ECO 303: MACROECONOMICS THEORY I

COURSE OUTLINE:
Concept of National income
Classical, Keynesian and Monetarist Systems Compared

Classical Economics
Classical economics is a system of economic analysis which was developed in England in the late 18 th and
19th centuries before the general theory of Employment, Interest and Money, the classicals were relevant
The main representative of the classicals were the British economists like David Ricardo, John Stuart
Mills, Alfred Marshall, and Arthur Cicel Pigou, who Keynes seriously attacked.
Analysis of the classical was to explain the workings of the capitalist economics system founded on the
institution of private property.
-Constructed principles that would explain how a market structure of competitive prices functions
-Explains how resources are allocated to produce goods and services
-How total output is distributed to the owners of economic resources
-Self-interest of entrepreneurs, resources and consumers acting respectively to maximize profit, income
and satisfaction. Thus, implicit within the theoretical structure of classical economists is a set proposition
that tend to explain how the employment level is determined in an economy.
As a body of economics principles, classical economists relied upon two major assumptions:
-Pure competition – Market gives prices to every player, i.e. consumers producers
-Free play of self interest in the in the commodity and resource market that led to the desired result in the
whole economy
The concept of self-adjusting market economy was first developed by Adam Smith, the father of modern
economic analysis.
They paced more emphasis on the importance of real factors in the determination of wealth of a nation.
Hence, in their model Money was added to facilitate only transaction and as medium of exchange.
Wealth of a Nation: Results of led stock of the factors of production and advances in technique of
production but not in the stock of Gold or Silver
I. They advocated for limited government intervention in the economy and harmony of
individual and national interest is attained when the market is left without interference by
government regulations.
II. Government roles be restricted to those measure necessary for the proper functioning of the
competitive market.
III. Free market mechanism would work to provide market for any goods produced in the
economy, supply creates its own demand (Say’s law).
 IV. Consequently, on the aggregate basis production of a given commodity stimulates sufficient
demand hence there would be no surplus in those commodities. This is underlying philosophy
of the famous says law of market supply creates its own demand. 19 th century French
economist called Jean Baptiste Say (1767-1832) opined that supply creates its own demand.
He says it is production that which creates market for goods. Mo sooner is a product created
than it affords a market for other products to the full extent of its values. Nothing is more
favorable to the demand of one product than the supply of others
- The original form of the law is only applicable to an economy that is in Autarky ( i.e. where there
is no foreign-trade-closed economy).
- The belief that supply of goods can’t exceed their demand.
- To them interest is reward for savings, and they are positively related.

Assumptions/Characteristics of the Classicals School

1. Full employment, no inflation
2. Autarky-Laissez Faire
3. Perfect competition in both labor and commodity markets
4. Labor is homogenous
5. Total output is distributed between consumption and investment
6. Wages and prices are flexible
7. The quantity of Money in the economy is given and fixed
8. Stock of capital and technology are given in the short run
9. Money wages and real wages are directly related and proportional.
Therefore, the assumption in that there is perfect competition and that there is vertically integrated
industry that controls input and output each firm only has workers and produces only final goods with a
given capital stock and natural resources. Each firm tries to maximize its profit. The unit of labor are
quantitatively homogenous force and the labor market has all the features of perfect competitive system

NB:
Read more on:
Vertical Integration
Horizontal integration

The Classical Economic Model

A model of the economy. The main building blocks of the model are production, employment, and
equilibrium output.
Production
Aggregate production is the central relationship in the classical model. Here the level of output as a
function of factor inputs of capital stock and labor value. Symbolically, the
Y = f (K, L)
In the short-run, classicals assume that capital is fixed while the state of technology and population are
held constant to this effect, in the short-run output varies mainly with variation in the labor input.
However, this occurs at a diminishing rate (See Fig 1. Below). Furthermore, the marginal product of labor
(MPL) is a downward sloping curve. This is equal to zero at the point where the production function is
optimal (see Fig 2. Below)
Employment
The factor input that varies in the classical model is the quantity of labor by labor employment in the
production process, they assume that the labor market works well. Here firms and individual workers
optimize there is no barrier to the adjustment to Money wage while the market clears itself to this effect,
the quantity of labor employed is determined by demand and supply in the labor market.
Real wage means the Money wage divided by the general price level, p.

