The classical model of macroeconomics The CLASSICAL model

The classical model of macroeconomics • The CLASSICAL model of macroeconomics is the polar opposite of the extreme Keynesian model. • It analyses the economy when wages and prices are fully flexible. • In this model, the economy is always at its potential level. ©The Mc. Graw-Hill Companies, 2002

The classical model of macroeconomics (2) • Excess demand or supply are rapidly eliminated by wage or price changes so that potential output is quickly restored. • Monetary and fiscal policy affect prices but have no impact on output. • In the short-run before wages and prices have adjusted, the Keynesian position is relevant whilst the classical model is relevant to the long-run. ©The Mc. Graw-Hill Companies, 2002

The Taylor Rule again • Previously it was assumed that prices were fixed and so we talked in terms of a simple Taylor Rule where interest rates responded to the output part of the rule. • Here, we allow prices to vary and think in terms of the Taylor Rule where interest rates respond to both output and inflation. – In this case, higher inflation leads to the bank raising the interest rate, thus reducing aggregate demand output. ©The Mc. Graw-Hill Companies, 2002

The macroeconomic demand schedule • Inflation The macroeconomic demand schedule (MDS) shows the combinations of inflation and output for which aggregate demand equals output when the interest rate is set by a Taylor Rule. Higher inflation is associated with lower aggregate demand lower output. MDS • Output 3 ©The Mc. Graw-Hill Companies, 2002

The macroeconomic demand schedule (2) • The slope of the schedule is determined by: – the reaction of interest rate decisions to inflation – and the responsiveness of aggregate demand to interest rate changes • Consequently: – It will be flat when • interest rate decisions respond a lot to inflation • and aggregate demand is highly responsive to interest rate changes. – It will be steep when • interest rate decisions do not respond much to inflation • and aggregate demand responds little to interest rate changes. ©The Mc. Graw-Hill Companies, 2002

Aggregate supply and potential output • Potential output depends upon: – the level of technology – the quantities of labour demanded and supplied in the long-run, when the labour market is fully adjusted – When wages and prices are fully flexible, output is always at the potential level • In the short-run we can treat potential output as given ©The Mc. Graw-Hill Companies, 2002

The classical aggregate supply schedule • The classical model has an aggregate supply curve which is vertical at potential output • This means that equilibrium output can be reached at different levels of inflation • In the classical model, people do not suffer from money illusion • Consequently, only changes in real variables influence other real variables ©The Mc. Graw-Hill Companies, 2002

Inflation The classical aggregate supply schedule (2) This schedule shows the output firms wish to supply at each inflation rate. When wages and prices are flexible, output is always at its potential level (Y*). Potential output is the economy’s long-run equilibrium output. AS Y* Output 7 ©The Mc. Graw-Hill Companies, 2002

The classical aggregate supply schedule (3) • Better technology will shift AS to the right and hence increase potential output. • Increased employment will also shift AS to the right and increase potential output • as will the use of more capital. • In the short-run, we can treat potential output as given. ©The Mc. Graw-Hill Companies, 2002

Equilibrium inflation Inflation AS * Overall equilibrium is shown where MDS = AS at the potential output level Y* and inflation level *. A MDS Y* At A, the goods, money and labour markets are all in equilibrium. Output 9 ©The Mc. Graw-Hill Companies, 2002

Equilibrium inflation: a supply shock Inflation AS 0 0 * A AS 1 C D 2 * Y 0 * Y 1 * MDS 1 MDS 0 Output A beneficial supply shock raises potential output by shifting AS 0 to AS 1 and lowers inflation to 2* at D. If the central bank pursues its target of 0* when the economy is at potential output, it must respond by reducing its target real interest rate. This will lead to an increased amount of money being demanded: to achieve, money market equilibrium at this interest rate, the bank must supply more money. 10 ©The Mc. Graw-Hill Companies, 2002

Equilibrium inflation: a demand shock Inflation AS 0 1 * B 0 * A MDS 1 MDS 0 Y 0 * Output Beginning at A, an increase in aggregate demand brought by an increase in investment say, would shift MDS 0 to MDS 1 moving us to a new equilibrium B. At B, potential output is the same but is higher at 1* Since potential output is the same at B, the bank must tighten its monetary policy in order to hit its target of 0*. Since the bank follows a Taylor rule, it will increase the target real interest rate and thereby reverse the increase in MDS. 11 ©The Mc. Graw-Hill Companies, 2002

