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neoclassical macroeconomics
Full employment and the self-
adjusting macroeconomy
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Neo-classical Economic Theory During the 1930s the Great Depression took
place with astronomical unemployment.
Classical economic theory could not explain this.
This lead to the popularity of Keynesian
economic theory (will be explained in a later
handout). However during the 1960s and 1970s there was
rising inflation and a stagnated economy
(stagflation) and now Keynesian theory
struggled to explain this.
As a result there was a return to classical theory
ideas called neo-classical economic theory (neo-
means new.
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neoclassical macro Neoclassical theory is similar to
Classical theory as be seen in thefollowing slides:
Assume to begin with, a pure market
economy with no government and noforeign trade.
We will also assume that labor demand is
wage-elastic, but we can worry about thatlater.
assume markets are perfectly competitive
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unemployment
Assume there is some unemployment dueto an exogenous shock to the economy
In neoclassical economics, if there is
unemployment:labor supply (Ls) > labor demand (Ld)
More workers are ready and willing to
provide their labor services at the goingwage rate than firms are ready and willingto hire.
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the neoclassical labor market
In neoclassical economics, when there is
unemployment, we start with the labor
market, which works similarly to the
product markets in neoclassical theory,except that there is a special kind of good,
called labor (L) or labor services, and a
special kind of price, called the wage.
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Labor Market
w (real wage)
L (Labor)
Labor Supply (Ls)
Labor Demand (Ld)
w*
L* (Ls = Ld)0
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neoclassical labor market
When there is unemployment, labor supply
is greater than labor demand, so the wage
must be above the equilibrium level.
Just as in neoclassical price theory,
competition between and among the
buyers and sellers will tend to push and
pull the market toward the equilibrium.
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Labor Market When Going Wage is
Above Equilibrium Wagew (real wage)
L (Labor)
Labor Supply (LS)
Labor Demand (LD)
w*
LD1
LS1
w1
0
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Labor Market When Going Wage is
Above Equilibrium Wagew (real wage)
L (Labor)
Labor Supply (LS)
Labor Demand (LD)
w*
LD1
LS1
Excess Supply of Labor = LS1 LD
1
w1
0
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equilibrating labor market
There are unemployment people who want
to work. Some offer to work for a little less
than the wage, w1, and when they do,
firms increase their demand to hire by alittle, and the supply contracts by a little. If
there is still an excess supply of labor
(unemployment) other unemployedworkers will offer to work for a little less,
and firms will increase their demand again.
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neoclassical self-adjusting labor
market
This process continues until the wage
reaches w*, and labor supply and labor
demand are equal. Firms are able to buy
exactly the amount of labor services theywant at that wage rate, and everyone who
is willing and able to work at that wage
rate is working (full employment) The labor market returns to equilibrium
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Labor Market
w (real wage)
L (Labor)
Labor Supply (Ls)
Labor Demand (Ld)
w*
L* (Ls = Ld)
0
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full employment
More people are working, so more
production is occurring, and more people
are working so more people are earning
income.
Output and income increase by the same
amount (national income accounting
identity):
Y (national output) = Y (national income)
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Spending and sales
Who is going to purchase the additional
output produced by the newly employed
workers, hired as a result of the fall in the
wage?
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Spending and sales
Who is going to purchase the additional
output produced by the newly employed
workers, hired as a result of the fall in the
wage?
Some will be purchased by the newly
employed workers, who will spend their
new income on goods and services.
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Spending and sales
Who is going to purchase the additional
output produced by the newly employed
workers, hired as a result of the fall in the
wage?
Some will be purchased by the newly
employed workers, who will spend their
new income on goods and services.
Will they buy all of it?
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Income, spending, and sales
Only if the newly employed all of their
income will they purchase the new output
in its entire.
Some people, especially with lower
incomes, spend all their income to live, but
as a society, we normally (but not always)
have some positive amount of savings (=income not spend).
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Savings, (not) spending, and sales
Savings is income not spent.
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Savings, (not) spending, and sales
Savings is income not spent.
Savings is output not sold.
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Savings, (not) spending, and sales
Savings is income not spent.
Savings is output not sold.
Whatever the amount of savings is willcorrespond exactly to the same amount ofoutput not sold. Firms will have excessinventories, and they will cut back output.
When they cut back output, they lay offworkers, and income and spending fallagain.
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full employment and
business sales
Businesses must have their level of output
validated or justified by sales. They
cannot continue to produce at a higher
level of production unless they can sellthat output. Otherwise, they will cut back
output, and when they do, they no longer
need as many workers.
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savings and spending
Even in an economy with no government
and no foreign trade, there is another kind
of spending besides consumption
spending.
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savings and spending
Even in an economy with no government
and no foreign trade, there is another kind
of spending besides consumption
spending.
Investment
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savings and spending
Even in an economy with no government
and no foreign trade, there is another kind
of spending besides consumption
spending.
Investment
Must look to the neoclassical analysis of
savings and investment, or the loanable
funds market.
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Loanable Funds Market: savings
function (supply of loanable funds)Interest Rate
S, I
S (Savings)
i1
S1
0
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investment function:
demand for loanable fundsInterest Rate
S, I
I (Investment)
i1
I1
0
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Loanable Funds Market
Interest Rate
S, I
S (Savings)
I (Investment)
i*
S = I0
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Analyzing the loanable funds
market
An increase in savings resulting from an
increase in income (rather than from a fall
in the interest rate) means that the savings
function (or supply of loanable fundscurve) shifts out.
