This document provides an overview of classical macroeconomic theory. It discusses how classical economics emerged as a revolution against mercantilism, emphasizing free markets and real factors of production over money and trade balances. Key aspects of classical theory covered include: - Labor and capital markets clear through price adjustments to equilibrium. - Firms maximize profits by equaling marginal revenue product to factor prices. - Production depends on labor, capital and technology. Increases in these real factors of supply are what increase output. - Money is neutral, having no long-run impact on real variables like output and employment.

1. CCllaassssiiccaall MMaaccrrooeeccoonnoommiiccss II
CChhaapptteerr 33
Professor Steve Cunningham
Intermediate Macroeconomics
ECON 219

2. CCllaassssiiccaall RReevvoolluuttiioonn
 Classical economics emerged as a
revolution against an earlier theory known
as mercantilism.
 Two tenets of mercantilism:
– Bullionism: a belief that the wealth and power
of a nation were determined by its stock of
precious metals, and
– Active Gov’t Policy: a belief in the need for
government coordination to direct the
development of the capitalist system.

3. BBuulllliioonniissmm
 In practical terms, this lead countries to believe
that the economic success of the country
depended upon running a trade surplus—more
exports than imports.
 This results in a positive flow of payments to the
country.
 Because the payments would be in gold and
silver, this leads to the country amassing a
growing stock of “bullion”.
 To achieve this, trade was carefully regulated,
and the export of bullion prohibited.

4. CCllaassssiiccaall TThheeoorryy
 Emphasized the importance of real factors and
productive capacity in determining the “wealth of
nations”.
 Emphasized the optimizing tendencies of free
markets in the absence of state controls.
 Classical analysis was real analysis—growth of
an economy was the result of the growth and
quality of the workforce, capital, and
technological advances.
 Money only facilitates exchange. The desire to
trade “reals for reals” is what motivates
transactions.

5. CCllaassssiiccaall VViieeww ooff MMoonneeyy
 Money is simply a convenience, a means of
exchange.
 Money has no intrinsic value. People hold money
only for the sake of the goods that it can
purchase.
 Mercantilists had argued that on the short run an
increase in the supply of money would increase
demand and stimulate employment and
production. Classical economists argued that
increases in the supply of money ultimately have
the effect of only causing inflation.

6. MMaarrkkeettss
 Mercantilists argued that the government needs
to make sure that markets exist for all goods.
 Classical economists argued that “consumption
never needs encouragement”, that the free
market mechanism would provide markets for
any goods that were produced.
 Classical economists argued that there will
always be sufficient demand for whatever was
produced.

7. OOvveerrvviieeww ooff tthhee mmooddeell
The story being told in this chapter is
about the classical view of the real
sector of the macroeconomy, and how
it produces optimal, stable outcomes
(equilibria).

8. LLaabboorr MMaarrkkeett
w/p
Ns
N* N
(w/p)*
Nd

9. CCaappiittaall MMaarrkkeett
S, I
r
S*, I*
r*
Investment (I) is the
change in the amount
(stock) of capital.
I
S
Saving = supply of funds
Investment = demand for funds

10. PPrroodduuccttiioonn FFuunnccttiioonn
Y Y=F(N,K*)
Y* The level of
N
N*
capital has already
been established in
the capital market.

11. CCllaassssiiccaall RReeaall SSeeccttoorr
4
N
Y
Y=F(N*,K*)
N*
Y*
S, I
r
S*, I*
r*
I
S
S*, I*, r*, K*
w/P
Ns
N* N
(w/P)*
Nd
(w/P)*, N*
Y* Y
P
1
2
3
LRAS

12. LLaabboorr MMaarrkkeett AAssssuummppttiioonnss
Differences among workers are not
considered.
Wages are determined in fully
competitive labor markets (with flexible
wages).
Firms’ sole concern is profit
maximization. In doing so, firms
consider the marginal revenue product
of labor (MRPN = P x MPN), comparing
it to nominal wages.

