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The Classical model Introduction

"The classical model" was a term coined by Keynes in the 1930s to represent basically all the ideas of economics as they apply to the macro economy starting with Adam Smith in the l700s all the way up to the writings of Arthur Pigou in the 1930s.

Describe the main characteristics of what we now call the classical model and how the macroeconomic variables are determined in this model. As discussed in the previous section, we focus on the cycles and all the components included in the GDP (consumption, investment, imports and exports) are variables where the trend has been removed.

Labor Market

We begin by describing the classical model of the labor market.

Demand for labor

The demand for labor L_D is assumed to be inversely related to the real wage W/P

Profit-maximizing firms will want to employ labor up to the point where the marginal product of labor MPL is equal to the real wage W/P. We have previously assumed that MPL is decreasing in L and the demand for labor can be illustrated in the following graph.

The demand for labor



From the graph you can conclude that the aggregate demand for labor, or just the demand for labor depends on the real wage. If the real wage increases, the demand for labor decreases and vice versa. F or example, the demand for labor will fall if W increases and! or if P decreases but it will not change if Wand P increase by the same percentage.

In the classical model, markets are characterized by perfect competition and the firms cannot affect W and P. However, they do decide how much labor to hire. If you sum all the labor that firms want to hire you get the total demand for labor.

The supply of labor

The supply of labour L_s is assumed to be positively related to the real wage W/P

The total labor supply is determined by utility-maximizing individuals. The total labor supply is also affected by the real wage. An increase in the real wage has two effects:

• Income Effect: With a higher income, individuals will want to consume more leisure (as long as leisure is a normal good). Higher real wages will lead to a lower labor supply.

• Substitution Effect: A higher real wage will make leisure relatively more expensive, causing individuals to substitute leisure for consumption. Higher real wages will lead to a higher labor supply.

The overall effect of a change in real wages is the sum of the income and substitution effects. For some individuals, the substitution effect will be stronger than the income effect and they will increase the labor supply as the real wage increases and for some it will be the opposite. In the classical model it is always assumed that the aggregate labor supply increases when real wages increase (the substitution effect is stronger than the income effect).

Equilibrium in the labor market

Real wage W/P will be equal to the equilibrium real wage in the classical model

Without government intervention and trade unions, the labor market will always be in equilibrium in the classical model. This means that the real wage will be equal to the equilibrium real wage - the level of real wage which will equilibrate the labor demand and the labor supply.

Fig: Equilibrium in the labor market

 

It is also clear from the graph that the total amount of labor L is determined in the labor market. When the real wage is equal to the equilibrium real wage, the supply of labor is equal to the demand for labor and this is the amount that will be used in the production.

If real wages are higher than the equilibrium real wage, the demand for labor will be less than the supply. The difference is the amount of unemployment beyond the natural rate of unemployment. In equilibrium, there is therefore no "involuntary" unemployment in the classical model.

Say's Law is sometimes stated as "supply creates its own demand". The motivation for this statement is something like this. If production (Y_s) increases by one billion, the national income will also increase by one billion. This means that individuals will have exactly one more billion for spending - just enough to buy the increase in production. Thus, Y_D will also increase by one billion. An increase in the supply of one billion has created an increased in the demand by the same amount.

In the classical model, observed GDP Y will be equal to the aggregate supply: Y = Y_s. GDP is determined entirely by the firms and there is no need to model aggregate demand. It is always the case that Y_D = Y = Y_s = j(L, K).

How not to justify Say's Law

At first, Say's Law may seem "obvious". However, it is not - actually, it is highly controversial. The reason it may seem obvious is that you have probably learned from microeconomics that in equilibrium, demand is equal to supply. If you are outside equilibrium, prices will adjust and you will be taken back to equilibrium.

This is not the motivation behind Say's Law which is not an equilibrium condition. In the classical model, Y_D and Ys are real variables that do not depend on the price level. This may strike you as odd. Ys depends only directly on Land K and indirectly on the real wage. If the price level increases in the classical model, the wage level will increase by the same amount leaving the real wage unchanged. As for aggregate demand, if the price level and the wage level both increase (by the same amount), there is really no change for the consumers. If all prices double while you income doubles, there is no need to adjust you demand.

The justification for Say's Law is not as an equilibrium condition through price adjustments. No price adjustment in the world will equilibrate aggregate demand and aggregate supply in the classical model. Instead, the justification is based on income effects rather than on price effects: higher supply ~ higher income ~ higher demand.

The reason why Say's law is so controversial is the following. Suppose that consumers and investors fear that the economy will slow down. They might then decide to save a substantial part of their income and aggregate demand may not be equal to aggregate supply. This is really the starting point for Keynesian economics.

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