CLASSIC AND MODERN ECONOMICS

CLASSIC AND MODERN ECONOMICS (MACROECONOMICS)

Lecture : Irvan Yoga Pardistya, SE., MM., Ak

By :

Armike Febtinugraini           1610631030049

ACCOUNTING – A8

ECONOMIC & BUSINESS FACULTY

SINGAPERBANGSA KARAWANG UNIVERSITY

2016

 

 PREFACE

            Thankyou almighty God, who has given His bless to the writer for finishing this macroeconomics assignment. Thankyou for Mr. Irvan Yoga Pardistya, SE., MM., Ak who given the writer the lesson of Keynesian Theory. Thankyou for my parents who given the writer strong support.

                Hopefully we as a student in “State Singaperbangsa Karawang University” can work more professional by using English as the second language whatever we done. Thank you.

Armike Febtinugraini

NPM : 1610631030049

THE CLASSICAL MODEL

INTRODUCTION

                “the classical model” was a term coined by Keynes in the 1930’s to repesent basically all the ideas of economis as they apply to the macro economy starting with Adam Smith in the 1700s all the way up to the writings of Arthur Pigou in the 1930s.

2.       Labor Market

a.       Demand for Labor

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 hat MPL is decreasing in L and the demand for labor can be illustrated in the following graph.

        From the graph, we can conclude the 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 vica versa. For example, the demand foor labor will fall if W increasesand/or if P decreases but it will not change if W and P increase by the same precentage.

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

b.      The supply of labor

        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).

c.       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.

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. We then have full employment.

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.

3.       GDP, and Say’s Law

a.       Aggregate supply

YS = f(L, K) in the classical model where

L is determined in the labor market while K is exogenous

        The aggregate supply Y_S is defined as the amount of finished goods and services firms in a country will want to sell under given conditions. In the classical model the aggregate supply is determined by production function, Y_S = f(L, K).

The amount of capital in the classical model is an exogenous variable; it is not determined within the model but assumed to be given. Although we typically assume that K is constant – which is reasonable in the short run – it need not be constant. K may increase over time, but we must know K at any point in time.

The amount of labor, however, is an endogenous variable that is determined in the labor market. This means that YS is determined entirely by the labor market in the classical model. The following chart illustrates.

b.      Aggregate demand and Say’s Law

Y_D = Y_S in the classical model (Say’s law)

        The aggregate demand YD is defined as the quantity of nationally produced finished goods and services that consumers, government and the rest of the world want to buy under given conditions. One of the key elements of the classical model is Say’s Law. According to Say’s Law the aggregate demand is always equal to the aggregate supply : YD = YS.

        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, YD will also increase by one1 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 = f(L, K).

c.       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, YD and YS are real variables that do not depend on the price level. This may strike you as odd.

        YS depends only directly on L and 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.

4.       The price level and the quantity theory of money

a.       The quantity theory of money

One of the key elements of the classical model is the quantity theory of money. The quantity theory of money connects three important variables : M, P, and Y : the money supply, the price level and the real GDP.

P•Y is equal to nominal GDP. Suppose that nominal GDP is equal to 100 for a particular year while the money supply is constant and equal to 20 throughout that year. Since we are using money to buy finished goods, we may conclude that every monetary unit (USD or euro or whatever) has been used an average of 5 times during the year (100/20). This value is called the velocity of money and it is denoted by V. We have

V = (P•Y)/M

This is not a theory but a definition. What makes it into a theory – the quantity theory of money – is the assumption that V is a stable variable that does not depend on other economic variables. In the quantity theory, the velocity of money is an exogenous variable.

The quantity theory of money: M·V = P·Y, V exogenous

The main consequence of the quantity theory of money is the direct relationship between M and P if Y is constant. For example, if the money supply increases while real GDP stays the same, P will increase exactly as much as M (in percentage).

b.      The price level

The price level is determined from the quantity theory of money:

P = (M·V)/Y

In the classical model, money supply M is an exogenous variable (hence, the growth rate in the money supply π_M is exogenous). It is determined by the central bank. Similarly V is an exogenous variable in agreement with the quantity theory of money. Thus, M.V is exogenous and given.

