Principles of Economics 6.2 - Classical Theory

Question 1

What’s a ‘closed economy’?

Answer 1

An economy that does not have any flows to /
from other economies in the rest of the world i.e. no imports or exports Imagine the circular flow of income but without the flows of import and export expenditure to / from overseas.

Question 2

Explain what ‘market clearing’ is

Answer 2

Market clearing
* What about “market clearing”? What does this mean?
* An important concept: flexible versus ‘sticky’ prices.
* Flexible: prices adjust quickly to bring S & D into equilibrium.
* Sticky: D doesn’t always equal S; variables can be slow to adjust.
* An economy’s behaviour depends on whether prices are flexible.
* The assumption of flexible prices is analogous with market clearing.
* The classical school of thought assumes flexible prices.
* Today we will assume that economic agents are rational, all
markets are perfectly competitive, and agents have complete
information. These assumptions assure ensure that all markets clear
in the classical model(s).

Question 3

Explain ‘consumption’ in classical AD-AS

Answer 3

• It’s a part of AD
• Consumption is spending by households (individuals) on final
  goods and services.
• Consumption depends on disposable income, Y-T.
• Y = Income, T = Net Taxes (taxes minus transfer payments).
• Note: for simplicity, we might think of this ‘T’ as income tax. However, by
  virtue of the fact that we assume that households own firms, it also
  implicitly includes taxes on firms (e.g. corporate tax).
• In general functional form, we can state that C(Y-T)
• Note some simplifying assumptions we are making:
• T does not depend on Y.
• C is not impacted by interest rates.
• A specific functional form of the C function could be something
  like (these are just made-up examples):
• C = 500 + 0.75(Y-T)
• C = 250 + 0.6(Y-T)
• C = 1000 + 0.5(Y-T)
• I.e. something with a constant and then a parameter before the Y-T term.
• Note: consumption and disposable income share a positive
  relationship. Further note:
• In these examples, the constant term represents autonomous
  consumption – consumption that is independent from the income level.
• The parameter before the parentheses is marginal propensity to
  consume (MPC), which varies with income.

Question 4

Explain MPC

Answer 4

Marginal propensity to consume
* MPC captures households’ inclination to spend their income (as
opposed to the alternative, which is saving).
* MPC will take some value between 0 and 1.
* It indicates the proportion of disposable income that is devoted to
consumption (as opposed to saving).
* If we were to draw a consumption function, plotting consumption (C)
against disposable income (Y-T):
* The intercept on the C axis would be the level of autonomous
consumption.
* The slope of the line would be the MPC.
MPC = deltaC/delta(Y-T)

Question 5

Explain ‘investment’ in classical AD-AS

Answer 5

• Investment is defined as spending on things that are not
  immediately consumed, but rather used in production or stored for
  later.
• Investment can be divided into three categories:
  1. “Business fixed investment”: spending on plants & equipment.
  2. “Inventory investment”: the accumulation of goods inventories.
  3. “Residential fixed investment”: spending on housing units.
• Note that (1.) & (2.) represent spending by firms, (3.) is typically by
  households.
• The level of investment depends on the interest rate, r
• r specifically denotes the real interest rate.
• (In later lectures we will distinguish between real and nominal interest
  rates but don’t worry about this for now).
• General functional form of the I function: I = I(r)
• Why does I depend on r?
• Well, we typically view investment as being funded by loans from banks
  (on a simple level).
• More generally, r captures the cost of borrowing… and we can also
  think about r in terms of opportunity cost
• I and r have an inverse (negative) relationship.
• If we were to draw the investment function, plotting I against r, it would be
  downward-sloping.
• On an intuitive level we can understand why investment and interest
  rates have a negative association.
• If interest rates are higher then loans for investment are more
  expensive and so less loans are taken out… thus less investment
  occurs… and vice versa.
• Alternatively, in terms of opportunity cost: if funds are invested (rather
  than deposited in the bank), the interest rate captures what is
  foregone in terms of interest earnt on those deposits.

Question 6

Explain classical AD

Answer 6

AD is defined as the total demand for all of the final goods and
services in the economy.
* We can derive AD for a closed economy by adding together the
functions for consumption, investment and government spending:
AD = C(Y-T) + I(r) + G
* When we plot AD against axes bearing the overall price level (P) and
income/output (Y) we produce a downward-sloping line, similar to
microeconomic demand.
* Important: do not think of AD in the same way as you think of
microeconomic demand; they are not the same
- We might think that AD is downward-sloping because
when the price level is higher people in the economy
wish to buy fewer goods – but this is misleading
The reason AD slopes downward is actually to do with
the amount of money in the economy