13. TThhee FFiirrmm PPrrooffiitt MMaaxxiimmiizzeess
Firm’s profit function: p = PY – wN – Pr(K – K0)
Maximize profit: Assume A=1, Y=F(N,K) and construct expressions for change
in profit relative to changes in employment (N) and capital (K) and set to zero.
Solve.
Dp = P(DY) – w DN = 0
Dp = P(DY) – Pr DK = 0
----------------------
DY/ DN = w/P
DY/ DK = r
The firm is profit- maximizing
when these conditions are met.
Marginal Product of Labor = Real Wage
Marginal Product of Capital = Real Interest Rate

14. IImmpplliiccaattiioonnss
S, I
r
I
w/P
N
Nd
Cet. Par., investment
demand by firms rises as
interest rates fall. The
investment curve slopes
downward.
Cet. Par., labor demand by
firms rises as real wages
fall. Labor demand slopes
downward.

15. LLaabboorr SSuuppppllyy
 Workers have a plan for things they wish to buy.
 Workers exchange their labor to buy the goods.
 In a monetary economy, workers exchange their
labor for money and use the money to buy the
goods, but it is not the money they want. It is the
goods.
 That is, households trade “reals for reals”, labor
for goods, to achieve the consumption they
desire to maximize their utility.

16. HHoouusseehhoollddss OOppttiimmiizzee
Households maximize utility by maximizing
consumption. This requires income.
So, within normal operating ranges,
households supply labor at an increasing rate
with increasing wage rates.
Saving increases with rising interest rates.
That is, DNs/ D(w/P) > 0 and DS/ Dy > 0
or (w/P)­Þ Ns­ and (S)­Þ r­

17. MMiiccrroo AAnnaallyyssiiss ooff LLaabboorr SSuuppppllyy
hours of leisure
U3
U2
24
W/P
4
3
2
15 16 18
W/P
4
3
2
6 8 9
hours of work
Ns
U1

18. IImmpplliiccaattiioonnss
S, I
r S
w/P
Ns
N
Cet. Par., saving by
households increases as
interest rates rise. The
saving curve slopes
upward.
Cet. Par., labor supply by
households rise as real
wages rise. Labor supply
slopes upward.

19. AAbbssttiinneennccee TThheeoorryy
 William Nassau Senior argued that, all else equal, people
would prefer to consume now rather than later.
 But people are induced by interest rates to forego current
consumption and save in anticipation of being able to
consume more in the future.
 Therefore the higher the interest rate, the more people will
be inclined to forego current consumption (abstinence from
consumption) in favor of the return which promises higher
consumption in the future.
 This means that the higher the interest rate, the higher the
saving rate.
 Saving makes the buying power available to firms and
other borrowers who will spend it, so buying power is
never lost. Ultimately all current income is spent in the
current period.

20. FFaaccttoorr MMaarrkkeettss aarree RReessoollvveedd
S, I
r
S*, I*
r*
I
S
S*, I*, r*, K*
w/P
Ns
N* N
(w/P)*
Nd
(w/P)*, N*
Each market has
supply and demand
related to a single
variable. The two
factor markets can
achieve stable
equilibrium.

21. Effect of aann IInnccrreeaassee iinn LLaabboorr PPrroodduuccttiivviittyy
w/p
N N 1
(w/p)1
Nd
1
Ns
Nd
2
N2
(w/p)2
1. Labor is more
productive.
2. Firms increase
demand for
labor.
3. Employment
increasese and
wages are bid
upward.

22. IInnccoommee TTaaxx CCuutt
w/p
Ns
2
N N 1
(w/p)2
Nd
N2
(w/p)1
1. The same real
wage is more
attractive to
workers.
2. Labor supply
increases.
3. Employment
increases and
wages fall.
4. Unemployment
Rate falls.
Ns
1

23. PPrroodduuccttiioonn
Capital (K)
Land (L)
Labor (N)
Production
AF(K,L,N) Output (Y)
Factors of Production
(Inputs)

24. PPrroodduuccttiioonn ((22))
A simplified form of the Production Function is
Y = AF(K,N)
where
Y = real output per period of time
A = total factor productivity
K = capital stock
N = labor (number of workers or labor hours used
F = function relating the amount of output produced
from the capital and labor used

25. PPrroodduuccttiioonn ((33))
 Y = AF(K,N) is a mathematical expression
that computes how much output will be
produced with a certain technology (A)
from inputs K and N.
 Example: Cobb-Douglas Production
Function:
Y = AKaN1-a , 0 < a < 1.
Typical values are
Y = AK0.3N0.7.

