Macroeconomics

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Macroeconomics

• Chapter 07 Classical Economic Theory
• Spring 2007

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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.

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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.

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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.

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Says Law

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

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Says 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.

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Equilibrium in the Credit Market
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An Increase in Savings is Offset by an Increase
in Investment
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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.

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A Recessionary Gap
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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.

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Closing a Recessionary Gap
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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.

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An Inflationary Gap
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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.

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Closing an Inflationary Gap
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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.

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Long-Run Equilibrium
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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.

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Long-Run Aggregate Supply
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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.