Classical Theory Flashcards
What model captures financial side of the economy?
Loanable funds market (LFM)
What are the 5 characteristics of a classical model?
Closed economy Market-clearing model
All markets are perfectly competitive
Agents have complete information
Agents aim to maximise utility
2 agents
Closed market
No flows to/from abroad (no exports or imports)
Market clearing
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
What does consumption depend on? And what relationship do they have?
Disposable income (y-t)
Positive relationship-increased income, increased consumption.
What 2 simplifying assumptions do we make for consumption
T does not depend on Y (tax does not depend on income)
Consumption is not impacted by interest rates
What is MPC in the formula
MPC is the parameter before parentheses (varies with income e.g when 0.5(y-t)+1000=C
MPC=0.5
What is autonomous consumption on a graph consumption (y axis) income (x axis)
Y intercept is autonomous consumption as it is consumption when income=0
3 types of investment
Business fixed-spending on plants/equipment
Inventory-accumulation of goods inventories
Residential fixed-housing
First 2 are firms, 3rd is spending by households
What does investment depend on, like consumption depends on disposable income?
Interest rate (r)
What is relationship between investment nd interest rates? and why (2 reasons)
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
What does G not include
Transfer payments (payments in exchange for nothing e.g benefits)
Assumption for G and T
Exogenous policy variable-does not depend on anything.
T is just tax revenue for the government.
AD formula
C(Y-T) + I(r)+ G
2 components of macroeconomy
Goods and services sector (AS-AS)
Financial sector
Loanable funds market model
Demand=desire to invest
Supply=Savings
Price=interest rate
Where does the demand for Loanable funds come from
Investment from firms or consumers
Where does the supply for Loanable funds come from, and what does it look like on the diagram?
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!
Private saving formula
S=(y-t)-c
Disposable income-consumption
Public savings formula
T-g
Tax revenue not spent
National saving formula
Private+public saving
S=Y-C-G
Net taxes formula (T)
Taxes - transfer payments
What effect would expansionary fiscal policy have in LFM model
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
What effect would a demand side change such as an increase in investment demand in LFM
Rightward shift of demand curve, however as S is vertical, only pushes the interest rate up
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
Labour market assumptions (4)
Labour is homogeneous
There is a single (equilibrium) wage for labour
Workers have no bargaining power-no unions
No limit of labour supply
Why is supply of labour upward sloping and why is demand for labour downward
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
Why does the supply line then become vertical
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
What does demand and supply curve for individual worker look like and why
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
Why do classical assume no unemployment
As workers can work as much as they want because of the horizontal demand curve for individual labour
So labour force is fully utilised.
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
S=Y-C-G
None are dependent on r, so saving is independent of r
What axis for labour diagram
Real wage y axis
Quantity of labour
Real wage formula
W/P
Why is classical supply of labour vertical, not upward sloping?
We assume labour market is of fixed size, and so independent of real wage rate
Aggregate supply in classical
Vertical-as we assume output is based on production F(K,L) which is independent of price level, hence vertical
Say’s law for AD-AS in classical
Supply creates its own demand (output=income)
Output created, creates income, creating demand to buy all the output.
Classical labour market diagram +axis
Y axis-real wage (W/P) X axis-Quantity of labour
Labour supply vertical-we assume labour force is fixed
Labour demand downward
