Compare the Classical and Keynesian models, making the reference to a) The labour market b) The AS curve c) The AD curve d) The relationship between real and monetary variables.
Compare the Classical and Keynesian models, making the reference to
a) The labour market
b) The AS curve
c) The AD curve
d) The relationship between real and monetary variables.
st lecture until 08/10/03
Plan
Classical
a) The labour market
b) The AS curve
c) The AD curve
d) The relationship between real and monetary variables.
Keynesian
a) The labour market
b) The AS curve
c) The AD curve
d) The relationship between real and monetary variables.
Introduction
Classical economics uses the fallacy of composition to aggregate individual components. It believes that microeconomic foundations are necessary. However, in contrast, Keynesian economists believe the behaviour of the whole economy to be different from the behaviour of individual components acting individually. It believes the whole economy has its own identity and therefore requires n a new theory. Keynesians believe, that by itself the economy may not produce optimum outcome and therefore government intervention is needed.
Classical
Useful because
* Background to Keynesian revolution
* Basis for new-classical models
Based upon
* Say's law of markets (supply causes demand)
* Quantity theory of money (money supply causes price level)
Implies
* If there is wage price flexibility then the economy quickly adjusts to voluntary full employment equilibrium
* Supply causes demand, therefore, concentrate on supply
* Direction of causation is from the labour market to aggregate supply
REAL SIDE
MONETARY SIDE
AS Aggregate Supply
AD Aggregate demand
w/p Real wage
w money wage
O Output/real income
p price level
N Employment
Classical Labour market demand and Aggregate Supply
Labour market demand
DN = firms demand for labour
MPP = marginal physical ...
This is a preview of the whole essay
Implies
* If there is wage price flexibility then the economy quickly adjusts to voluntary full employment equilibrium
* Supply causes demand, therefore, concentrate on supply
* Direction of causation is from the labour market to aggregate supply
REAL SIDE
MONETARY SIDE
AS Aggregate Supply
AD Aggregate demand
w/p Real wage
w money wage
O Output/real income
p price level
N Employment
Classical Labour market demand and Aggregate Supply
Labour market demand
DN = firms demand for labour
MPP = marginal physical product
w = MPP x P
DN curve is downward sloping because MPP diminishes with fixed capital and technology due to the law of variable proportions.
SRAPF = short run aggregate production function for labour
O = output. Output is a function of N.
Labour market supply
SN = supply of labour
MDU = marginal disutility of labour
MDU = w/p
SN curve has a positive slope because work is assumed undesirable. It is a trade off with leisure.
LABOUR MKT
The above diagrams show Classical Output and Employment Theory.
Model a)
* Depicts labour market equilibrium real wage (w/p) 0 at equilibrium point A.
* In the aggregate, DN = DS
* Equilibrium employment = N0
Model d)
* Determines equilibrium aggregate output at O*. In the classical model, aggregate supply always determines real output, due to the vertical AS curve.
* Output can change due to changes in
o Real choices
o Technological conditions
The above diagrams show Classical Derivation of AS from a perfectly flexible labour market. If price increases, wage increases in the competitive market to keep w/p constant. Therefore the AS curve is vertical. Conversely, if price level falls, the wage falls.
Output is invariant (perfectly inelastic) with respect to price level, as with an equilibrium level of real wage (w/p), any change in price level is offset by a change in wages to maintain w/p.
Aggregate Demand-Monetary side
Sm is fixed exogenously (externally) by monetary authority
Sm and Dm-----the quantity theory-----2 versions:
Fisher: M V = P T VELOCITY DETERMINED - CLASSICAL
M=money stock
V=Velocity of circulation
P=average level of P
T=output of goods and services
Cambridge: Md = kPY DEMAND DETERMINED - KEYNESIAN
k=proportion of nominal income
KEYNESIAN
Labour market
Unlike classical, Keynesian Labour market not perfectly flexible market as wages downwardly rigid
In the monetarist, classical labour market, employment is at the natural rate. Keynesian theory was introduced after chronic unemployment in the 1920s in the UK and 1930s in other industrialised nations. It explained unemployment was due to a lack of AD. For output to be at equilibrium, output must equal aggregate demand. In the Keynesian model, unemployment is involuntary, due to an insufficient level of AD. This is because of the nature of the Keynesian labour market.
Causation: A level of involuntary unemployment that is associated with any level of employment is cause and effect of that level of employment.
Cause: Classical view of Keynes, the labour market won't work (strictly fixed wage) therefore attention shifts to AD
Effect: Keynesian view is that w/p is a determinate of a system that works on different principles, Say's Law is wrong (supply does not cause demand) and so a new theory of effective demand is needed.
Keynesian aggregate supply
Keynesian Aggregate Demand
Unlike, Classical theory where AD plays no part in determining output, and has a purely monetary role, the Keynesian theory of AD is very important in determining Y and N, and much of Keynesian theory is a development theory of AD. Keynes spoke of the point of effective demand (POED) where AD=AS. Given this, we can say that Keynesian AD is a point on the Keynesian AS curve, and is determined by (in a closed, laissez faire market): Y = C + I where
C = f(Y)
I = f (r, mec)
mec = marginal efficiency of capital, determined by supply price and perspective yield
r = interest rate, determined by LP (liquidity preference) and M (demand for money).
With a given p and expectations (taking mec out of the equation), Keynes AD is determined by r and Y, and is expressed in equilibrium terms (goods market and monetary market) in the IS-LM.
Conclusion
In the Classical model, due to the vertical AS curve, supply alone determines real output. In the Keynesian model, both supply and demand factors affect real output.
In the Classical model, the position of the AD curve is determined by purely monetary variables (the role of demand was to determine p), whereas in the Keynesian model, both monetary and real variables determine its position.