Remember that Y is determined by the labor market and the production function. If we combine this with the quantity theory of money, we can determine the price level P: P = (M.V)/Y.

Now, suppose that GDP is constant over time. Since V is stable (let’s say it too is constant), the percentage change in P is equal to the percentage change in M. That is, inflation is equal to the growth rate of money or π = π_M.

Remember that we have removed the trend in Y which means that Y cycles around some average over time. Thus, Y is not constant over time but there is no growth in Y. Therefore, π = π_M will still be approximately true even when Y is not constant (it will be true on average and in the long run).

If we do not remove the trend in Y, the result would instead be that inflation is equal to the growth in money supply minus the growth in real GDP.

c.       Aggregate demand

        P and Y are both endogenous variables and according to the quantity theory of money we need PY = constant. If we divide both sides by P we get Y = constant / P. Since Y = YD in the classical model, we can write YD = constant / P. This relationship is sometimes called “classical aggregate demand” as it relates the real aggregate demand for goods and services YD to the price level P.

 

d.      Nominal wages

W = (W/P)•P

The nominal wage is equal to the real wage times the price level.

        Since the real wages W/P is determined in the labor market and P is determined by the quantity theory of money, we can also determine the nominal wage in the classical model: W = (W/P)P. From the labor market, Say’s Law and the quantity theory, we have now determined W, P, Y and L. We can also demonstrate how all these four are determined simultaneously:

5.       Interest rate, consumption and investment

a.       The consumption function

Consumption C(r) is assumed to be negatively related to the real interest rate r

        The aggregate demand for consumer goods is defined as the total amount of finished goods and services that households wish to buy under different conditions. There is no specific supply of consumer goods – firms offer final goods but do not distinguish between the supply to consumers, the supply to investors and the supply to foreigners.

We have used the symbol C for the observed consumption. To be consistent with the notation we should denote the demand for consumer goods by CD. However, this is not common practice in macroeconomics. Instead, the symbol C is used for the demand for consumer goods as well. Fortunately, it is almost always obvious from the context if the symbol C represents the observed consumption – it is then a variable – and when C represents the demand for consumer goods – it is then a function.

Moreover, the term “demand for consumer goods” is often shortened to the “demand for consumption” or simply “consumption”. Whenever you see “consumption”, you need to figure out if it means observed consumption or consumption demand.

In the classical model, the demand for consumption is assumed to be negatively related to the real interest rate r. Higher real interest rates makes it more expensive to borrow money for consumption today. Similarly, it will be more favorable to postpone consumption to the future.

Consumption is therefore denoted by C(r) and this notation makes it clear that we are talking about demand for consumption and not observed consumption.

b.      Investment demand

Investment I(r) is assumed to be negatively related to the real interest rate r

        The total demand for investment goods is defined as the total amount of investment goods firms wish to purchase under different conditions. Again, as for consumption, there is no “investment supply” and we often use “Investments” as short for the demand for investment. We use the same symbol I for observed investments and for the demand for investments.

In the classical model, investments are also negatively related to the real interest r. Investments will lead to a higher income in the future and with a higher real interest rate, such future income is worth less today. Fewer projects requiring investments will be profitable and investments will declines. Investments are denoted by I(r) in the classical model.

c.       Government revenue, government spending and net exports

G, NT and NX are exogenous variables in the classical model

        In the classical model (and in most macroeconomic models) government spending and net taxes are assumed to be exogenous variables determined by the government.

Net Exports NX is also an exogenous variable which means that both imports Im and exports X are exogenous variables. Exports are determined by the rest of the world and this variable is exogenous in most macro models. It is possible to assume that imports depend on the real interest rate by the same arguments we used for consumption. It would be possible to modify the classical model such that imports depended on the real interest rate but the results would be largely the same. Therefore, we assume that imports are exogenous as well.

d.      Household savings

Remember that consumption may refer to the observed consumption as well as to the demand for consumption. The same is true for “household savings”, which may be the observed household savings as well as the supply of savings by the household sector. The supply of savings by the household sector is defined as the net amount that all households together which to lend under different conditions.

