Chapter 7: Classical Economics The Economy at Full Employment Issues in 2006 for the Midterm Elections How does increased immigration affect wages and the level of output in the economy? What are the benefits of increased investment? What happens to wages, jobs, GDP if employers must pay higher taxes for hiring labor? If our government spends more, does this mean we must have a lower level of consumption or investment in the economy? Classical Economics  A school of thought that provides insights into the economy when it operates at or near full employment Supply-Siders  Economists / politicians who emphasize the role of taxation for influencing economic activity  Favored by the Republican Party New School: Real Business Cycle Theory  Tries to explain why there are booms and busts in the economy REMEMBER!  With the classical model, wages and prices are assumed to adjust freely and quickly according to the laws of supply and demand  No Keynsian price controls KISS: What determines output?  Stock of Capital (K)   Labor (L)   The total of all machines, equipment and buildings in the economy The total effort of all employed workers in an economy Y = F(K,L)  Y = Income = GDP Y = F (K,L)  Aggregate Production Function: How much output is produced from the inputs of capital or labor  More inputs of either leads to increased output  Could this be a factor in the immigration battles? Aggregate Production Function   In most situations we assume capital is fixed at a constant level! LABOR is the only variation that changes the level of output in the economy! SO: What is the relationship between labor and Output?    If capital is fixed? Increases at a decreasing rate WHY?  See page 133 for graph 7.1 Laffer’s Curve and Capital Gains Taxes   Capital Gains: Profit you get from selling a stock at a higher price than you bought it at Since the tax on capital gains is too high, people don’t sell their stock – bringing down Y and decreasing govt revenue Laffer’s Curve and Capital Gains Taxes  Some politicians say lowering – or removing – the capital gains tax would increase Y and maybe other ways to tax people since they will have more jobs Real Business Cycle Theory  What causes fluctuations in economic activity?    Natural disasters Shifts in technology Small shocks at the same time Real Business Cycle Theory  Theory that emphasizes how shocks to technology an cause fluctuations in economic activity Examples of Real Business Cycle Theory   Changes in technology will change the level of full employment or potential output Adverse developments will cause shocks that cause output and employment to fall Real Business Cycle School of Thought     Very influential Very controversial Doesn’t explain some historical situations Makes the assumption that labor is always at equilibrium between demand and supply Proponents of Real Business Cycle Theory   Other models handle unemployment So far, it hasn’t made it into the macro policy circles  BUT it is an area of active research in classical economics Division of Output Among Competing Demands   Y = f(L,K) In a full employment economy, total GDP is determined by the factors of production (K) Division of Output Among Competing Demands  Full-employment must be divided up between C, I , G, X-M  OR C + I + G + NX  Governments – for whatever reasons – increase government spending Division of Output Among Competing Demands  Government spending might affect other types of expenditures (C, I, X-M)  CROWDING OUT Crowding Out (See pg 145)  NOTE: US Consumes 67% of its GDP and invests a smaller portion than Germany or Japan   Is it due to savings rates cutting into consumption? Is it due to higher payroll taxes cutting into Consumption? Closed Economy: GDP = C+I+G+X   Closed Economy: No international trade Increasing government spending comes at the expense of other uses of GDP  Higher taxes means less money to spend  Crowding out Crowding Out in an Open Economy: GDP = C+I+G+X-M    An economy with international trade Government spending does not need to crowd out either C or I What does get crowded out?  Net exports Crowding In?  IF output (GDP) is fixed:  Decreases in Govt spending means other aspects of C, I, X-M are going to “crowd in”  Net exports could increase Crowding In in a Closed Economy    C or I will increase if G decreases BUT inflationary pressures will be on There is no “leakage” for the excess money