Notes on Classical Economics
The first fact that one associates Classical Economics with is a “hands-off” policy
prescription. In particular, the Classical economists believe that we are better off with a
hands-off approach as opposed to trying to fine tune the economy through countercyclical
policy (the Keynesian philosophy). In the simplest terms, the Classical economists
believe in perfectly flexible prices and wages (both of these are nominal variables) so that
all markets clear all the time. The result is a vertical aggregate supply curve (in the short
and long run).
Real Business Cycle Theory
Real Business Cycle Theorists argue that the re-current fluctuations that occur in
economic activity (i.e., business cycles) are caused by productivity shocks (supply
shocks) and not shocks to aggregate demand (Keynesians argue that business cycles are
caused by shocks to aggregate demand – the animal spirits argument).We consider two
episodes, each with clear productivity shock implications. The first is the well known
stagflation in the US in the 70s / Japan earthquake example where we have an adverse
shock to the production function (aka, adverse supply shock). For the US 1970s
example, it would be due to an oil shock (oil is part of “land”) and for the Japan example,
the adverse shock is due primarily to all the physical capital (K) that was destroyed by
mother nature. In the series of graphs below, we ignore the demand side effects but
consider them later in a new economy example, the second episode that we consider.
Note importantly, that inflationary pressures (the “flation” part) of stagflation in Japan
will occur only if aggregate demand remains relatively stable. Of course, this is an
unrealistic assumption and to be more complete, we would let aggregate demand fall due
to all the real estate wealth that was destroyed, the lack of consumer and investor
confidence, low expected wealth and income, and probably a fall in the expected
marginal product of capital, all of these result in aggregate demand falling which would
certainly lesson if not reverse the inflationary effects associated with the adverse supply
shock.
We consider two shocks to the production function – the first set of graphics ignores any
demand side shocks and is the standard ‘stagflation’ example. The second set of graphs
considers positive productivity (supply) shocks as well as positive shocks to aggregate
demand. This is a New Economy example that explains the facts extremely well!
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STAGFLATION
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How do the implications of Real Business Cycle theory match the business cycle facts
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Real Business Cycle (RBC) theory does very good in explaining the business cycle facts.
There are a few contradictions that RBC theorists have to address:
1) Inflation is pro-cyclical according to the facts but countercyclical according to the
theory. RBC theorists argue that the empirical results, (i.e., that inflation is procyclical)
are sensitive to the sample period chosen. In other words, this is no ‘biggie’ in terms of a
weakness in the theory according to the RBC theorists.
2) Average labor productivity is “too” procyclical in the RBC theory – that is, in reality,
average labor productivity is weakly procyclical. RBC theorists fix this by considering
the effects on the cyclicality of average labor productivity when considering fiscal policy
shocks (see the bar chart below).
3) Government Purchases are procyclical according to the business cycle facts – this is a
problem for RBC theorists, since they believe that the aggregate supply curve is vertical
and so demand side policies will not effect real variables such as output– so according to
RBC theorists, G should be acyclical (i.e., ‘does not mater’, neutral). The RBC theorists
have a neat fix for this apparent weakness in their theory. In fact, their ‘fix’ takes care of
problems 2) and 3) together – it’s like killing 2 birds with one stone.
4) The final weakness is that according to the business cycle facts, money is procyclical
and leading, implying that money is not neutral in reality. Of course this is a huge pitfall
if true, since the linchpin of classical economics is money neutrality. The RBC theorists
again, come up with a clever way to deal with this apparent shortfall while maintaining
the money neutrality assumption.
5. The biggest shortfall of RBC theory and classical economics in general is that they
cannot explain cyclical unemployment/involuntary unemployment. They argue that
constant productivity shocks cause matching problems and thus, the amount of structural
unemployment changes constantly, explaining the up and downs of unemployment. Most
economists find this observation interesting and worthy of thought, but few really believe
that matching problems can push the unemployment rate above 9%, as it was during the
Great Recession. Keynesian economic theory gets the gold star here, as their model does
a much better job explaining cyclical/involuntary unemployment. We will explain the
Keynesian theory when we complete our discussion of classical economics.
