Classical Model

Classical economics advocated the laissez faire or free market system. They believe that
government interference in competition or the functioning of the market markets it worse.
Government should not intervene in the economy to correct any problems. The
government should simply ensure that the free market economy works by eliminating any
imperfections in the market and maintaining a balance fiscal budget. The economy will
automatically return to equilibrium where full employment is reached.
Says a classical economist posits thats that supply creates its own demand.
Assumptions
1. And wages are flexible, therefore the market clears itself very rapidly (prices and
wages will always work back to equilibrium).
2. Expectations are rational but are based on imperfect information. (They are not
based on facts).
3. Labour is homogenous and all factor inputs except capital are in abundant supply
and fully employed
Classical Unemployment
Unemployment refers to people between the ages of 15-65 who are willing and able to
work but cannot find paid jobs.
Classical assume that the economy reaches full employment without government
intervention as a result of the labour market being allowed to clear itself instantaneously.
Unemployment implies surplus labour in the market and all employers have to do is to
reduce wages and employ more people until the surplus is eliminated. The classicals
focus on the economy being in equilibrium at all times. They believe that disequilibrium
unemployment is caused by the government and the trade union. The government and/or
the trade union bids up the wage rate causing surplus labour (unemployment), firms must
then reduce the wage rate which increases demand for labour until the economy is back
in equilibrium. The unemployment that remains is called voluntary unemployment
(people who have chosen not to work for lower wages in the long run)

Graph
Labour market equilibrium and classical unemployment

Potential and actual labour market

Potential supply of labour all workers who are able to supply their labour services to the
market (this lessens as the voluntarily unemployed withdraw themselves from the market.
Actual labour supply workers who are willing to work at the existing wage rate after the
voluntarily unemployed have left the labor market.
Classicals believe the disequilibrium unemployment exists because of structural and
frictional unemployment as well as government intervention (real wage unemployment).
Graph

Savings and Investment

The demand for loanable funds is determined by the demand for investment. However,
the supply of loanable funds is derived from savings. The price/cost of investment is the
interest rate. If savings differs from investment then the interest rate will adjust until they
are equal.
Graph

If savings werent sufficient to match investment then interest rate increases, savings
increases (as people divert investment to savings since interest rate is high)
Graph

If the initial rate of interest is IR2 planned investment will be greater than planned
savings resulting in a shortage of loanable funds. Interest rate will increase to IR1
(equilibrium) resulting in an increase in savings and a decrease in investment. However,
if IR were to go above equilibrium financial institutions would have surplus funds which
they would get rid of by lowering the IR.
Aggregate Demand
AD = C+I+G+X-M
This shows how equilibrium output for the economy is determined with the general price
levels. The AD curve represents all planned expenditures in the economy or the total
amount of goods and services in the whole economy that are demanded at any given price
level.
Price level
The average price for all goods and services in the economy
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Graph

As price levels fall from P1 to P2 AD increases from Y1 to Y2 causing a movement down

the AD curve and vice versa.
Factors that cause the AD curve to shift
1.
2.
3.
4.

Consumer spending
investment spending
Government spending
Net export spending

Consumer spending
If consumers expect the income in the economy to increase then at any price level they
will demand more goods and services. However, if incomes were to decrease and the
economy is thrown into a recession then AD will fall causing the demand curve to shift to
the left.
Investment Spending
If investors believe that the economy is going to grow in the future then they will be
motivated to invest today. Investors will also watch the interest rates to see how it is
changing. If they expect the interest rate to fall then they will be motivated to invest thus
increasing AD.
Government Spending
To increase AD government generally undertake expansionary fiscal policies. When they
spend more in the economy and collect less tax. This results in, a rightward shift in the
AD curve (expansionary fiscal policy involves spending on factors such as job creation
hence consumers will have more money to spend which causes increases in AD.
Net export spending
The increase in importation by foreign economies will lead to a rise in exports from the
domestic economy leading an increase in production, increase in employment, increase in
income and ultimately lead to an increase in AD and vice versa. If the price of foreign
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goods were to increase then the domestic economy will import less which will cause AD
to fall and vice versa.
Aggregate Supply
This is the real value of output produced by an economy. It shows the relationship
between average price levels and final output within the economy.
Movement along the AS curve
Graph

