11.1 Introduction and Aims<\/strong><\/p>\n In Chapter 10, we discussed issues relating to labour market measurement. In this Chapter we will focus on theoretical concepts that underpin the measurement of economic activity in the labour market and the broader economy.<\/p>\n The Chapter has five main aims:<\/p>\n NOTE:<\/p>\n At present, I am outlining the Classical theory of employment determination and output – which is the basis of their denial of involuntary unemployment. In the section last week – Keynes and the Classics – Part 1<\/a> – I explained how the Classical system conceives of labour supply and demand and how these come together to define the equilibrium level of the real wage and employment.<\/p>\n Yesterday – Keynes and the Classics – Part 2<\/a> – we showed how the labour market determined the level of employment and real wage, which in turn, via the production function set the real level of output.<\/p>\n In other words, all the major real variables in the macroeconomics system were considered to be determined by the labour market and the production technology – a supply-side approach.<\/p>\n We also introduced the concept of unemployment into the Classical system and saw that it could only be a temporary phenomenon if real wages were flexible. Only so-called institutional rigidities such as trade unions and government minimum wage legislation could lead to a situation where unemployment was persistent.<\/p>\n We then started to see why the Classical system denied the possibility of generalised over-production – and in that context introduced the Classical theory of interest via the loanable funds doctrine.<\/p>\n That is where I am picking up from today. Note Section 11.9 is a slightly revised version of yesterday’s text – to get me rolling again!<\/p>\n NEW TEXT STARTS TODAY<\/p>\n 11.9 The loanable funds market – Classical interest rate determination<\/strong><\/p>\n The Classical theory of interest rate determination provided them with a mechanism for denying the possibility that there could be a generalised deficiency in planned aggregate spending, which would result in idle productive capacity and persistent unemployment.<\/p>\n They admitted that specific goods and services could be “over-produced” relative to the preferences of the consumers and firms but believed that rapid market adjustments would ensure there could never be a generalised glut .<\/p>\n The denial that generalised over-production could occur has become known as “Say’s Law” after the French economist Jean-Baptiste Say, who popularised the view.<\/p>\n The idea is sometimes summarised by the epithet – “supply creates its own demand”. The logic is that by supplying goods and services into the market, beyond the output intended for own-use consumption, producers are signalling a desire to exchange their surplus output for other goods supplied into the market.<\/p>\n Using the terminology developed in Chapter 9, and assuming for simplicity a closed economy without a government sector, which is the typical depiction of the Classical system, we know that in equilibrium, the total flow of spending in the economy is equal to total real GDP and national income (Y).<\/p>\n Total spending is the sum of consumption (C) and investment (I):<\/p>\n (11.6) Y = C + I<\/p>\n Equilibrium requires that the flow of real output (Y) is sold in each period.<\/p>\n National income is either consumed (C) or saved (S) which allows us to write:<\/p>\n (11.7) Y = C + S<\/p>\n In equilibrium:<\/p>\n (11.8) C + I = C + S<\/p>\n Which means that the equilibrium condition is S = I, or planned saving is equal to planned investment. This means that all goods designed to be consumed are sold and the remaining national income is equal to investment (designed to provide for future consumption).<\/p>\n The Classical system considers that withheld consumption in each period is matched by (planned) investment spending given that the saving is just a signal that consumers wanted to consume in the future. Firms are thus assumed to invest in future productive capacity to ensure they can meet that demand.<\/p>\n From an existing equilibrium, imagine that the desire to save rose. Consumption would fall in the current period and to maintain the equilibrium output level planned investment would have to rise.<\/p>\n What mechanism exists that would bring planned saving and planned investment into equality each period to allow for shifts in, for example, consumer behaviour (a rise in the desire to save in this case)?<\/p>\n Ignoring questions relating to the logistics of how an economy might quickly shift between the production of consumption and investment goods, the answer lay in the way the loanable funds market<\/strong> operated.<\/p>\n The theory of loanable funds – which is the Classical theory of interest rate determination – provided the Classical system with the vehicle to explain how aggregate demand could never fall short of aggregate supply. The continuous equilibration would be achieved by interest rate adjustments, which would always bring planned saving and planned investment into equality as household and firms preferences changed.