neoclassical macroeconomics

7/28/2019 Neoclassical Macroeconomics

1/51

neoclassical macroeconomics

Full employment and the self-

adjusting macroeconomy


2/51

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.


3/51

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


4/51

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.


5/51

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.


6/51

Labor Market

w (real wage)

L (Labor)

Labor Supply (Ls)

Labor Demand (Ld)

w*

L* (Ls = Ld)0


7/51

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.


8/51

Labor Market When Going Wage is

Above Equilibrium Wagew (real wage)

L (Labor)

Labor Supply (LS)

Labor Demand (LD)

w*

LD1

LS1

w1

0


9/51

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


10/51

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.


11/51

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


12/51

Labor Market

w (real wage)

L (Labor)

Labor Supply (Ls)

Labor Demand (Ld)

w*

L* (Ls = Ld)

0


13/51

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)


14/51

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?


15/51

Spending and sales




wage?

Some will be purchased by the newly

employed workers, who will spend their

new income on goods and services.


16/51

Spending and sales




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?


17/51

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).


18/51

Savings, (not) spending, and sales

Savings is income not spent.


19/51



Savings is output not sold.


20/51



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.


21/51

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.


22/51

savings and spending

Even in an economy with no government

and no foreign trade, there is another kind

of spending besides consumption

spending.


23/51





spending.

Investment


24/51





spending.

Investment

Must look to the neoclassical analysis of

savings and investment, or the loanable

funds market.


25/51

Loanable Funds Market: savings

function (supply of loanable funds)Interest Rate

S, I

S (Savings)

i1

S1

0


26/51

investment function:

demand for loanable fundsInterest Rate

S, I

I (Investment)

i1

I1

0


27/51

Loanable Funds Market

Interest Rate

S, I

S (Savings)

I (Investment)

i*

S = I0


28/51

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.



29/51


Shift in Savings

Interest Rate

S, I

S1

I

i1

I1

S2

0 S2


30/51

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.



31/51


Shift in Savings

Interest Rate

S, I

S1

I

i1

S1 = I

S2

S2 = I

i2

0

Neoclassical self adjusting


32/51

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.


33/51

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.


34/51

Minimum Wage Above Equilibrium

WageWage

Quantity of Labor

LS

LD

w*

LD

Min LS

Min

Unemployment = LSMin LD

Min

Min. Wage

0


35/51

Minimum Wage Below Equilibrium

WageWage

Quantity of Labor

LS

LD

w*

LS

Min LD

Min

Excess Demand

= LDMin LS

Min

Min. Wage

0


36/51

Monetarism, NeoClassical Theory, and

Supply-Side Economics


37/51

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.

37 of 38


38/51

Keynesian Economics

Two major neoclassical-schools

decidedly against government

intervention have developed:monetarism and supply classical

economics.

38 of 38


39/51

Monetarism

The main message of monetarists is that

money matters.

Monetarism, however, is usually

considered to go beyond the notion that

money matters.

39 of 38


40/51

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

40 of 38

VGDP

M

orV

P Y

M

M V P Y

GDP P Y since

then,


41/51

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:

41 of 38

M V P Y


42/51


42 of 38

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.


43/51


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.

43 of 38


44/51

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


45/51

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


46/51

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.

46 of 38

Th K i /M t i t


47/51

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.

47 of 38

Th K i /M t i t


48/51


Debate Most monetarists do not advocate an

activist monetary policy stabilization

expanding the money supply during bad

times and slowing its growth during goodtimes.

48 of 38

Th K i /M t i t


49/51


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).

49 of 38

Th K i /M t i t


50/51


Debate Many Keynesians advocate the application

of coordinated monetary and fiscal policy

tools to reduce instability in the

economyto fight inflation andunemployment.

50 of 38

Th K i /M t i t


51/51


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.

51 of 38

neoclassical macroeconomics

Documents