Classical/Neoclassical ModelA Simple Neoclassical Model AssumptionsAgentsNeoclassical Model, ContinuedSlide 5Slide 6Production FunctionProduction Function: MPKProduction Function: MPNCapital ChangeTechnology ChangeThe ModelThe Firm Profit MaximizesTheory of DistributionLabor DemandImplicationsHouseholds OptimizeMicro Analysis of Labor SupplyHouseholds Optimizing IncomeHouseholds Optimize (2)Slide 21Capital Market SummaryCapital Market/Bond Market/Loanable Funds MarketSlide 24Labor Market SummaryInvoluntary UnemploymentEffect of an Increase in Labor ProductivityThe effects of skill-biased technical change on wage inequalityPersonal Income Tax CutClassical Real SectorClassical DichotomyIncrease in Labor ProductivitySupply-side Tax CutQuantity Theory of MoneyEquation of Exchange (1)Velocity of CirculationEquation of Exchange (2)Velocity of MoneyEquation of Exchange (3)Eq. Of Exchange (3) ContinuedSlide 41On to Aggregate DemandAdding Money (1)Adding Money (2)Classical Model in EquationsExpanding the Capital MarketGov’t Increases SpendingGov’t Increases Spending, Details (1)Gov’t Increases Spending, Details (2)Piercing the VeilEffects of Taxes and InflationTax PoliciesSupply-side Effects of Tax CutMonetary PolicyClassical/Neoclassical ModelClassical/Neoclassical ModelGraduate Macroeconomics IECON 309 -- CunninghamA Simple Neoclassical ModelA Simple Neoclassical ModelAssumptionsAssumptionsMarket economy with private property.Markets are fully competitive.All variables in the model are either endogenous, or exogenous and supplied.Initially, there is no government.Except when indicated, the general equilibrium assumptions obtain.Two kinds of individual agents exist in this economy — firms and households.AgentsAgentsFIRMS: -produce commodities-supply the commodities at the market price-demand labor, paying the market wage-undertake investmentHOUSEHOLDS:-Consume (purchase) commodities (at market prices)-Supply labor at a wage-SaveNeoclassical ModelNeoclassical Model, Continued, ContinuedNo agent suffers “money illusion;” therefore, the analysis is real, with the “price level” determined separately from the “relative prices.”Firms and households are each homogeneous. Therefore, we collapse the analysis to that of a single “representative firm” and a “representative household,” and aggregate to form the firm and household sectors.The commodities are also homogeneous, so that we consider a single commodity whose real quantity is “Y.” (Usually, we use “y” for real output, and “Y” for nominal. Therefore, the price of the commodity is the price level, “P.”There are three (3) markets in this economy:- Commodity Market- Labor Market- Capital Market (Loanable Funds or Bond Market)Neoclassical ModelNeoclassical Model, Continued, ContinuedThe nominal wage is “w,” and the real wage is therefore “w/P.”The rate of interest (the price of capital) is “r.” (The convention is to use “i” for the nominal interest rate and “r” for the real interest rate. There are three factors of production— capital (K), labor (N), and land (L). These factors are perfectly homogeneous. E.g., all workers look the same (have the same productivity and skills).At times, we assume that some of these factors, L and sometimes K, are fixed. That is, K=K0 and L=L0. This leads to Y = AF(K,L0,N) = AF(K,N) = F(K,N) = AF(K0,L0,N) = AF(N) = F(N)Neoclassical ModelNeoclassical Model, Continued, ContinuedFirms are technically efficient. That is, they produce the maximum output possible from the factors.Diminishing returns apply to production. Mathematically, this is equivalent to: 0,0 KFNF0,02222KFNF022NKFKNFPositive marginal returns to labor and capital.Diminishing marginal returns to labor and capital.Capital and labor marginal productivities are independent of one another.Production FunctionProduction FunctionKYY=F(N*,K)K2Y2The level of employment has alreadybeen established in the labor market.Y1Y3K1K3Production Function: MPKProduction Function: MPKKYY=F(N*,K)K2Y2Y1Y3K1K3BAThe slope of the tangent at point A is the MPK at point A. The slope of the tangent at point B is the MPK at point B.Production Function: MPNProduction Function: MPNNYY=F(N,K*)N2Y2Y1Y3N1N3BAThe slope of the tangent at point A is the MPN at point A. The slope of the tangent at point B is the MPN at point B.Capital ChangeCapital ChangeNYY=F(N,K2)Y2Y1N1Y=F(N,K1)Technology ChangeTechnology ChangeNYY2Y1N1Y=A1F(N,K*)Y=A2F(N,K*)The ModelThe ModelThe Firm Profit MaximizesThe Firm Profit MaximizesThe firm is profit- maximizing when these conditions are met.Marginal Product of Labor = Real WageMarginal Product of Capital = Real Interest RateWe begin with a representative firm: The firm’s profit function is  = PY – wN – Pr(K – K0)Maximize profit: Assume A=1, Y=F(N,K) and construct expressions for change in profit relative to changes in employment (N) and capital (K) and set to zero. Solve. First Order Conditions:d = P(dY) – w dN = 0d = P(dY) – Pr dK = 0----------------------dY/dN = w/PdY/dK = rTheory of DistributionTheory of DistributionThis is a theory of distribution. It explains how output is shared by the various agents. Workers (households) are paid according to what they actually contribute to the production process (on the margin). Capital is also paid according to its contribution (on the margin). This implies that for the real wage of workers to rise (their real buying power to increase) while prices remain stable, real labor productivity must also rise.Labor DemandLabor DemandIf we differentiate the first result with respect to real wages (w/P), we have by the chain rule:divide by the first term:but by assumptiontherefore 122PwNNF 221NFNPw022NF 0PwNLabor demand slopes downward.ImplicationsImplicationsS, IrIWe can show similarly, cet. par., that investment demand by firms rises as interest rates fall. The investment curve slopes downward.w/PNNdCet. Par., labor demand by firms rises as real wages fall. Labor demand slopes downward.Households OptimizeHouseholds Optimize•The representative household maximizes utility. •Since utility is assumed to result from consumption only, this turns out to be the same as maximize real income. •If utility were maximized in a multi-period model, we