Now, at the same old equilibrium rate of
interest that used to equate savings andinvestment, savings is now higher.
Loanable Funds Market
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Loanable Funds Market
Shift in Savings
Interest Rate
S, I
S1
I
i1
I1
S2
0 S2
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Banks with excess currency to lend startlowering their interest rates to try toundersell their competition.
As interest rates fall, investment demandincreases, and savings contracts by a littlebit.
If there are still excess loanable funds,banks will cut interest rates again, and soon.
Loanable Funds Market
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Loanable Funds Market
Shift in Savings
Interest Rate
S, I
S1
I
i1
S1 = I
S2
S2 = I
i2
0
Neoclassical self adjusting
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Neoclassical self-adjusting
mechanism: necessary and
sufficient conditions When S rises, interest rates fall,
Investment increases, until:
S = I at Yf
Perfectly flexible wages, prices, and interest
rates constitute the self-adjustingmechanism that ensures a tendency to fullutilization of resources, including labor.
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Necessary and sufficient conditions
Perfectly flexible wage is a necessary but
NOT sufficient condition for full
employment. Must also have perfectly
flexible interest rates.
Another way of stating it: all markets,
including factor markets, must be perfectly
competitive.
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Minimum Wage Above Equilibrium
WageWage
Quantity of Labor
LS
LD
w*
LD
Min LS
Min
Unemployment = LSMin LD
Min
Min. Wage
0
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Minimum Wage Below Equilibrium
WageWage
Quantity of Labor
LS
LD
w*
LS
Min LD
Min
Excess Demand
= LDMin LS
Min
Min. Wage
0
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Monetarism, NeoClassical Theory, and
Supply-Side Economics
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Keynesian Economics
In a broad sense, Keynesian
economics is the foundation of
modern macroeconomics. In anarrower sense, Keynesian
refers to economists who
advocate active government
intervention in the economy.
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Keynesian Economics
Two major neoclassical-schools
decidedly against government
intervention have developed:monetarism and supply classical
economics.
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Monetarism
The main message of monetarists is that
money matters.
Monetarism, however, is usually
considered to go beyond the notion that
money matters.
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Monetarism
The monetarist analysis of the economy
places emphasis on the velocity ofmoney (V), or the number of times a dollar
bill changes hands, on average, during ayear; the ratio of nominal GDPto the stock
of money (M):
Y volume of final output; P is averageprice level
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VGDP
M
orV
P Y
M
M V P Y
GDP P Y since
then,
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The Quantity Theory of Money
The quantity theory of money isa theory based on the identity
MxV= PxYand the assumption
that the velocity of money (V) is
constant (or virtually constant).
Then, the theory can be written as
the following equality:
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M V P Y
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The Quantity Theory of Money
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If there is equilibrium in the money
market, then the quantity of money
supplied is equal to the quantity of
money demanded. When Mis takento be the quantity of money
demanded, this equality would make
the quantity of money demanded
dependent on nominal GDP, but not
the interest rate.
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The Quantity Theory of Money
The demand for money may depend not
only on nominal income, but also on the
interest rate.
Whether velocity is constant or not may
depend partly on how we measure the
money supply.
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The Velocity of Money,
1960 I 2003 II
The velocity of money is far from constant. There is
a rising long-term trend, but fluctuations around this
trend have been quite large. 44 of 38
f
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Inflation as a Purely
Monetary Phenomenon
Inflation is always a monetary
phenomenon. If the money
supply does not change, theprice level will not change.
The view that changes in the
money supply affect only the
price level, without a change in
the level of output, is called the
strict monetarist view.45 of 38
I fl ti P l
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Inflation as a Purely
Monetary Phenomenon
The strict monetarist view isnot compatible with anonverticalAS curve.
Almost all economists agree thatsustainedinflation is purely amonetary phenomenon.
Inflation cannot continueindefinitely without increases inthe money supply.
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Th K i /M t i t
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The Keynesian/Monetarist
Debate Milton Friedman has been the leading
spokesman for monetarism over the last
few decades.
Most monetarists argue that inflation in the
United States could have been avoided if
only the Federal government had not
expanded the money supply so rapidly.
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Th K i /M t i t
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The Keynesian/Monetarist
Debate Most monetarists do not advocate an
activist monetary policy stabilization
expanding the money supply during bad
times and slowing its growth during goodtimes.
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Th K i /M t i t
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The Keynesian/Monetarist
Debate Time lags are the most common argument
against such management.
Monetarists advocate a policy of steady
and slow money growth, at a rate equal to
the average growth of real output (Y).
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Th K i /M t i t
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The Keynesian/Monetarist
Debate Many Keynesians advocate the application
of coordinated monetary and fiscal policy
tools to reduce instability in the
economyto fight inflation andunemployment.
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Th K i /M t i t
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The Keynesian/Monetarist
Debate Others reject the strict monetarist position
in favor of the view that both monetary and
fiscal policies make a difference and at the
same time believe the best possible policyis basically noninterventionist.
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