The (neo) Classical Model

The Classical Model

Today we build up our first macro model – the classical model. Prior to Keynes’ publication of the General Theory of Employment, Interest, and Money (1936), there was not a conception of “macroeconomics.” There was just this idea of economics.

Why the difference? 

Well, when we develop the Keynesian model, we’ll see that we need a theory of output and employment determination that is distinct from the theories that describe individual and firm level decisions. This is because as I suggested earlier in the course, there is this phenomena in economics we call the “paradox of thrift,”  which shows how seemingly rational decisions to save for the future can lead to the inability of society as a whole to do so. This is closely related to Say’s Law and its failure, which leads to unemployment, declining incomes, and ultimately diminishes our ability to save.

In order to understand Keynes’ critique of Say’s Law we need to first lay out the classical model which relies upon Say’s Law.
What is the overall objective of this model?

It shows how four variables are determined: output, employment, prices and interest rates. What you need to keep in mind as we walk through these graphs is that output and employment, which are “real” variables, are determined in a completely different sphere than that of the loanable funds market, which determines the interest rate - a monetary phenomenon. Thus, we have the “classical dichotomy” which separates the forces which determine the production of goods and services from issues which relate to money and interest rates.

1. Output is determined by the production function given a level of employment
2. Employment is determined in the labor market
3. Prices are determined by the equation of exchange (MV = PY)
4. Interest rates are determined in the loanable funds market.

And, one more nugget of wisdom before we finish: How is Say's Law Preserved? I have already hinted toward this idea that saving constitutes a demand leakage from the economic system. How can this resolved?

We have three supply curves in the loanable funds market: S (the one in the middle), S', and S''. Starting from S, we can say that if individuals decided to save less and consume more, then we would shift the savings curve from S to S'. You should see that if we hold constant the investment demand for loanable funds, then this will cause the interest rate to rise. Tracing this up to the PPF graph that shows the trade-off between consumption goods and investment goods, we see that the decision to save less corresponds to the decision to produce more consumption goods and less investment goods. If individuals decide to save more, then we shift from S to S'', which causes the interest rate to fall, ceteris paribus. Tracing this equilbrium condition, where supply of loanable funds is equal to the demand for loanable funds, up to the graph above, we see this decision to save is also a simultaneous decision to produce more investment goods. The intuition here is that the decision to save in the classical model does not produce unemployment, because the resources that would otherwise be unused as a result of saving are used to produce goods for future consumption (investment).