First note that for savings, we are always interested in the net. Some individuals will want to borrow and some will want to lend and some will want to do both. Household savings is the sum of all items where lending is defined as positive amounts and borrowing as negative amounts. If you borrow money in the bank, you are in effect reducing the total amounts of savings.

In the classical model the supply of savings SH depends positively on the real interest rate in the classical model. This follows by the fact that C depends negatively on r. When r increases, we consume less and save more. Therefore, household savings is denoted by SH(r).

e.      Total savings

Total savings S(r) depends positively on the real interest rate.

        Remember that total savings is defined as S = SH + SG + SR, the sum of net savings from the household, the government and the rest of the world. As with SH, S may be the observed amount of savings or the total supply of savings. In the classical model, SG and SR are exogenous variables. SG = NT – G and SR = Im – X depend only on exogenous variables and are therefore themselves exogenous.

The only part of savings that is endogenous is household savings. Since household savings depend positively on the real interest rate, total savings will depend positively on the real interest rate. In the classical model we use S(r) to denote total savings and we have

S(r) = S_H(r) + S_G + S_R.

Note that S_H, S_G, and/or S_R may very well be negative. For example, when SG is negative, G > NT and the government is a net borrower.

f.        Interest rate determination

The real interest rate r will be equal to the equilibrium real interest rate

        In the classical model we define the equilibrium real interest rate r* as the real interest rate where savings is equal to investments, S(r*) = I(r*). From section 4.9 we know that S = I is a requirement for the financial market to be in equilibrium.

In the classic model, the real interest rate determines the flow of funds into and from the financial market. A higher real interest rates will lead to larger flows of funds into the market (savings depends positively on r) and the smaller flows out from the market (investment depends negatively on r). The real interest rate will be such that the flows into the market are precisely equal to the flows out of the market.

 

        From this graph we can also determine the size of investments and savings. In equilibrium when r = r*, S = I which is what we need for the GDP identity to hold. Once we know savings, we can determine household savings from S_H = S − S_G − SR.

In the classical model, expected inflation π^e is an exogenous variable and since R = r + π^e we can determine the nominal interest rate from the real rate.

g.       Consumption

        The final variable to be determined in the classical model is consumption C. Consumption may be found in several ways which will all produce exactly the same answer:

•     C = C(r) from the consumption function as we know r.

•     By solving for C in the equation SH = Y − NT − C. We have found Y and SH while NT is exogenous.

•     By solving for C in the GDP identity Y = C + I + G + NX. We have found Y and I, while G and NX are exogenous.

6.       Determination of all the variables in the classical model

 

    Start at the top right. Here we determine L and real wage W/P  

     1. Follow L down to the point on the production function in the middle to the right. Here you can find real GDP.

3.    2. Follow GDP to the left to the graph of the left in the middle. This graph consists of a single 45-degree line. All points on a 45-degree line have the same x and y coordinates. Such graph is used to transform a variable from the y axis to the x axis.

4.   3. Follow Y up to the top left graph. In this graph you find aggregate supply which is independent of P and aggregate demand which is just the quantity theory of money. From this graph, you get up P.

5.  4. If you multiply P from the upper left-hand chart, by W/P from the upper right-hand chart, you get nominal wage W.

6.  5. Follow Y from the middle left graph down to the bottom left graph. Here is S (r) and I (r) and a determination of real r and I in the balance. In C + + NX + G = Y, and since NX and G is exogenous, we can calculate C.

KEYNESIAN CROSS MODEL

1.       Introduction

a.       The keynesin model

        The Keynesian model has as its origin the writings of John Maynard Keynes in the 1930s, particularly the book “The general theory of Employment, Interest, and Money”. Although this book was written as a criticism of the classical model, the similarities between the Keynesian model and the classical model are definitely greater than the differences. Lets point out the three most important differences directly:

·         Say’s Law does not apply in the Keynesian model.

·         The quantity theory of money does not apply in the Keynesian model.

·         The nominal wage level W is an exogenous variable in the Keynesian model.

Remember that W being exogenous means that it is pre-determined outside the model. It does not necessarily mean that it is constant over time – even though this is a common assumption. However, the nominal wage must be known at any point in time in this model. To simplify our description of the Keynesian model, we will begin by assuming that W is constant.

