Chapter 3: Classical Macroeconomics (I) : Output and Employment

CHAPTER 3: CLASSICAL MACROECONOMICS (I):
OUTPUT AND EMPLOYMENT

CHAPTER OVERVIEW
The chapters in Part II analyze the major macroeconomic models. Chapter 3 is the first of two
chapters on the classical macroeconomic model and deals with the classical theory of output and
employment.
After an introductory section that explains the background for the development of classical
economics as an attack on the mercantilist position, the classical equilibrium model is presented. The
building blocks of the classical system are derived, including the aggregate production function, the labor
demand schedule, and the labor supply schedule. With these relationships, the classical aggregate supply
schedule is derived. The vertical aggregate supply schedule is used to illustrate the supply-determined
nature of output and employment in the classical system. The effects in the labor market of an increase in
the aggregate price level are analyzed to show how the money wage must rise proportionately to restore
equilibrium (Figure 3-5). The real wage and, as a consequence, the level of employment are unchanged.
Given the supply-determined nature of output in the classical system, factors such as changes in the
quantity of money do not affect output.
Two assumptions in this classical theory of output are:
1. Perfectly flexible prices and wages.
2. Perfect information on the part of all market participants about market prices, in this case the
relevant market price being the real wage.
We return to the discussion of these assumptions when other macroeconomic systems are
discussed.
ANSWERS TO QUESTIONS IN CHAPTER 3

1. First, the classical economists attacked the mercantilist notion of bullionism, the belief that the wealth
of a nation was closely tied to its stock of precious metals. The classical economists argued that real
factors, the productive resources in the economy, were the important determinants of the wealth of a
nation. This led them to the view that money had no intrinsic utility; it was useful only in facilitating
transactions. In their theory, therefore, they confined money to this transaction function and
neglected, for the most part, other roles for money, including possible monetary effects on the short-
run level of economic activity.
Second, the classical economists attacked the mercantilist belief in the need for state action to direct
the capitalist system. They stressed the optimizing tendencies of the free market. This view led them
to noninterventionist conclusions in the area of macroeconomic policy as well.
2. An aggregate production function gives the level of output that will be produced for given levels of
the factor inputs, capital, and labor. In the short run, the stock of capital (K) is fixed. Output (y)
varies, as shown in Figure 3.1, as we change the labor input. An increase in the average and marginal
productivity of labor, due to increased education of the labor force, would shift the F (K, N) schedule
upward in Figure 3.1. Because the slope of this curve is the marginal productivity of labor (MPN), the
curve would become steeper at each point.
3. On the demand side of the labor market, firms maximize profits by moving output to the point where
marginal cost (W/MPN) equals price (P), or equivalently the real wage (W/P) is equated with the
marginal product of labor (MPN). For a given real wage, the firm moves to the point along the
marginal product of labor schedule at which this latter equality holds. If the equality does not hold,
the firm can increase profits by changing the amount of labor demanded. Because the marginal
product of labor declines as employment increases, this implies that the quantity of labor demanded
varies inversely with the level of the real wage.
The classical theory of labor supply assumed that individuals maximize utility, which depends
positively on leisure and consumption of goods. There is, then, a labor leisure trade-off because the
individual must work (give up leisure) in order to earn income, with which to buy goods. The real
wage represents the terms by which the individual can trade off leisure for income. With the
assumptions made in the text, as the real wage rises, making this trade-off more favorable, the
individual increases labor supply.
4. A change in taste with leisure becoming more valuable would cause indifference curves in Figure
3.3a to rotate such that they are steeper at a given level of labor supplied. This reflects the fact that
with a higher value placed on leisure, to maintain a given level of utility as employment increases
(and leisure declines), the individual requires a greater income payment. With steeper indifference
curves, a given real wage line will be tangent to an indifference curve at a lower employment level;
less labor will be supplied at each level of the real wage. In terms of Figure 3.4, the labor supply (Ns)
schedule will shift to the left. Employment, and therefore output, will fall; the real wage will rise.
5. The key assumptions underlying the classical auction market characterization are:
a. Perfectly flexible prices and wages.

b. Perfect information on the part of all market participants about market prices.
6. At the level of the firm we are able to assume that the money wage is given. An increase in the price
level lowers the real wage. The firm then hires more workers until the marginal product of labor
declines sufficiently to again equal the real wage. In the aggregate we cannot, in general, assume that
the money wage is fixed. In the classical system, to clear the labor market the money wage must rise
proportionately with increases in the price level. There is, as a consequence, no decline in the real
wage and output does not increase; the aggregate supply schedule is vertical.
7. The major determinants of output and employment in the equilibrium version of the classical system
are the factors that determine the level of aggregate supply. These include factor supplies (labor and
capital) and the state of technology in the economy. Aggregate demand is not a determinant of output
and employment in the classical system.
8. An increase in the capital stock leads to an upward shift in the labor demand curve, which increases
the equilibrium real wage and quantity of labor. The production function shifts upward, and in
addition there is a movement along the new production function as labor increases. The aggregate
supply curve shifts to the right.
9. A reduction in the money wage would necessitate a reduction in the marginal product of labor by
increasing the quantity of labor. The aggregate supply schedule in Figure 3-6 would shift to the right.

Chapter 3: Classical Macroeconomics (I) : Output and Employment

Uploaded by

Copyright:

Available Formats

Chapter 3: Classical Macroeconomics (I) : Output and Employment

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Chapter 3: Classical Macroeconomics (I) : Output and Employment

Uploaded by

Copyright:

Available Formats

CHAPTER 3: CLASSICAL MACROECONOMICS (I):

OUTPUT AND EMPLOYMENT

Two assumptions in this classical theory of output are:

1. Perfectly flexible prices and wages.

ANSWERS TO QUESTIONS IN CHAPTER 3

a. Perfectly flexible prices and wages.

You might also like