Chapter 7: Classical Economics

The Economy at Full Employment

Issues in 2006 for the Midterm Elections

How does increased immigration affect wages and the level of output in the economy?

What are the benefits of increased investment?

What happens to wages, jobs, GDP if employers must pay higher taxes for hiring labor?

If our government spends more, does this mean we must have a lower level of consumption or investment in the economy?

Classical Economics

A school of thought that provides insights into the economy when it operates at or near full employment.

Supply-Siders

Economists / politicians who emphasize the role of taxation for influencing economic activity. Favored by the

Republican Party

New School: Real Business Cycle Theory

Tries to explain why there are booms and busts in the economy.

REMEMBER!

With the classical model, wages and prices are assumed to adjust freely and quickly according to the laws of supply and demand. No Keynsian price

controls

KISS: What determines output?

Stock of Capital (K) The total of all machines,

equipment and buildings in the economy.

Labor (L) The total effort of all

employed workers in an economy

Y = F(K,L) Y = Income = GDP

Y = F (K,L)

Aggregate Production Function: How much output is produced from the inputs of capital or labor. More inputs of either

leads to increased output.

Could this be a factor in the immigration battles?

Aggregate Production Function

In most situations we assume capital is fixed at a constant level!

LABOR is the only variation that changes the level of output in the economy!

SO: What is the relationship between labor and Output?

If capital is fixed? Increases at a

decreasing rate. WHY?

See page 133 for graph 7.1

Principle of Diminishing Returns

Suppose that output is produced with two or more inputs and that we increase one input while holding the other inputs fixed.

Beyond some point – called the point of diminishing returns – output will increase at a decreasing rate. See pgs. 133 - 135

Short-Run Production Function

Show how much output is produced when capital stock is constant and labor varies.

The Demand and Supply of Labor

Firms hiring depends on the REAL WAGE. The wage paid to

workers adjusted for changes in prices.

What determines the REAL WAGE?

The Marginal Principle determines the Real Wage

Marginal Benefit > Marginal Cost Increase level of

activity Marginal Cost >

Marginal Benefit Reduce activity

Marginal Cost = Marginal Benefit IDEAL!

Huh!?

Marginal Benefit: Benefit a firm receives from hiring an additional worker is the VALUE of the EXTRA OUTPUT from the hiring.

Huh?!

Marginal Cost: Is the REAL WAGE a firm pays to hire the additional worker See page 135 for

wage scenario.

Here’s the Payoff

If real wages fall, then MB > MC and more people can get employed. Is that why some

politicians / employers favor undocumented workers?

Changes in Real Wages Affect Workers Two Ways:

SITUATION: Workers have to decide how many hours they want to work and how much leisure time they want.

#1 Way: Increasing Real Wages

Make working more attractive and raise the opportunity costs of NOT working. SUBSTITUTION

EFFECT: Substitution of work for leisure time.

#2 Way: Raising Real Wages

Higher wage raises workers income for the same hours worked. Workers may choose more leisure over work. INCOME EFFECT:

Leads to decreased supply of labor.

Substitution Effect v. Income Effect

Do NOT work together. See pages 136 – 137

scenarios.

Capital Stock Changes?

Marginal Benefit for hiring workers increases. Workers are becoming

more productive with the additional capital.

Labor Market Equilibrium and Full Employment

Read scenario pg. 138 - 139

SO: Y = F (K,L)

Potential output increases as the supply of labor increases or the stock of capital increases.

Liberal immigration plans will shift the labor curve RIGHT and lead to higher level of employment.

OUTPUT increases.Investors are happyVoters are happy

Make sure to read VARIATIONS IN LABOR

SUPPLY

Page 140.

Other Names in Classical Economics

Jean Baptiste Say, David Ricardo, John Stuart Mill, Thomas Malthus, etc.

ACTUALLY a term created by Keynes to contrast his theory from “theirs.”

Theories from 18th – early 20th Century.

Say’s Law

The doctrine that states that supply creates its own demand.

Demand would always be sufficient to purchase the goods and services produced.

Questions to ponder:

Why would Say’s Law appeal to classical economists?

Could you give an example of Say’s Law? Why would Say’s Law apply to the labor

situation in the US? Would you agree or disagree with the

statement that “undocumented workers do the jobs Americans don’t want to do.”

Role of Taxes in Classical Economics

What do you think Republicans / Classical Economists think about taxes? Taxes only to cover infrastructure (small) More independence for individuals /

businesses Trickle-down taxes

Regressive taxing not progressive. Reason?

MC>MB = less jobs

Can a tax cut create more government revenue?

Economist Arthur Laffer said YES!

KEEP IN MIND! Laffer’s example was with net exports and tariffs.

Politicians applied it to income taxes / payroll taxes!

Laffer’s Curve

IF government RAISES the tariff taxes on imports – they will actually collect LESS tax, because no one can afford the goods. Inverse relationship

Laffer’s Curve and Capital Gains Taxes

Capital Gains: Profit you get from selling a stock at a higher price than you bought it at.

Since the tax on capital gains is too high, people don’t sell their stock – bringing down Y and decreasing govt. revenue.

Laffer’s Curve and Capital Gains Taxes

Some politicians say lowering – or removing – the capital gains tax would increase Y and maybe other ways to tax people since they will have more jobs.

Real Business Cycle Theory

What causes fluctuations in economic activity? Natural disasters Shifts in technology Small shocks at the

same time

Real Business Cycle Theory

Theory that emphasizes how shocks to technology an cause fluctuations in economic activity.

Examples of Real Business Cycle Theory

Changes in technology will change the level of full employment or potential output.

Adverse developments will cause shocks that cause output and employment to fall.

Real Business Cycle School of Thought

Very influential Very controversial Doesn’t explain some

historical situations. Makes the

assumption that labor is always at equilibrium between demand and supply.

Proponents of Real Business Cycle Theory

Other models handle unemployment.

So far, it hasn’t made it into the macro policy circles. BUT it is an area of

active research in classical economics.

Division of Output Among Competing Demands

Y = f(L,K) In a full employment

economy, total GDP is determined by the factors of production (K).

Division of Output Among Competing Demands

Full-employment must be divided up between C, I , G, X-M OR C + I + G + NX

Governments – for whatever reasons – increase government spending.

Division of Output Among Competing Demands

Government spending might affect other types of expenditures (C, I, X-M) CROWDING OUT.

Crowding Out (See pg. 145)

NOTE: US Consumes 67% of its GDP and invests a smaller portion than Germany or Japan. Is it due to savings rates

cutting into consumption? Is it due to higher payroll

taxes cutting into Consumption?

Closed Economy: GDP = C+I+G+X

Closed Economy: No international trade.

Increasing government spending comes at the expense of other uses of GDP. Higher taxes means

less money to spend. Crowding out

Crowding Out in an Open Economy: GDP = C+I+G+X-M

An economy with international trade.

Government spending does not need to crowd out either C or I

What does get crowded out? Net exports

Crowding In?

IF output (GDP) is fixed: Decreases in Govt.

spending means other aspects of C, I, X-M are going to “crowd in”

Net exports could increase.

Crowding In in a Closed Economy

C or I will increase if G decreases.

BUT inflationary pressures will be on.

There is no “leakage” for the excess money.