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History
of Economic Doctrines Session 11 Classical Macroeconomics Real Output: Classical economic theory from the eras of Richard Cantillon, David Hume and Adam Smith to the present focuses on “real” good and resources, and largely ignores the financial sector of the economy on the intuitive argument that paper documents and their manipulation are primarily a way to keep score (money as a unit of account) and facilitate exchange (money is a medium of exchange). Thus, real output is constrained by technology and the amounts of resources available. In modern form, real national output [Q] is determined by technology (f) and resources. Real GDP = Q =
f(K,L) where real GDP is represented by shmoo—whatever people are willing and able to buy, either directly (consumption) or indirectly (investment in economic capital that ultimately produces consumer goods).
The idea that Aggregate Demand might significantly affect output was largely rejected. The only major economic thinker of the classical era who disagreed was Thomas Robert Malthus, who theorized that economy-wide “gluts” potentially arise from disparities in the distribution of income. [The poor always spend all their income, but the wealthy may sometimes fail to spend all their income.] Subsequent thinkers of the classical era believed that David Ricardo had successfully rebutted Malthus by arguing that any “excessive” saving would be invested. Classical Perspectives on Money and Finance Nominal Gross Domestic Product [GDP] can be written as PQ, where Q is output and P is the price level. Economists who accepted Ricardo’s logic focused on factors affecting Aggregate Supply, and real output Q, which is fixed at full employment because of Adam Smith’s “invisible hand.” Aggregate Demand was dismissed as strictly a monetary phenomenon. Thus, the money supply [MS] determined only the price level. P = g(MS) = α × MS, where α is constant.
Conclusion: The
Neutrality of Money: In the long run, the money supply is “neutral” according to the classical (and the neoclassical) view, which means that it affects only the price level and the nominal (monetary) values of prices. The “crude” quantity theory of money posits precise proportionality between the money supply and the price level. Thus, in the long run, a neutral supply of money does not affect the composition or level of total output, nor does it affect the “natural rates” of unemployment, interest rates, or any other “real” variable. Example:
Classical monetary theory concludes that if your money income doubles
and all other prices also double, you ultimately change your “real” behavior
not one iota – or even a smidgen. According to classical reasoning, money merely facilitates accounting and exchange; it does not affect production. Money as a unit of account: In a barter economy with no money, relative prices to consider for good decisions explode as the number of goods available becomes large. Instead of simple Pa / Pb = Pb / Pa, as we have in a
2-good world è 3 goods yield 3 different sets of relative prices. Relative prices can be calculated as [ N(N -1)] / 2. 4 goods yield 6 sets. 100 goods = 4, 950 sets of relative
prices Our brains might be overtaxes
if we had to consider all price permutations for say, a million goods. But
with money as a common denominator, 100 goods can be seen as 100 only100
relative prices. Money as a medium of exchange. Do people want money, or do they want what money represents? In transactions, you give up something that is worth less, subjectively, than your expectation about the value of what you get. (You want what you buy more than you want the money.) For instance, the value of $100 cash < what you expect to get for $100. The Market as a System of Homeostasis Biological entities have automatic adjustment mechanisms. Does the market system? Are these automatic adjustments disrupted when the government gets involved? Classical reasoning suggests that governmental attempts at countercyclical policies disrupt automatic adjustments towards market equilibrium. Example: Shortages and upward movements of prices. Suppose government enacts price controls. This distorts information about the relative scarcity of various goods and resources. If inflation is a problem, the root cause is an excessive supply of money. Would society be better off if the money supply was governed by market forces? John Stuart Mill’s Model of
the Money Supply Issue: Although government may need to coin gold into money to prevent counterfeiting and to ensure uniformity, can private market activities alone generate price level stability under a gold standard? John Stuart Mill’s model assumed that gold mining is a constant resource cost industry, in which case the answer to this question is affirmative.
If Analytical Determinism
of Classical Economics vs. Historicism and Path Dependence Determinism suggests that historical events and the ways we measure things don’t really matter. -
Ex: Use of metric system vs. English measures…
If we switched to a metric system, we would probably get the same gas
mileage, marry the same people, pursue the same occupations, have the same
children, live the same lives, etc. Historicism (Path Dependency) - Ex 2: QWERTY Keyboards: o
If the first keyboards had been better designed,
would we type faster? Quesnay, Hume, Smith, Cantillon and Ricardo: - Laissez-faire à government should stay out of things - General gluts? à Production > demand o
Solution? Price cuts à
in the LR, market cures everything Aside Under assumptions of zero transaction costs and hyper-rationality à markets will always operate efficiently. But how about conditions of positive transaction costs, or arational behavior? Byrns’ Pinball Theory of Inflation: People seem to want bigger (or smaller) numbers. Examples: Pinball score (across time) to
win free games: 100 à 400 à
1000 à
1,000,000 Women’s dress sizes: Size 10 circa 1965 is now size 4. Pole vaulting = permissible flexibility of pole increases à new record heights. Grade inflation = what customers (students? families?) want, they get. Sports: Most rule changes favor offense over defense. Income/wealth? Inflation helps folks get more every year. Lots of millionaires. Optional Reading: The Demand for Inflation |
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These web pages are significantly edited and elaborated versions
of student notes based on lectures by Ralph Byrns, 2002-2007.
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