Handout_2_8-21-2011(1) - Classical Macroeconomics(chapters...

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1 Classical Macroeconomics (chapters 3 & 4 in R. Froyen, 9ed) Chapter 3 “… Equilibrium Output and Employment” A Timeline of Economic Theory Mid 1930s Mid 1970s ... Classical Theory Keynesian Theory Monetarist Theory …. Classical Theory 1. Competitive equilibrium: prices and allocations such that agents optimize and markets clear. 2. Stability: when an economy is not in equilibrium, market forces act so as to move the economy toward the equilibrium. 3. There was no distinction between macro and micro economics. 4. Implication for policy: because of the self correction nature of the economy, the role of the government is minimal. 2 Keynesian Theory 1. Keynesians take issue with the stability assumption and argue that markets are not stable because of frictions that restrict price movements (e.g. wage rigidity in labor market). 2. Economic agents’ expectations are backward- looking because the expectation of a variable such as the price level adjusts (slowly) to the past behavior of the variable. 3. Differentiate between micro and macro economics. 4. Implication for the policy: During the recessions various stimulative demand policies may be useful. These include: a. Increasing government expenditures (G), b. Decreasing taxes (T), c. Decreasing interest rate (r). 3 Monetarist Thinking 1. Somewhat hybrid between classical and Keynesian thinking: a) Agrees with Keynesians about the stickiness of the prices, b) Agrees with classical economists on the size of the “h” parameter in the money demand expression (slope of LM curve which we will discuss in more detail later on). 2. These imply that monetary policy is very powerful. 3. Although monetary policy is powerful, monetarists do not advocate its use for business cycle correction. Instead, they argue the primary objective of the Central Bank should be price stability, and this can be obtained through a constant money growth rule. 4 The Classical Model The classical model assumed a closed economy (no international trade) comprising a real and nominal sector. Two key features of the classical analysis: 1. Classical economics stressed the role of real as opposed to nominal (monetary) factors in determining output and employment levels. There is no connection between the real and nominal sector; money serves merely as a medium of exchange, hence changes in money supply had no impact on real variables). 2. Classical economics stressed the self-correcting market mechanism as a way of maintaining full employment equilibrium. Full employment was a normal state of affairs. If the classical view is correct then government intervention, in the form of stabilization policies, are unnecessary and generally leave the economy worse off (e.g. inflation).
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5 A. Key Assumptions of Classical Model 1. Competitive Equilibrium: A competitive equilibrium is prices and allocations such that agents optimize and markets clear. In the classical framework this implies perfectly flexible prices and wages, and simultaneously, that agents are rational and have stable expectations due to perfect information about
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This note was uploaded on 10/10/2011 for the course ECONOMICS 8220 taught by Professor Markwohar during the Fall '11 term at UNO.

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Handout_2_8-21-2011(1) - Classical Macroeconomics(chapters...

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