W = W ---------------- 1.2
P
Note that the real wage will fall if the general price level rises. However, many wages will remain
constant, because at such a decline the purchasing power of any given Money wage increase while the
general price level remains constant.
In classical thinking, the demand for labor is a function of the real wage symbolically represented thus;

N = f(w) -----------------1.3

The equilibrium we have earlier described, retains to the employment of an individual firm but the same
reasoning may be applied to the whole economy for short period of time for the economy, as well as for
individual firm labor in the variable input. Employment for the whole economy can be increased up to the
point at which marginal product of the last increment of employed labor workers is just equal to the real
wage. This is a condition of employment equilibrium for the whole economy.

If ΔY stands for the change in real output and ΔN for the change in employment level
Then;
ΔN is the change in marginal product of labor for the whole economy. Therefore, the
equilibrium
ΔY condition is the employment level at which the marginal product of labor equal the real wage
this is symbolically expressed as:

ΔY = W --------------- 1.4
ΔN P

We can, therefore, conclude from the above, that the necessary condition for profit maximization is
ΔYP = NW

In this equation the monetary value of the increment of output equals the monetary cost exchange for last
increment of output. From the above it is important to note the aggregate demand curve for labor is
identical with the individual firm demand schedule for labor as shown in figure 3 below, the aggregate
demand schedule slopes downward to the right other things being equal, the volume of employment for
whole economy varies inversely with the level of real wages

Fig 3: The classical demand schedule for labor. Regarding the aggregate schedule for labor classical
ideas concerning the supply schedule of labor may be expressed as N = f (U)--------------5
In the above equation N represents the number of workers in the labor force actively seeking employment
however supply schedule may be interpreted to mean not only the number of worker but also the hours of
labor supply by both old and workers. The equation simply stated that the supply schedule of labor is a
positive function of the real wage. Here the supply schedule curve for labor in the classical system has a
positive slope see (figure 4). This means that the number of workers seeking employment is a function of
real wage rate. this is perfectly due to the classical assumption that the worker in selling his service in the
labor market seeks to maximize his income in the same the entrepreneur seeks to maximize his profit.
The equilibrium level of employment

The demand for labor and supply of labor are important in the classical system when brought together
they eventually determine both the employment level and the real wage moreover, the classical demand
and supply schedule for labor normally intersect at the level of full employment the process by which
employment and real wage are actually determined in the classical analysis is shown in (figure 5) Below
Fig 5: the Equilibrium level of employment
In the figure dd represent the demand schedule for labor while ss is the supply schedule for labor using
these two schedules competition in the market among employers for worker and among workers for
employment will drive the real wage and the employment to the values represented at the point of
intersection of the two schedules. As long as the two schedules do not slide to alter level of their
employment or real wage full employment prevails if subsequently real wage were at the represented by
W, the number of workers actually seeking employment is equals to the distance ON. However, at W
level of real wage the amount of labor demanded will be equal only to the distance ON2 consequently,
N1, N2 represent the supply of workers seeking employment of at the prevailing level of real wage but
not employed.

Certainly, competition for employment among these workers will lead some of them to offer their service
to prospective employers at reduced Money income as a result of this development the real wage will
decline assuming other things remain constant. Eventually employment will increase. Consequently, the
equilibrium in the labor market will prevail at the level of real wages Wo and the level of full employment
NF. This is the classical explanation of how the condition of full employment is determined in the
economy.