Dealing with 2) and 3) – Average labor productivity is “too procyclical” according to the
theory and Government purchases are procyclical.
The RBC theorists simply argue that higher G makes people poorer, since they either
have to pay higher taxes now or in the future, to pay for the higher G. When people feel
(are) poorer, they will be willing to work more at any given real wage – i.e., the labor
supply curve (Ns) will shift to the right. If we add this notion to the theory, we fix two of
the shortfalls at once – 1) higher G is indeed procyclical and 2) average labor
productivity is countercyclical in this particular case. When you add in supply shocks as
in our previous analysis, the combination of supply shocks and government spending
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shocks result in average labor productivity being weakly procyclical, consistent with the
facts. The first graphic shows that the RBC theory matched the facts extremely well
except for the average productivity correlation.
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FISCAL SHOCK – RBC THEORY
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The Final issue that the RBC theorists had to “deal with” is that according to the facts,
money is leading and procyclical. The RBC theorists are the first ones to point out that
correlation does not imply causation. The example they use is a storm window example.
Just because homeowners put up storm windows before winter comes certainly does not
imply that they, by putting up storm windows, are causing winter to arrive. Actually, it is
the other way around (the fact that winter is coming causes people to put up storm
windows). The RBC theorists refer to this phenomenon as “reverse causation.” To apply
and understand the concept of reverse causation in the money output correlation, we must
recall the traditional way many think that monetary policy is supposed to work (this is
Keynesian). The traditional thought is that increases in the money supply lower real rates
and thus stimulate C, I, and NX., and thus, Y rises. This process takes time which
explains why money is a leading variable. Reverse causation suggests that changes in
output (Y) is causing changes in money. Note importantly that money is a leading and
procyclical variable so that changes in money must occur before changes in output. The
way that RBC theorists deal with this short coming is to assume that L (real money
demand) is not only a positive function of current Y but also a function of future expected
income denoted Yf. The idea is that if firms expect higher output in the future, they will
demand more money now for raw materials, wages, etc. The increase in economic
activity will not show up in data until later, but firms need the money now. This is where
it gets clever. The increase in money demand today will shift the LM curve to the left as
the money market will clear at a higher interest rate. Importantly, this occurs before there
is any change in output – that comes later. The Fed seeing this has two choices: 1) they
can sit on their hands and let prices fall, because that is the adjustment that has to take
place given the shock to L (real money demand). or 2) they can accommodate the shock
to real money demand by conducting open market purchases to keep the price level from
falling. Of course, the Fed has a dual mandate and half of that mandate is stable prices –
so the RBC theorists argue that if the Fed is doing their job, we will see money increasing
today and output rising in the future, consistent with the business cycle fact that money is
leading and procyclical. Note importantly that money is still neutral in this example,
consistent with the linchpin of classical economic theory. Output is going up in the
future due to perhaps a positive shock to the production function. Whether or not the Fed
did anything, it doesn’t matter, output is still going up, they just increase the money
supply to prevent the deflation that would occur otherwise. In terms of the storm window
example, it doesn’t matter that you put up your storm windows or not, winter is still
coming – it is prudent for you to put up the storm windows, just like increasing the
money stock due to the shock to L is a prudent thing for the Fed to do. Can you show
this graphically? See below:
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The Monetary Mis-perceptions Model, aka, the “fooling model” aka, the Lucas
Island Model.
Reverse causation is a clever way to explain why money is a pro-cyclical and leading
variable while maintaining the all important money neutrality, meaning that a “hands off:
policy approach is the best. If you tried to get output to be beyond full employment
output, then you will just be creating inflation, something that is undesirable and
therefore welfare reducing.
But there was some evidence that there was clearly causation directly from money to
output, especially in during the Volcker
period. This evidence was revealed in a very
famous work done be Milton Friedman and
Anna Schwartz “A Monetary History of the
United States, 1867-1960.”