The short run AS curve

1. All factors of production are fixed; the firm will therefore suffer from diminishing
returns causing the cost of production to rise. They will pass on the increase in
price to the consumer.
2. The curve is upward sloping because an increase in output is accompanied by an
increase in price. Price is the only factor that causes a movement along the curve.
All other factors cause the curve to shift.
Shifts in the Short run supply AS curve
Graph

Factors that cause the AS curve to shift

1. Cost of production Increase in output leads to an increase in AS thus causing the
curve to shift outwards. However, if C.O.P increases then output decreases AS
decreases causing the curve to shift inwards.
2. Improvement in technology Output increases then AS increases. If there is no
improvement in technology output would decrease causing AS to fall.
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3. Expectations bright future for say JA then employment will increase, output
would rise leading to an increase in AS.
4. Welfare Benefits If welfare is reduced then the unemployed will want to work
for lower wages thus reducing the cost of production, thereby increasing output
and AS.
5. Quality of the labour force If productivity per worker increases so too will
output and AS.
6. Wages As wages and salaries fall AD fall triggering a fall in AS and vice versa.
Supply-side Economic Policies
1. The aim of these policies is to improve efficiency.
2. It is argued that government policy should target the level of total or AS of goods
and services rather than trying to directly manipulate the level of AD for goods and
services. As AS creates its own demand therefore, it is non-inflationary. Therefore
govt. should say reduce tax to increase production which creates employment.
3. The main role of govt. is to create an environment which fosters free enterprise
and competition where market forces will allocate resources most efficiently.
4. Supply side policies shift the AS curve to the right. NB These policies are seen as
the only non-inflationary means of achieving growth in output in the long run.
Supply side policies in the Long Run
Graph

The shift of the LRAS to the right results in a new equilibrium at a higher level of income
(YF2) whilst the price level remains the same.
Supply side policies focus on increasing AS by using microeconomic policies to improve
the performance of markets, workers and firms. These include:
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1. Reducing govt. spending, hence reducing the crowding out of private investment.
2. Reducing taxation for firms
3. Reduce trade union power to increase the flexibility in the labour market.
4. Encouraging entrepreneurial culture.
5. Making it easier for firms to set up and provide advice
6. Deregulating and privatizing to increase competition
Long run AS curve
1. Classical believe that all markets will be equilibrium in the long run
2. All markets will function efficiently if the govt. does not interfere enabling
resources to be fully utilized. Therefore the economy will always be on the PPF
producing at its full potential, for full employment output level with its given
resources.
3. The LRAS is a vertical line where there is full employment of output at Yf. There
is absolutely no spare capacity in the economy. Therefore, AD was to increase
price would increase output would remain the same.
4. Classical believe that if govt. intervenes AD will increase resulting in inflation as
in point 3 above.
Graph

Price Level Determination

The classicalists base their analysis of inflation on the quantity theory of money. It states
that the general price level (P) in the economy depends on the supply of money (M2),
therefore P = f (M) (price as a function of money). The greater the quantity of money, the
higher the level of prices. Inflation is caused by an increase in the money supply. The
classicalist come up with the equation of exchange ie MV=PY where MV is the total
level of spending.

M Supply of money
V- Velocity of circulation (how often money change hands)
PY is the total value of goods and services produced that makes up the GDP.
P is the general price level and
Y is the real value of National Income.
V and Y they claimed were determined independently on the money supply. V was
determined by how frequently people were paid for instance weekly or monthly, the
banking system and other institutional arrangements for holding money. Says Law would
ensure that the real value of output Y was maintained at the full employment level.
Interaction between AD and AS
An increase in AD graph

NB: Classical aim for full employment which is the reason

1. If the govt. expands the economy then AD will increase at full employment
causing price to increase and real output to increase.
2. General price levels are increasing (P1 P2), economic activity is increasing
(YF1 to YF2) resulting in cost of production increasing and people demanding
higher wages to offset increased prices.
3. Firms will supply less causing output to fall to full employment at a higher price.
Decrease in AD graph

Government contracts the economy by increased taxation and decreased govt. spending
causing AD, price and wages to fall. Cost of production decreases, firms purchasing
power increases resulting in AS increasing and price falling at equilibrium full
employment (Yf)
Increase in cost graph

Cost of production increases AS falls Real output falls but price increases govt.
reflates the economy by increasing govt. spending and reducing tax AD increases, price
increases at full employment.

