An Introduction to the Classical Model and Macroeconomic Policy

Overview

What do you do as president if you are faced with a stock market crash that produces headlines like "STOCK PRICES SLUMP \$14,000,000,000 IN NATION-WIDE STAMPEDE TO UNLOAD" and banks begin to close their doors all across the country?   And that is just the beginning as the stock market crash ushers in double digit declines in output and prices, unemployment approaches 25 percent of the labor force, and protesters have taken to the streets.

This sounds very much like the situation in Asia in 1997-1999, but it was also the situation in America in the 1930s.  These were difficult times for President Hoover, one's that required action.  Aggressive government intervention was not, however, in the cards.  To make matters worse, on September 21, 1931 the United Kingdom announced that it would abandon the gold standard presenting policy makers in the United States, as well as the rest of the industrialized world, with the problem of deciding on an appropriate response to this drastic policy shift. What should be the appropriate macroeconomic responses to England's abandonment of the gold standard?

In retrospect it would seem as though the solutions should have been obvious - at least hundreds of former students have been able to come up with a few.  It seems reasonable, to most, for the government to help by printing money and / or by increasing its spending.  But why were theorists and policy makers so averse to any active fiscal and monetary responses?  The answer was that policy makers, including president Hoover and Federal Reserve Chair Eugene Meyer, were guided in their thinking by the prevailing views on how the macroeconomy operates. To them there was a logic in their policies.  It is therefore our first task to outline the basics of the Classical model that dominated economic thinking at the time.  This should help us understand why these policies seemed correct at the time.

To explain the classical model we are going to use tools that we discussed in the earlier section on macro models - the national income identity and the AS - AD model - and a little bit of simple supply and demand.

The starting point is the income identity AS = AD introduced on the first day:

Y = C + I + G + X - M

If the economy is in equilibrium, there is no tendency for the economy to expand or contract and AS = AD.  With a little bit of algebra, this equation can be transformed into the following form:

(I - S) + (X - M) = (T - G)

Although both of these equations contain the same information, the second formulation provides the basis for our discussion of the Classical model. The first term in parentheses (I-S) represents the balance in the financial / capital market. Investment spending (I) represents business demand for credit to build factories and buy machines, while households' supply of credit is represented by Savings (S).  This supply and demand for credit provides us with the basic structure of one of the key markets in the circular flow - the domestic capital market.

The second term in parentheses (X-M) represents the balance in the international flow of goods and services. Exports (X) represent the level of foreign demand for current US production, while Imports (M) represent the level of domestic demand for current foreign production. Because any international transactions will require the use of foreign currency, exports and imports provide the basic structure for the foreign currency market.  When the US exports its goods there is a supply of US currency to the market, and when the US imports goods there is a demand for currency.

The third term (T-G) is simply the government budget surplus - the difference between how much the government brings in tax revenue and how much it spends.  If the government is spending more than it is bringing in, it is running a deficit and (T - G <0).  A balanced budget, meanwhile, would happen if ( T - G = 0).

So far so good.  But what are the implications of this for macro policy?  What guidance does this provide for policy makers confronted with a deepening Depression in the US in the 1930s, and Asia in the late 1990s?  Will the market system left on its own, right itself and reestablish equilibrium at a level that fully employs the nation's resources, or will there be a need for government intervention?

To answer this question we need to look more closely at the individual pieces of the second equation.  Is there any reason to believe there is a natural tendency in the market system to produce a domestic balance [ I=S ]?  Should we expect an international balance [ X=M ]?  If balance is automatically created by the market system, then the implication of the equation is that the government must balance its budget [T=G].  In the world envisioned by the Classical economists, the answer to the question was yes - the market system could be expected to create balance, and the macroeconomic policies of the early days of the Depression were grounded in this belief.  This certainly helps explain the natural reaction on the part of Hoover and Roosevelt to raise taxes and / or cut spending when faced with mounting budget deficits at the onset of the Depression.  According to the Classical economists, an increase in government spending financed by borrowing money would simply "crowd-out" business and household borrowers and leave the economy unchanged.

The monetary policy response was also weak as the Federal Reserve did not undertake an aggressive expansionary policy in the face of a collapsing economy  To explain the Fed's inaction we will need to look more carefully at the Classical economists' view of money and its role in the economy, as well as their view of the labor market. We will begin with a brief discussion of what a gold standard is and how it operates.  What emerges from the Classical view is the Neutrality of Money - money cannot be expected to alter the performance of the real economy and all we can expect from an aggressive expansionary monetary policy is inflation.

Now let's try to fill in the details by returning to the national income identity and looking more closely at the domestic capital and international capital market balances.

Domestic Balance (I - S)

Is there any reason to believe there are market forces that will produce domestic balance, that will equate savings and investment?  To answer this we must look more closely at savings and investment - at the factors that influence the level of savings households want to make and the level of investment firms want to make.   First, the easy one - savings.  Why do people save?  What would make people save more?  What would make them save less?  Classical economists tended to focus on one factor - interest rates.  As they saw it, an increase in interest rates would prompt people to save more since they would earn more.   Savings and interest rates are positively related - any increase in interest rates will raise the return on savings, making current consumption less attractive and savings more attractive.

