Economics Unit 2

Topic: Classical models in the macroeconomy

Who/What is an Economic Agent?
Economic Agent – An economic decision maker who can recognise that different factors influence and motivate different
economic groups. They shape the world we live in. The allocation of resources is dependent on their choices. There are 3
types of economic agents. They are: Consumers, Firms (Producers), Governments.
The Classical Theory

The fundamental principle of the classical theory is that the economy is self‐regulating. Classical economists maintain
that the economy is always capable of achieving the natural level of real GDP or output, which is the level of real GDP
that is obtained when the economy's resources are fully employed. While circumstances arise from time to time that cause
the economy to fall below or to exceed the natural level of real GDP, self‐adjustment mechanisms exist within the
market system that work to bring the economy back to the natural level of real GDP. The classical doctrine—that the
economy is always at or near the natural level of real GDP—is based on two firmly held beliefs: Say's Law and the belief
that prices, wages, and interest rates are flexible.

Say's Law. According to Say's Law, when an economy produces a certain level of real GDP, it also generates the income
needed to purchase that level of real GDP. In other words, the economy is always capable of demanding all of the output
that its workers and firms choose to produce. Hence, the economy is always capable of achieving the natural level of real
GDP.
The achievement of the natural level of real GDP is not as simple as Say's Law would seem to suggest. While it is true
that the income obtained from producing a certain level of real GDP must be sufficient to purchase that level of real GDP,
there is no guarantee that all of this income will be spent. Some of this income will be saved.Income that is saved is not
used to purchase consumption goods and services, implying that the demand for these goods and services will be less than
the supply. If aggregate demand falls below aggregate supply due to aggregate saving, suppliers will cut back on their
production and reduce the number of resources that they employ. When employment of the economy's resources falls
below the full employment level, the equilibrium level of real GDP also falls below its natural level. Consequently, the
economy may not achieve the natural level of real GDP if there is aggregate saving. The classical theorists' response is
that the funds from aggregate saving are eventually borrowed and turned into investment expenditures, which are a
component of real GDP. Hence, aggregate saving need not lead to a reduction in real GDP.
Consider, however, what happens when the funds from aggregate saving exceed the needs of all borrowers in the
economy. In this situation, real GDP will fall below its natural level because investment expenditures will be less than the
level of aggregate saving. This situation is illustrated in Figure .
Aggregate saving, represented by the curve S, is an upward‐sloping function of the interest rate; as the interest rate rises,
the economy tends to save more. Aggregate investment, represented by the curve I, is a downward‐sloping function of the
interest rate; as the interest rate rises, the cost of borrowing increases and investment expenditures decline. Initially,
aggregate saving and investment are equivalent at the interest rate, i. If aggregate saving were to increase, causing
the S curve to shift to the right to S′, then at the same interest rate i, a gap emerges between investment and savings.
Aggregate investment will be lower than aggregate saving, implying that equilibrium real GDP will be below its natural
level.
Flexible interest rates, wages, and prices. Classical economists believe that under these circumstances, the interest rate
will fall, causing investors to demand more of the available savings. In fact, the interest rate will fall far
enough—from i to i′ in Figure —to make the supply of funds from aggregate saving equal to the demand for funds by all
investors. Hence, an increase in savings will lead to an increase in investment expenditures through a reduction of the
interest rate, and the economy will always return to the natural level of real GDP. The flexibility of the interest rate as
well as other prices is the self‐adjusting mechanism of the classical theory that ensures that real GDP is always at its
natural level. The flexibility of the interest rate keeps the money market, or the market for loanable funds, in
equilibrium all the time and thus prevents real GDP from falling below its natural level.
Similarly, flexibility of the wage rate keeps the labor market, or the market for workers, in equilibrium all the time. If
the supply of workers exceeds firms' demand for workers, then wages paid to workers will fall so as to ensure that the
work force is fully employed. Classical economists believe that any unemployment that occurs in the labor market or in
other resource markets should be considered voluntary unemployment. Voluntarily unemployed workers are
unemployed because they refuse to accept lower wages. If they would only accept lower wages, firms would be eager to
employ them.
Graphical illustration of the classical theory as it relates to a decrease in aggregate demand. Figure considers
a decrease in aggregate demand from AD 1 to AD 2.
The immediate, short‐run effect is that the economy moves down along the SAS curve labeled SAS 1, causing the
equilibrium price level to fall from P 1 to P 2, and equilibrium real GDP to fall below its natural level of Y 1 to Y 2. If real
GDP falls below its natural level, the economy's workers and resources are not being fully employed. When there are
unemployed resources, the classical theory predicts that the wages paid to these resources will fall. With the fall in wages,
suppliers will be able to supply more goods at lower cost, causing the SAS curve to shift to the right from SAS 1 to SAS 2.
The end result is that the equilibrium price level falls to P 3, but the economy returns to the natural level of real GDP.
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theory
Assumptions of the classical model
A very brief version of the classical model starts from the following assumptions:
1. All economic agents can decide how much to buy or sell, in order to maximize their utility, as rational agents;
2. All economic agents have the same level of information regarding prices;
3. Prices are perfectly flexible which allows them to adjust until the market-clearing level;
4. There is a fictional Walrasian auctioneer who makes sure that no good is traded until the market-clearing price is
agreed;
5. Agents have stable expectations.
Fig. 1

