Potential output

• Generally thought of as the maximum level of output that an

economy can be sustained without generating inflationary pressure
(Okun, 1962). This definition is particularly prevalent among
monetary policy makers, as it allows them to communicate their
policy stance in the context of the short-run tradeoff between output
and inflation.
The Mercantilism

• Mercantilism . Mercantilist thought was associated with the rise of the

nation state in Europe during the sixteenth and seventeenth centuries.
Two tenets of mercantilism were:
1. Bullionism: belief that the wealth and power of a nation were
determined by its stock of precious metals.
2. Belief in the need for state action to direct the development of the
capitalist system.
• Adherence to bullionism led countries to attempt to secure an excess of exports
over imports to earn gold and silver through foreign trade. Methods used to
secure this favorable balance of trade included export subsidies, import duties,
and development of colonies to provide export markets. State action was
believed to be necessary to cause the developing capitalist system to further
the interests of the state. Foreign trade was carefully regulated, and the export
of bullion was prohibited to serve the ends of bullionism. The use of state
action was also advocated on a broader front to develop home industry, to
reduce consumption of imported goods, and to develop both human and
natural resources.
• Money spurred economic activity. In the short run, mercantilists argued, an
increase in the quantity of money would lead to an increase in demand for
commodities and would stimulate production and employment.
 Classical School of Thought in Economics
• The classical model provides the starting point for challenges that have been
mounted against the Keynesian theory by monetarists, new classical
economists , and real business cycle theorists .
• Classicists: Adam Smith (Wealth of Nations , 1776), David Ricardo (Principles of
Political Economy, 1817), and John Stuart Mill (Principles of Political
Economy,1848).
• Neoclassicists : Alfred Marshall ( Principles of Economics , 1920) and A. C.
Pigou (The Theory of Unemployment, 1933).
Keynes: Macroeconomic theory of the classicists and new was similar enough to
be dealt with as a whole.
Classicists: the equilibrium level of output would always converge to full
employment. Actual output would converge to potential output. No output gap
 The Classical Revolution
• Classical economics emerged as a revolution against a body of economic
doctrine of mercantilism.
• Importance of real factors in determining the “wealth of nations” and stressed
the optimizing tendencies of the free market in the absence of state control.
• Primarily real analysis; the growth of an economy was the result of increased
stocks of the factors of production and advances in techniques of production.
• Money played a role only in facilitating transactions as a means of exchange .
Most questions in economics could be answered without analyzing the role of
money (veil).
• Mistrusted government and stressed the harmony of individual and national
interests when the market was left unfettered by government regulations,
except those necessary to ensure that the market remained competitive.
• Stress on real factors and the belief in the efficacy of the free-market
mechanism—developed in the course of controversies over long-run questions
concerning the determinants of economic development.
• These classical positions on long-run issues were, however, important in shaping
classical economists’ views on short-run questions.
Classical economics stressed:

1. the role of real as opposed to monetary factors in determining

output and employment. Money had a role in the economy only as
a means of exchange.
2. the self-adjusting tendencies of the economy.
3. Government policies to ensure an adequate demand for output
were unnecessary and generally harmful.
The classical model
• Production
• Employment
• Equilibrium Output and Employment
Aggregate Production function

Relationship
between total inputs
and total outputs
assuming a given
technology.

