| The term macroeconomics was
introduced to the
profession after the onset of the Great Depression.
Nonetheless,
prior to 1930, there was a body of theory that attempted to
explain
the workings of the aggregate economy. Today, this body of theory is
collectively
termed classical macroeconomics, although that is not a label
its
authors would have given themselves. |
| Classical macroeconomic theory consists of
three distinct
bodies of theory. The first is an equilibrium model of the supply of,
and
demand for labor. Coupled with a description of the technology of
production
-- the production function -- that defines how labor inputs are
converted
to output of final goods and services, the model provides an
explanation
of the determination of output and employment. |
| The second body of theory is concerned with
the determination
of the price level and the interest rate. Prices depend, above
all,
on the supply of money circulating in the economy, through a
relationship
known as the quantity theory of money. The theory equates the
supply
of money to its demand. |
| The third body of theory is concerned with
the determination
of the interest rate. The equilibrium interest rate is the rate that
equates
the amount of funds people wish to lend with the amount that others
wish
to borrow. |
| In short, the classical model consists of
three simple
supply and demand models: one for employment, one for money, and one
for
borrowing and lending. There is remarkably little interaction between
them,
and little of complexity behind the basic ideas. |
How well does such a simple model do in
explaining macroeconomic
phenomena? The answer is mixed. The classical model embodies some
policy
implications that find support in the data:
| Output can be permanently stimulated by
appropriate changes
in tax policy. |
| Inflation is primarily a problem of too
much growth in
the money supply |
| Excessive government spending induces
high interest rates
which in turn crowd out private sector spending. |
But the classical model also had one major, and
untimely,
failing: It had very little useful to say about the causes of, and cure
for, the Great Depression. |
Download lecture notes for this section here. |
| Review questions for this section can be
found here. |