demand for output increases from ∗ 1
• Recall that IS-LM determines quantity demanded of real output (i.e. aggregate quantity demanded)
• Hence the AD curve shifts Right from to ′
=
= (ഥ,)
∗
∗
∗
∗
Labour Market
Production FunctionFlip Vertical Axis to Horizontal Axis
∗
∗
AD-AS Diagram
∗
∗
IS-LM Diagram
′
′
′
∗
∗′
1
′
∗
∗′
1
2
1
3
4
Changes in Fiscal Policy in the Classical Model
(Δ ҧ > 0)
• At ∗, now there is excess aggregate demand
• Aggregate quantity demanded is 1 but aggregate quantity supplied remains at
∗ - since there were no changes in supply side factors
(∗, ഥ )
• Excess aggregate demand drives up price levels from ∗ to ∗′.
• Increase in price levels causes real money supply to fall in the money market (from
ഥ
∗
to
ഥ
∗
′, with
ഥ
∗
<
ഥ
∗
′)
• Since real output/income remains unchanged at ∗, liquidity demand stays constant.
• LM-Curve shifts to the LEFT
• Left ward shift of LM curve continues drives up interest rates to ∗
′
(decreasing planned investment) until equilibrium demand for
output in IS-LM returns to ∗ (until quantity of aggregate demanded returns to quantity of aggregate output supplied – at which
point here is no longer any upward pressure on price levels.)
• End result – no change in ∗,
W
P
∗
, N∗, but an increase in ∗ and ∗
• the increase in ҧ is matched by an equal decrease in planned investment (complete crowd out)
• End result of the expansionary fiscal policy is only inflation (Δ∗ > 0)
Changes in Monetary Policy
in the Classical Model (Δ ഥ > 0)
• Let’s next examine in detail the impact of expansionary monetary policy in the context
of the classical model
• E.g. an increase in nominal money supply Δ ഥ > 0
• Let the initial equilibrium be at
∗
0
∗ ,
∗, ∗ 0
∗, 0
∗ ,∗ (in the diagram on the next slide)
• Holding price level unchanged at 0
∗ and income unchanged at ∗, the increase in
nominal money supply (0 1) initially increase real money supply (
0
∗
to
1
∗
) which
shifts the LM curve to the left.
• The new IS-LM equilibrium implies demand for output increases from (∗ 1)
• Hence the AD curve shifts Right from to ′
=
= (ഥ,)
∗
∗
∗
∗
Labour Market
Production FunctionFlip Vertical Axis to Horizontal Axis
∗
∗
AD-AS Diagram
∗
∗
IS-LM Diagram
0
1
′
0
∗
1
∗
1
′
0
1
∗
1
1
2
Changes in Monetary Policy
in the Classical Model (Δ ഥ > 0)
• At ∗, now there is excess aggregate demand
• Aggregate quantity demanded is 1 but aggregate quantity supplied remains at
∗ - since there were no changes in supply
side factors (∗, ഥ )
• Excess aggregate demand drives up price levels from 0
∗ to 1
∗.
• Increase in price levels causes real money supply to fall in the money market (from
ഥ
0
∗ to
ഥ
1
∗ , with
ഥ
0
∗ >
ഥ
1
∗)
• Since real output/income remains unchanged at ∗, liquidity demand stays constant.
• LM-curve shifts Left
• Leftward shift of LM curve continues) until equilibrium demand for output in IS-LM returns to ∗
(until the LM curve returns to its original position)
• End result – no change in ∗,
W
P
∗
, N∗ or i∗, but an increase in ∗
• End result of the expansionary monetary policy is only inflation (Δ∗ > 0) in the classical model
Monetary Policy in the Classical Model
%Δ∗ = %ΔഥM
• In the Classical Model, the growth rate of the price level will exactly equal the growth rate of the
money supply.
• That is, in absence of any other changes in exogenous variables,
• for example, a 10% growth rate in the money supply
• will lead to an inflation rate of exactly 10%.
%Δ
ഥ
= % ഥ −%∗ = 0
• Any changes in nominal money supply ( ഥ) will leave real money supply
ഥ
∗
unchanged.
• We see this from the IS-LM diagram, because the LM curve returns to its original position
• Since there is no change in liquidity demand (real output remains unchanged at ∗)
• When the LM curve returns to its original position (0), it must be because real money supply returned to its original value.
• In the Classical model, then, the central bank is powerless to affect the value of the real money
supply (at least in the Long-run)
• For this reason, monetary policy is “neutral” in the Classical model
Investment into Capital Stock in Classical
Model (Δഥ > 0)
• Finally, let’s consider the impact of an increase in capital (Δഥ > 0)
• Holding
unchanged, Δഥ > 0
• Increases marginal productivity of labour () and hence demand for labour
↑= ഥ ↑ −
• Labour demand curve shifts right
• Also shifts the production function up – i.e. holding unchanged,
output increases as ഥ increases (. . ഥ′, > (ഥ′, ) if ′ > )
• Equilibrium labour employed increases from ∗ to ∗
′
• Equilibrium output increases from ∗ to ∗
′
• Shifting the AS curve to the right – to ′
Investment into Capital Stock in Classical
Model (Δഥ > 0)
• Rightward shift of AS curve causes price level to fall from ∗ to ∗′
• Holding income constant, fall in price level causes real money supply to shrink
(
ഥ
∗
>
ഥ
∗
′ as
∗ > ∗
′
)
• In turn causing the LM curve to shift right – i.e. at the same income and hence liquidity demand,
equilibrium interest rates fall.
• LM curve continues to shift right until equilibrium output quantity demanded (or equivalently,
aggregate quantity demanded) equals the new aggregate quantity supplied ∗′ - restoring general
equilibrium in the economy.
• Overall impact:
• Increase in real wages, Increase in equilibrium output, Fall in interest rate (that increases investment)
Conclusion
• The Classical model puts aggregate supply, through factor markets,
in the central role as driving the economy.
• Fiscal and monetary policy, and aggregate demand management
more generally, have no effect on output or employment, or real
wages.
• The key drivers for improving living conditions, in the Classical model,
are the capital stock and technological improvements.
• The missing piece of the puzzle, though, is unemployment (excess
supply of labor), which appears nowhere in this model.
Looking Ahead: Lecture 6 – Keynesian Model
• The Keynesian Labour Market
• The Keynesian Aggregate Supply Curve
• General Equilibrium in the Keynesian Model
• Policy in the Keynesian Model
• CML 2 released next week.
• Opens 1pm, 27 March
• Closes 1 pm, 3 April
• Covers Topic 3-4 (IS-LM and IS-LM Policy)
