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Unit 8: Classical Theory

Unit 8: Classical Theory. The moment that government appears at market, the principles of the market will be subverted. - Edmund Burke. Evolution of Macro Economic Theories. Classical Theory Is a market-system stable? What role does a government play in a market system?

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Unit 8: Classical Theory

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  1. Unit 8: Classical Theory • The moment that government appears at market, the principles of the market will be subverted. • - Edmund Burke

  2. Evolution of Macro Economic Theories • Classical Theory • Is a market-system stable? • What role does a government play in a market system? • How to react to “supply shocks” (war, industrial revolution, population growth) • Explain periodic inflation/deflation • Keynesian Theory • Explain Great Depression • Role of government in industrialized economy • Can government “manage’ industrial economy? • Modern Issues • Explain role of fiat money & banking • Persistent inflation & govt deficits • Effects of expectations • Global/open economies

  3. Classical theory evolved in 1800’s to explain business cycle and justify free-market policies.

  4. Why Classical Theory? • Context • Agricultural Productivity Improved • Industrial Revolution • Evolution of war • Rapid but erratic growth • Periodic inflations/deflations • Frequent financial panics/depressions

  5. The Classical Theory Using AD-AS Model

  6. Major Concerns of Classical Economists • ‘Persistent glut' possible? • Rapid Growth • Industrial Revolution • Agricultural Productivity Improved • Will technology make unemployment inevitable? • Why inflation? • Can government: • improve welfare? • “manage” economy?

  7. Classical Theory Assumptions • All markets are competitive • Goods, resource, financial markets • Equilibrium prices in all markets: • no shortages or surpluses • Government balanced budget: G=T • Households spend all income • unless high interest rates “bribe” them to save. • Firms borrow to finance I. • Financial markets make sure S = I. • No R.O.W. • Say's Law --> improved supply drives economy

  8. Circular Flow - Classical Economy. Balanced Budget: G =T. What ever is taken away from consumers as taxes gets spent anyway as G. There is no govt borrowing. Competitive financial markets cause S = Firm Borrowing.. Firms borrow to finance I. So, S=I. In effect, whatever households save gets spent eventually as I anyway.. Ignore ROW.It’s a closed economy model.

  9. Classical Model Assumptions: Implications • Real GDP (real output) depends on Firms’ production plans • SRAS and LRAS drive everything • AD doesn’t change much • Say’s Law : Supply Creates Demand(people will spend all of their income)

  10. Recessionary Gap: High unemployment LRAS PPrice Level(price index) SR-AS Gap represents amount of unemployment Price Index @start start AD Real GDP@start Real GDPif we had full employment

  11. Recessionary Gap:Classical Adjustment As wages and resource prices drop, the profitability of production improves. SRAS shifts right. As firms hire more workers, firms produce more. Newly hired households spend more. Result: • one-time drop in price level (deflation) • increase in Real GDP • return to full employment. LRAS PPrice Level(price index) SR-ASinitial SR-ASafter start after Price Index after AD Real GDP@start Real GDPfull employment

  12. Expansionary Gap:- Shortages of workers/resources- Dropping inventories PPrice Level LRAS SR-AS Inflationary pressure start AD Real GDP@start

  13. Expansionary Gap:Classical Adjustment SR-ASafter PPrice Level • Firms bid up resource prices • Firms raise product prices to replace inventory Result: • one-time increase in price level (inflation) • decrease in Real GDP • return to full employment. • Shortages end. LRAS SR-ASintial after start AD Real GDP@start Full Emp.GDP

  14. In Classical theory Contractionary Gaps are caused by Supply Shocks. LRAS PPrice Level LRAS supply shock SR-AS SRAS supply shock start Price Index @start AD Full Emp. Real GDP

  15. Classical Policy Rx • Market Economy will • Return to Full-Employment Equilibrium • BY ITSELF! • No government intervention needed • Laissez-Faire Policies • Small government • Promote markets & capitalism • Balanced budget • Taxes = G (C+I reduced by G)

  16. Classical Model Predictions • ‘Supply Shocks' Determine Real GDP & Business Cycle • Recessionary gaps • temporary then deflation • 'Inflationary' gaps • temporary then inflation • Gold standard or “hard money” stabilizes prices • Market economies are stable & tend to equilibrium • Persistent 'glut' impossible • Long-run Growth from technology & capital accumulation

  17. Classical History • Reasonable approximation of much: • 19th & early 20th century experience • Better explanation than alternative at the time • High-growth & rising living standards

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