Classical Views on the
Macroeconomy
Classical economists were those beginning
with Adam Smith, David Ricardo, John Stuart
Mill, and extending to Alfred Marshall
The business cycle
was called the trade
cycle by the classical
economists….they
felt that the
economy would selfcorrect…there was
no need to use the
government to help
the economy
Real GDP – Trend GDP
Recessions go
from peak to
trough …
expansions go
from trough to the
next peak
Business Cycle = Trade Cycle
What was causing the business cycle?
Classical economists claimed that it could NOT be a lack of
demand, since the circular flow proved that expenditure
must equal output. It could not be excess supply. Of course,
a single market might have a surplus, but then the price
would fall and output would fall and eliminate that surplus.
All markets could never be in surplus for very long, since
expenditure = output, always. Therefore, the problem was
eliminating surpluses through reduced output and falling
prices. This was a natural cycle for them. Leave the markets
alone. Free markets only….no need for government.
Prices and Quantities Move to Produce Equilibrium – It Takes Some Time
Classical economists felt that besides output (Y), there
were three variables that would change to produce
equilibrium in the overall economy – these were prices
(P), interest rates (r), and wage rates (w)
Recession
P will decrease
Recession
r will decrease
Recession
w will decrease
Classical economists believed that business cycles were
inevitable and even performed a good function by
eliminating weak companies and low productivity
workers….thus providing a signal to them to change and
do something different.
Free markets must be maintained in order to allow the
natural cleansing of the economy from bad business. As
prices fall, spending will increase, as interest rates fall,
saving falls and investment increases, and as wages fall
business costs fall and unemployment decreases.
From a list of the 20 texts that shaped our times, curated
by leading British academics as part of Academic Book
Week, John Maynard Keynes’s The General Theory of
Employment, Interest and Money was voted the most
significant for modern Britain.
Keynes knew what he was on to when he wrote The
General Theory. In a letter to playwright and socialist
George Bernard Shaw, he wrote: “I believe myself to be
writing a book on economic theory, which will largely
revolutionize – not, I suppose, at once but in the course of
the next few years – the way the world thinks about
economic problems.”
https://www.theguardian.com/books/2017/jan/25/keynesseconomic-theory-voted-most-influential-academic-book-onbritish-life
Keynes' General Theory – from the Preface
Those, who are strongly wedded to what I shall call “the classical theory”, will
fluctuate, I expect, between a belief that I am quite wrong and a belief that I am
saying nothing new. It is for others to determine if either of these or the third
alternative is right. My controversial passages are aimed at providing some
material for an answer; and I must ask forgiveness if, in the pursuit of sharp
distinctions, my controversy is itself too keen. I myself held with conviction for
many years the theories which I now attack, and I am not, I think, ignorant of
their strong points.
Keynes Denied that Prices, Interest Rates, and
Wages would Adjust
1. Companies would not reduce their prices so quickly. The reason is that
most companies would think that lowering their prices would be matched
by competitors. Therefore, no benefit from reducing prices.
2. Even if interest rates fell, investment would continue to fall because of a
loss of confidence and thus lower rates would not stimulate investment
spending. Keynes also felt the interest rate would have difficulty falling
because during the recession many people would seek to hold more money
and sell their bonds, lowering bond prices and raising interest rates.
3. Wages may not fall because workers would refuse to accept the cuts.
Even if wages fall, if they are expected to continue to fall, investment may
not be stimulated.
Basic Structure of the Keynesian Model
has Four Big Markets (supply and demand in each)
1. Good and Services Market
2. Money Market
3. Non-Money Asset Market
4. Labor Market
Walras' Law
Md Ms
Bd Bs
(C + I p + G + NX - Y) + ([ ] - [ ] ) + ([ ] - [ ] ) + (Ld - Ls )  0
P
P
P
P
Note that if three of the markets are in equilibrium then
the fourth market must also be in equilibrium also.
We will be looking at goods, money, and labor market
equilibrium in our study of the Keynesian model
This model will show that output, interest rates, prices,
and wages will adjust to produce equilibrium. The model
is called the IS-LM, AS-AD model.