LECTURE NOTES. Chapter 3: Classical Macroeconomics: Output and Employment. 1. The starting point

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1 LECTURE NOTES Chapter 3: Classical Macrecnmics: Output and Emplyment 1. The starting pint The Keynesian revlutin was against classical ecnmics (rthdx ecnmics) Keynes refer t all ecnmists befre 1936 as classical ecnmics This is wrng: Classical ecnmics: Ecnmic thery (price thery) between Adam Smith s Wealth f Natins (1776) and the marginal revlutin in 1980s (C. Menger, L. Walras, and S. Jevns.) Jhn Stuart Mill (Principles f Plitical Ecnmy -1848) was the last classic ecnmist Neclassical ecnmics refer t similar plitical ecnmy after the marginal revlutin, nt t similar (price) thery Classical price thery (csts define prices in the lng run) is different frm neclassical Classic ecnmics: Csts define prices in the lng-run Neclassical ecnmics: Csts and utility define prices Austrians: Utility (final prices) define csts f prductin (the ppsite t Classical price thery) Classical macrecnmics: Output is always at full emplyment (equilibrium) level Only full-emplyment pints culd be psitins f even shrt-run equilibrium There is perfect infrmatin Classical ecnmics Output is nt always at full emplyment (equilibrium) level There can be n full-emplyment in the shrt-run There is n perfect infrmatin T criticize classical macrecnmics is nt the same than t criticize classical ecnmics Page 1 f 5

2 2. The Classical Revlutin Classical ecnmics was a reactin against mercantilism The idea that wealth is in the stck f mney (precius metals) and nt in hw much can be cnsumed The idea that the state needs t impse regulatin s that exprts have t mre than imprts s the cuntry accumulates increasing stcks f precius metals Ecnmics started as an explanatin f why the ecnmies f different kingdms were nt ding well Classical ecnmics It is real factrs what determines the level f wealth A free ecnmy is required fr an efficient use f the real factrs Mney is a facilitatr fr trade by aviding the prblem f duble cincidence f wants, it is a unit f accunt, nt wealth per se Page 2 f 5

3 3. Prductin Aggregate prductin functin ( ) ( ) ( ) Hicks neutral: ( ) Labr-augmenting: ( ) Capital-augmenting: ( ) Three sectins 1 st : Increasing r cnstant returns t scale, 2 nd : Diminishing returns, 3 rd : Negative returns, ( ) ( ) Returns t scale ( ) ( ) Sme prductin functins Linear: Lentieff: { } Cbb-Duglas: ( ) (CRS) (DRS) (IRS) CES (Cnstant Elasticity f Substitutin): ( ) Page 3 f 5

4 4. Emplyment Assumptins Firms and individuals ptimize efficiently There is perfect infrmatin and n barriers t price adjustment Therefre the market clears (is in equilibrium) Labr demand Firms are perfect cmpetitrs Shrt-run analysis: Output can nly change by changing emplyment Firm maximizes prfits ( ) when marginal revenue (MR) equals marginal cst (MC) ( ( )), ( ) Then: ( ) The firm will hire N units f labr until Because labr demand has a negative slpe Because ( ) Labr supply Individuals maximize utility (U) Utility has tw cmpnent, cnsumptin (C) and leisure (L) Time is limited t 24hs per day, therefre there is trade-ff between C and L ( ) There is an indifference curve with C and L. At each pint Therefre, a change in prduces analgus incme and substitutin effects t cnsumptin f tw gds (review yur micrecnmic ntes) If increases, then C increases because (1) higher real wage per hur and (2) mre hurs f wrk. Then hurs f leisure decrease and Substitutin effect > incme effect als increases If is high enugh, then hurs f wrk may decline t have mre hurs fr leisure until Substitutin effect < incme effect Intuitin: is s-high that is smaller than. ( ) we assume a psitive slpe fr the whle curve (unless specified therwise) Page 4 f 5

5 5. Equilibrium Output and Emplyment Three functins ( ) ( ) ( ) There exists (subject t mathematical cnditins ) a ( ) such that Therefre, equilibrium utput is ( ) Assume tw perids ( ) Shck: P dubles: 1 st : declines 2 nd : quantity f labr supplied declines 3 rd : declines 4 th : MR > MC 5 th : increases (by all firms) 6 th : w increases until ( ) ( ) All this ccurs simultaneusly Shck: Assume an increase in K r A 1 st : Output increases 2 nd : MR > MC 3 rd : fr all firms increase (by all firms) 4 th : increases 5 th : New equilibrium: mre utput, higher real wages, and lwer P All this ccurs simultaneusly Shck: Assume an increase in 1 st : Output increases 2 nd : MPN decreases 3 rd : decreases 4 th : decreases mre than w. 5 th : New equilibrium: mre utput, lwer real wages, and lwer P All this ccurs simultaneusly T see wh P is determined see next chapter Page 5 f 5