Basic Classical Model

Following up from my previous post, The Main Cause of Disagreement between Economists: Long Run vs. Short Run, I’m going to talk about the key assumptions of the basic “Classical Model” of Macroeconomic theory in this post. Understanding the fundamental assumptions of this model in a robust fashion will make all future discussions much easier. 

Like I mentioned in the previous post, I’m using Chapter 8, 'The Classical Long-Run Model' of 'Macroeconomics: Principles and Applications' (5th edition; Robert Hall and Marc Lieberman) as a base for this exercise. 

What is the Classical Model?

In simplistic terms, the Classical model asserts that markets/economies function best when there is minimal interference from the government. The Classical model was developed in the late 18th, 19th and early 20th centuries. Adam Smith’s seminal work “The Wealth of Nations”, published in 1776 birthed the Classical school of thought. 

While there is a distinction between Classical and Neoclassical economics (build on the Classical tradition) that I will cover in a subsequent post, for now, I’m going to club these two together. 

The Classical model attempts to explain the observation that economies perform rather well over the long run (multiple years, decades). While there may be business cycles in the short run, over the long term, economies tend to operate at "full employment" or at "potential output". There are strong forces that push economies towards full employment. Lets see what these are.....

1. All Markets Clear - the fundamental Classical assumption 

A critical assumption of the Classical model is “market clearing”. This means that in every market, price adjusts till market demand is = market supply.

This is why the Classical model is a much better predictor of the long run rather than the short run. While in the long run, the forces of demand and supply will tend to force markets to clear, in the short run there are rigidities like minimum wage, government imposed price-floors, reluctance of firms to cut product prices etc. that may not allow markets to clear. 

2. The Economy achieves “Full Employment” on its own

2 (a). In the Classical Model, determining how much Output an economy will produce starts with the Labour market.

Let’s start with a very simple economy. Let’s assume Output (Y) in this economy is a function of Labour (L) and Capital (K). Let's also assume that the amount of K and the production technology are fixed. Y= f (L, K) represents the aggregate Production Function for this economy. The aggregate production function shows us the total amount of output that this economy can produce with different quantities of labour, given the fixed amount of capital and constant production technology. 

In the Classical model, the process of determining how much output this economy will produce begins in the labour market. Note: we assume that all markets (markets for products and factors of production) are perfectly competitively. 

Per the market clearing assumption, the real wage in the labour market adjusts to equilibrate labour demand (DL) and labour supply (SL). The labour market clears at point E, with equilibrium level of employment determined at L0 (see the top graph in Chart 1 below). 

Chart 1: Output Determination in the Classical Model

2 (b). The Equilibrium level of Employment in the Labour market is the “Full Employment” level. 

By “Full Employment” Classicals mean that all those people who are willing to work at the prevailing wage (w0) are able to find employment. Those workers who are not willing to work at the existing wage are voluntarily unemployed. Consequently, in the chart above, at point ‘E’, the labour market is at full employment.

Since prices are flexible and markets always clear (in the Classical model), the economy automatically moves towards full employment and no government action is needed to achieve this. 

Per Classicals, wide spread unemployment should not occur. The only type of unemployment witnessed is frictional unemployment (that happens when workers are in-between jobs) or sectoral unemployment. This type of unemployment happens when demand for the products of a sector goes down and workers lose jobs. When this happens, wage rates in the affected sector fall and workers move to other sectors where wage rates are higher i.e. there is higher demand for that sector’s end product. This leads to a rebalancing of the labour force, so that again, price flexibility causes the labour market to come back to full employment. 

If extensive unemployment is witnessed, Classicals would tend to blame this on “sticky” prices (prices that don’t adjust downward easily) due to unions, government intervention etc. 

2 (c). Once the Equilibrium level of Employment (Full Employment) is determined in the Labour market, the aggregate Production Function determines the Equilibrium level of output (or Potential output).

As I mentioned above, the aggregate production function shows us the total output an economy can produce when we vary the amount of labour (capital and technology are fixed). Once the full employment level (L0) is achieved in the labour market, the production function gives us the total amount of output (Q0) that the economy will produce with L0 amount of labour (See chart 1 above). 

So (again), in the Classical model, the economy achieves its “Potential Output” where labour is at “Full Employment” on its own, without the need for any government intervention. 

3. Spending is always equal to Equilibrium Output (Say’s Law)

This follows from the Classical assumption of full employment. If the economy has to remain at the full employment, spending has to be = output. If this is not the case and businesses are not able to sell what they produce (i.e. spending < output), inventories will pile up and businesses will lay off workers which means that the economy will no longer be at full employment. 

This Classical belief is rooted in Say’s Law. In essence, Say’s law states that “supply creates its own demand” i.e. by the very act of producing goods and services, a firm creates a demand (for goods/services) equal to what it has produced. 

So, per Say’s law, Y = C + I + G 

where Y = output, C = consumption spending, I = investment, G = government spending, and C + I + G = total spending. 

This is the basic national income identity. We haven’t included net exports in here because we are using the example of a simple, closed economy. 

Subtracting T (net taxes) from both sides of this identity gives us:

Y - T = C + I + (G - T)                      where G - T = the Budget Deficit

Y - C - T = I + (G - T)          

Now, total output/income (Y) for a household = consumption + savings + taxes i.e. Y = C + S + T, which means that Y - C - T = S (Private Savings i.e. savings of households). 

Putting this in the equation above gives us:

S = I + (G - T) 

So, for Say’s law to hold i.e. for Output to be = Spending, Savings must be = Investment + Government deficit spending. What this means is that whatever households save must be channeled into private investment spending (I) and government deficit spending (G - T), so that there are no leakages and the total income earnt (from producing the output) is fully spent on buying it. 

Per Classicals, the flexible interest rate in the loanable funds market adjusts to ensure that the supply of funds (S) = the demand for funds (I + G - T), so that Say’s law holds and the economy remains at full employment. 

Chart 2: Loanable Funds Market Equilibrium in the Classical Model 

4. Fiscal Policy is ineffective in the Classical Model

In the Classical Model, Fiscal policy does not change total output, it only changes its composition. Let me explain with an example.

Let’s assume government spending is initially = G, and then increases to G1. To finance this increased spending (G1-G), the government will have to borrow funds from the loanable funds market. 

The total demand for funds will now increase by G1 - G (or S2 -S0 in chart 3) at every interest rate i.e. the demand for funds curve will move to the right by this amount. 

As a result, the equilibrium in the loanable funds markets will move from point ‘A’ to ‘B’. At B, the interest rate (r1) will be higher and Investment spending (I) will be lower by S2 - S1 (vs. what it would have been at r0). 

Additionally at B, Savings (S) will be higher which means that Consumption (C) will lower by S1 - S0 (vs. what it was at r0). 

This implies that total spending will remain the same. The increase in government spending (S2 - S0) will be exactly offset by the decrease in Investment (S2 - S1) and Consumption (S1 - S0) Spending. 

In other words, in the Classical model, an increase in government spending (G) completely “crowds out” private sector spending (I + C), leaving total spending unchanged. 

As a result, fiscal policy has no impact on the level of output or employment in the economy. All it does is change the composition of output. 

Chart 3: In the Classical Model, an increase in Government spending completely crowds  out private sector spending (Investment + Consumption)

This is enough to absorb and mull over for now. Ciao.