The Keynesian model is slightly more complicated than the classic model, and it is developed in four stages by analyzing four separate models. Each model has, however, a value in itself. The models we will consider and the major characteristics of each are:

·         Cross model: W, P and R are constant (and exogenous).

·         IS-LM model: W, P are constant and R is endogenous.

·         AS-AD model: W is constant, P and R are endogenous.

·         The full Keynesian model: W is exogenous (but not constant), P and R are endogenous.

Once we have developed the full Keynesian model, we will combine it with the clasmodel which will lead to the neoclassical synthesis. The final chapter covers the Mundell-Fleming model – an extension of the neoclassical synthesis to an open economy where we also analyze the exchange rate.

b.      Summary of the cross model

The following list summarizes the cross model and relates it to the classical model:

ü  Labor Market: The real wages W/P is exogenous in the cross model (W is exogenous in all the Keynesian models and P is exogenous in cross model). The detrmination of L is very different from the classical model.

ü  Aggregate supply Ys is determined by the production function Ys = f(L, K). Again, we always remove any trend in GDP and its components.

ü  Aggregate demand is not always equal to the aggregate supply. Say’s Law does not apply in any of the Keynesian models. Therefore, we must describe how aggregate demand and GDP is determined in the cross model. This can be found in Section 11.3.

ü  The Quantity theory of money does not apply anymore. Fortunatelly, we don’t need it since P is given in the cross model.

ü  Consumption was a function of the real interest rate in the classical model. In the cross model it is a function of Y.

ü  Investment was also a function of r in the classical model. In the Keynesian model it is exogenous.

ü  Government spending (G) is exogenous but the net tax NX is endogenous (in the classical model, they were both exogenous). Net tax is assumed to be a function of Y which means that government savings will be endogenous (SG(Y)= NT(Y) – G).

ü  Exports (X) is exogenous, as it is in the classical model, but imports (Im) is endogenous. Imports will also be a function of Y. Net imports and external savings will therefore also be endogenous variables (NX(Y) = X – Im(Y) and SR(Y) = Im(Y) – X).

ü  Household savings and total savings were functions of the real interest rate in the classical model. In the cross model they are functions of Y.

ü  The real interest rate is exogenous in cross model. This follows by the fact that the nominal interest rate is exogenous and prices are constant (π^e must be zero, and r = R).

We can divide our analysis of the cross model into three parts:

Ø  Aggregate demand. Aggregate demand is a major component of the cross model. The main purpose of this section is to arrive at the conclusion that aggregate demand depends on real GDP.

Ø  Determination of GDP. GDP is determined very differently in the cross model compared to the classical model.

Ø  Labor market. One of the main points of the Keynesian model is to allow for unvoluntary unemployment. In the classical model of the the labor market, we are always in equilibrium and there is no unvoluntary unemployment.

2.       Aggregate demand

a.       The consumption function

Consumption C(Y) depends positively on GDP in the cross model

Remember that in the classical model, consumption depends on the real interest rate. In the cross model it depends on GDP. Note that it is not possible to include r in the cross model as it is fixed. However, we need to justify the dependence of C on Y.

b.      Consumption and GDP

        At first, it might seem obvious that consumption will depend on Y. If GDP is doubled in real terms over a number of years, private consumption, government consumption and investment will also each roughly be doubled. If you draw a graph of GDP and consumption over time you see that consumption does grow by about the same rate as GDP.

However, from this reasoning, we cannot conclude that C depends on the Y because growth has been removed from our variables C and Y. We need to think of Y as a variable that varies over time around some average. Sometimes it is above the average and sometimes it is below the average but there is now upward trend. The same is true for C.

The crucial question then is whether consumption is above its average in periods when GDP is above its average and vise versa (technically, if the detrended variables are correlated over time). Keynes would have said yes, while classics would have said no.

Keynes’ motivation: In good times, when Y is high (above its trend), national income is high (above it trend). Consumers will take the opportunity to buy things they otherwise cannot afford. In bad times, on the other hand, consumers simply cannot buy things they would have bought if income was higher.