<\/p>\n The loanable funds market is really a primitive depiction of a financial system. The interest rate (r) is a price that ensures that planned investment is equal to planned saving in any period and is determined within the loanable funds market.<\/p>\n Savers (lenders) enter the market to seek a return on their savings to enhance the future consumption possibilities. Equally, firms seeking to invest (borrowers) enter the loanable funds market to get loans.<\/p>\n The interest rate that is determined in this market provides the return to households for their saving and determines the cost of borrowing funds for investment.<\/p>\n The following diagram shows the market for loanable funds. The supply of loans is derived from current saving which is assumed to be positively related to the interest rate. As the interest rate rises, the return on saving rises and so the supply of funds (saving) rises (and current consumption falls).<\/p>\n The demand for funds comes from borrowers who wish to invest in houses, factories, and equipment among other productive projects. Firms form expectations of future returns that they will derive from different projects and rank the profitability of projects for the current cost of funds. As the cost of borrowing (the interest rate) rises, the demand for funds falls because the net return on the planned projects diminishes.<\/p>\n In other words, the demand for loans (investment) is negatively related to the rate of interest. The higher the rate of interest, other things equal, the lower will be investment.<\/p>\n The interest rate adjusts to ensure the supply of funds (saving) equals the demand for loans (investment). In Figure 11.7, the equilibrium interest rate is r* per cent, and this corresponds with equilibrium saving (S*) and investment (I*).<\/p>\n If the interest rate was below the equilibrium rate then the volume of funds demanded from the loanable funds market by would be borrowers would exceed the supply of loanable funds and competition among the borrowers would force the interest rate up. As the interest rate rises, planned saving would increase and planned investment would decline. At the equilibrium interest rate, the imbalance between supply and demand would be eliminated and planned saving would equal planned investment.<\/p>\n The converse then follows if the interest rate is above the equilibrium.<\/p>\n Figure 11.8 shows the impact on the interest rate and the equilibrium level of saving and investment when households decide to consume more of their income in the current period. In this circumstance, the Supply of Loans (S) shifts to the left (say to S2<\/sub>).<\/p>\n At the previous equilibrium interest rate r*, there is now an excess demand for loans equal to the distance AB. Competition for the scarce funds drives the interest rate up and a new equilibrium is established at r*2<\/sub> per cent, and this corresponds with equilibrium saving (S*2<\/sub>) and investment (I*2<\/sub>).<\/p>\n You should be very clear that the real GDP level does not change as it is determined by the real wage and employment equilibrium set in the labour market.<\/p>\n What changes in the Classical system is the composition<\/strong> of final expenditure and output rather than the total flow. The lower saving is replaced by higher consumption and investment contracts accordingly.<\/p>\n You might also wonder how an economy could make these shifts quickly given that production of consumption goods and services would require a different mix of capital than the production of capital goods. We will discuss that point later.<\/p>\n You should now be able to articulate a story of what might happen should the borrowers expect stronger revenue flows from investment projects or consumers become more cautious and decide to save more of their income.<\/p>\n As a final observation, the Classical system considered the interest rate to be a real<\/strong> variable which adjusted to bring real aggregate demand into line with aggregate supply (via the loanable funds market).<\/p>\n Thus the entire real side of the simple economy is explained in the Classical system without reference to money. Real GDP, national income, employment, the real wage and the interest rate are all determined in the Classical system once we know the state of technology and the preferences of households between work and leisure and consumption and saving.<\/p>\n As we will see, the only function the introduction of money serves in the Classical system is to determine the aggregate price level (and the inflation rate). In the economics literature this separation in the explanation of the real side of the economy and the nominal side (price level determination) is referred to as the classical dichotomy.<\/p>\n 11.10 Classical price level determination<\/strong><\/p>\n To complete the Classical system, we consider their conception of aggregate demand, which allows the system to determine an aggregate price level.