Classical Macroeconomics and

the Self-Regulating Economy 9

CHAPTER
The Classical View

 The term classical economics is often used to

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

 Although classical economists lived and wrote

many years ago, their ideas are often employed
by some modern-day economists.
Classical Economists and Say’s Law

 The theory of supply and demand suggests that markets

can experience temporary shortages and surpluses.

 But can the economy have a general surplus of goods

and services?

 The classical economists thought not, largely because

they believed in Say’s law (named after J. B. Say).

 In its simplest version, Say’s law states that supply

creates its own demand.
Classical Economists and Say’s Law

 So, does it mean that Say’s law does not hold in a

money economy?

 According to classical economists - NO

 They argued that even in a money economy, where

individuals sometimes spend less than their full incomes,
Say’s law still holds.

 Their argument was partly based on the assumption of

interest rate flexibility.
Classical Economists and Interest Rate
Flexibility
 For Say’s law to hold in a money economy, the funds
saved must give rise to an equal amount of funds
invested.

 This means, what leaves the spending stream through

one door must enter it through another door.

 If not, then some of the income earned from supplying

goods may not be used to demand goods (good-bye
Say’s law).

 As a result, goods will be overproduced.

 Savings and Investments

The Demand for Loanable Funds Curve or the Investment

Demand Curve
The demand for loanable funds is the relationship between
the quantity of loanable funds demanded and the real interest
rate when all other influences on borrowing plans remain the
same.
Investment is the main item that makes up the demand for
loanable funds.
Savings and Investments

This Figure shows the

Investment demand curve.

A rise in the real interest

rate decreases the quantity
of investments.

A fall in the real interest rate

increases the quantity of
investments.
 Savings and Investments

The interest rate is the cost of

borrowing funds. The higher
the interest rate is, the fewer
funds firms borrow and
invest; the lower the interest
rate, the more funds firms
borrow and invest.
Savings and Investments

The Supply of Loanable Funds Curve or the Saving

Supply Curve
The supply of loanable funds is the relationship between
the quantity of loanable funds supplied and the real
interest rate when all other influences on lending plans
remain the same.
Saving is the main item that makes up the supply of
loanable funds.
Savings and Investments

This Figure shows the

saving supply curve.

A rise in the real interest

rate increases savings.

A fall in the real interest rate

decreases savings.
 Savings and Investments

Savings Supply curve is upward

sloping, indicating a direct
relationship between the amount of
funds that households save and the
interest rate.

The reason is that the higher the

interest rate is, the higher the
reward is for saving (or the higher
the opportunity cost of consuming).
So fewer funds are consumed and
more funds are saved.
Savings and Investments

Equilibrium in the Loanable Funds Market

The loanable funds market is in equilibrium at the real
interest rate at which the quantity of loanable funds
demanded (investments) equals the quantity of loanable
funds supplied (savings).
 The Loanable Funds Market

This Figure illustrates the

loanable funds market.
At 7 percent a year, there is a
surplus of funds (S > I) and
the real interest rate falls.
At 5 percent a year, there is a
shortage of funds (S < I) and
the real interest rate rises.
Equilibrium occurs at a real
interest rate of 6 percent a
year.
 Classical Economists and Interest Rate
Flexibility
Suppose now that saving
increases at each interest
rate level. In this Figure, the
saving increase is
represented by a rightward
shift in the saving supply
curve from 𝑆1 to 𝑆2 . The
classical economists believed
that an increase in saving
puts downward pressure on
the interest rate, moving it
from 𝑖1 to 𝑖2 , thereby
increasing the number of
dollars firms invest.
Classical Economists and Interest Rate
Flexibility
Classical Economists and Interest Rate
Flexibility
 According to the classical view of the economy, then,
Say’s law holds both in a barter economy and in a
money economy.

 In a money economy, according to classical economists,

interest rates will adjust to equate saving and
investment. Therefore, any fall in consumption (and
consequent rise in saving) will be matched by an equal
rise in investment.

 In essence, at a given price level, total expenditures will

not decrease as a result of an increase in saving. So:
Saving is not the same as “Not Spending”.
Classical Economists and Interest Rate
Flexibility
 What does an increase in saving imply for aggregate
demand (AD)?

