Classical Macroeconomic Theory
Economics
The classical theory of macroeconomics
The classical theory of macroeconomics is based on two major pillars. Number one is sales law of market. Since law indicates supply, creates each own. Demand. And next is the quantity theory of money. Quantity theory, you have money, let us consider the Cambridge equation, which gives embody goals to gain two pain to Hawaii. Inverse transfer money supply is constant, P is the price level and why is the level of output in the economy? And from here, we get that neutrality, utility of money, which says if money supply increases that will only change the price level, other things will be met at once. So basically classical theory is a Supply-side theory. A
ggregate supply is that dominating factor in here. So let us whenever we are considering the supply chain theory will consider both supply and demand side. But first to really come to the supply side. And then we will come to the demand side. To supply side or the classical aggregate supply in the classical theory is determined by the two markets. Number one is commodity market and number two is factor market. Or in to be specific here, the level market. So first we will consider the labor market. So in this case, equilibrium employment of labor in a macro economy model will be determined to buy the interacts and not be demand and supply. What is the source of demand? The labor is demanded by the farms and in classical theory we consider the existence of perfect company selling the property market. So for all the competitive equilibrium condition we can write, price is equal to the marginal cost.
Now, what is the marginal cost? If we consider labor is the for the sake of simplicity, we consider labor is the only factor of production. So marginal cost will be given as the first order derivative of $2 cost that means total cost will be given as wage rate multiplied by employment, divide the pastoral derivative of which it might be planned by employment. So we can write that MC who wants to wait is given and will get be white by the inverse of my general productivity of labor. So P equals double by MPL equals to B, this gives the right demand function, or in other robots, W equals two, P into my genome activity of labor. So demand of my value is derived by the marginal productivity theory of what marginal productivity theory of issues and so if we consider, we can consider it in other ways also by being equal to what the left hand side stands for. We always and write and side stands for marginal productivity of labor. Now, let's draw the liver demand out.
From the standard production function, we can find that if this is labor and this is marginal productivity of labor, more flavor implied less will be the marginal productivity. So inverse it is uncertain between liver and marginal productivity of labor in a standard production function. So nobody divide for labor will be immersed in related to the real wage or we can write it more. So in particle axis we measure real base in horizontal axis in the liver environment. So we are available that demand for labor will be inversely related to the real wage. So higher the realization lower will be the demand for labor and vice versa. Let's come to the labored supply concept. So there were some playgrounds that is mainly designed to buy the utility maximizing peer review or the waters. So level of workers and two joys incumbent laser, they are preference will be, their utility is a function of income and a laser engine. And from which there whenever you can come up the labor will depend upon the real witch, so if we consider that higher real ovaries indicates that.
I have a purchasing power. So in this case, we have already discussed the microcontrollers. We normally get from individually, that's what bending liver supply curve because initially there are two effects in commercial equations. There are two way lips. One is income effect and another is substitutes an effect. What is substrate user method? If waste rate increases, opportunity cost of laser will also increase. That means by taking one additional hour of breather, one person has to sacrifice the wage rate. And second thing is that so wherever there will be a higher will be the wage rate, there will be a tendency of the workers to substitute laser by work, but there is another thing in common fit whenever the wage rate increases the labor cost. So sometimes they may choose reason over a work, but whenever we are considering it in a macro level, in macro level, we have to consider that that relationship between it and $1. So from here, we get the liver supply balance and this. We consider here real wage.
So here is live our supply is up from somehow real ways. So if real wage increases, labor supply will also increase in the economy. So we will get a little bit of an upward rising carb as the liver supply car. Now, let us consider the liver market equilibrium. So if we consider the relationship between liver and real wage, this is the labor demand curve, this is the lever supply. And this is the equilibrium not real wage equilibrium and what employment here. So whenever we are going to, if we block this in the products and function, we will get the, how good level produce with the economy. Now, if we are if we are going to direct the aggregate supply curve in the economy, we have to find the relationship between price and the output produced. So this is the sensitivity if we consider a negative supply curve particle axis will measure P and marginal taxes will reserve wine.
The question is how this level of output is related to that price. Or if there is any change in price, how the output will be whether there will be any change in output or how the output will respond to our price change. But in this case, we have to consider first if there is change in price, how we do it, affect the labor market and employment. This is the most crucial point in the classical theory. So let us consider the relationship between. So whenever we are introducing the price whether we have to also need to consider the money was not the real vision, but the workers are always concerned about their real wage. So they are not there is no case of money illusion. They actually are actually concerned about their purchasing power or real income. Which is dependent on the real witch. So in this case, in classical economy, let us consider the relationship between. Output and labor employed and real vision. The demand and supply of labor and money which so here we are considering money was not real rich. So money was equal to what money was equal to price in too much productivity of labor.
So if we consider initially, this is the demand curve for labor. And this is the subway car world driver. This is the level of employment. So this is the equilibrium level up environment. So now, consider it price increases. What will happen to surprising increases now we will consider from the perspective of two agents number one is employers or the pumps and number two is the workers themselves. So whenever price increases, the marginal productivity of labor will increase. So demand for labor will also increase. Because in one hand, what we see, what is real wage equals to the blue fighting P so people is money where he price increases that means the real way will form and therefore that producers will be willing to acquire more wireless demand curve will ship to be less. No, question is how the workers will this point. I have already mentioned that the workers are more concerned about the real wage. They are not concerned about the money which that means they don't have any money illusion. So what will happen? Laborers are clever enough. Workers are never enough.
