PART II: CLASSICAL ECONOMICS AND THE

KEYNESIAN REVOLUTION
CHAPTER 3: CLASSICAL MACROECONOMICS:
(I) EQUILIBRIUM OUTPUT & EMPLOYMENT
ADDITIONAL QUESTIONS
Problems and/or Essay Questions:
1. Briefly define an endogenous variable and an exogenous variable. What variables are endogenous in
the classical model? What variables are exogenous.
An endogenous variable is a variable whose value is determined within or by the model whereas the
value of an exogenous variable is determined by forces outside the model. The real wage, the level of
labor, and output are endogenous in the classical model. Exogenous variables include labor supply,
capital, and technology.
2. Explain how an increase in technology, which increases the productivity of labor, will affect the labor
market, the production function, and aggregate output. Provide graphs to illustrate.
An increase in technology will shift the labor demand curve to the right, leading to an increase in the
real wage and an increase in labor. The aggregate production function will shift upward because of
the increase in technology, and there will also be a movement along the production function as the
quantity of labor increases. Both of these factors will increase aggregate output.
3. What are the two key features of perfectly competitive markets in the Classical Model?
1. Perfectly flexible prices and wages
2. Perfect information on the part of all market participants about market prices
4. Explain how an increase in the publics taste towards less leisure would affect the labor market, the
production function, and aggregate output. Provide graphs to illustrate.
An decrease in the demand for leisure would shift the labor supply curve to the right (up), which
would decrease the real wage and increase the quantity of labor. This increase in the quantity of labor
would lead to a movement along the production function towards higher output.

5. Explain why the labor supply curve is positively sloped. Explain why labor demand is downward
sloping.
It is assumed that additional labor is supplied at higher real wage rates. At a higher real wage rate, the
price of leisure is greater in terms of foregone income. Along the labor demand curve, the real wage
is equal to the marginal product of labor. Because of diminishing marginal returns, the marginal
product of labor falls as the quantity of labor rises, so the real wage must also fall as the quantity of
labor rises.
6. Using a graph of the classical labor market, illustrate the effects of a real wage existing in the market
that is lower than the equilibrium real wage. What will eventually happen in this labor market if it is
perfectly competitive?
If the real wage is lower than the equilibrium real wage then the quality of labor demanded is greater
than the quantity of labor supplied. In the auction for labor, the real wage being paid to labor will
eventually be bid up, increasing quantity supplied and reducing quantity demanded until the market is
in equilibrium.
7. What two principles of mercantilism did the classicists attack?
The belief that the wealth and power of a nation were determined by its stock of precious metals and
the belief in the need for state action to direct the development of the capitalist system.
8. In the classical model, what is the impact of changes in the demand for goods and services on
aggregate output? Do they affect any real variables?
Factors such as the quantity of money, the level of government spending, and the level of demand for
investment goods by the business sector are all demand-side factors and have no role in determining
output and employment. Also, changes in taxes, to the degree that they affect the demand side, will
neither affect output nor employment. The level of aggregate demand has no effect on output because
output and employment are supply-determined.
9. What is Real Business Cycle Theory? What drives business cycles in this model? Where do these
shocks come from?
In the Real Business Cycle Theory, changes in output are driven by changes in technology, which
change aggregate supply. The changes in technology can be driven by new inventions, natural
disasters, changes in the publics preferences for work, discoveries of natural resources, or
government regulations and taxation which affect both firms and workers incentives to produce.
10. Is there a positive or negative relationship between real wages and output in the classical model?
Explain.
The answer depends upon whether labor supply or labor demand is shifting. If an increase in output
is caused by an increase in labor supply, then there is a negative relationship between real wages and
output. If an increase in labor demand causes the increase in output, then real wages and output are
positively related.

.
Additional Problems and/or Essay Questions:
11. Consider an economy where the marginal product of labor is characterized by the following equation:
MPN = L-1/2
The labor supply curve is given by the following equation:
Ls = 4(W/P)
Calculate the labor demand curve, the equilibrium real wage, and the equilibrium level of labor.
The labor demand curve is Ld = (W/P)-2 and is derived by setting the MPN equal to the real wage
(W/P). Setting labor demand equal to labor supply allows you to solve for the equilibrium real wage,
W/P = .63, and equilibrium labor, L = 2.52.
12. A well known aspect of the classical model is Says Law, which states that supply creates its own
demand. In what sense does Says law hold in the classical model?
13. Use the graph of the aggregate production function (Figure 3.1) to explain the concept of the marginal
productivity of labor. Draw a graph of the marginal productivity of labor schedule, with the level of
employment on the horizontal axis. Explain the properties of this schedule.
14. Suppose that you observe an fall in real wages at the same time that output is rising. How would you
explain this within the classical model of aggregate supply?
15. What factors change aggregate supply in the classical system? How do these factors affect aggregate
output? What factors change aggregate demand in the classical system? How do these factors affect
aggregate output?

