Home Economics Essentials of Macroeconomics

## The classical model## Introduction"The classical model" was a term coined by Keynes in the 1930s to represent basically all the ideas of economics as they apply to the macro economy starting with Adam Smith in the 1700s all the way up to the writings of Arthur Pigou in the 1930s. In this chapter I will describe the main characteristics of what we now call the classical model and how the macroeconomic variables are determined in this model. As discussed in the previous section, we focus on the cycles and all the components included in the GDP (consumption, investment, imports and exports) are variables where the trend has been removed. The classical model in this chapter will not discuss the determination of the exchange rate. In chapter 16 we will look at an extension of the classical model which will also include the exchange rate. ## Labor MarketWe begin by describing the classical model of the labor market. ## Demand for labor
Profit-maximizing firms will want to employ labor up to the point where the marginal product of labor We have previously assumed that W/P. is decreasing in MPL and the demand for labor can be illustrated in the following graph.L
From the graph you can conclude that the increases and/or if W decreases but it will not change if P and W increase by the same percentage.P In the classical model, markets are characterized by perfect competition and the firms cannot affect ## The supply of labor
The total labor supply is determined by utility-maximizing individuals. The total labor supply is also affected by the real wage. An increase in the real wage has two effects: • Income Effect: With a higher income, individuals will want to consume more leisure (as long as leisure is a normal good). Higher real wages will lead to a lower labor supply. • Substitution Effect: A higher real wage will make leisure relatively more expensive, causing individuals to substitute leisure for consumption. Higher real wages will lead to a higher labor supply. The overall effect of a change in real wages is the sum of the income and substitution effects. For some individuals, the substitution effect will be stronger than the income effect and they will increase the labor supply as the real wage increases and for some it will be the opposite. In the classical model it is always assumed that the aggregate labor supply increases when real wages increase (the substitution effect is stronger than the income effect). ## Equilibrium in the labor market
Without government intervention and trade unions, the labor market will always be in equilibrium in the classical model. This means that the real wage will be equal to the
It is also clear from the graph that the total amount of labor If real wages are higher than the equilibrium real wage, the demand for labor will be less than the supply. The difference is the amount of unemployment beyond the natural rate of unemployment. In equilibrium, there is therefore no "involuntary" unemployment in the classical model. |

< Prev | CONTENTS | Next > |
---|

Related topics |

Academic library - free online college e textbooks - info{at}ebrary.net - © 2014 - 2019