004: Macroeconomic Theory

004: Macroeconomic Theory

Lecture 1

Mausumi Das

Lecture Notes, DSE

July 24, 2014

Keynes & the Classics: Reference

W. Scarth: Macroeconomics; Chapter 1; Pages 1-21.

(Photocopy of the chapter available at the Photocopy Shop and in the course folder of the CDE server (C:/Courses/004)

Keynes & the Classics: Some Preliminaries

Both the system summarise the aggregate economy in terms of three institutions:

The Goods Market The Labour Market The Money Market

The major di¤erence between the two system arises from the description of the labour market.

The Classical System (in equations)

The Goods Market:

Supply Equation:

Y =F(N,K¯);F_N,F_K >0;F_NN,F_KK <0 (1) Demand Equation:

Y =C(Y) +I(r) +G;^¯ 0<C⁰(Y)<1;I⁰(r)<0 (2) The Labour Market:

Supply Equation:

W =Pg(N);g⁰(N)>0 (3) Demand Equation:

W =PF_N(N,K¯) (4) The Money Market:

Supply Equation:

M =M^¯ (5)

Demand Equation:

M =PL(Y,r);L_Y >0;L_r <0 (6)

The Classical System: Solution

Solution consists of

Equilibrium values of the Price & Quantity in the Goods Market:

P ,Y

Equilibrium values of the Price & Quantity in the Labour Market:

W ,N

Equilibrium values of the Price & Quantity in the Money Market:

r ,M

(A Clari…cation: We have assumedi =r; i.e., the nominal and the real interest rates are the same. This happens only under speci…c

assumption about the expected rate of in‡ation. We shall get back to this point later)

The equations being interdependent, we cannot solve for the

equilibrium values of quantities & prices in each market separately. So we follow a more round-about method.

The Classical System: Solution (contd.)

We club the SS & DD equations in the Labour Market and the SS equation in the Goods Market together:

Y =F(N,K¯);F_N,F_K >0;F_NN,F_KK <0 (1) W =Pg(N);g⁰(N)>0 (3) W =PFN(N,K¯) (4) This sub-system involves four endogenous variables: Y,N,W andP. We eliminate two of these variables to get a relationship between P andY - which we call the aggregate supply curve (AS).

The Classical System: Solution (contd.)

We then club the SS & DD equations in the Money Market and the DD equation in the Goods Market together:

Y =C(Y) +I(r) +G^¯;0<C⁰(Y)<1;I⁰(r)<0 (2)

M =M^¯ (5)

M =PL(Y,r);LY >0;Lr <0 (6) This sub-system involves four endogenous variables: Y,r,M andP. We eliminate two of these variables to get another relationship between P andY - which we call the aggregate demand curve (AD).

The Classical System: Solution (contd.)

We then simultaneously plot the theASandAD schedule in theY-P plane to determine the equlibrium price level P and equlibrium output Y in the Goods Market.

Once these two values are determined, other equilibrium values can be found by substituting these back in the other equations.

Derivation of the AS Schedule under the Classical System:

Graphical Method

Plot (3) and (4) in the N-W plane (assuming some arbitrarily given value ofP):

Derivation of the AS Schedule under the Classical System:

Graphical Method (Contd.)

Now increaseP to a higher level, sayP⁰ :

TheN^S curve shifts out proportionally - diverging away from the earlier curve for higher values ofN (Why?)

TheN^D curve also shifts out proportionally - but it converges closer to the earlier curve for higher values ofN(Why?)

However the new point of intersection still remainsN (Why?)

Derivation of the AS Schedule under the Classical System:

Graphical Method (Contd.)

Correspondingly, the output supplied remains …xed at Y :

Derivation of the AS Schedule under the Classical System:

Graphical Method (Contd.)

In other words,the AS Schedule under the Classical System is Vertical:

Derivation of the AD Schedule under the Classical System:

Graphical Method

In deriving the AD Schedule, …rst notice that the Money Supply Function is constant. This allows us to write the Money Market Equlibrium condition as:

M¯ =PL(Y,r);LY >0;Lr <0 (7) This is the so-calledLM curve, which represents a relationship between Y,r andP.

On the other hand the Demand Equation for the Goods market represents another relationship between Y andr :

Y =C(Y) +I(r) +G^¯;0<C⁰(Y)<1;I⁰(r)<0 (2) This is the so-calledIS curve.

Derivation of the AD Schedule under the Classical System:

Graphical Method (Contd.)

Plot the IS and the LM curve in the Y-r plane (assuming some arbitrarily given value of P):

Derivation of the AD Schedule under the Classical System:

Graphical Method (Contd.)

Now increaseP to a higher level, sayP⁰ :

The LM curve shifts out proportionally - diverging away from the earlier curve for higher values of Y (Why?)

Derivation of the AD Schedule under the Classical System:

Graphical Method (Contd.)

The IS Curve remains unchanged.

Thus the new point of intersection shifts to the left:

Derivation of the AD Schedule under the Classical System:

Graphical Method (Contd.)

In other words,the AD Schedule under the Classical System is Downward Sloping:

Characterization of the Equilibrium under the Classical System:

Equilibrium price and quantity in the Goods Market -P andY - are determined simultaneously by the intersection of the AS and the AD schedule: