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Classical economics is often used to refer to

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an era in the history of economic thought that stretched from about 1750 to the early 1900s.

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Says Law:

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- Supply creates its own demand. Production creates demand sufficient to purchase all goods and services produced.

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Say's law implies that there cannot be either

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- (1) a general overproduction of goods (where supply in the economy is greater than demand in the economy) or - (2) a general underproduction of goods (where demand in the economy is greater than supply in the economy).

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This law is most easily understood in terms of a barter (trade) economy.

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- Consider a person baking bread in a barter economy; the baker is a supplier of bread. - According to Say, the baker works at his trade because he plans to demand other goods. - As he is baking bread, the baker is thinking of the goods and services he will obtain in exchange for it. - Thus, his act of supplying bread is linked to his demand for other goods. =Supply creates its own demand.

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Say's Law in a Money Economy

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- We might think that Say's law does not hold in a money economy - Because the act of supplying goods and services—thus earning income—need not create an equal amount of demand. For Say's law to hold in a money economy, the funds saved must give rise to an equal amount of funds invested.

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Say's Law in a Money Economy

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If consumption drops and saving rises, economic forces are at work producing an equal increase in investment. C↓ S↑→ I↑

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In classical theory, the interest rate is

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flexible and adjusts so that saving=investment

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Investment (I) is graphically described as

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- a downward slope

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Savings (S) is graphically described as

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- an upward slope

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Investment (I) slopes downwards because?

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- there is an inverse relationship between the amount of funds firms invest and the Interest rate (i). - The higher the interest rate (i) is, the fewer funds firms barrow and invest (I) Note: the interest rate is the cost of borrowing funds

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Savings (S) slopes upwards because?

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- there is a direct relationship between the amount of funds that households save and the interest rate. - the higher the interest rate is, the higher the reward for saving is. (the higher the opportunity cost for consuming is)

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If saving increases...

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- the saving curve shifts rightward - the increase in saving eventually puts pressure on the interest rate and moves it downward. - A new equilibrium is established where once again the amount households save equals the amount firms invest.

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In short, Says law is upheld in

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- a money economy were there is saving - because of changes in the interest rate

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Saving (S)=Disposable Income (Yd)-Consumption (C)

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Example: If I earn (Yd) $40,000 and consume/spend (C) $38,000, then I save (S) $2,000

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If Savings increases

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- consumption must decrease the same amount - but investment increases the same amount Note: that is how the total expenditures remains equal.

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The classical view is that prices and wages are?

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- flexible - they rise and decline in response to shortages and surpluses.

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3 possible states of the economy considering the relationship between Real GDP and Natural GDP

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1. Real GDP is less than Natural Real GDP (recessionary gap). 2. Real GDP is greater than Natural Real GDP (inflationary gap). 3. Real GDP is equal to Natural Real GDP (long-run equilibrium).

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Recessionary (Contractionary) Gap (page 200)

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The condition where the Real GDP the economy is producing is less than the Natural Real GDP and the unemployment rate is greater than the natural unemployment rate.

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Inflationary (Expansionary) Gap (page 200)

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The condition where the Real GDP the economy is producing is greater than the Natural Real GDP and the unemployment rate is less than the natural unemployment rate.

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(No Gap) Long-run equilibrium=

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Real GDP is equal to Natural Real GDP

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3 different states of the Labor Market

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1. Equilibrium - the same number of jobs are available as the number of people who want to work. - The quantity demanded of labor is equal to the quantity supplied. 2. Shortage - more jobs are available than are people who want to work. - The quantity demanded of labor is greater than the quantity supplied. 3. Surplus - more people who want to work than jobs that are available. - The quantity demanded of labor is lower than the quantity supplied.