The Model – the fooling model is based on
imperfect information. Suppose the
economy was made up with a series of
islands, and each island produced their own
unique product. Suppose you produce loaves
of bread on island B. Now the model is based
on you having perfect information as to your own island price (of bread) but you have
imperfect information on the prices of all the other goods and services that are produced
on the other islands. Given this imperfect information, you have to form expectations as
to the prices of all other goods and services in this economy. Importantly, you consume
all these other goods and services that are produced on the other islands.
Your nominal wage vs. your real wage. To really understand the island model we need to
understand the difference in nominal wages and real wages. Suppose that you, the bread
maker, makes (produces) 200 loaves of bread every day (say in 8 hours of work) and sell
them initially for $1 each. Your nominal wage is therefore $200. What is your real
wage? We know that real wages are expressed in terms of real goods and services. Since
you eat more than just bread and that you consume more than just food, we could
imagine a basket of goods and services made up of all the other goods and services
produced in this island economy – the price of the basket of all these other goods and
services is referred to as the aggregate price level. Let’s initially set the aggregate price
level at $100 (price per basket) so that your real wage from working is 2 baskets of all
these other goods and services (W/P = $200/$100 = 2).
We now add time and uncertainty to the analysis. Since you live on an island producing
bread, you don’t have timely or accurate information as to the general price level, you
only have perfect information as to your own island price (of bread). Given that you
don’t have information as to the aggregate price level, you must form expectations of the
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aggregate price level, through time. Suppose that overall inflation has been running at
2% for years and thus, you expect over all inflation to run at 2% over the next year.
Scenario #1 – The price that you can sell your bread for rises to $1.02, equal to your
expectation as to overall inflation. What has happened to your nominal wage? What has
happened to your real wage? Nominal wage has gone up! 200 x $1.02 = $204. Your
(expected) real wage, given your πe=2% is now W/P = $204/$102 = 2 baskets of all other
goods and services – which is exactly the same as the old real wage. In this case, you do
not change your behavior and thus, you produce the same amount of bread as you did
before the price changes. Importantly, remember the following: If the expected price
level equals the actual price level, then the economy is operating at full employment.
Scenario #2 – The price that you can sell your bread for rises to $1.10, well above the
overall expected rate of inflation (i.e., πe = 2%). What has happened to your nominal
wage? W = 200 x $1.10 = $220. Your (expected) real wage is now W/P = $220/ $102 =
2.16 baskets of all other goods and services, higher than you expected. Since you think
your real wages havegone up (you are not sure since you can’t observe other island
prices) you work more – recall a positively sloped labor supply curve. In the space
below, draw point A when the real wage was 2 baskets of all other goods and services
and locate point B where your real wage is 2.16 baskets of all other goods and services.
Expanding example: Suppose now that you hire five workers to make bread. We hold
the productivity of each worker the same at 200 loaves per worker per 8 hour day. You
pay each worker $100 for a day’s work and the revenue that is generated initially by each
worker is $200 = 200 loaves x $1.00 per loaf. So in a sense, you, the owner of the bread
factory is making a profit of $100 per worker. Let us assume that there are taxes,
insurance and all other kinds of costs associated with running this business so your profit
is not as large as it first appears, but let’s assume that it is equal to your opportunity costs,
meaning equal to the value of your next best alternative employment.
Now importantly, each worker cares about their real wage in terms of all goods and
services since they consume all the goods and services that are produced in this island
economy. So the initial real wage for each worker is 1 basket of goods and services =
W/P = $100/$100. Let us consider scenario #2 again. Suppose that the island price of
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bread jumps to $1.10 as before and the workers expect the general price level to rise by
only 2%. We know that to keep the workers from complaining, that the boss better give
them a raise in nominal wages to compensate them for the 2% expected rise in the cost of
living. Here is where it gets interesting. The worker cares about the real wage based
on all other goods and services but the boss pays real wages in terms of their output,
bread! This asymmetry is important to remember and is crucial in understanding
how this model works.