Classical Macroeconomic System

Classical Economics is a school of economic thought which stresses that economic function most
efficiently if one is allowed to pursuit their self-interest, in an environment of free and open competition
based on the ideas of 18th & 19th century British economists from Adam Smith (1723-1790) through
Alfred Marshall (1842-1846). Also called the classical school of economic thought.
It is an English school of economic thought (idea) that originated during the late 19 th century with Adam
Smith and reached maturity in the works of Davis Ricardo and John Stuart Mill. The theories of the
classical school, which dominated economic thinking in Great Britain until about 1870, focused on
economic growth and economic freedom, stressing laissez-Faire ideas and free competition. Many of the
fundamental concepts and principles of the classicals were set forth in Smith’s “Enquiry into the Nature
and the Causes of the Wealth of Nation” (1776). Strongly opposed to the Mercantilist theory and policy
that had prevailed in Britain since the 16 th century. Smith argued that free competition and free trade,
neither hampered nor cuddled by government, would best promote a nation’s economic growth. As he
saw it, the entire community benefits most when each of its members follows his/her own self-interest. In
a free enterprises system individuals make profit by producing goods and services that other people are
willing to buy. By the same taken individuals spend Money for goods that they want or used most.

Classical Economic Assumptions: Classical economic, especially as directed towards macroeconomics

relies on three key assumptions:
1. Flexible prices
2. Say’s law
3. Saving-investment equality
Flexible prices ensure that markets adjust to equilibrium to eliminate shortages and surpluses

Keynesian Macroeconomic Model

The nature of Keynesian Economics:
Based on Say’s law market, the classicals believe that market economies was self-adjusting, so the need
for government intervention the 1st and 2nd world wars which brought the great depression disapproved
the classical thinking
In his famous book “The General Theory of Employment, Money and Interest “(1936), John Maynerd
Keynes argued that there was a potential instability in the capitalist economy which the market idea cant
solve. He therefore advocated for government intervention through the use of fiscal policy to stimulate
aggregate demand.
Fiscal policy refers to the measure of government to intervene in the economy through the key
instruments of government revenue, generated by the means of taxation and expenditure programs

To the classicals market forces could bring about full employment ensuring economic stability to them,
this was the ultimate goal of macroeconomic policy based on the firm belief on the Say’s law market
Keynes argued that the forces of demand and supply couldn’t achieve full employment because the
aggregate demand structure has shortened periodic deficiency tendencies in the economy and the
attendant decline in production.
Keynes therefor argued that these deficiencies of demand and subsequent decline in production and
employment can be stimulated using government intervention.
This can be done by the way of government taxation and expenditure on public goods that will
stimulate the economy to further activities, the multiplier and acceleration principles
This new thinking by Keynes ushered in a new era in economic thinking policies.
Fiscal policy brings about government active participation and regulation and investment in the aggregate
economic activities
Keynes says changes savings and investment are necessary for changes in business activities and
employment in an economy, He therefore, advocated for fiscal by by government through deficit
financing to tackle economic depression.
Fiscal policy of government involves taxation, debt and expenditure has to be anti-cyclical in behavior
Government spends more in a depression and less in a prosperity by fiscal policy measures to bring
macroeconomic stability.
It is intended to ensure adequate allocation of income and employment levels of the economy, distribution
of resources to and optimum allocation of productive resources.
Ultimately brings reduction in inequalities in income and wealth
The Simple Keynesian Model
The basic assumption is that for a level of output to be in equilibrium level, aggregate supply must be
equal o aggregate demand
Thus; GNP = C+I+G
Where
GNP = Gross National Product
C = Aggregate Expenditure Consumption
I = Private Investment
G = Government Purchases for Goods and Services
But the model is for closed economy where here is no foreign trade (Autarky).
Is it also assumed that Gross National Product (GNP) are equal, depreciation neglected.
Income is the major variable, and some variables used in the classical model feature, except that for each
nominal value there is a real income components (Y), real employment (I), Nominal Money
supply (M), Interest rate (R), Nominal and real wages (WO and WC), and the price level (P).
In the Keynesian system, there are three markets;
I. Product
II. Money
III. Labor
In each there are demand and supply
Components of Aggregate Demand
The simple Keynesian model for equilibrium is expressed in terms of the components of aggregate
demand. These are consumption, investment, and government expenditures.
The Role of Money and Interest in Keynesian Theory
The liquidity preference concept forms the core of modern analysis of Money and its role in the economy.
Keynes argued that there are 3 motives for holding Money in liquid form instead of in its other
form.
These motives are;
1. Transaction
2. Precaution
3. Speculation

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