The classical motivation: Consumers want to smooth their consumption over time. In good times, consumers know that this is a temporary state. Instead of increasing consumption, they save and use their savings in bad times.

c.       The rest of the world in the cross model

Imports Im(Y) depends positively on Y in the cross model

        In the classical model, imports does not depend on Y. The discussion whether imports depends on Y or not is the same as for consumption. However, in the cross model, it is always assumed that when Y increases, consumption will increase by more than imports. This makes sense since C is ususally larger than Y. For example, suppose that C is 1000 while Im is 100 and that Y increases by 10%. If C and Im increase by 5% each, C will increase by 50 while Im will increases by only 5.

        Net exports NX = X – Im will depend negatively on the Y and rest of the world savings SR = Im − X depends positively on Y in the cross model. If we want to be explicit about these dependences we write:

NX(Y) = X − Im(Y)

S_R(Y) = Im(Y) – X

d.      The government in the cross model

Net taxes NT(Y) depends positively on real GDP in the cross model

        In this model, when national income increases, the amount individuals pay in income taxes will increase. This is because income tax is specified as a percentage of total income. Other taxes may also increase when Y increases. However, government transfers to households will decrease. Therefore, net taxes NT will increase when Y increases.

Even though NT depends on Y, is still under the control of the government. NT may change even if Y does not change. This means that NT is part exogenous (as it may be controled by the government) and part endogenous (as it will automatically change when Y changes). Therefore, we write NT(Y) but we must remember the exogenous nature of net taxes. Government savings, which is also part endogenous and part exogenous, depends positively on Y and we write:

S_G(Y) = NT(Y) − G

e.      Savings

Household savings S_H(Y) and total savings S(Y) depend positively on Y

        Household savings depends on Y because S_H = Y − C − NT and C and NT both depend on Y. How it depends on Y cannot be conclusively be determined from this relationship as C and NT both dpeends positively on Y. We always assume that this dependence is positive and the following example illustrates why this assumption makes sense.

Suppose that NT = t∙Y where t is a constant between 0 and 1. t is the the proportion of income that we pay in taxes. Next, suppose that C = c∙Yd where c is a constant between 0 and 1. c is proportion of disposable income that we use for consumption. If income Y increases by 1, NT increase by t, disposable income increases by 1 – t and C increases by c(1 – t). Thus, SH increases by 1 – c(1 – t) – t = (1 – c)(1 – t) > 0.

Since S = S_H + S_G + S_R and all parts on the right hand side depends positively on Y, total saving S will depend on positive Y and we write S(Y) for total savings (net total supply of savings).

f.        Aggregate demand in the cross model

        Since C and Im depends positively on Y while G, I and X are exogenous, aggregate demand YD will depend positively on Y:

Y_D(Y) = C(Y) + I + G + X − Im(Y)

When Y increases, C and Im increases but since C increases more than Im, aggregate demand will increase when Y increases.

You may react to the the notation Y_D(Y). But if you think of Y as the national income (GDP = national income) then Y_D(Y) simply tells us that aggregate demand depends on income. Aggregate demand is the total quantity of finished goods and services that all sectors (consumers, firms, government and the rest of the world) together wish to buy under different conditions. The notation Y_D(Y) tells us that the only endogenous variable that affects aggregate demand is national income. The higher the income, the more we wish to buy. Y_D, C, Im, S, S_H, S_G, S_R and NT all depend on Y while I, G and X are exogenous. We can illustrate this using the following diagrams

Each diagram has real GDP on the x-axis.

o   The first diagram shows exports (X), imports (Im), net exports (NX) and rest of the world savings (S_R). In this diagram, X = 1.3 and Im = 0.56 + 0.2Y.

o   The second diagram shows private consumption (C), investment (I ), government spending (G), net exports (NX) and aggregate demand (Y_D = C + I + G + NX). Here, C = 0.22 + 0.4Y, I = 0.5, G = 0.7.

o   The third diagram shows private savings (S_H), public savings (S_G), the rest of the world savings (S_R) and the total savings (S = S_H + S_G + S_R). They are created from NT = 0.26Y.

This diagram summarizes all varaiables in the cross model and how they depend on Y. Actually, these dependences will be the same in all of the Keynesian models.