Consider the following experiment: The boss decides to give each worker a 5% increase
in their nominal wage. Are the workers happy? Yes!! Since they think the over all price
level is only rising by 2%, they are happy with a 5% bump in nominal wages since real
wages go up anytime %∆W >%∆P. In terms of numbers, the workers real wage rose
from $100/$100 = 1 to $105/$102 = 1.03. Given that the price of leisure has risen with
the real wage, each worker will desire to work more (assuming the substitution effect in
labor supply dominates the income effect of labor supply). So workers will rationally
want to work more but will the boss be willing to allow them to work more? Please show
on a diagram labeling point A where real wage = 1 and point B where the real wage =
1.03.
The Boss: Again, the boss pays real wages in terms of their product and not the overall
price level. Originally, the real wage they paid in terms of bread was W/PB = $100/$1 =
100 loaves of bread. With the price changes as above, the real wage that the firm pays
now is $105/$1.10 = 95.45 loaves of bread. So in effect, the firm is paying lower real
wages and thus will rationally want to expand labor input by letting workers work
over time or by hiring more workers. We explained this phenomenon many times – at
the same level of labor input, W/P is now less than the MPN, hire more to lower MPN to
the new lower real wage!. Please draw another diagram in real wage space showing point
A with a real wages of 100 loaves and point B as the real wage at 95.45 loaves.
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Bottom line: If the actual price level PA is greater than the expected price level Pe, then
firms and workers will rationally produce/work more. In fact, we can represent this
model with what is referred to as the Lucas Aggregate Supply Curve.
Y = Y* + b (PA – Pe)
B is a positive parameter so that when PA > Pe then Y > Y*
Let’s do a problem to get a feel for this model
Problem 4 from chapter 10 – tweaked a little
4.
The AD And AS equations are given below
AD: Y  300  30(M/P),
AS: Y  Y*  10(P – Pe), M  400.
Full employment Y = Y* = 500, M=400, and Pe = 60
a) What are the equilibrium values of P and Y
(answer for a) P e  60. Setting AD  AS to eliminate Y, we get 300  30(M/P)  500 
10(P – P e ). Plugging in the values of M and P e gives 300  (30  400/P)  500  10(P –
60), or 300  (12,000/P)  500  10P – 600, or 400  (12,000/P)  10P. Multiplying this
equation through by P/10 gives 40P  1200  P 2, or P 2 – 40P – 1200  0. This can be
factored into (P – 60)(P  20)  0. P can’t be negative, so the only solution to this
equation is P  60. At this equilibrium P  P e, so Y  500, and the economy is at fullemployment output.
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Draw and AD and AS curve depicting this initial equilibrium as point A
b) Suppose the Fed fools everyone and raises the money supply to 700. Find the new
‘short run’ equilibrium Price level and output.
(answer for b) With an unanticipated increase in the money supply to M  700, the
expected price level is unchanged at Pe  60. The aggregate demand curve is Y  300 
30(M/P)  300  (30  700/P)  300  (21,000/P). The aggregate supply curve is Y  500
 10(P – Pe)  500  10(P – 60)  10P – 100. Setting AD  AS to eliminate Y gives 300 
(21,000/P)  10P – 100, or 400  (21,000/P)  10P, or P – 40 – (2100/P)  0.
Multiplying through by P gives P2 – 40P – 2100  0. This can be factored as (P – 70)(P 
30)  0, which has the positive solution P  70. From the AD curve, Y  300  (21,000/P)
 300  (21,000/70)  600.
Add this development, i.e., the surprise change in M to your diagram as point B
c) We now consider the long run, people can’t e fooled forever and thus, in the long run,
Pe = PA. Solve for the equilibrium price level and output
(answer for c) When M  700 and is anticipated, P  Pe. Then the AD curve is Y  300 
(21,000/P) and the AS curve is Y  500. Setting AD  AS gives 500  300  (21,000/P),
which has the solution P  105. Add this long run development to your diagram as point
C
d) Now compare the change in the general price level from the initial conditions (as in
part a) to the long run conditions (part c) to the change in the nominal money stock from
part a to part c). What inferences can you make in terms of money being neutral and
proportional to the general price level.
(answer for d) the percent change in prices (inflation) equals the percent change in
nominal money balances = 75% - money is neutral, consistent with one of the linchpins
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of the classical model (i.e., hands-off is best)
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