 In chapter 8, we learned that aggregate demand

changes only if total spending in the economy changes
at a given price level.

 Therefore, because total spending does not change

as a result of an increase in saving, aggregate
demand does not change.
Classical Economists on Prices and
Wages: Both Are Flexible
 Classical economists believed that most, if not all, markets are
competitive; that is, supply and demand operate in all markets.

 If the labor market has a surplus, the wage rate will decline, and the
quantity supplied of labor will equal the quantity demanded of it.
Similarly, given a shortage in the labor market, the wage rate will
rise, and the quantity supplied will equal the quantity demanded.

 What holds for wages in the labor market holds for prices in the
goods and services market. Prices will adjust quickly to any
surpluses or shortages, and equilibrium will be quickly re-
established.

 In short, the classical view is that prices and wages are flexible:
They rise and decline in response to shortages and surpluses.
Three States of the Economy

Real GDP and Natural Real GDP: Three Possibilities

Economists often refer to three possible states of an

economy when considering the relationship between Real
GDP and Natural Real GDP:

●Real GDP is less than Natural Real GDP

●Real GDP is greater than Natural Real GDP
●Real GDP is equal to Natural Real GDP
 Three States of the Economy

REAL GDP IS LESS THAN

NATURAL REAL GDP
(RECESSIONARY GAP)
This Figure shows an AD curve,
an SRAS curve, and the LRAS
curve. It also shows that Natural
Real GDP (𝑄𝑁 ) is produced in the
long run.
Short-run equilibrium is at the
intersection of the AD and SRAS
curves; so, in this Figure, short-
run equilibrium is at point 1. The
Real GDP level that the economy
is producing at point 1 is
designated by 𝑄1 .
 Three States of the Economy

REAL GDP IS LESS THAN

NATURAL REAL GDP
(RECESSIONARY GAP)
Compare 𝑄1 with 𝑄𝑁 . Obviously,
𝑄1 is less than 𝑄𝑁 . In other words,
the economy is currently producing
a level of Real GDP in the short
run that is less than its Natural
Real GDP level. When the Real
GDP that the economy is
producing is less than its Natural
Real GDP, the economy is said to
be in a recessionary gap.
Three States of the Economy

REAL GDP IS GREATER THAN

NATURAL REAL GDP
(INFLATIONARY GAP)
In this Figure, 𝑄1 is greater than 𝑄𝑁 .
In other words, the economy is
currently producing a level of Real
GDP in the short run that is greater
than its Natural Real GDP level, or
potential output. When the Real
GDP that the economy is producing
is greater than its Natural Real
GDP, the economy is said to be in
an inflationary gap.
Three States of the Economy

REAL GDP IS EQUAL TO

NATURAL REAL GDP (LONG-
RUN EQUILIBRIUM)
This time, 𝑄1 is equal to 𝑄𝑁 . In
other words, the economy is
currently producing a level of Real
GDP that is equal to its Natural
Real GDP, or potential output.
When the Real GDP that the
economy is producing is equal to its
Natural Real GDP, the economy is
in long-run equilibrium.
Three States of the Economy

The Labor Market and the Three States of the Economy

The labor market consists of the demand for and the supply
of labor. Like a goods market, the labor market can have
three possible scenarios:

(1) Equilibrium
(2) Shortage
(3) Surplus
Three States of the Economy

The Labor Market and the Three States of the Economy

Equilibrium: When the labor market is in 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.

Shortage: When the labor market has a shortage, more jobs are
available than are people who want to work. The quantity demanded of
labor is greater than the quantity supplied.

Surplus: When the labor market has a surplus, more people want to
work than there are jobs available. The quantity supplied of labor is
greater than the quantity demanded.
Three States of the Economy

The Labor Market and the Three States of the Economy:

Recessionary gap and the labor market
The unemployment rate that exists when the economy produces Natural
Real GDP is, of course, the natural unemployment rate. So if the economy is
in a recessionary gap, is the labor market in equilibrium, shortage, or
surplus?