3.       Determination of GDP in the cross model

a.       Main result

In the cross model, GDP is determined as the solution to the equation Y_D(Y) = Y

        All points on the 45-degree line has the same x- and y-coordinates. Since we have Y on the x-axis, and Y_D on the y-axis, Y_D = Y for all points on the 45-degree line. The AD curve shows the aggregate demand Y_D as a function of Y. There is only one level of Y where aggregate demand is equal to Y, the point where AD cutts the 45-degree line. This level is called the equilibrium level of GDP and it is denoted by Y*. Formally, Y* is defined implicitly by Y_D(Y*) = Y*.

b.      Justification

        Note that we have not said anything about the aggregate supply so far. In order to justify why GDP is determined solely by aggregate demand we have to explain why aggregate supply Y_S plays no role and why Y_S always will be exactly equal to Y_D (which is required for the goods market to be in equilibrium).

We can explain why Y_S = Y* by analyzing what would happen if firms did not supply this quantity.

1.       Imagine that the firms supplied and also produced a larger quantity so that Y > Y*.

2.       From the diagram above, Y_D < Y and firms cannot sell everything they produce.

3.       Unplanned stock investments will increase by Y − Y_D when companies are forced to put unsold products in stock.

4.       Firms will then want to lower their supply. The reduction will continue until Y_S = Y*.

5.       If, on the other hand, they supply and produce too little, Y < Y* and then Y_d > Y. Stocks will now be reduced and firms will want to increase the supply.

Note that the Keynesian model always assumes quantity adjustment to get back to equilibrium. There are no price adjustments in the Keynesian model.

c.       Say’s Law

        Also note how the entire outcome of the cross model depends on the elimination of Say’s Law. With Say’s Law, aggregate demand would always be equal to aggregate supply and the cross model would be incorrect.

        Keynes’s argument as to why Say’s Law does not apply can be illustrated in the cross model. According to Say’s law, supply creates its own demand. When supply increases, income increases and a higher income creates an equally large increase in demand. Households and firms are stimulated to a higher demand by cuts in the real interest rates. Higher aggregate supply will lower the real interest rate and consumption and investment will increase. According to Say’s Law, r will fall to the level where the total increase in C and I is exactly as large as the increase in aggregate supply.

        According to Keynes and cross model, this will not happen. When Y increases, C will increase but not as much as Y (and I will not change at all). Aggregate demand will not increase as much as aggregate supply and Say’s Law will fail.

d.      Reversed Say’s Law

        In the cross model, supply must instead follow demand. The cross model not only rejects Say’s Law, it turns it completely upside down. In the cross model “demand creates its own supply”.

Just as Say’s Law is criticized by many economists, there is criticism of this reversed form of Say’s Law. In this reversed form, firms passively produce exactly what the consumers want. If there is an increase in demand, firms will just produce this additional quantity. The motivation for this behaviour by the firms is further analyzed when we describe the labor market in the cross model.

e.      Determination of other variables

Once Y is determined, almost all of the other variables are determined because they are either exogenous or they depend on Y. From Y we can determine C by the consumption function, Im from the import function and NT from the net tax function.

        When these variables are determined, we can determine net exports, household savings, government savings and rest of the world savings. All macro variables except L and U are thus determined.

4.       Labor market

a.       Labor supply and labor demand in the Keynesian model

        Remember that the supply of labor, L_S(W/P), depends positively on real wages in the classical model. It is not always clear which individuals are included in the labor supply. The labor supply may consist of only individuals in the workforce or it may have a wider definition including individuals that are outside the labor force but would like to work if they could find a job. The second category may contain so-called “discouraged workers” and individuals that are in school but who would rather work.

The Keynesian labor supply differs from the classic labor supply in that it includes individulas that are outside the workforce. Therefore, for a given real wage, the Keynesian labor supply is larger than the classic labor supply. However, the Keynesian labour supply is still a positive function of the real wage.

The demand for labor L_D(W/P) is the same as for the classical model. It is derived from the marginal product of profit maximizing firms. The following graph shows the classical labor supply, the Keynesian labor supply and the labor demand.

