The classical model of
macroeconomics
• The CLASSICAL model of macroeconomics is
the polar opposite of the extreme Keynesian
model.
• It analyses the economy when wages and
prices are fully flexible.
• In this model, the economy is always at its
potential level.
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The classical model of
macroeconomics (2)
• Excess demand or supply are rapidly
eliminated by wage or price changes so that
potential output is quickly restored.
• Monetary and fiscal policy affect prices but
have no impact on output.
• In the short-run before wages and prices
have adjusted, the Keynesian position is
relevant whilst the classical model is relevant
to the long-run.
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The Taylor Rule again
• Previously it was assumed that prices were
fixed and so we talked in terms of a simple
Taylor Rule where interest rates responded to
the output part of the rule.
• Here, we allow prices to vary and think in
terms of the Taylor Rule where interest rates
respond to both output and inflation.
– In this case, higher inflation leads to the bank
raising the interest rate, thus reducing aggregate
demand and output.
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The macroeconomic demand
schedule
•
MDS
The macroeconomic
demand schedule (MDS)
shows the combinations
of inflation and output for
which aggregate demand
equals output when the
interest rate is set by a
Taylor Rule.
Higher inflation is
associated with lower
aggregate demand and
lower output.
•
Output
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The macroeconomic demand
schedule (2)
• The slope of the schedule is determined by:
– the reaction of interest rate decisions to inflation
– and the responsiveness of aggregate demand to interest
rate changes
• Consequently:
– It will be flat when
• interest rate decisions respond a lot to inflation
• and aggregate demand is highly responsive to interest rate
changes.
– It will be steep when
• interest rate decisions do not respond much to inflation
• and aggregate demand responds little to interest rate changes.
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Aggregate supply and potential output
• Potential output depends upon:
– the level of technology
– the quantities of labour demanded and supplied in
the long-run, when the labour market is fully
adjusted
– When wages and prices are fully flexible, output is
always at the potential level
• In the short-run we can treat potential output
as given
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The classical aggregate supply
schedule
• The classical model has an aggregate supply
curve which is vertical at potential output
• This means that equilibrium output can be
reached at different levels of inflation
• In the classical model, people do not suffer
from money illusion
• Consequently, only changes in real variables
influence other real variables
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The classical aggregate supply
schedule (2)
This schedule shows the
output firms wish to supply at
each inflation rate.
When wages and prices are
flexible, output is always at its
potential level (Y*).
Potential output is the
economy’s long-run
equilibrium output.
AS
Y*
Output
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The classical aggregate supply
schedule (3)
• Better technology will shift AS to the right
and hence increase potential output.
• Increased employment will also shift AS to
the right and increase potential output
• as will the use of more capital.
• In the short-run, we can treat potential
output as given.
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Equilibrium inflation
AS
*
Overall equilibrium is
shown where MDS = AS
at the potential output
level Y* and inflation level *.
A
MDS
Y*
At A, the goods, money
and labour markets are
all in equilibrium.
Output
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Equilibrium inflation: a supply shock
AS0
0*
A
AS1
C
D
2*
MDS1
MDS0
Y0*
Y1*
Output
A beneficial supply shock raises
potential output by shifting AS0 to
AS1and lowers inflation to 2* at D.
If the central bank pursues its
target of 0* when the economy
is at potential output, it must
respond by reducing its target
real interest rate.
This will lead to an increased
amount of money being demanded:
to achieve, money market
equilibrium at this interest rate,
the bank must supply more money.
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Equilibrium inflation: a demand shock
AS0
1*
B
0*
A
MDS1
MDS0
Y0*
Output
Beginning at A, an increase in
aggregate demand brought
by an increase in investment
say, would shift MDS0 to MDS1
moving us to a new equilibrium
B. At B, potential output is the
same but  is higher at 1*
Since potential output is the same
at B, the bank must tighten its
monetary policy in order to hit its
target of 0* .
Since the bank follows a Taylor
rule, it will increase the target real
interest rate and thereby reverse
the increase in MDS.
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The speed of adjustment
• Adjustment in the Classical world is rapid, so
the economy is always at potential output
(full employment).
• If wages and prices are sluggish, then output
may deviate from the potential level.
• A Keynesian world of fixed wages and prices
may describe the short run period before
adjustment is complete.
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Supply-side economics
• The pursuit of policies aimed not at
increasing aggregate demand, but at
increasing aggregate supply.
• A way of influencing potential output, seen as
critical in the classical view of the economy.
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Adjustment in the labour market
Short-run
(3 months)
Medium run
(1 year)
Long-run
(4-6 years)
WAGES
Largely
given
Beginning
to adjust
Clearing
the labour
market
HOURS
Demanddetermined
EMPLOYMENT
Largely
given
Hours/
employment
mix
adjusting
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Normal
work week
Full
employment
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Short-run aggregate supply
• If adjustment is not instantaneous, output may
diverge from Yp in the short run.
• Firms may vary labour input
– via hours of work (overtime or layoffs).
• Wages may be sluggish in falling to restore full
employment in response to a fall in aggregate
demand.
• The short-run aggregate supply schedule shows the
prices charged by firms at each output level, given
the wages they pay.
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The short-run aggregate supply schedule
Suppose the economy is initially at Y* in fullemployment equilibrium at A, with inflation 0
In response to a fall in
aggregate demand,
firms in the short run
vary labour input, thus
moving along SAS to B.
SAS
0
A
SAS1
B
SAS2
2
In time, the firm is able to
negotiate lower wages,
and the SAS shifts to
SAS1 and then to SAS2,
until equilibrium is
restored at A2.
A2
Y
Y*
Output
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The adjustment process
• When SAS and MDS are combined, changes
in MDS lead mainly to a change in output in
the short-run.
• Over time, deviations from full employment
gradually change wage growth and short-run
aggregate supply.
• The economy, therefore, gradually works its
way back to potential output.
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A lower inflation target
Starting from long-run
equilibrium at E:
the inflation target is cut
from * to 3*: the raising of
interest rates to achieve this
shifts MDS to MDS'.
Given wage levels, firms
adjust to E' in the short run.
With inflation at  ' but wages
unchanged, the real wage
rises bringing involuntary
unemployment.
As the labour market (wage)
adjusts SAS shifts e.g. to
SAS’.
AS
SAS
*
1*
2*
E
E'
SAS'
E2
SAS3
3
E3
MDS'
Y*
MDS
Output
Equilibrium is eventually reached at E3, back at Y*.
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A temporary supply shock
e.g. an increase in the price of oil
Higher oil prices force firms to
charge more for their output,
so SAS shifts to SAS’.
SAS'
*''
'
Equilibrium moves from E to E’.
E''
SAS
Higher prices cause a move
along MDS and output falls to
Y’.
If the bank maintains the
inflation target of *, in time,
unemployment reduces
wages and SAS gradually
shifts back to SAS', so Y*
is restored.
E'
*
E
MDS
Y'
Y*
Output
If the bank had accommodated the supply shock by relaxing its
target, the economy could have moved straight back to Y*, at E’’.
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Tradeoffs in monetary objectives
• Inflation targeting works well when all shocks
are demand shocks.
• When shocks are supply shocks, stabilising
inflation may lead to highly variable output.
• Conversely, a policy of stabilising output may
lead to highly variable inflation.
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Tradeoffs in monetary objectives (2)
• One way round this is to to steer a middle
course by using a Taylor Rule, i.e. a rule that
takes into account deviations of both inflation
and output from their long-run levels.
• Another is to allow flexible inflation targeting
– because the inflation target is a medium-run one,
this allows some discretion for reducing variability
in output
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