When the economy is in a recessionary gap, the unemployment rate is

higher than the natural unemployment rate. This implies a surplus in the
labor market: The quantity supplied of labor is greater than the quantity
demanded; that is, more people want to work than there are jobs available.

Summary: If the economy is in a recessionary gap, the unemployment rate

is higher than the natural unemployment rate, and a surplus exists in the
labor market.
Three States of the Economy

The Labor Market and the Three States of the

Economy: Inflationary gap and the labor market
When the economy is in an inflationary gap, the unemployment rate is
lower than the natural unemployment rate. This implies a shortage in
the labor market: The quantity demanded of labor is greater than the
quantity supplied; that is, more jobs are available than there are people
who want to work.

Summary: If the economy is in an inflationary gap, the unemployment

rate is less than the natural unemployment rate, and a shortage exists
in the labor market.
Three States of the Economy

The Labor Market and the Three States of the Economy:

Long-run equilibrium and the labor market
When the economy is in long-run equilibrium, it is producing a Real GDP
level equal to Natural Real GDP. In this state, the unemployment rate in
the economy is the same as the natural unemployment rate. This implies
that the labor market has neither a shortage nor a surplus but is in
equilibrium.

Summary: If the economy is in long-run equilibrium, the unemployment

rate equals the natural unemployment rate, and the labor market is in
equilibrium.
Three States of the Economy

The Labor Market and the Three States of the Economy

State of the What Do We Relationship State of the
Economy Call It? Between Labor Market
𝑼 and 𝑼𝑵

𝑄 < 𝑄𝑁 Recessionary 𝑈 > 𝑈𝑁 Surplus exists

Gap

𝑄 > 𝑄𝑁 Inflationary 𝑈 < 𝑈𝑁 Shortage exists

Gap
Long-run Equilibrium
𝑄 = 𝑄𝑁 𝑈 = 𝑈𝑁
Equilibrium exists
Common Misconceptions About the Unemployment
Rate and the Natural Unemployment Rate

 Some people mistakenly think that the economy’s

unemployment rate cannot be lower than the natural
unemployment rate (as it is in an inflationary gap).

 In other words, if the natural unemployment rate is 5

percent, then the unemployment rate can never be 4
percent.

 But that assumption is a myth.

 Common Misconceptions About the Unemployment
Rate and the Natural Unemployment Rate
A society has both a physical PPF
and an institutional PPF. The
physical PPF illustrates different
combinations of goods the
economy can produce given the
physical constraints of (1) finite
resources and (2) the current state
of technology.

The institutional PPF illustrates

different combinations of goods the
economy can produce given the
physical constraints of (1) finite
resources, (2) the current state of
technology, and (3) any institutional
constraints (e.g., minimum wage).
 Common Misconceptions About the Unemployment
Rate and the Natural Unemployment Rate

The economy is at the natural

unemployment rate if it is located
on its institutional PPF, such as at
points A, B, or C. An economy can
never operate beyond its physical
PPF, but it is possible for it to
operate beyond its institutional
PPF because institutional
constraints are not always equally
effective (e.g., inflation reducing
minimum real wage). If the
economy does operate beyond its
institutional PPF, such as at point
D, then the unemployment rate in
the economy is lower than the
natural unemployment rate.
Three States of the Economy and Two
PPF Curves
Question

Assume that in year 1 country A’s unemployment rate is

equal to its natural unemployment rate at 4.7 percent. In
year 2, its unemployment rate is still equal to its natural
unemployment rate at 5.4 percent. If there was no change
to the country’s Physical PPF, what was going on in the
country over the two years?
Answer

 If 𝑈 = 𝑈𝑁 , then the country is operating on its institutional PPF, i.e.,

economy is at long-run equilibrium.

 So, the country must be operating on its institutional PPF in both

year 1 and year 2.

 Then why are both 𝑈 and 𝑈𝑁 higher (each at 5.4 percent) in year 2
than in year 1? What does this difference mean?

 Since there is no change in the country’s physical PPF, it has to be

that the country’s institutional PPF has shifted inward between the
two years.

