Lecture 6. Classical School Theory of National Income Determination
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1. Overview
2. Theory of National Income Determination
**1. Overview **
⑴ Assumption 1. Flexible adjustment of price variables
① Adam Smith’s “invisible hand” : He believed that, due to flexibility in the labor market, a high unemployment rate could not persist.
② When the Great Depression in 1929 led to a high unemployment rate persisting for a period of about ten years, this assumption broke down.
⑵ Assumption 2. Perfect foresight
① Economic agents are assumed to have complete information about the market.
② The expected inflation rate is assumed to equal the actual inflation rate.
⑶ Assumption 3. Assumptions about the labor market
① Workers are also assumed to fully know price information, so when prices rise they immediately demand an increase in the nominal wage.
② Therefore, in the labor market, labor supply and labor demand become functions of the real wage.
③ The labor market is a perfectly competitive market that always achieves equilibrium, so full employment is achieved.
④ (Reference) Keynes assumed that, in reality, labor supply is a function of the nominal wage, while labor demand is a function of the real wage.
⑤ Reason : Because workers respond slowly to price changes.
⑷ Assumption 4. Money illusion does not exist
① Money illusion : Accepting that income has risen when the nominal unit increases even though the real value of income has not changed.
② This is an error that occurs when economic agents think in nominal variables.
⑸ Assumption 5. Perfectly competitive markets
2. The Classical Approach
⑴ Step 1. Labor market equilibrium : Equilibrium employment and the equilibrium real wage are determined simultaneously.
Figure. 1. Labor market equilibrium]
① Labor demand curve : A decreasing function of the quantity of labor; a function of the real wage.
② Labor supply curve : An increasing function of the quantity of labor; a function of the real wage.
③ Under full employment, only voluntary unemployment exists : In a situation of excess labor supply, involuntary unemployment exists.
④ Case 1. When the nominal wage is at a level higher than the equilibrium real wage (excess labor supply, unemployment)
○ The nominal wage falls, and the real wage w/P returns to the same level.
○ Ultimately, full employment is achieved.
⑤ Case 2. When the nominal wage is at a level lower than the equilibrium real wage (excess labor demand)
○ The nominal wage rises, and the real wage w/P returns to the same level.
○ Ultimately, full employment is achieved.
⑵ Step 2. Determination of equilibrium national income : Since we know the equilibrium employment level, we determine equilibrium national income.
Figure. 2. Determination of equilibrium national income]
① The economy’s aggregate production function
○ Y : Real GDP
○ z : Technology level
○ K : Capital
○ L : Labor
② Short-run aggregate production function
○ Feature 1. The labor input is always fixed at the full-employment level (∵ labor market equilibrium).
○ Feature 2. A positive correlation between labor input and output.
○ Feature 3. The law of diminishing returns : A concave shape when viewed from below.
○ Regardless of the price level, labor input and national income are constant : National income at this point is called full-employment national income.
③ Say’s law (Say’s law)
○ Definition : The law that supply creates its own demand.
○ That is, all income earned in the process of producing goods or services must be entirely spent.
○ That is, the market supply curve appears as a vertical line with a fixed quantity supplied.
○ This means the classical theory can be interpreted purely as a supply-centered convenience.
○ (Reference) In reality, situations where aggregate supply ≠ aggregate demand are frequent (e.g., prolonged excess demand leading to long-term unemployment).
④ (Reference) Supplement to Say’s law
○ Total output (Y)
○ Total demand (effective demand) : Excluding the foreign sector,
○ IP : Planned investment expenditure. This excludes unintended inventory investment from investment.
○ (Reference) Total expenditure
○ Total output = total demand
⑶ Step 3. Quantity theory of money (quantity theory of money) : Determine the price level P.
Figure. 3. Quantity theory of money]
① Fisher’s transactions theory
○ M : Money supply
○ V : Velocity of money; the average frequency with which one unit of money is used
○ P : Price level
○ Y : Real GDP
○ Marshall’s k : 1 / V
② Assumptions of the quantity theory of money
○ Velocity of money is constant.
○ Real GDP is determined at the full-employment level.
○ ∴ The price level does not change full-employment income YF.
○ ∴ The price level is proportional to the money supply.
③ Conclusion
○ The income elasticity of money demand is infinite : It says money does not have a store-of-value function and is merely a medium of exchange.
○ Neutrality of money : Real variables that move due to real factors are distinguished from nominal variables that change due to monetary factors.
○ Therefore, the cause of inflation is argued to be nothing more than a monetary phenomenon due to a rapid increase in the money supply.
○ The quantity theory of money is also the core of Milton Friedman’s economics.
○ Counterargument : Although velocity was generally stable, it has not been stable since the 1980s due to alternative means of payment.
⑷ Step 4. Loanable funds theory : Determine the interest rate.
Figure. 4. Loanable funds theory]
① Supply of loanable funds
○ Private saving (SP, saving private) : An increasing function of the interest rate
○ Government saving (SG, saving government) : Determined by the government’s fiscal policy, so it is unrelated to the interest rate
○ National saving (SN, saving national) : An increasing function of the interest rate
② Demand for loanable funds (IP–r curve) : A decreasing function of the interest rate (∵ borrowing costs rise)
③ Determination of the equilibrium interest rate : The intersection of the total saving supply curve and the loanable funds demand curve
④ Increase in government spending
○ The interest rate rises as demand for loanable funds increases.
○ As borrowing costs rise, investment decreases, and as saving increases, consumption decreases.
○ The decrease in investment and consumption shifts the interest rate back to its original level.
○ Because the interest rate is determined regardless of the money supply, it is called the real interest rate.
⑸ Conclusion
① Flexible prices and guaranteed demand : All markets adjust automatically. Suitable for long-run explanations.
② Full employment of factors of production : The risk of unemployment disappears.
③ Neutrality of money : Changes in the money supply cannot affect the real sector.
④ Saving is a virtue : Saving is encouraged to secure investment resources.
⑤ Based on unrealistic assumptions
Entered: 2020.09.26 14:53