Macroeconomics concepts and applications

Macroeconomics Models

The Classical Model (1776-1935)

The classical model largely follows the conclusions reached in Microeconomics. The fundamental equilibrium is in the supply and demand for labor. The Demand for Labor and Labor Supply, Income Taxes, and Transfer Payments are the major microeconomic references in the Classic Economic Models (Hicks and Keynes, 1937).

Keynesian Models (1936-1969)

The simple keynesian model, a greatly oversimplified view of the economy, constructs an equilibrium without referring to the labor market. This shows that the economy can be in an equilibrium that is far from full employment (Gordon, 1990).

The keynesian IS/LM model shifts from the Classical Model's focus on the wage rate to a focus on long-term and short-term interest rates. These interest rates are taken to be equal. Income and the interest rate are the variables that adjust to achieve equilibrium. The model is presented in two versions, one with fixed prices and one where the Aggregate Supply/Aggregate Demand extension adds adjustments in the nominal price level to the mix (Gordon, 1990).

The Mundell-Fleming Model adds the Balance of Payments (BP) curve to the IS/LM Model. Equilibrium is reached by adjustments in the exchange rate, the interest rate, and income (Parke, par. 1).

The New Classical Model (1970-

Real Business Cycles shifts attention from nominal interest rates back to the real factors of production that dominated the original Classical Model. By considering a "Robinson Crusoe" economy with only one representative agent, the model is able to explain business cycles without introducing even a nominal wage rate (Friedman, 1970).

New Keynesian Economics (1982-

The recession of 1982 reopened the debate about the real effects of nominal monetary policy, and the decade of the 1980's reopened the debate about the stimulative effects of government budget deficits. The Classic Economic Models collection includes a recent reworking of the Keynesian Model:

The IS/MP Model addresses a perceived shortcoming of the IS/LM Model by replacing the price level with the inflation rate and by replacing the nominal interest rate with the real interest rate (Gordon, 1990).

An In-Depth Look

The Classical Model of Macroeconomics

The classical model of macroeconomics largely follows the conclusions reached in microeconomics. The fundamental equilibrium is in the supply and demand for labor. The demand for labor and labor supply, income taxes, and transfer payments are the major microeconomic references in the classic economic models. The classical model spans from the years 1776-1935. These dates are derived from publication dates for major works. The classical model builds on the principles developed in microeconomics to explain how equilibrium production and employment might be determined from profit maximizing and utility maximizing behavior.

The economic model presentation of the classical model deal with the following model elements:

Production

Labor Demand

Labor Supply

Aggregate Supply and Demand

Loanable Funds

Establishing an analytic basis for supply and demand is the cornerstone of achievement of classical economics. The classical model of production and employment builds on this framework to explain the level of aggregate economic activity in terms of supply and demand for labor. While assuming that the demand for labor equals the supply of labor does not lead to an explanation for unemployment, the classical model provides an important point of reference for later models that do attempt to explain unemployment. Similarly, the classical model provides little support for activist government monetary fiscal and stabilization policies, but it does establish a background for thinking about models that do support such policies (Parke, paragraphs 1-2).

The Classical Model of Production and Employment

The production function shows how much output (Y) results from a given amount of labor (N). One study represented this relationship in the following manner:

0.00 + (3.00 + TECH) *N - 0.01 *N*N.

The variable TECH represents the possibility of changes due to shocks to the production technology. The capital stock is treated as fixed (Parke, par.1).

Labor Demand

The labor demand curve is derived from the marginal product of labor, represented by MPN. The MPN is the output of one additional worker, which in calculus terms equals the dY/dN. For the study examined, the equation was represented in the following way:

MPN = 3.00-0.02 *N + TECH.

The marginal contribution of one more worker to the firm's revenues is the price (P) of the output, multiplied by the number of units (MPN) that worker produces. For the firm to maximize profits, the product P * MPN must be at least as large as the wage rate (W) paid to the marginal unit of labor. At the profit maximizing level of output, P * MPN will equal W, so that W/P = WPN (Parke, paragraphs 2-3). To maximize profits, firms hire workers until this condition is just satisfied.

Labor Supply

Labor supply is represented by the following calculation:

Ns = 60.00 * W/P - 6.00 * W/P * W/P

In this case, labor supplied is an increasing function 60.00 * W/P of the real wage rate W/P. This creates a quadratic term - 6.00 * W/P * W/P. Additionally, as the real wage reaches high levels, additional wage increases have less effect on labor supplied. The classic economic models application of labor supply, income taxes, and transfer payments, shows how the labor supply function can be derived from a "utility maximization and a labor-leisure tradeoff" (Parke, par. 5).

