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Macroeconomics

2. Classical Economic Theory. Refers to the theory first proposed by Adam Smith in ?An Inquiry into the Nature and Causes of the Wealth of Nations."Classical theory was the predominant theory in industrialized nations from the time of Adam Smith until the Great Depression.. 3. The Self-Regulating

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Macroeconomics

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    1. Macroeconomics Chapter 07: Classical Economic Theory Spring 2007

    2. 2 Classical Economic Theory Refers to the theory first proposed by Adam Smith in “An Inquiry into the Nature and Causes of the Wealth of Nations.” Classical theory was the predominant theory in industrialized nations from the time of Adam Smith until the Great Depression.

    3. 3 The Self-Regulating Economy The ideal quantity of total output is the quantity that will yield full employment of labor. The quantity of total output that results in full employment of labor is called Natural Real GDP. According to classical theory, a market economy is self-regulating and will automatically adjust to Natural Real GDP.

    4. 4 Marx and Market Instability Karl Marx argued that market economies do not automatically adjust to Natural Real GDP. Marx said that market economies would be unstable because of inadequate demand.

    5. 5 Say’s Law Classical theory argues that inadequate demand cannot be a problem in a market economy due to Say’s Law. Say’s Law Supply creates its own demand. The act of production leads to equivalent income to resource owners.

    6. 6 Say’s Law, Savings and Flexible Interest Rates According to classical theory, flexible interest rates in the credit market cause any consumer savings to be exactly offset by business investment. This assumes that the quantity of both savings and investment is determined by the interest rate.

    7. 7 Equilibrium in the Credit Market

    8. 8 An Increase in Savings is Offset by an Increase in Investment

    9. 9 A Recessionary Gap If Real GDP is less than Natural Real GDP, the economy is in a recessionary gap. Example: Natural Real GDP is $13,000 billion Equilibrium Real GDP is $12,500 billion The economy is in a recessionary gap.

    10. 10 A Recessionary Gap

    11. 11 Closing a Recessionary Gap According to classical theory, the economy is self-regulating and will automatically close a recessionary gap. The surplus of labor will cause wage rates in the economy to fall. The decrease in wage rates will shift the SRAS curve to the right, until Natural Real GDP is reached.

    12. 12 Closing a Recessionary Gap

    13. 13 An Inflationary Gap If Real GDP is greater than Natural Real GDP, the economy is in an inflationary gap. Example: Natural Real GDP is $13,000 billion Equilibrium Real GDP is $13,500 billion The economy is in an inflationary gap.

    14. 14 An Inflationary Gap

    15. 15 Closing an Inflationary Gap According to classical theory, the economy is self-regulating and will automatically close an inflationary gap. The shortage of labor will cause wage rates in the economy to rise. The increase in wage rates will shift the SRAS curve to the left, until Natural Real GDP is reached.

    16. 16 Closing an Inflationary Gap

    17. 17 Long-Run Equilibrium If Real GDP is equal to Natural Real GDP, the economy is in long-run equilibrium. Example: Natural Real GDP is $13,000 billion Equilibrium Real GDP is $13,000 billion The economy is in long-run equilibrium.

    18. 18 Long-Run Equilibrium

    19. 19 Long-Run Aggregate Supply If the economy is self-regulating, Real GDP will always tend to adjust back to Natural Real GDP. Thus, the LRAS curve will be vertical at Natural Real GDP. Changes in AD will have no effect on output in the long run, but will affect only the price level.

    20. 20 Long-Run Aggregate Supply

    21. 21 Laissez-faire If the economy is self-regulating and automatically adjusts to Natural Real GDP, the proper macroeconomic policy is laissez-faire. Laissez-faire – leave it alone, do nothing.

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