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
cant 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. SAYs 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.

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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 “.

1. Macroeconomic Analysis; SHAPHIRO, Edward 2. Macroeconomics Analysis And
Policy; REYNOLDS, Lloyd G. 3. Economics; LIPSEY, Richard G. – STEINER, Peter O.

PURVIS, Douglas D. 4. Principles Of Economics; SCOTT, Robert Haney NIGRO.