Macro Economics
Classical macroeconomics is the theory and the
classical model of the economists
Adam Smith, David Ricardo, John Mills and
Jean Baptiste Say. Below the
assumptions of the classical macroeconomics are
described. 1. Assumptions:
? Competitive markets: Classical theories all make
many assumptions about
the markets and their competitiveness.these
assumptions are that all the markets
are easy to enter and exit. No monopoly
elements are present in the market to
prevent newcomers from entering the
market or stopping the present ones from
quiting the market. Pricess and
wages are flexible in both upward and downward
directions according to the
demand and supply forces. No single seller or buyer
of a product has
sufficient market power to influence the industry price, nor
does any
supplier or purchaser of labor services have sufficient market power
to
influence the market wage rate. Thus all economic agents are price-takers
and
not price-setters. Because the markets are competitive, a disequilibrium
can
only exist for a short period of time which economists call the short
run. The
firm can not change some of its aspects of operation. So every firm
has some
fixed inputs while the pricess and the wages are changing and
flexible. So, if
for some reason the product market were experiencing excess
demand in some
industry, with quantity demanded greater than quantity
supplied, prices would
rise until quantity demanded once again equaled
quantity supplied. The rise in
price returns the market to equilibrium. On
the factor side, if there were an
excess supply of workers, wages would
decline until equilibrium in the labor
market was restored and everyone who
wanted to work can find a jobwhich is
called the full employment. ? Perfect
information: In classical theory
all economic decision-makers are assumed to
be operating by having all the
information they needed to make the best
decisions. The cost of acquiring
information, transactions costs are so low
that they can be assumed to be
negligible. So, consumers, producers and
workers know the prices and wages
existing among traders in the markets and
aware of their options and new
products which recently entered the market. No
one would be privy to some
special information providing them with an
advantage for long. ? Full
employment: As a result of the above assumptions,
a prediction of the classical
system is that is essentially operates at full
employment on a long-run
equilibrium path over time. While in the short run
unemployment can result, it
can’t exist permanently because wage rates fall
when there is excess supply of
labor. As workers compete for jobs,then by the
law of demand wage rates fall and
the quantity of labor services hired by
firms increases. Alternately, if there
were a labor shortage, the wage rate
would rise as firms compete for workers.
The classical model incorporates
the notion that the economy is on a long-run
moving equilibrium path, and any
deviations from long run equilibrium are nor
permanent because wage and price
flexibility can remove excess demands or excess
supplies. Let us summarise
the assumptions we made above: 2. SAY’s Law : The
equilibrium real wage
defines full employment of the labor force, and full
employment of the labor
force ( with a given production function ) defines the
full employment level
of output. Classical theory found no obstacle to the
attainment of these
positions as long as the money wage was flexible - that is,
as long as it
would fall in the face of unemployment. The possibility that this
level of
output once produced wouldn't find a market was dismissed; Say's Law
ruled
out any deficiency of aggregate demand. Say's Law, simply states that
"
supply creates its own demand. " More precisely it states that
whatever the
level of output, the income created in the course of producing that
output
will necessarily lead to an equal amount of spending and thus an amount
of
spending sufficient to purchase the goods and services produced. Thus,
if
output is below that which can be produced with a fully employed labor
force,
inadequate demand can not stand in the way of an expansion of output.
