# Classical Macroeconomic Theory - Chapter...

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Classical Macroeconomic TheoryChapter 3 : Classical Macroeconomic TheoryChapter 3 Classical model examines: Determination of aggregate supply Factor prices & Income Distribution Demand for goods and services Tendency toward full employment Closed-economy, Market-clearing Model : Closed-economy, Market-clearing Model Supply Factor markets Determination of output/income Demand Determination of demand components Equilibrium Goods markets Loanable funds market Supply of national income : Supply of national income Aggregate Production Function Y = F(K,L)  Relate output to factors of production Technology constant _ K= K _ L = L Returns to Scale : Returns to Scale Production function has constant returns to scale zY = F(zK,zL) If increase in Y equal to z, constant returns to scale If increase in Y > z, increasing returns If increase in Y < z, decreasing returns Supply of output : Supply of output _ _ _ Y = F(K,L) = Y Distribution of Output : Distribution of Output Assume competitive firms in economy Factor prices determine distribution of output Wage, W, is price of labor Rental rate, R, is price of capital P = price level W/P = real wage R/P = real rental rate Demand for factors : Demand for factors Firms maximize profits Profit = PY – WL – RK Profit = PF(K,L) – WL – RK Marginal Product of Labor MP = F(K,L+1) – F(K,L) Diminishing Marginal Product The MPL and the production function : Y output The MPL and the production function L labor MPL Demand for Labor : Demand for Labor ?Profit = ?Revenue - ?Cost = (P x MPL) – W  Hire labor until ?Profit = 0  P x MPL = W  MPL = W/P MPL and the demand for labor : MPL and the demand for labor Each firm hires labor up to the point where MPL = W/P Rental Rate : Rental Rate MPK = R/P = real rental price of capital Economic Profit = income after factor payments Economic Profit = Y–(MPL x L)–(MPK x K) ?Profit = ?Revenue - ?Cost =(P x MPK) – R MPK = R/P Euler’s Theorem : Euler’s Theorem F(K,L) = (MPL x L) + (MPK x K) For constant returns to scale Since firms own capital, accounting profit is Accounting Profit = Economic Profit +(MPK x K) Economic Profit is zero Accounting Profit is the return to capital Factor Shares : Factor Shares Cobb-Douglas Production Function The Cobb-Douglas production function is: where A represents the level of technology. Each factor’s marginal product is proportional to its average product: The Cobb-Douglas Production Function : The Cobb-Douglas Production Function The Cobb-Douglas production function has constant factor shares: ? = capital’s share of total income: capital income = MPK x K = ? Y labor income = MPL x L = (1 – ? )Y Growth in real wages due to productivity Slide 15: Figure 3.5 The Ratio of Labor Income to Total IncomeMankiw: Macroeconomics, Sixth EditionCopyright © 2007 by Worth Publishers Demand for Goods and Service : Demand for Goods and Service Y = C + I + G + NX Assume NX = 0 Consumption : Consumption C = C(Y-T) Y-T = Disposable Income MPC = Marginal Propensity to Consume MPC = ?C/?Y The consumption function : The consumption function Investment : Investment I = I(r) Nominal and Real Interest Rates r = real interest rate Cost of borrowing Opportunity cost of own funds The investment function : The investment function Government : Government _ G = G (exogenous) _ T = T (exogenous) Transfers not included in G Equilibrium : Equilibrium _ _ _ _ Y = C(Y – T) + I(r) + G  Only variable is r Real rate adjusts to equilibrate markets Full employment model Factor markets clear Supply and Demand for Loanable Funds : Supply and Demand for Loanable Funds Y – C – G = I Y – C – G = National Saving (Y – C – T) + (T – G) = I (Y – C – T) = Private Saving (T – G) = Public Saving _ _ _ _ Y – C(Y – T) – G = I(r) _ S = I(r) Interest rate adjusts to equate supply and demand for loanable funds Loanable funds supply curve : Loanable funds supply curve National saving does not depend on r, so the supply curve is vertical. Loanable funds market equilibrium : Loanable funds market equilibrium Real interest rate : Real interest rate Equilibrates loanable funds market Equilibrates goods market Loanable Funds Market : Loanable Funds Market Increase in government purchases or tax cut Reduces public saving – r increases Investment crowded out CASE STUDY The Reagan Deficits : CASE STUDY The Reagan Deficits Reagan policies during early 1980s: increases in defense spending: ?G > 0 big tax cuts: ?T < 0 According to our model, both policies reduce national saving: 1. The Reagan deficits, cont. : 1. The Reagan deficits, cont. I1 2. …which causes the real interest rate to rise… I2 3. …which reduces the level of investment. 1. The increase in the deficit reduces saving… Are the data consistent with these results? : Are the data consistent with these results? variable 1970s 1980s T – G –2.2 –3.9 S 19.6 17.4 r 1.1 6.3 I 19.9 19.4 T–G, S, and I are expressed as a percent of GDP All figures are averages over the decade shown. An increase in investment demand : An increase in investment demand An increase in desired investment.. r1 An increase in investment demand when saving depends on the interest rate : An increase in investment demand when saving depends on the interest rate

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