The classical model: Say's law, the credit and labor market summarized

The classical model: Has origins from the 1770’s, and was the first real attempt to explain what determines the price level of the economy as well as the other national measures of GDP, employment, consumption, savings, and investment. Writings from classical economists continued until around 1930, the time of the great depression. Generally, these economists believed that prices and wages were flexible, and that all markets in the economy were competitive (perfectly competitive).

Say’s Law: Supply creates its own demand. J.B. Say believed that when a firm produces something (supplies it) then someone will automatically have a demand for it, the act of producing the good generates the means and ability for others to purchase that good. A simplified analogy would be you producing an Ipad and selling it for $500. You use that $500 to buy other things so the money circulates the economy and the $500 ends up back with you after someone purchases the ipad (think of the whole chicken and the egg argument).

Say also allowed for there to be an oversupply in the market, but if this occurred then prices would simply fall until market equilibrium is reached. A quick way to remember this principle is that
Income = Output, or supply = demand.

The four assumptions of the classical model:

1 All markets are perfectly competitive: This means that no one buyer or seller of a good or service can affect the market price (so no monopolies, or oligopolies).

2. Wages and prices are flexible: prices, wages, and interest rates adjust based on the market conditions of supply and demand, and are free to move until equilibrium is reached.

3. People are motivated by self-interest: Businesses want to make the most money they can (maximize their profits), and households want to have the highest well-being possible (maximize their utility).

4. People are not fooled by money illusion: This means that people respond to relative prices, rather than nominal prices. So if the price of everything and your wages double, then nothing real has changed. But if the price of hamburger goes down, and the price of hot dogs stays the same, then more hamburgers will be purchased because their relative price has gone down (think of prices as a ratio, price of hamburgers over price of hot dogs, if the ratio is the same (ie both double) then no real change has occurred).

The credit market:

Some people might think that money saved by consumers is not reflected in the GDP equation (because it will be subtracted from consumption), but the classical economists have accounted for this by assuming that every dollar saved, will be reinvested in the economy by firms. In general, businesses as a whole would only invest as much as households wanted to save.  This idea is shown on the graph to the right.  You can see that desired savings slopes up (higher interest rates mean higher willingness to save), and that desired investment slopes down (lower interest rates motivate higher investment).  Where they cross gives us the equilibrium interest rate and savings and investment amounts for the economy.

Remember that classical economists believe that savings is equal to investment, so any change in the credit market has no immediate impact on real GDP.  However, if investment (or savings) were to go up, then future time periods would see an increase in real GDP (due to capital accumulation).

Labor market: supply of labor, demand for labor and the equilibrium employment and wage rate.

 In the labor market, we again have two curves.  Labor supply (the people like you and me) slopes upward because the higher the wage, the more likely people are willing to work, or are willing to work longer hours.  Labor demand (the firms/businesses) have a downward sloping curve, because they want to pay the lowest price possible for people to work in their businesses (more accurately, the lower the wage, the more they are willing to hire). 

Where these lines cross is the equilibrium, it shows us the wage necessary to achieve full employment.  This amount of employment is directly related to the amount of Real GDP we see in our economy because labor is a very important input to the production process.

Classical theory: price level, and the vertical aggregate supply curve.

In the classical model, unemployment above the natural unemployment rate is impossible because of flexible wages. Also, since the interest rate and prices are also flexible, these will adjust to give us full employment, which means that we will always have one employment level, which translates to one level of real GDP. Since only one level of real GDP is possible, we get the vertical nature of the aggregate supply curve, or the long run aggregate supply curve (LRAS).  Any change in Real GDP results in either inflation or deflation, and we will again end up on the LRAS curve.

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