 In other words, some institutional changes came about between

years 1 and 2—perhaps changes in the regulatory climate—that
made it more difficult to produce goods and services.
The Self-Regulating Economy

 Some economists believe that the economy is self-

regulating.

 In other words, if the economy is not at the natural

unemployment rate (or full employment)—that is, it is not
producing Natural Real GDP—then it can move on its
own to this position.

 The notion of a self-regulating economy is very classical,

but it is also a view held by some modern-day
economists.
The Self-Regulating Economy

Self-Regulating Economy in a Recessionary Gap

If the economy is in a recessionary gap:

1. It is producing a Real GDP level that is less than

Natural Real GDP.

2. The unemployment rate is greater than the natural

unemployment rate.

3. A surplus exists in the labor market.

The Self-Regulating Economy

Self-Regulating
Economy in a
Recessionary Gap
According to economists who
believe the economy is self-
regulating, the surplus in the
labor market begins to exert
downward pressure on wages.
In other words, as old wage
contracts expire, business firms
negotiate contracts that pay
workers lower wage rates.
The Self-Regulating Economy

Self-Regulating Economy
in a Recessionary Gap
This Figure illustrates the
adjustment to long-run
equilibrium.

Initially, the economy is at

below-full employment
equilibrium.

In the long run, the money wage

falls until the SAS curve passes
through the long-run equilibrium
point.
The Self-Regulating Economy

Self-Regulating Economy in a Recessionary Gap

The Self-Regulating Economy

Self-Regulating Economy in an Inflationary Gap

If the economy is in an inflationary gap:

1. It is producing a Real GDP level that is greater

than Natural Real GDP.

2. The unemployment rate is less than the natural

unemployment rate.

3. A shortage exists in the labor market.

The Self-Regulating Economy

Self-Regulating
Economy in an
Inflationary Gap
According to economists
who believe the economy is
self-regulating, the shortage
in the labor market begins
to exert upward pressure on
wages. In other words, as
old wage contracts expire,
business firms negotiate
contracts that pay workers
higher wage rates.
The Self-Regulating Economy

Self-Regulating
Economy in an
Inflationary Gap
This Figure illustrates the
adjustment to long-run
equilibrium.

Initially, the economy is at an

above-full employment
equilibrium.

In the long run, the money

wage rate rises until the SAS
curve passes through the long-
run equilibrium point.
The Self-Regulating Economy

Self-Regulating Economy in an Inflationary Gap

The Self-Regulating Economy: Role of
Flexible Wage Rates
 Flexible wage rates (and other resource prices) play a critical
role in the self-regulating economy.

 For example, suppose wage rates are not flexible and do not
fall in a recessionary gap. Then the SRAS curve does not shift
to the right, the price level does not fall, and the economy
doesn’t move down the AD curve toward long-run equilibrium.

 Similarly, if wage rates are not flexible and do not rise in an

inflationary gap, then the economy won’t move up the AD
curve toward long-run equilibrium.
The Self-Regulating Economy: Role of
Flexible Wage Rates
 The economists who say the economy is self-regulating
believe that wage rates and other resource prices are
flexible and that they move up and down in response to
market conditions.

 These economists believe that wage rates will fall when there
is a surplus of labor and that wage rates will rise when there is
a shortage of labor.

 You will see in the next chapter that this flexible wages and
prices position has not gone unchallenged.
Policy Implication of Believing the
Economy Is Self-Regulating
 For economists who believe in a self-regulating economy, full
employment is the norm: The economy always moves back to
Natural Real GDP.

 Stated differently, if the economy contracts an “illness”—in the

form of a recessionary or an inflationary gap — it is capable of
healing itself through changes in wages and prices.

 This position on how the economy works has led these

economists to advocate a macroeconomic policy of laissez-
faire, or noninterference. In these economists’ view,
government does not have an economic management role to
play.
Changes in a Self-Regulating Economy:
Short Run and Long Run
 If the economy is self-regulating, how does a change in
aggregate demand affect the economy in the short run and
the long run?

 Suppose, the economy is initially in long-run equilibrium.

An increase in aggregate demand is brought about by, say,
an increase in government purchases.