Equilibrium

Labor supply and labor demand now establish an equilibrium lever for labor hired, and, given a fixed capital stock, for the level of output. The production function and the labor supply and demand emphasize the relation between the production function and the labor demand curve (Parke, par. 8).

Aggregate Supply and Demand

The aggregate supply and aggregate demand bares two relations between aggregate real output and the nominal price level. Aggregate supply is the total production, which in the case of the classical model, is a quantity already determined by the equilibrium in the labor market. The real output does not depend on the nominal price level. The aggregate demand function is derived from the classical money demand, which is represented by the following calculation:

MONEY = 1.00 * P * Y.

This equation states that supporting the flow of nominal transactions P * Y requires a stock of money equal to 1.00 times P * Y. Therefore, doubling real output, or doubling prices, doubles the necessary money stock. The money stock is fixed. There is an inverse relation between P. And Y that is known as the "Aggregate Demand Curve" (Parke, paragraphs, 8-11).

Loanable Funds

The supply and demand of loanable funds is not a chief element of the classical model, however, it is often included for comparisons with other models - especially the Keynesian Model. The demand for loanable funds is the sum of investment, which depends upon the interest rate (R), and the government deficit GT = G - T, which is taken to be exogenous. This principle is represented by the following:

LFd = 100.00-10.00 * R + GT

The supply of loanable funds is savings, which also depends on the interest rate R, and on income Y. This is represented by the following:

LFs = - 50.00 + 20.00 * R + 0.10 *Y

The simplest reason why the equilibrium is the loanable funds market is not linked to the determination of real output is that nothing in the labor demand and supply equilibrium depends on the interest rate (Parke, par. 12).

Technology Shocks

Technology shocks change the equilibrium level of output by shifting the production function, which has two effects. First, it changes the output for a given level of labor. Second, it shifts the marginal product of labor curve, and, ultimately, the amount of labor hired (Parke, par. 14).

Taxes on Labor Income change in the personal income tax rate can change the amount of output by changing the labor supply curve.

Monetary Policy and Fiscal Policy

One will find the changing the money supply moves the aggregate demand curve. Additionally, changing government spending changes the demand for loanable funds. Neither policy, however, has any effect on production and employment (Parke, paragraphs 14-15).

The Simple Keynesian Model

The Simple Keynesian Model, which is also known as the Keynesian Cross, emphasizes one basic point. That point is that a decrease in aggregate demand can lead to a stable equilibrium with substantial unemployment. The Simple Keynesian Model explains the roles of consumption and investment and then explains the accounting identity Y = C + I + G. Together, these elements determine the equilibrium level of output.

The policy analysis experiments study the effects of animal spirits and fiscal policy. The numerical results illustrate the calculation of a fiscal policy multiplier.

A concluding experiment extends the model to make investment a function of the interest rate. Graphing the shifts in investment caused by changes in interest rates then reveals a simple version of the IS curve found in an IS/LM analysis.

The simple keynesian model is important for its ability to capture the details of recessions, but more importantly -- for its ability to demonstrate the possibility of a stable equilibrium at less than full employment. While the real wage rate adjusts in the classical model to move the economy to full employment, the real wage rate does not appear in the simple keynesian model and equilibrium is achieved by adjustments in aggregate demand, which equals aggregate income. The equilibrium aggregate income need not imply full employment (Parke, paragraphs 21-30).

Animal Spirits?

The 2001 U.S. recession could fit the Simple Keynesian Model. The dot-com meltdown and the 9/11 shock had psychological as well as economic impacts. Could this be the recession that is due to a failure of animal spirits?

A most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits -- of a spontaneous urge to action rather than inaction, and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities...if the animal spirits are dimmed and the spontaneous optimism falters... enterprise will fade and die," - J.M Keynes: The General Theory of Employment, Interest, and Money.

The Keynesian IS/LM Model

The Keynesian IS/LM Model explains how the economy can be in equilibrium even with unemployment in the labor market. There are two versions of this story in this application. The IS/LM Basics application shows you how to derive the IS and LM curves and how to do the basic short-run analysis of monetary and fiscal policy assuming a fixed price level. The steps involved include the following:

Derive IS Curve

Derive LM Curve

Monetary Policy

Fiscal Policy

Tax Model (The Simple Keynesian Model)

The Tax Model is a necessary part of the Simple Keynesian Model. The tax model is explained using the following formulas:

C + I + G

• C = a + b (Y-T)

• T = tY marginal vs. effective tax rate

• Substitute up the stack C = a + b (Y - tY)

• Y = a + b (1-t) Y + I + G

• [1 - b (1-t)] = a + I + G

• Y = k1(a + I + G) where k1 = 1/[1-b (1-t)]

University of Texas, p. 4)

G, T and I simple model (The Simple Keynesian Model, cont.)