26. TThhee SShhaappee ooff PPrroodduuccttiioonn
 The production function slopes upward from left
to right--more capital stock results in more
output. (DY/DK > 0)
 The production function becomes flatter as
capital increases--more capital results in more
output, but at a diminishing rate. (You get less
increase in output from adding the second unit of
capital than you did from adding the first.)
 This is referred to as diminishing marginal
returns to capital.

27. PPrroodduuccttiioonn FFuunnccttiioonn
Y Y=F(N*,K)
K
K2
Y3
Y2
The level of
employment has already
been established in
the labor market.
Y1
K1 K3

28. PPrroodduuccttiioonn FFuunnccttiioonn:: MMPPKK
A The slope of the
K
Y
Y=F(N*,K)
K2
Y3
Y2
Y1
B
K1 K3
tangent at point A is
the MPK at point A.
The slope of the
tangent at point B is
the MPK at point B.

29. PPrroodduuccttiioonn FFuunnccttiioonn:: MMPPNN
N
Y
Y=F(N,K*)
N2
Y3
Y2
Y1
B
A
N1 N3
The slope of the
tangent at point A is
the MPN at point A.
The slope of the
tangent at point B is
the MPN at point B.

30. CCaappiittaall CChhaannggee
N
Y
Y=F(N,K2)
Y2
Y1
N1
Y=F(N,K1)

31. TTeecchhnnoollooggyy CChhaannggee
Y=A2F(N,K*)
N
Y
Y2
Y1
N1
Y=A1F(N,K*)

32. CCllaassssiiccaall RReeaall SSeeccttoorr
4
N
Y
Y=F(N*,K*)
N*
Y*
S, I
r
S*, I*
r*
I
S
S*, I*, r*, K*
w/P
Ns
N* N
(w/P)*
Nd
(w/P)*, N*
Y* Y
P
1
2
3
LRAS

33. IInnccrreeaassee iinn LLaabboorr PPrroodduuccttiivviittyy
w/P
N
Y
P
S
I
S,I
r
r*
S*,I*
Ns
Nd
2
LRAS1
Y=F(N,K)
Nd
1
LRAS2
+
+
+

34. DDeetteerrmmiinnaannttss ooff OOuuttppuutt && EEmmppllooyymmeenntt
 Only real variables affect output and employment.
Money is irrelevant.
 Only supply/production factors affect output and
employment. Demand factors are irrelevant.
 Only changes in labor supply, labor productivity,
capital formation, or improvements in production
technology can increase output.
 Note that taxes, to the extent that they affect the
supply of labor or the cost of capital formation,
can affect output. (How they affect demand is
irrelevant.)

35. SSuuppppllyy--ssiiddee TTaaxx CCuutt
w/P
N
Y
S
I
S,I
r
r*
S*,I*
Ns
1
Ns
2
LRAS1
Y=F(N,K)
Nd
LRAS2
-
+
+
P

36. SSaayy’’ss LLaaww
 Jean Baptiste Say argued that widespread,
prolonged over-production of goods was
impossible.
 This implies that prolonged, widespread
unemployment is also impossible.
 He argued that “supply creates its own
demand.” The production process creates
the incomes to buy the goods produced.
 Recessions and depressions can’t
happen?

37. WWaallrraass’’ LLaaww
If there are n markets in the
economy, and n-1 of them are in
equilibrium, then the nth one must
also be in equilibrium.
Equivalently, it is impossible to have
only on market in disequilibrium.

38. NNeeuuttrraalliittyy
 We say that money is long-run neutral if the level
of the money supply is irrelevant to the real-sector
outcomes (output and employment) in the
long-run.
 We say that money is short-run neutral if the level
of the money supply is irrelevant to the real-sector
outcomes (output and employment) in the
short-run.
 Neutrality implies that we still need to consider
the money supply to compute the real-sector
equilibrium, but ultimately the money supply
doesn’t change the real sector equilibrium.

39. DDiicchhoottoommyy
We say a model is dichotomous, or that
there is a dichotomy of money, if it is
possible to solve a model for all the real
sector variables without ever using the
monetary sector equations.
 That is, we can separate the model into
real sector equations and monetary sector
equations, and solve the two halves of the
model independently.
 The classical model is dichotomous.