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3 possible states of the economy related to the 3 states of the Labor Market

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State of the Labor market: Surplus Unemployment rate > Natural Unemployment Rate State of the Economy: Real GDP > Natural GDP What Do We Call It?: Recessionary Gap State of the Labor market: Shortage Unemployment rate < Natural Unemployment Rate State of the Economy: Real GDP < Natural GDP What Do We Call It?: Inflationary gap State of the Labor market: Equilibrium Unemployment rate = Natural Unemployment Rate State of the Economy: Real GDP = Natural GDP What Do We Call It?: Long-run Equilibrium

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Common misconceptions about the Unemployment Rate and the Natural Unemployment Rate.

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- that the economy's unemployment rate cannot be lower than the natural unemployment rate (like in the inflation gap). -FALSE - this can be explained through the Physical and Institutional PPF's (production possibilities frontier.)

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The physical PPF illustrates (page 203)

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- different combinations of goods the economy can produce given the physical constraints of finite resources - and the current state of technology.

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The institutional PPF illustrates (page 203)

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- different combinations of goods the economy can produce given the physical constraints of finite resources, - the current state of technology, - and any institutional constraints. (like the minimum wage law)

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A point under the Institutional PPF represents

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- an economy in a recessionary gap (shortage)

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A point on the Institutional PPF represents

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- an economy in long-run equilibrium (equilibrium)

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A point above of the Institutional PPF and under the Physcical PPF represents

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- an economy in an inflationary gap (surplus)

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An economy can never operate beyond

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- its physical PPF - But it is possible for it to operate beyond its institutional PPF, because institutional constraints are not always equally effective.

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If the economy does operate beyond its institutional PPF (i.e. minimum wage)

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- then the unemployment rate in the economy is lower than the natural unemployment rate.

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Unemployment rate:

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- The percentage of the civilian force that is unemployed Unemployment rate = Number of unemployed persons/civilian labor force

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Natural Unemployment rate:

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- Unemployment caused by frictional and structural factors in the economy. Natural Unemployment rate= frictional unemployment rate + structural unemployment rate

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If a self-regulating economy is in a recessionary gap? (page 205)

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1. It is producing a Real GDP level that is less than Natural GDP 2. The unemployment rate is greater than the natural unemployment rate 3. A surplus exists in the labor market.

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What happens if a self-regulating economy is in a recessionary gap?

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Recessionary gap --> Unemployment rate > Natural Unemployment Rate --> Surplus in labor market --> Wages fall--> SRAS curve shifts to the right --> Economy moves into long-run equilibrium

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If a self-regulating economy is in an inflationary gap?

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1. It is producing a Real GDP level that is greater than Natural GDP 2. The unemployment rate is less than the natural unemployment rate 3. A shortage exists in the labor market.

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What happens if a self-regulating economy is in an inflationary gap?

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Inflationary gap--> Unemployment rate Shortage in labor market --> Wages rise--> SRAS curve shifts to the left --> Economy moves into long-run equilibrium

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Classical, new classical, and monetarist economists believe that

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- the economy is self-regulating. - For these economists, full employment is the norm: The economy always moves back to Natural Real GDP.

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Laissez-faire

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- A public policy of not interfering with market activities in the economy.

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Changes in self-regulating economy: short run and long run

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(page 209) draw and understand the steps and graphs

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Recap of Classical Macroeconomics

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1. Say's law holds. 2. Interest rates change such that savings equals investment. 3. The economy is self-regulating, making full employment and an economy producing Natural Real GDP the norm. 4. Prices and wages are flexible. In other words, if the economy is in a recessionary gap, wages fall and the economy soon moves itself toward producing Natural Real GDP (at a lower price level than in the recessionary gap). If the economy is in an inflationary gap, wages rise and the economy soon moves itself toward producing Natural Real GDP (at higher price level than in the inflationary gap). 5. Because the economy is self-regulating, laissez-faire is the policy prescription.

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Business-cycle macroeconomics can be described as

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- changes in Real GDP with respect to a fixed LRAS curve.

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Economic-growth macroeconomics deals with (page 211)

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- rightward shifts in the long-run aggregate supply curve (LRAS).

Econ Chapter 9 – Classical Macroeconomics and the self-regulating economy – Flashcards

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