Multiple-Choice Questions:
1. One factor which did not influence the levels of real output and employment in the classical system
was the
a. stock of capital.
b. level of technology.
c. the price level.*
d. size of the labor force.
2. The classical economists attacked the mercantilist propositions that
a. state action was necessary to direct the capitalist system.
b. money had no intrinsic value.
c. output was completely supply-determined.
d. the wealth of a nation was closely linked to the countrys stock of precious metals.
e. Both a and d*
3. The supply-determined nature of output and employment is a crucial feature of
a. the Keynesian theory.
b. the classical system. *

c. monetarism.
d. the rational expectations model.

4. Which of the following is not consistent with perfect competition?

a. Workers bargain individually for their wages.
b. Labor demand is determined by real wages and the marginal product of labor.
c. The marginal product of labor is diminishing.
d. Workers have no influence on their wages but accept them as given.
e. None of the above.*
5. The supply of labor in the classical system is a function of the
a. marginal product of labor.
b. real wage.
c. the publics preference for leisure.
d. money wage.
e. b and c*
6. For a given level of the money wage, an increase in the price level will cause the
a. supply of labor to rise.
b. quantity of labor demanded to rise.
c. price of leisure to rise.
d. quantity of labor demanded to rise.
e. both b and d.*
7. Which of the following is not consistent with perfect competition?
a. all firms face the same costs.
b. firms cannot determine the price of the goods they sell.*
c. the marginal product of labor is diminishing.
d. firms negotiate the same wages for different workers.
8. The author of The Wealth of Nations; The author of the General Theory
a. David Ricardo; John Maynard Keynes.
b. Adam Smith; A. C. Pigou.
c. Adam Smith; David Ricardo
d. Adam Smith; John Maynard Keynes.*
e. Adam Smith; John Stuart Mills.
9. In the classical macroeconomic model, a decrease in the real wage would cause
a. a decrease in the marginal product of labor and an increase in the quantity demanded for labor.*
b. an increase in the marginal product of labor and an increase in the quantity demanded for labor.
c. no change in the quantity demanded for labor.
d. an increase in both the supply of and demand for labor.
10. As the real wage increases, assuming that the substitution effect dominates, then
a. individuals move to lower indifferent curves and consume less leisure.
b. individuals move to higher indifferent curves and consume less leisure.
c. individuals move to higher indifferent curves and consume more leisure.*
d. individuals stay on the same indifferent curve and consume more leisure.

11. Technological change that increases the marginal productivity of labor in the classical model would
cause
a. labor demand, output and the price level to rise.
b. labor demand to fall, the price level to fall, and output to rise.
d. labor demand, output and employment to rise.
c. output to rise but labor demand to fall.
12. A proportionate increase in the price level and the money wage in the classical model
a. increase labor supply.
b. decrease labor supply.
c. leave labor supply unchanged.*
d. affect labor supply but the direction of the effect is uncertain.
13. A production function relates
a. the level of output to the level of technology.
b. the price level to the level of aggregate output.
c. aggregate output to the level of inputs and technology.*
d. aggregate demand to aggregate supply.
14. If the demand for labor is plotted against the money wage, with the money wage on the vertical axis,
then
a. an increase in the price level will cause the labor demand schedule to shift to the right.*
b. an increase in the money wage will cause the labor demand schedule to shift to the left.
c. an increase in the money wage will cause the labor demand schedule to shift to the right.
d. the labor demand schedule will be upward sloping.
15. The classical economists believed that
a. labor supply is upward sloping because the income effect is greater than the substitution effect.
b. labor supply is upward sloping because the substitution effect is greater than the income effect.*
c. labor supply is downward sloping because the income effect is greater than the substitution effect.
d. in equilibrium, the marginal product of labor must exceed the real wage.
e. both b and d.
16. The marginal product of labor is
a. the value of output for an addition dollars worth of input.
b. output divided by the quantity of labor.
c. the additional output produced by adding an additional unit of labor.*
d. the price of the output produced by increasing labor.