 

        Note that for the classical equilibrium real wage, the Keynesian supply exceeds the demand. In the Keynesian models, we do not assume that the real wage will be equal to the equilibrium real wage. The labor market need not be in equilibrium in the classical sense. However, in the Keynesian models, the real wage is such that there is always an excess supply of labor (using the Keynesian supply).

b.      The labor in the cross model

In the cross model, both P and W are constant and exogenous. Therefore, the real wage is constant and it is not necessarily equal to the equilibrium real wage. The modle of the labor market in the cross model can be illustrated by the following figure:

 

c.       Aggregate supply

Remember that labor demand gives us the profit-maximizing quantity of L for a given real wage. If W/P is given (as it is in cross model), we can find the profit-maximizing quantity of L from the graph. We

denote this by L_OPT. If firms use L_OPT amount of labor, they wil produce Y_OPT = f(L_OPT, K) where f is the production function and K the amount of capital (exogenous).

        An important assumption in the cross model is that Y_OPT is always larger than Y_D – the aggregate demand is not sufficient for the amount that firms would like to supply at the given real wage. This assumption has a very important consequence. Even though producing Y_OPT would maximize profits, firms will not produce this level due to the lack of demand. They will only produce Y_D and we see why it is aggregate demand that is important in the cross model. Again, note how the Keynesian cross model works with quantity adjustments instead of price adjustments as in the classical model. We denote the level of output produced by the firms by Y*.

d.      Determination of L in the cross model

        Since firms will produce less than Y_OPT, they need less labor than L_OPT. We can figure out exactly how much L they need in order to produce Y* and this level of L is denoted by L*.

 

1.       Start at the bottom left. Here, the equilibrium level of GDP (denoted by Y*) is determined. We can add Y* on the y-axis as well since Y_D = Y* in equilibrium.

2.       Extend Y* to the bottom-right graph. This is the aggregate supply.

3.       From the production function we can figure out exactly how much labor we need to produce Y*. This amount is denoted by L*.

4.       Extend L* up to the upper right-hand graph. Since real wage is fixed, we must be on the horizontal line and we find the equilibrium for the labor market.

5.       In the same diagram you will also find also find L_OPT, the quantity of labor firms would choose if aggregate demand was sufficient.

Note a crucial difference between the classical and the Keynesian model: in the classical model we first determine L and go from L to Y while in the cross model we go from Y to L.

e.      Equilibrium analysis

        An important question is whether the equilibrium we have identified in the labor market (with a high unemployment rate) can remain in the long run. Will there not be adjustments that will take us back to a point with no unemployment? The Keynesian justification for why unemployment will persist is as follows.

The goods market is in equilibrium since firms will sell everything they produce and the demand for finished goods is satisfied. Firms then have no reason to hire more labor (they will only increase L when Y_D increases). And since the goods market is in equilibrium, they have no reason to change prices.

However, we have involuntary unemployment in the diagram above which may create a downward pressure on wages. In the cross model, this will not happen for the following arguments:

1.       Nominal wages are sticky, particularly downwards. We hardly ever observe cuts in nominal wages.

2.       Nominal wage cuts would not help. With lower wages, income would fall, reducing aggregate demand even more, making the situation worse. Lower nominal wages would allow firms to lower prices. But if prices fall as much as nominal wages, real wages will no, and we had stayed in the same paragraph.

As with the classical model, we study most of the check model characteristics in an exercise book. A couple of comments, however, may be of interest already here.

•        It is difficult to explain long periods of high unemployment in the classic model with the model of labor used there.

•        During the Great Depression in the early 1930s (the great depression), it became increasingly evident that the traditional model had flaws. Unemployment was very high for a long time and any adjustment to the balance of the labor market was not.

•        In the Keynesian model, can the economy to be in balance even with a high level of involuntary unemployment and the model appeared to be a good explanation for depression.

•        I check the model, financial policy is a very important role. By increasing G so, the government can increase GDP and thus reduce unemployment.

•        The classic dichotomy between real and nominal variables will disappear in all Keynesian models.

*Source : Jochumzen, Peter. Essentsials of Macroeconomics. 2010. Bookboon. Page 62-92