The speed of adjustment • Adjustment in the Classical world is rapid, so the economy is always at potential output (full employment). • If wages and prices are sluggish, then output may deviate from the potential level. • A Keynesian world of fixed wages and prices may describe the short run period before adjustment is complete. ©The Mc. Graw-Hill Companies, 2002

Supply-side economics • The pursuit of policies aimed not at increasing aggregate demand, but at increasing aggregate supply. • A way of influencing potential output, seen as critical in the classical view of the economy. ©The Mc. Graw-Hill Companies, 2002

Adjustment in the labour market Short-run (3 months) Medium run (1 year) Long-run (4 -6 years) WAGES Largely given Beginning to adjust Clearing the labour market HOURS Demanddetermined EMPLOYMENT Largely given Hours/ employment mix adjusting 14 Normal work week Full employment ©The Mc. Graw-Hill Companies, 2002

Short-run aggregate supply • If adjustment is not instantaneous, output may diverge from Yp in the short run. • Firms may vary labour input – via hours of work (overtime or layoffs). • Wages may be sluggish in falling to restore full employment in response to a fall in aggregate demand. • The short-run aggregate supply schedule shows the prices charged by firms at each output level, given the wages they pay. ©The Mc. Graw-Hill Companies, 2002

The short-run aggregate supply schedule Inflation Suppose the economy is initially at Y* in fullemployment equilibrium at A, with inflation 0 In response to a fall in aggregate demand, firms in the short run vary labour input, thus moving along SAS to B. SAS 0 A SAS 1 B SAS 2 2 In time, the firm is able to negotiate lower wages, and the SAS shifts to SAS 1 and then to SAS 2, until equilibrium is restored at A 2 Y Y* Output 16 ©The Mc. Graw-Hill Companies, 2002

The adjustment process • When SAS and MDS are combined, changes in MDS lead mainly to a change in output in the short-run. • Over time, deviations from full employment gradually change wage growth and short-run aggregate supply. • The economy, therefore, gradually works its way back to potential output. ©The Mc. Graw-Hill Companies, 2002

A lower inflation target Starting from long-run equilibrium at E: the inflation target is cut from * to 3*: the raising of interest rates to achieve this shifts MDS to MDS'. Given wage levels, firms adjust to E' in the short run. With inflation at ' but wages unchanged, the real wage rises bringing involuntary unemployment. As the labour market (wage) adjusts SAS shifts e. g. to SAS’. Inflation AS SAS * 1 * 2 * 3 E E' SAS' E 2 SAS 3 E 3 MDS' Y* MDS Output Equilibrium is eventually reached at E 3, back at Y*. 18 ©The Mc. Graw-Hill Companies, 2002

A temporary supply shock e. g. an increase in the price of oil Higher oil prices force firms to charge more for their output, so SAS shifts to SAS’. SAS' Inflation *'' ' E'' SAS E' * Equilibrium moves from E to E’. Higher prices cause a move along MDS and output falls to Y’. If the bank maintains the inflation target of *, in time, unemployment reduces wages and SAS gradually shifts back to SAS', so Y* is restored. E MDS Y' Y* Output If the bank had accommodated the supply shock by relaxing its target, the economy could have moved straight back to Y*, at E’’. 19 ©The Mc. Graw-Hill Companies, 2002

Tradeoffs in monetary objectives • Inflation targeting works well when all shocks are demand shocks. • When shocks are supply shocks, stabilising inflation may lead to highly variable output. • Conversely, a policy of stabilising output may lead to highly variable inflation. ©The Mc. Graw-Hill Companies, 2002

Tradeoffs in monetary objectives (2) • One way round this is to to steer a middle course by using a Taylor Rule, i. e. a rule that takes into account deviations of both inflation and output from their long-run levels. • Another is to allow flexible inflation targeting – because the inflation target is a medium-run one, this allows some discretion for reducing variability in output ©The Mc. Graw-Hill Companies, 2002