<\/p>\n While the output level once the real wage and employment is determined in the labour market and the loanable funds doctrine ensures that real aggregate demand will be sufficient to absorb that level of output, the question that remains is how are the nominal variables in the Classical system determined.<\/p>\n The two key nominal variables are the aggregate price level and the money wage rate. The determination of the money wage follows once we know the price level because the real wage is just the ratio of nominal wage to the price level.<\/p>\n The Classical system explains the determination of the price level by reference to the Quantity Theory of Money. Money is exclusively a means of exchange<\/strong> to overcome the problem of double-coincident of wants in traditional barter models. For example, a plumber who desires the services of an electrician, no longer has to find an electrician who simultaneously desires the services of the plumber.<\/p>\n A given nominal stock of money (Ms), which is a sum of dollars, is considered to be moved between individuals as various transactions are made during some period. The number of times the stock of money turns overs each period in the course of these transactions is called the velocity of circulation (V).<\/p>\n The product of the stock of money and the velocity of circulation (MsV) must therefore equal the total nominal value of real output in a given period. The total nominal value of output is the product of real output (Y) times the price level (P). You will note that this is the definition of current price GDP, which we analysed in Chapter 6.<\/p>\n The Quantity Theory of Money is thus captured by the following expression:<\/p>\n (11.9) MsV = PY<\/p>\n The product MsV is a nominal amount and represents total nominal aggregate demand in a given period, whereas the product PY represents the nominal value of aggregate supply in the same period.<\/p>\n The Classical system assumed that V was constant being determined by spending habits and other shopping customs (including the time of wage and salary payments).<\/p>\n Further, given that the Classical system assumes that the real side of the economy is determined without reference to the stock of money and that real wage flexibility ensures that full employment output will be supplied in each period (as a result of continuous labour market clearing), then Y is also assumed to be fixed in each period.<\/p>\n It becomes clear from Equation (11.9) that if V and Y are fixed, then changes in Ms will cause changes in P.<\/p>\n The Classical system also assumed that the central bank controlled the nominal stock of money in circulation and thus were in a position to determine the nominal value of total spending.<\/p>\n In Chapter 15 Money and Banking, we will examine the concept of the money multiplier, which is the theorem that the Classical system relies upon for their assumption that the central bank can control the money supply. We will learn that there is in the real world the assumptions that underpin the concept of the money multiplier do not hold and that the central bank is unable to control the stock of money in the economy at any point in time.<\/p>\n But for now, we continue to assume that the central bank can control Ms. It follows that with the real variables determined in the labour market, the only variable that the central bank (government) can influence is the price level.<\/p>\n This idea resonates throughout the history of economic thought and as we will see later in the Chapter when we consider the Phillips curve, it led to the current policy resistance to the use of fiscal policy and the promotion of monetary policy as the primary counter-stabilising policy tool.<\/p>\n It follows logically that if V and Y are fixed in any period, then if the central bank was to accelerate the growth in the money supply (Ms) then all it would accomplish was an accelerating growth in the price level, which we call inflation. This theory thus became the central authority for the claims that inflation is caused by lax monetary policy.<\/p>\n 11.11 Summary of the Classical System<\/strong><\/p>\n The simplified Classical system has the following features:<\/p>\n 11.12 Pre-Keynesian criticisms of the Classical denial of involuntary unemployment<\/strong><\/p>\n Understanding the meaning of involuntary unemployment requires a prior understanding of the concept of effective demand, which we discussed in Chapters 8 and 9.<\/p>\n The 1936 publication of – The General Theory of Employment, Interest, and Money<\/a> – by John Maynard Keynes is credited by most as providing the definitive analysis of the concept of effective demand. Later in this Chapter we will consider how Keynes attacked the Classical view that the real outcomes of the economy were determined by the full employment equilibrium achieved in the labour market via real wage flexibility.<\/p>\n However, the essential elements underpinning the critique of Say’s Law and the modern understanding of involuntary unemployment in a monetary capitalist economy can be found in the work of Karl Marx, particularly in his – Theories of Surplus Value<\/a>.<\/p>\n\n
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