Figure 3.1

17. With respect to Figure 3.1, the classicists argued that

a. the relevant aggregate supply curve is labeled B.*
b. the curves labeled B and G are both relevant during recessions.
c. only the supply curve labeled M is important.
d. None of the above
18. If the wealth effect of an increase in the real wage was greater than the substitution effect of an
increase in the real wage
a. the labor supply curve would slope upward.
b. the labor supply curve would slope downward.*
c. the labor supply curve would be vertical.
d. the labor demand curve would solely determine the real wage.
19. In the classical model, a decrease in immigration would
a. decrease labor supply, increase the real wage, and decrease output.*
b. increase labor supply and the real wage, and decrease output.
c. increase labor demand and the real wage, and increase output.
d. reduce real wages and reduce output.
20. In the classical model, and increase in tax on firms that hired labor would
a. decrease labor demand and the real wage and increase output.
b. decrease labor supply, increase the real wage, and decrease output.
c. decrease labor demand, decrease the real wage, and decrease output.*
d. reduce real wages and increase output.
21. With respect to the classical labor market analysis, it is not assumed that
a. firms have complete information with respect to relevant prices.*
b. workers negotiate for unique wages individually.
c. money wages adjust with a short lag.
d. All of the above
e. None of the above
22. If a natural disaster destroys some of the capital stock, then the classical model predicts
a. labor demand, real wages, and output will fall.*
b. labor demand and real wages will rise, output will fall.
c. the labor market remains unchanged but output falls.
d. None of the above

23. Which of the following factors will not determine output and employment in the classical model?
a. Taxes that affect the incentive to work or hire labor
b. The level of government spending*
c. The quantity of capital
d. Preferences for leisure
e. None of the above
24. Which of the following will increase the marginal product of labor in the labor market?
a. An increase in the price level and the money wage.
b. An increase in the real wage.*
c. A decrease in the capital stock.
d. An increase in the supply of labor.
25. In the classical model,
a. firms are assumed to be perfect competitors who choose their output level so as to maximize
profits.
b. the perfectly competitive firm will increase output until the marginal cost of producing one unit of
output equals the marginal revenue received from the sale of that particular unit of output.
c. marginal revenue is equal to product price for the perfectly competitive firm.
d. All of the above*
26. If there is an increase in the price level in the classical model,
a. the equilibrium level of output will remain unchanged.
b. real wages remain constant.
c. money wages will rise proportionally.
d. all of the above.*
27. The aggregate demand curve for labor is the
a. vertical summation of the individual firms' demand curves.
b. horizontal summation of the individual firms' demand curves.*

c. horizontal summation of all the individual supply curves.

d. vertical summation of the individual firms' supply curves.
28. Diminishing marginal returns refers to the fact that
a. holding other inputs constant, additional increases in labor lead to smaller changes in output.*
b. holding other inputs constant, additional increases in labor lead to lower output.
c. additional increases in labor always lead to smaller changes in output
d. the returns to labor fall as real wages rise.
29. The classical model is a model in which
a. governmental policies are needed to ensure full employment.
b. wages and prices are perfectly flexible.
c. the public has perfect information.
d. None of the above
e. b and c*
30. A profit-maximizing firm hires labor until
a. the price of output equals the price of labor.

b. the price of output equals the marginal product of labor

c. the real wage equals the marginal product of labor.*
d. the real wage equals the marginal product of labor multiplied by the price of output.
31. Which of the following are endogenous variables within the classical model?
a. output*
b. technology
c. quantity of money
d. level of capital
e. a, b, and d
32. In the classical model, the factors determining output and employment are the factors that ascertain
the position(s) of
a. the labor supply curve only.
b. the labor demand curve only.
c. the aggregate production function.
d. both the labor supply curve and the labor demand curve.
e. Both c and d*
33. Assuming a 10-percent decrease in both the nominal (money) wage and the price level in the classical
model, then the quantity of labor supplied will
a. also decrease by 10 percent.
b. increase by 10 percent.
c. remain constant.*
d. decrease by less than 10 percent.
34. According to Figure 3.2, the marginal product of labor
a. falls short of the real wage at point b.
b. is higher at point a than at point e.
c. equals the real wage at point c.
d. All of the above*
e. None of the above.

