Classical Theory

Question 1

What model captures financial side of the economy?

Answer 1

Loanable funds market (LFM)

Question 2

What are the 5 characteristics of a classical model?

Answer 2

Closed economy Market-clearing model
All markets are perfectly competitive
Agents have complete information
Agents aim to maximise utility

2 agents

Question 3

Closed market

Answer 3

No flows to/from abroad (no exports or imports)

Question 4

Market clearing

Answer 4

Prices are flexible, they adjust quickly to bring S&D into equilibrium.

Unlike sticky prices, where demand does always meet supply and slow to adjust

Question 5

What does consumption depend on? And what relationship do they have?

Answer 5

Disposable income (y-t)

Positive relationship-increased income, increased consumption.

Question 6

What 2 simplifying assumptions do we make for consumption

Answer 6

T does not depend on Y (tax does not depend on income)

Consumption is not impacted by interest rates

Question 7

What is MPC in the formula

Answer 7

MPC is the parameter before parentheses (varies with income e.g when 0.5(y-t)+1000=C

MPC=0.5

Question 8

What is autonomous consumption on a graph consumption (y axis) income (x axis)

Answer 8

Y intercept is autonomous consumption as it is consumption when income=0

Question 9

3 types of investment

Answer 9

Business fixed-spending on plants/equipment
Inventory-accumulation of goods inventories
Residential fixed-housing

First 2 are firms, 3rd is spending by households

Question 10

What does investment depend on, like consumption depends on disposable income?

Answer 10

Interest rate (r)

Question 11

What is relationship between investment nd interest rates? and why (2 reasons)

Answer 11

Inverse, when r is high borrowing becomes expensive so investment falls (vice versa for lower)

Even if investment is not financed by loans, in terms of opportunity cost as banks saving could be fruitful

Question 12

What does G not include

Answer 12

Transfer payments (payments in exchange for nothing e.g benefits)

Question 13

Assumption for G and T

Answer 13

Exogenous policy variable-does not depend on anything.

T is just tax revenue for the government.

Question 14

AD formula

Answer 14

C(Y-T) + I(r)+ G

Question 15

2 components of macroeconomy

Answer 15

Goods and services sector (AS-AS)
Financial sector

Question 16

Loanable funds market model

Answer 16

Demand=desire to invest
Supply=Savings
Price=interest rate

Question 17

Where does the demand for Loanable funds come from

Answer 17

Investment from firms or consumers

Question 18

Where does the supply for Loanable funds come from, and what does it look like on the diagram?

Answer 18

Saving from households or government if in a budget surplus

2 options
Vertical line as S=Y-C-G which are not dependent on r, so S is independent of r
Or
Upward sloping if we assume not independent of r, e.g if we say high interest rates increase saving.

Choose which one you use and make sure you state so!

Question 19

Private saving formula

Answer 19

S=(y-t)-c
Disposable income-consumption

Question 20

Public savings formula

Answer 20

T-g

Tax revenue not spent

Question 21

National saving formula

Answer 21

Private+public saving

S=Y-C-G

Question 22

Net taxes formula (T)

Answer 22

Taxes - transfer payments

Question 23

What effect would expansionary fiscal policy have in LFM model

Answer 23

Either increase gov spending or decrease taxes

If G increases, supply (savings) falls, as S=Y-C-G

So interest rate increase

Fiscal policy creates a supply side change in terms of LFM model

Question 24

What effect would a demand side change such as an increase in investment demand in LFM

Answer 24

Rightward shift of demand curve, however as S is vertical, only pushes the interest rate up

Question 25

Note:it is possible too have an upward sloping LFM supply curve, as if interest rates are higher, it means saving should increase. THEREFORE ESSENTIAL TO STATE ASSUMPTIONS WHEN MAKING MODEL

Question 26

Labour market assumptions (4)

Answer 26

Labour is homogeneous
There is a single (equilibrium) wage for labour
Workers have no bargaining power-no unions
No limit of labour supply

Question 27

Why is supply of labour upward sloping and why is demand for labour downward

Answer 27

Willing to supply more as wage increases, however not the actual classical view as not realistic! Explained later

As wage rate increases, demand decreases as more expensive

Question 28

Why does the supply line then become vertical

Answer 28

As labour is finite, it cannot keep increasing so at a point it becomes independent of the real wage rate.

It will stop increasing at a point despite wages going up still

Question 29

What does demand and supply curve for individual worker look like and why

Answer 29

Horizontal demand-they can work as much as they like at the wage rate, they operate where marginal benefit (wage)= marginal cost of working

This explains why in classical, everyone who wants to work is able to find a job, labour force is fully utilised, should be no unemployment at

Question 30

Why do classical assume no unemployment

Answer 30

As workers can work as much as they want because of the horizontal demand curve for individual labour

So labour force is fully utilised.

Question 31

Why is saving/ supply curve in LFM model vertical?
Of course remember we could assume saving is dependent on r, creating an upward sloping supply curve

Answer 31

S=Y-C-G
None are dependent on r, so saving is independent of r

Question 32

What axis for labour diagram

Answer 32

Real wage y axis
Quantity of labour

Question 33

Real wage formula

Answer 33

W/P

Question 34

Why is classical supply of labour vertical, not upward sloping?

Answer 34

We assume labour market is of fixed size, and so independent of real wage rate

Question 35

Aggregate supply in classical

Answer 35

Vertical-as we assume output is based on production F(K,L) which is independent of price level, hence vertical

Question 36

Say’s law for AD-AS in classical

Answer 36

Supply creates its own demand (output=income)

Output created, creates income, creating demand to buy all the output.

Question 37

Classical labour market diagram +axis

Answer 37

Y axis-real wage (W/P) X axis-Quantity of labour

Labour supply vertical-we assume labour force is fixed

Labour demand downward