 What will happen?

Changes in a Self-Regulating Economy:
Short Run and Long Run
Fluctuations in Aggregate
Demand
This Figure shows the
effects of an increase in
aggregate demand.
An increase in aggregate
demand shifts the AD curve
rightward.
Firms increase production
and the price level rises in
the short run.
Changes in a Self-Regulating Economy:
Short Run and Long Run

Fluctuations in Aggregate
Demand
At the short-run equilibrium,
there is an inflationary gap.
The money wage rate
begins to rise and the SAS
curve starts to shift leftward.
The price level continues to
rise and real GDP continues
to decrease until it equals
potential GDP.
Changes in a Self-Regulating Economy:
Short Run and Long Run
Fluctuations in Aggregate Demand

Summary: If the economy is self-regulating, an increase in

aggregate demand can raise the price level and Real GDP in the
short run, but in the long run the only effect is a rise in the price
level. In other words, in the long run, we have only higher prices
to show for an increase in aggregate demand.

So, what would happen if aggregate demand falls for some

reason?
Changes in a Self-Regulating Economy:
Short Run and Long Run
Fluctuations in Aggregate Demand

Summary: If the economy is self-regulating, a decrease in

aggregate demand can lower the price level and Real GDP
in the short run, but in the long run the only effect is a lower
price level.
A Recap of Classical Macroeconomics
and a Self-Regulating Economy
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 a higher price level than in the inflationary
gap).

5. Because the economy is self-regulating, laissez-faire is the policy

prescription.
Business-Cycle Macroeconomics
and Economic-Growth Macroeconomics
 You have enough background now to understand the difference
between business-cycle macroeconomics and economic-growth
macroeconomics.

 Both can be explained with respect to Real GDP and a few curves.
Business-cycle macroeconomics can be explained with changes in
the AD and SRAS curves around a fixed LRAS curve.

 Economic-growth macroeconomics can be explained with rightward-

shifting changes in the LRAS curve.

 Business-cycle and economic-growth macroeconomics essentially

make up two categories of macroeconomics. Keep these two
categories in mind as you continue your study of macroeconomics.
The Business Cycle in the AS-AD Model

The business cycle occurs because aggregate demand

and the short-run aggregate supply fluctuate, but the
money wage does not change rapidly enough to keep real
GDP at potential GDP.
The Business Cycle in the AS-AD Model

Point A in these Figures:

represent above full-
employment equilibrium.
The amount by which real
GDP exceeds potential
GDP is called an
inflationary gap.
Point B in these figures
represent full-employment
equilibrium.
The Business Cycle in the AS-AD Model

Point C in these figures

represent below full-
employment equilibrium.
The amount by which real GDP
is less than potential GDP is
called a recessionary gap.
The Figure at the bottom shows
how, as the economy moves
from one type of short-run
equilibrium to another, real GDP
fluctuates around potential GDP
in a business cycle.
Economic Growth and Inflation in the
AS-AD Model
This Figure illustrates
economic growth.
Because the quantity of
labor grows, capital is
accumulated, and
technology advances,
potential GDP increases.
The LAS curve shifts
rightward.
Explaining Macroeconomic Trends and
Fluctuations

This Figure illustrates

inflation.
Suppose the quantity of
money grows faster than
potential GDP. Then
aggregate demand will
increase by more than
long-run aggregate supply.
The AD curve shifts
rightward faster than the
rightward shift of the LAS
curve.
True or False

“Suppose, in year 1, an economy is in a recessionary gap,

i.e., 𝑄 < 𝑄𝑁 . In year 2 , the economy is no longer in a
recessionary gap. It is in long-run equilibrium, producing 𝑄𝑁 .
However, you notice that the price level hasn’t declined.
Since price level has not declined, it must be that the
economy is NOT self-regulating.”
True or False

The answer is: FALSE

A constant price level does not mean that the economy is

not self-regulating. While the economy was self-regulating
(and the SRAS curve was shifting to the right), aggregate
demand in the economy might have risen. Moreover, the
rise in aggregate demand could be totally unrelated to the
change occurring on the supply side of the economy.
True or False