As long as
there are idle resources that can be put to work, the very
expansion of output
resulting from the utilization of such resources will
create a proportionate
rise in income that will be used to purchase the
expanded output. In this way,
this law, denied that involuntary unemployment
could be caused by a deficiency
of aggregate demand. 3. Markets The
equilibrium levels of output and employment
are determined in the classical
system as soon as we are given (a) the economy's
production function, from
which is derived the demand curve for labor, and (b)
the supply curve of
labor. ? Goods market: P S P1 Pe A D D’ S,D First,
let us show the supply of
a good and demand for a good on the horizontal axis,
and the price of that
good on the vertical axis. Demand for a certain good
depends on its
price.Demand is an inverse function of the price, whereas there
is a positive
relation between supply and price. Pe is the equilibrium price,
that is at
point A, quantity supplied is equal to quantity demanded. With the
economy
already operating at capacity, a rise in the aggregate demand from D
to
D' will have zero effect on output and 100% effect on prices. The
price level
will increase from Pe to a new equilibrium level P1. Classical
economists also
regarded this apparatus as reversible. A fall in the demand
would lower the
prices, with no effect ( or at most a temporary effect ) on
output. Labor market
: W SN A DN SN,DN As we can see from the graph above the
labor supply ( SN ) is
a direct function of the wage, whereas the amount of
labor hired or demanded (
DN ) is an inverse function of the wage. In
this system, both workers and the
firms that employ them, are maximizing
their units. Firms will not hire more
labor at a lower wage rate if the
prices at which they can sell their output
falls proportionately with the
money wage rate. Of relevance to the firm is the
cost of a unit of labor
relative to the price at which the firm's ouput sells-it
is the real wage
that counts in the same way, workers will not supply more labor
at a higher
money wage rate if the prices of the goods purchased with their
wages rise
proportionately with the money wage rate. Of relevance to the worker
is the
money wage received per unit of labor supplied relative to the prices of
the
goods that can be purchased with that money wage-it is the real wage
that
counts. The intersection of the supply and demand curve for labor
determines the
level of employment and the real wage. At point A, there is
equilibrium between
the supply and demand for labor. In the classical scheme
of things, any wage
rate other than the equilibrium wage rate, in a system of
competitive markets
will generate forces causing the wage rise or fall by the
amount necessary to
establish equilibrium in the labor market. The
equilibrium level of employment
so determined is also the full employment
level; that is, at this level all
those who are able, willing and seeking to
work at prevailing wage rates are
employed. Since any other level of
employment is a disequilibrium level, a
familiar proposition of classical
theory is that the equilibrium position in the
market for labor is
necessarily one of full employment. Whatever unemployment,
apart from
frictional unemployment, persists in the face of this equilibrium
must be
voluntary unemployment. ? Capital market: i S A I S,I Classical
model fails
to break aggregate demand down into demand for consumption goods and
demand
for capital goods. We must recognize that not every dollar of income
earned
in the course of production is spent for consumption goods; some part of
this
income is withheld from consumption, or saved. A part of classical
theory
provides the mechanism that assures that presumably planned saving
will not
exceed planned investment. This mechanism is the rate of interest.
Classical
theory treated saving as a direct function of the rate of interest
and
investment as an inverse function. Competition between savers and
investors will
move the rate of interest to the level that equated saving ( S
) and investment
( I ). If the rate were above the equilibrium rate, there
would be more funds
supplied by savers than demanded by investors, and the
competition among savers
to find investors would force the rate down. If the
rate were below the
equilibrium rate, competition would force the rate up. 4.
Money: Traditionally
in economics money has been defined as any generally
accepted medium of
exchange. A medium of exchange is anything that will be
accepted by virtually
everyone in a society in exchange for goods and
services. Money has several
functions. It acts as a medium of exchange, as a
store of value and as a unit of
account. ? A Medium of Exchange If there were
no money, goods would have
to be exchanged by barter, one good being swapped
directly for another. He major
difficulty with barter is that each
transaction requires a double coincidence of
wants. For an exchange to occur
between A and B, not only must A have what B
wants, but also B must have what
A wants. If all exchange were restricted to
barter, anyone who specialized in
producing one commodity would have to spend a
great deal of time searching
for satisfactory transactions. The use of money as
a medium of exchange
removes these problems. People can sell their output for
money and
subsequently use the money to buy what they wish from others. The
double
coincidence of wants is unnecessary when a medium of exchange is used.
To
serve as an efficient medium of exchange, money must have a number
of
characteristics. It must be readily acceptable. It must have a high
value
relative to its weight. It must be divisible, because money that come
only in
large denominations is useless for transactions having only a small
value. 5.
The Quantity Theory Of Money In the early classical tradition,
all intermediate
transactions involving money were accounted for in the
equation of exchange. But
most people are concerned about the level of income
that an economy generates,
because it is income that determines the standard
of living that people enjoy.
Therefore, the relation between money and
income should be emphasised. The
equation of exchange is; MV=PY where, M is
the money supply, V is the velocity
of money, P is the general price level
and Y is the physical output. M is the
stock of money. It is the supply of
money at a given time. Velocity of the money
means the number of times the
money supply is used to purchase goods. The
classical economists assumed that
the velocity of the money was constant. They
believed the institutional,
structural and customary conditions determined the
velocity. P is the general
price level. It is an average of prices of all those
final goods and services
provided and exchanged in the economy over the time
period chosen for
observation. The classical macroeconomists assumed that,
because of full
employment and flexibility of price, wage and interest, physical
output would
be constant. As a result, a change in the amount of money supply
will cause a
proportional change in the general price level. This is called
"The Quantity
Theory of Money ".
Bibliography
1. Macroeconomic Analysis;
SHAPHIRO, Edward 2. Macroeconomics Analysis And
Policy; REYNOLDS, Lloyd
G. 3. Economics; LIPSEY, Richard G. - STEINER, Peter O.