C + I + G

• C = a + b (Y-T)

• Solution

• Y = a + b (Y-T) + I + G

• Or Y - bY = a + I + G -bT

• Y = k (a + I + G - bT) where k = 1/(1-b)

University of Texas, p. 7)

The Simple Keynesian Model, cont.

The feedback loop is why investment and government spending have multiplier effects. (To view a diagram of the feedback loop, please go to (http://wueconb.wustl.edu/E1043S00/schenk/Keynes/DifferentViews.html.) drop in investment, for example, has the effect of reducing actual income by the amount of the drop. Additionally, the lower the level of actual income changes expected income, and consumption also declines. Hence a $1.00 decline in investment will, according to the logic of this model, cause a decline in income of more than $1.00 (Schenk, 1998).

The equilibrium condition for this model is that expected income equal actual income. There is another way to look at this equilibrium condition which is often useful. According to Schenk, expected income can be divided into three parts. First some is removed as taxes, and then what is left is divided between consumption and expected savings, or:

Yexp = T + C + Sexp

We have also argued that actual income is made up of three types of spending: consumption, investment, and government spending, or:

Yact = C + I + G

In equilibrium these two equation are equal, or:

C + Sexp = C + I + G

Subtracting C. from both sides gives us the equilibrium condition in this form:

Sexp + T = I + G

According to Schenk, this equation says that equilibrium exists at that level of income for which the amount people intend to withdraw from the flow of spending either as taxes or savings just equals the amount they intend to add to the flow of spending as investment or government spending (1998).

This way of explaining equilibrium is best illustrated with an analogy to a leaky bucket. In the leaky bucket higher levels of water create more pressure and thus faster leakage. An equilibrium level of water occurs when the leakage just equals the inflow of water. In the income-expenditure model, investment and government spending are inflows and taxes and expected saving are leakages. As income increases, so does leakage in the form of expected savings. Just as there will be only one level of water in the bucket for which leakages will equal inflows, so there will be only one level of income in the model for which leakages will equal inflows (Schenk, 1998). Thus equilibrium exists when investment plus government spending equals expected savings plus taxes.

Paradox of Thrift

What if people decide to save more money? That is, people decide to save more at each level of income. One might expect that this would increase the total amount of savings. However, the simple-expenditure model predicts a paradox of thrift. This prediction is that total savings will remain the same and income will decline. If people become more thrifty, the consume less at each expected level of income (Schenk, 1998).

The Mundell-Fleming Model

The Mundell-Fleming Model adds a balance of payments equilibrium condition, and a BP curve, to an IS-LM Model. This extends the closed economy IS/LM framework to allow discussion of the interplay between monetary policy and exchange rate policy. In particular, the model emphasizes the differences between fixed and floating exchange rates.

Having IS, LM, and BP curves that can intersect at one, two, or three points makes understanding the dynamics of the Mundell-Fleming Model a challenge. The model can be worked and graphed in the following manner:

1. Determine capital mobility

Perfect Capital Mobility, Horizontal BP

Imperfect Capital Mobility, Shallow BP

Limited Capital Mobility, Steep BP (steeper than LM)

2. Find the equilibrium and draw the curves

3. Pick a policy (choose one)

Money Supply

Government Spending

Foreign Income

Foreign Interest Rate

4. Check the trade balance

5. Final Equilibrium (choose one)

Solve Fixed Rate: Permanent BP Surplus/Deficit

Solve Fixed Rate: No Permanent BP Imbalance

Solve Flexible Rate

6. Find the equilibrium and draw the curves

Parke, paragraphs 21-29).

Real Business Cycles

The classical model builds on the principles developed in microeconomics to explain how equilibrium production and employment might be determined from profit maximizing behavior and utility maximizing behavior. The real business cycles model further refines this to a simple model that explains how Robinson Crusoe could have business cycles on an island with no other agents, no wage rate, no price level, and, in particular, no monetary authority. In the following discussion found in the book The Life and Strange Adventrues of Robinson Crusoe, the demonstration removes monetary policy and wage/price stickiness from the discussion.