Diminishing marginal
returns to a factor
Employment - Labor
Demand and Supply
• Assumptions: The market
works well. Firms and
individual workers optimize.
They have perfect information
about relevant prices. There
are no barriers to the
adjustment of money wages;
the market clears. Marginal
productivity theory. The firm
will hire up to the point where
the additional output obtained
by hiring one more worker
(MPN) is just equal to the real
wage (W/P) paid to hire that
worker.
• The condition for profit maximization is met at the point where the
real wage ( W/P ) is equated with the MPN. If the real wage is 8, then
the firm will maximize profits by hiring 3 workers because the MPN is
8. This is shown at point D on the graph of the demand for labor,
MPN. In order to get the firm to hire more labor, the real wage must
fall because the additional output produced by each additional
worker is declining.
LABOR SUPPLY
This depicts the individual’s labor–leisure
choice. The individual will supply labor (Nj s)
up to thepoint where the rate at which labor
may be traded for leisure in the marketplace,
which is given by the real wage (W/P ) and is
equated with the rate at which the individual
is willing to trade labor (give up leisure) in
return for income, which is measured by the
slope of the individual’s indifference curves
(U1, U2, U3). At a real wage of 2.0, the
individual will choose 18 hours of leisure,
point A on the income–leisure trade-off
graph. Hours of work chosen will then be 6
(24 hours in the day 18 hours of leisure). This
is shown at point A on the labor supply curve.
At a real wage of 3.0, the individual will
choose 16 hours of leisure, point B on the
income–leisure trade-off graph.
LABOR SUPPLY b. Labor Supply Curve • Hours of work chosen will
then be 8 (24 hours in the day
16 hours of leisure). This is
shown at point B on the labor
supply curve. At a real wage of
4.0, the individual will choose
15 hours of leisure, point C on
the income–leisure trade-off
raph. Hours of work chosen
will then be 9 (24 hours in the
day 15 hours of leisure). This
is shown at point C on the
labor supply curve.
• Two features of the classical labor supply theory require further comment.
1. The wage variable is the REAL wage. Labor supply is determined by the W/P, not the money
wage. The worker receives utility ultimately from consumption, and in making the labor–
leisure decision, the individual is concerned with the command over goods and services
received for a unit of labor.
2. The SL is positively sloped; more labor is assumed to be supplied at higher W/P. This relation
reflects the fact that a higher W/P means a higher price for leisure in terms of foregone
income. At this W/P, we assume that the worker will choose less leisure. This effect is
analogous to the substitution effect in the theory of consumer demand. There is another
effect: the equivalent of the income effect in consumer demand theory. As W/P increases,
the worker is able to achieve a higher level of real income.
Backward Bending SL: At higher levels of real income, leisure may become more desirable relative
to further increments in income. With successive increases in the W/P, a point may be reached at
which the worker chooses to supply less labor as the W/P increases and consumes more leisure.
At this point, the income effect outweighs the substitution effect; the SL assumes a negative slope
and bends back toward the Y axis. Almost certainly, at extremely high wage rates, we would
reach a backward-bending portion of the SL, and perhaps W/P need not be so “extremely” high.
The empirical evidence is inconclusive, we will assume that the aggregate SL does have a positive
slope; the substitution effect outweighs the income effect.
Equilibrium Output and Employment
THE DETERMINANTS OF OUTPUT AND
EMPLOYMENT
• Endogenous variables: Output, employment, and the real wage
are designated as the endogenous variables (determined by the
solution of the model).
• Exogenous Variables: Determined outside the model, and if
change, these cause changes in output and employment.
• Technical change
• capital stock changes
• Changes in productivity of labor
• size of the labor force changes (Population growth)
• changes in individuals’ preferences regarding labor–leisure trade-offs
• A common feature of the factors determining OUTPUT in the classical
model is that all are variables affecting the supply side of the market
for output—the amount firms choose to produce. In the classical
model, the levels of output and employment are determined solely by
supply factors.
• Because the supply-determined nature of output and employment is
a crucial feature of the classical system.
Classical Output and Employment Theory
Part a depicts labor
market equilibrium at the
real wage (W/P)0 at
equilibrium point A. In
the aggregate, labor
supply equals labor
demand, Nd = Ns.
Equilibrium employment
is N0. Substitution of
equilibrium employment
into the production
function in part b
determines equilibrium
aggregate output, Y0 at
point A.
Labor Market Equilibrium and the Money Wage
• Part a shows equilibrium
employment (at N1 )
where labor supply equals
labor demand.
W = MPN xP • In part b labor supply and
demand are plotted as
functions of the money
wage. Increases in the
price level (from P1 to 2P1,
then to 3P1 ) shift the
labor supply and demand
schedules upward
proportionately.
• The money wage rises
proportionately with the
price level (from W1 to
2W1, then to 3W1 ). The
real wage and level of
employment are
unchanged.
Classical Aggregate Supply Curve

• The vertical classical

aggregate supply curve
reflects the fact that higher
values of the price level
require proportionately higher
levels of the money wage for
labor market equilibrium. The
real wage, employment, and
therefore level of output are
the same at P1, 2P1, and 3P1.
FACTORS THAT DO NOT AFFECT OUTPUT
• Factors such as the quantity of money, level of government spending,
and level of demand for investment goods by the business sector are
all demand-side factors that have no role in determining output and
employment. The case of government tax policy is more complex.
Changes in taxes, to the degree that they affect the demand side, will
not affect output or employment. But changes in tax rates also have
incentive or supply-side effects that do matter for output and
employment.
Conclusions
Vertical aggregate supply curve, supply-determined nature of output
and employment.
Classical aggregate supply curve is vertical because of the assumptions
made about the labor market. In general, portrayal of the labor and
product markets can be characterized by the term auction market .
Labor and output are assumed to be traded in markets that are
continually in equilibrium and in which all participants make decisions
based on announced real wage rates and product prices.
Two assumptions implicit in this classical representation of the labor
market are as follows:
1. Perfectly flexible prices and wages
2. Perfect information on the part of all market participants about
market prices
• Equilibrium model determines employment and output, equilibrium must be
achieved. If such a model is to explain employment and output in the short run,
prices and wages must be perfectly flexible in that time period.
• The auction market characterization of the labor market also requires that market
participants have perfect information about market prices. Both suppliers and
purchasers of labor must know the relevant trading prices. This condition requires
that when selling and buying labor at a given money wage ( W ), both workers and
employers know the command over commodities that will result from such a wage
(W/P ).
• These two assumptions, essential for the nature of the classical equilibrium theory
ofemployment and output, are the elements of the classical theory that Keynes
attacked.