Figure 3.2

35. According to the classical model, workers chose a level of labor that equates the
a. real wage and marginal product of labor.
b. nominal wage and marginal product of labor.
c. the marginal utility of consumption and the marginal disutility of lost leisure.*
d. the marginal utility of consumption with the real wage.
36. If real wages fall as output rises, then in the classical model it must be the case that
a. labor demand rose.
b. labor demand fell.
c. labor supply rose.*
d. labor supply fell.
e. none of the above.
37. The vertical classical aggregate supply curve reflects that
a. money wages adjust proportionally with the price level.*
b. real wages are always the same.
c. aggregate output is always the same.
d. None of the above.
e. Both b and c.
38. Assuming a 5-percent decrease in both the nominal (money) wage and 5-percent increase in the price
level in the classical model, then
a. both the quantity supplied and demanded of labor will increase.
b. the quantity supplied of labor will increase and the quantity demanded of labor will decrease.
c. both the quantity supplied and demanded of labor will decrease.
d. the quantity of labor supplied and demanded would remain constant.*
.

39. An increase in immigration would

a. have no effect on the labor supply curve and real wages.
b. shift the labor supply curve to the left and increase real wages.
c. shift both the labor demand curve and the labor supply curve to the left.
d. shift the labor supply curve to the right and decrease real wages.*

40. An increase in taxes on labor earnings, everything else equal

a. shifts the labor supply curve to the left and increases the real wage.*
b. shifts the labor supply curve to the right and increases the real wage.
c. shifts the labor supply curve to the right and reduces the real wage.
d. shifts the labor supply curve to the left and reduces the real wage.
41. Which of the following is consistent with diminishing marginal returns?
a. increasing labor by 10% and output increasing 10%.
b. increasing labor by 10% and output prices increase by less than 10%.
c. increasing labor by 10% and the marginal product of labor increasing 10%.
d. increasing labor by 10% and output increasing by less than 10%.*
42. Which of the following is not an exogenous factor of production in the aggregate production
function?
a. Technology
b. The real wage*
c. Capital
d. Labor
e. These are all factors of production.
43. The increased willingness of women to enter the workforce has most likely lead to what outcome in
the labor market?
a. an increase in labor demand and higher real wages.
b. an increase in labor supply and higher real wages.
c. an increase in labor supply and high real wages.
d. a decrease in labor demand and lower real wages.
e. none of the above.*
44.

To classical economists, it is always true that

a. there is zero unemployment.
b. actual output is always equal to potential output.*
c. excess demand for goods is possible unless prices are forced to fall.
d. the marginal product of labor exceeds the real wage.

45. In the classical model, the supply-determined nature of output is illustrated by a(n)
a. horizontal aggregate supply curve.
b. vertical aggregate supply curve.*
c. upward sloping aggregate supply curve.
d. downward sloping aggregate supply curve.
46. Which of the following statements is (are) correct?
a. It was the apparent failure of the classical equilibrium model to explain cyclical movements in
output that led to the classical revolution.

b. Some economists have argued that the business cycle in the post-1980 period is caused by
changes in real supply-side variable, much along classical lines.*
c. Economists agree that supply-side factors can fully explain the business cycle.
d. All of the above.

e. Both a and b.
47. According to the classical model, in the labor market
a. perfect information about the market price by market participants is required.
b. the labor market is always in equilibrium.
c. prices and wages are perfectly flexible.
d. both suppliers and purchasers of labor must know the relevant trading prices.
e. All of the above.*
48.

With respect to an auction market,

a. labor and output are assumed to be traded in markets that are not always in equilibrium.
b. all participants make decisions based on announced nominal wage rates.
c. all participants make decisions based on announced product prices.*
d. All of the above
e. None of the above
49. A vertical aggregate supply schedule implies that
a. real wages cannot impact output.
b. unemployment cannot impact output.
c. aggregate demand is horizontal.
d. the price level does not impact output.*
50. In the classical model, a tax on capital will
a. increase the demand for labor, the real wage, and output.
b. increase the supply of labor, reduce real wages, and increase output.
c. decrease the demand for labor, the real wage, and output.*
d. have no effect on the labor market.
e. increase both labor demand and supply, which will increase output.
51. Assuming a workers money wage rose from $10 per hour to $20 per hour while all product price
have doubled, then in the classical model, this worker would
a. supply more labor after the wage increase.
b. supply less labor after the wage change.
c. supply the same amount of labor after the hourly wage increase.*
d. demand less leisure.
52. Classical economists
a. focused on the role of money as an asset for savings.
b. stressed the need for money in order to spur economic activity.
c. argued that, in the short run, an increase in the quantity of money would lead to an increase in
demand for commodities and would stimulate production and employment.
d. None of the above*
53. Which of the following statements is correct? Classical economists
a. believe demand as well as supply determines aggregate output.
b. believed in an active role for government in managing the economy through tax policy.
c. gave little explicit attention to factors that determined the overall demand for commodities.*

d. were worried about depressions that could come about because of too little government
consumption.