 N = employment level
 W = real wage (nominal wage/price)
 Sn = labour supply
 Dn = labour demand
 Y = output (production)
 P = price level
 AS = aggregate supply
 AD = aggregate demand
 ω = nominal (money) wage
 r = interest rate
 S = savings
 I = investments

Mechanisms of the classical model

Based on the assumptions of the classical model, all markets clear since prices are perfectly flexible and able to adjust
until supply equals demand.
This is also valid for the labour market. Under the classical model frame, an increase in the money supply, for instance,
does not alter real variables like employment level or real wage. Real wage, which we can of as the price of the labour
market, will adjust until labour demand will be equal to labour supply. The only thing that will change is the level of
nominal (money) wages and price level, as seen in Fig. 2.
An increase in money supply, from M1 to M2 leads to a shift in the aggregate demand curve, from AD to AD’. This is
because the classical model employs the Quantity Theory of Money: MV = PY, where M is the money supply, V is the
velocity of money in circulation, P is the level of price and Y is the output. The Quantity Theory of Money, reinterpreted
in the Cambridge approach, equates PY with the demand for money times the velocity of money, which can be aggregated
under AD.
To come back to the previous point, when money supply increases, the aggregate demand curve will shift to the right.
This will yield a higher price, but the aggregate supply is independent of the price level. Since prices are perfectly
flexible, changes in the price level will be matched by corresponding changes in the nominal (money wage) to maintain
the same market-clearing level of employment.
The new equilibrium will be reached at the same level of employment and same real wage, but at a higher price level and
nominal wages. The fact that values of the real variables in the model are independent of the value of nominal money
stock generates a paradox which is often called the classical dichotomy.
The last part of the classical model, the determination of the interest rate, is ‘Say’s law’ which suggests that ‘supply
generates its own demand’. It shows that savings increase when the interest rate increases and that investments decrease
when the interest rate decreases. Moreover, the market clears when savings equate investments. In our discussion about
the impact of the money supply on the labour market and goods market, this last part can be omitted. Due to the classical
dichotomy, a change in the money supply will not affect interest rates.
Fig. 2

How can the Classical Model be used today

At this point, it should be mentioned that the classical model was not held in its entirety by any economist. Therefore,
even if economists and policy makers still refer to the classical model nowadays, the points being made refer to specific
components of the classical model, taking in consideration only some assumptions.
Theorists of the classical model argued that the ‘normal state’ of the economy is the one at full employment. Hence, if
unemployment arises, this is only because of market rigidities, like trade union pressures and minimum wage legislation.
Although today’s global economy is too complex to be looked at through ‘the classics’ glasses’, discussions on balancing
the power of trade unions in France and debates on removing the minimum wage in the U.S. make the model useful. Of
course, the classical economic model should not be treated as anything else than a simplified tool to work with in solving
more complex problems.
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