Whenever the price level rises, they realize that they are being worse off. Hence, they will also demand for higher wage. So liver supply curve. There will be equally increasing wage demand by the workers and the liver supply curve will ship glimpse towards. So they will be identically no change in the employment level. Only the if they are increasing, there is increasing price in the loan that there will be. The question will increase by the same proportion and it will have more effect on employment. So if we consider that whatever may be the price, if there is further increase in demand, level demand for increasing price automatically work at the labor supply curve will shoot left over because of our personal demand for they will increase their labor supply price. So they will go for a wish by raining and wage rate will increase. So what do you see? We see that the level of employment is not influenced by the price level. So if level of employment is not influenced by the price level, the output will also not be influenced by the price level, because I would put these up on some of. Our output is a function of environment. So there if there is changing price, there will be no change in employment of labor. And that is why we find that the relationship between price and output that will be. So this is the we can say this Y one is the aggregate supply carbon classical theory that this is called an inelastic supply curve. But what will happen if there is any increase in productivity? So a very considered level of market really and wage rate.
So if there is an increase in productivity. So question business considered, this is the equilibrium. So this is the thing that ultimately we are measuring. So what we will see if there is any increase in productivity, there will be increasing demand for Levi. And hence, in this situation, the workers will not demand for higher wage because this increase in Labor Day demand is created by increasing productivity, not due to increase in price level. So what we will find, we will find that raise your rate will increase. There will be increasing wage rate. They are even increasing environment. So in this case, the aggregate level of employment will increase and there will be increasing everyday supply. So just consider that these increase in aggregate supply, this is this has happened due to any technological change, which is also slow as supply side factor. So from here, we can come to the conclusion that in classical theory, the output level is supply determined. Determined by this appliance side factors product, it will be over labor demand, lower supply, and production function.
Now we'll come to the aggregate demand side of the economy. So again we come back to the Cambridge version of quantity theory of money. So embarks to gain into being two white. When gays known as we have already discussed queries, the inverse of the velocity of money. So in not much concern about these in this part. So now if we consider this is the right hand side as the demand for money and Democrat side as the supply of money. Next, if we would introduce to want to introduce demand, let us consider that Y equals two. For timing, we considered it less of Y, YD demand. So demand for money will depend double so here, the demand for money will be. Multiplied by price level multiplied by aggregate demand of the economy. Because if we consider the demand for commodity increases, we've given the price level that we demand for money will increase. And now if we consider the. Supply of money, which is determined by the Central Bank, to be widened, so from here, we will find out that we will price and aggregate demand in the economy. So how? To see, price will be if we consider taking the right hand side, we can find that K two YD calls to environment. Or why the equals to what? In part by K into P so a.m. is constant, gaze constant, so we can write if the price increases aggregate demand, really. Big like, this is the inverse lessons between price and democracy.
So the quantity theory of money that gives us that inverse relationship between price and demand and from here we can draw that aggregate demand curve for the economy. So in particular axis, if we consider price, if we consider here we give them the money supply, this will be the aggregate demand curve. The economy. So what do we see that there is an inverse relationship between price and demand? The zero Y zero, the price wants to be one, then we get demand will increase two by two one. And so we have already determined one thing that is the supply side. Whenever it will be the interaction of demand and supply, the big 51 and aggregate stuff like that will give the aggregate price level of the economy and they will get leveled up output. So now we will. Be selling produce that demand and supply both.
So that's why vertical axis region is adding wide that means output and supply and in particle axis speed. So we have already got that aggregate supply of Y bar. And this is the AD card. So we get in last week's supply curve and normally people come. So this is not equilibrium price level. Now, if we consider that the money supply is increasing. So if money is applying increases, we have already discussed why they want to invert by gain to P so if minus apply increases what will happen, the aggregate demand will be constant. Aggregate demand curve will shift right to what. So this is AD does. So at this what will happen then. We get a demand for time being prices or B and we get supplies over every year demand is widely. So this gets us demand will put upward pressure on price and consequently when price starts to rise, there will be contracts are not aggregate demand. And this will, that new equilibrium will be, this is E one OP one will be the new price level. So from a year, weekend, come to one more point, that usually of money.
If there is increase in money supply, or if there is increase in environment, the money server increases in the economy, that will cause an increase in aggregate demand, but supplying that will have more equipment. So the output level of the country will remain unchanged, but the price level will increase, so any change, any increase in aggregate demand will cause an inversion, any big lining every yard, and a decrease in aggregate demand, will cause a deflection. So aggregate demand here does not here the electric demand has no influence on output and employment here only changing in demand only cause a change in price. So this classical economics, this is the supply side Equinox. The level of output will be determined by the supply side factors, and any change demand will live the output and employment unaffected. There will be only change in consequent price level. This is what classical economics is