Economic Models Essays - Labour Economics, Keynesian Economics

Economic Models The Classical model of the economy says that all markets always clear. The labor market failing to clear does not exist in the Classical model because of competitive exchange equilibrium in which prices and quantities always adjust perfectly. The Classical model is of a closed economy and the variables are real output, employment, real and nominal wages, the price level, and the rate of interest. It is easier to understand the classical model using five diagrams that are numbered one through five in Appendix One, The Classical Model. These diagrams represent the separate parts of the model that together illustrate, for the most part, the entire Classical model. Diagram one represents the production function, which shows the assumption that real output, y, is determined by the level of employment, N. So y is a function of N and from the slope of the function we can see that output rises as employment is increased. But there is a diminishing marginal productivity of labor, which means that each time employment increases, the increase in output will get smaller and smaller. Diagram one illustrates the relationship between output and employment in the short run, but does not determine the level of output or the level of employment. But when used together with other diagrams of the model, diagram one can be used to figure these things out. Diagram two is the labor market with the real wage, w, on the vertical axis and employment, N, on the horizontal axis. In the classical model, the supply of labor depends upon the real-wage level because as the real wage rises, more people are willing to work. The line SN represents the labor supply function and the line DN represents the demand for labor. As the real wage increases so does the labor supply function, but as the labor supply function increases, the demand for labor decreases. Because the Classical model makes real wages perfectly flexible and allows it to adjust to the level that clears the labor market, the real wage and the level of employment can be figured out by using diagram two. Once given the level of employment determined from diagram two, it is possible to use diagram one to figure out the level of output. So diagrams one and two, also know as the real sector, can be used to determine employment, real output, and the real wage without any knowledge of the monetary sector of the classical model. The monetary sector, given the level of real output, determines only the monetary or nominal variables such as the price level and the money wage. The separate treatment of the monetary sector and real sector is known as the 'Classical dichotomy.' To complete the model, diagrams three, four, and five are needed. Diagram three represents the Classical aggregate demand curve, which shows the relationship between real aggregate demand for output, y, on the horizontal axis, and the price level P, on the vertical axis. Real aggregate demand represents the sum of the demands for output of all the individuals in the economy. The Classical aggregate demand curve, AD, illustrates the level of aggregate demand for a given price level. Since the government or the central bank can control the quantity of money in circulation, it also controls the position of the Classical aggregate demand curve. But it can only control the price level and other nominal variables because it is independent of the monetary sector. The full understanding of the classical model comes with diagrams four and five, which consider money-wage determination and interest rate determination respectively. In diagram four, the real wage, w, is defined as the money wage, W, divided by the price level, P. For this reason there is a relationship between money wages and the price level which results in a straight line through the origin that corresponds to the real wage. The higher the price level, the higher the money wage must be to maintain any given real wage. Diagram five determines the interest rate, r, which is expressed as a percentage per period and depends upon the interaction of the savings and investment functions. The investment function, I, shows that the lower the rate of interest, the higher the amount of investment. The savings function, S, shows that the higher the rate of interest, the more will be saved. Because of the Classical dichotomy, diagram five is basically to show the breakdown of the use of income, or the demand for output, between expenditure on consumption and new capital goods. Like the Classical model,