Keynesian Model
This model was created by Maynard Keynes who argued for govt. to intervene in the
economy to reflate it when it was growing too slowly through fiscal policies and deflate it
when it was growing too quickly.

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They argue that markets would not achieve a state of equilibrium at the full employment
level of income.
Inflation is often caused by cost push factors such as the high cost of production.
Fiscal policy is more effective than monetary policy
Keynes use 4 things to justify his arguments:
1. Labour market
2. Market for loanable funds
3. The multiplier
4. The inflationary and deflationary gap
Keynesian Labour Market
Keynes believes that markets do not clear instantaneously and are slow to adjust, for
instance the labour market. The economy can be at equilibrium below the full
employment level, therefore cyclical or involuntary unemployment does exist.
People are not willing to work for lower wages because it erodes their purchasing power
and ultimately the SOL. Therefore, if there is surplus labour, wages would not decline but
remain rigid causing unemployment to persist.
Graph

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At W 1 the level of unemployment is between Q1 and Q2 ie S > D.

During a recession if wages were to fall. It would worsen the recession and
disequilibrium would be made worse.
The Market for Loanable Funds
Savings and Investments
Savings = Investment at various levels of employment. An increase in savings reduces
investment because this would mean a reduction in consumption and ultimately a fall in
aggregate expenditure. Unsold stock would increase, production decreases as well as
investment. Keynes rejected the classicals belief that by increasing savings investment
will increase. He believed that an increase in savings decreases investment and suggested
that for investment to occur it really depends on business confidence about the future.
Interest rate would have to be very low to encourage investment.
Graph

Note
1. The order for investment to increase, interest rate must decrease.
2. Keynes rejected the quantity theory of money because he believed that an increase
in the money supply may not necessarily cause prices to increase and inflation to
occur. An increase in the money supply may mean that an economy faced with
high unemployment, idle machines and idle resources now has the opportunity to
use these resources to increase real income without necessarily increasing price. A
decrease in the money supply to reduce price may instead cause employment to
fall, output to fall and prices to increase.
3. Keynes rejected says law and instead noted that demand creates its own supply. If
AD increases then AS will increase as well as employment and vice versa.
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4. Keynes believe that an unregulated market would stimulate demand. The govt.
should intervene to control AD. The cure for unemployment is to increase govt.
spending thus increasing AD and economic activity.
The Consumption Function
The Keynesian Consumption Function shows the relationship between the level of
consumption and the level of income.
The curve is upward sloping because consumption increases with income.
The point where the consumption function cuts the vertical (1) axis is where income is
zero (0) (autonomous consumption). Consumers consume when income is zero because
they can borrow, beg or use their savings. There is however, consumption which is based
on income and therefore varies with the level of income. This consumption is known as
induced consumption.
Keynes highlighted two assumptions regarding the behaviour at consumption spending.
These are:
1. Peoples consumption decisions are based on their current income.
2. Increments of income are partially spent and partially saved.
Consumer is spending $20, 000.00 when income is zero (0). Therefore the $20,000.00 is
autonomous consumption.

Consumption Function Graph

NB Consumption can never start at zero because consumers are always consuming.
The Consumption Function Formula is C = a+by
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C consumption, a autonomous, b MPC (marginal propensity to consume),

y National income
There are 2 concepts associated with the consumption function, namely:
1. MPC marginal propensity to consume
2. APC average propensity to consume
APC that proportion of income devoted to consumption
APC = C/Y
MPC the proportion of the change in disposable income devoted to consumption
MPC = C/Y
APS Average Propensity to Save the proportion of income devoted to savings S/Y.
MPS The proportion of the change in disposable income devoted to savings
MPS = S/Y
Y = C+S
C= Y-S
S= Y-C
APS + APC = 1
MPS + MPC = 1
Table
Y
0
25
50
75
100

C
20
35
50
65
80

APC

MPC

The APC decreases while the MPC remains constant as income increases.
NB. As income increases people tend to save more, hence the APC is always falling.

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The MPC is constant because the Consumption Function is linear and therefore has a
constant gradient.
Graph

The change in the MPC causes the consumption function to pivot which changes the
gradient of the consumption function.
Graph

Savings

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