As for investment, Classical economists also focused attention on one factor - interest rates.  Their theory, untested at that time, was that higher interest rates would raise businesses' cost of  buying new machinery and building new factories and offices, and this would lower demand for investment funds.  As interest rates rise monthly payments on business loans would rise, just as they would on car loans or mortgages. At some point the business would decide not to make the investment just as you might decide not to buy the car or the home. (You can check out the math with the financial calculators).

Now all we need to do is put these ideas into a graph - a graph of the capital market with interest rates (price) on the vertical axis and quantity of funds (savings and investment) on the horizontal axis.  The decision to increase savings as the interest rate rises is reflected in the positively sloped S curve.  The investment curve (I) slopes downward because of as the interest rises, investment spending falls. From your earlier work with supply and demand, we know the equilibrium point, where the two curves intersect, is different from all the rest. It is at this interest rate (r*) where supply = demand, where the demand for credit (I) just equals the supply of credit (S). But can we expect the economy to automatically move to this interest rate?

For Classical economists the answer was yes.  Domestic balance will be achieved because the interest rate can be expected to adjust in such a way as to bring about the balance.  We can answer this question by examining what happens if the interest rate were above r*? Would there be a natural tendency for the rate to fall?  At a rate above r* there would be an excess supply of funds, the savings of people would exceed the investment demand for these funds. The result would be a surplus of funds accumulating in financial institutions (banks).  Now if you were a banker paying out interest on your depositors' money, but you could find no one to lend the money to, you would have a sale to unload the inventory.  The sale would be lower interest rates which could be expected to attract additional demand for funds. Banks are just like T-shirt shops - if their inventory is rising, they can be expected to have a sale.

Diagram 1
Capital Market in the Classical Model

Similarly, if the interest rate was below r*, there would be excess demand. In this situation not enough funds would be attracted into the financial institutions to satisfy the demand for loans, so higher prices would be needed to attract additional funds and eliminate the shortage. If the interest rate were free to move, we could expect that it would settle at r* where we would have I = S.

We are now half-way there - the market system has a natural tendency to equate I and S so that we can expect to see (I - S) = 0.   It's now time to turn our attention to the issue of international balance.

International Balance (X - M)

Will the market system left on its own, equate the international flow of goods and services?  Will it create balance in the foreign exchange market?  This will be a little more difficult to 'prove,' but we can outline the nature of the process.   First, however, we need to know a little bit about the gold standard - the international financial system that linked the national economies.  We can start by looking at what happens when US consumers buy 100£ worth of "stuff" from English and English consumers buy \$400 worth of "stuff" from the US.

First, we need to know what the exchange rate is - now many \$s it takes to buy a £.   Under the gold standard each national currency had a price set in terms of gold.   An ounce of gold was set at approximately 20 US \$s and 10 English £s. In this case it would take twice as many US \$s as English £s to buy an ounce of gold. The exchange rate would be set at 2, people would exchange 2\$s for each £.

Returning to the example above, we can now convert the flows into gold. The English purchase of \$400 of US goods means there will be a flow of 20 ounces of gold to the US to pay for these US exports.  Similarly, the 100£ spent by the US on imports from England creates a flow of 10 ounces of gold to England.  The result is a net inflow to the US of 10 ounces of gold.

The question now is: what happens when the supply of gold decreases in England and increases in the US?   Because the world at this time was on a gold standard,  the supply of a nation's money depended upon the nation's ownership of gold.   A government could print money only if there was gold backing the currency - a process we will explore more carefully toward the end of this section.  In this case the 10 ounces that moved into the US from England would mean the money supply in the US could increase by \$100, and the money supply in England would decrease by 50£.

The process described to this point explains the first link in Diagram 2 - the relationship between a trade imbalance and the supply of gold.

Diagram 2
Foreign Exchange Market in the Classical Model:
The Gold Standard

But this is only the beginning.  What happens to the gold after it enters the US?  It is converted back into US \$s so the money supply in the US increases [we will discuss this link in the next section].  What happens when this new money enters the economy?  The answer depends upon what happens when US households and businesses try to spend their new money.  If firms were already at capacity, then they would simply raise prices when they got the new orders. The result would be inflation.   If, on the other hand, it was possible to find additional resources to meet the additional orders, then there would be an increase in output.

According to the Classical economists, the result would be higher prices.  This is a key piece of the logic, and one that we will address shortly.  Here, however, let's look at the implication of this view.   If the supply of money increases in the US and decreases in England, prices in the US begin to rise and US consumers find foreign goods are cheaper than the American goods.  As American consumers switch to foreign goods, US imports rise.  Similarly, in England the decrease in the money supply leads to lower prices so US consumers will increase their purchase of English goods.  This increase in US imports, coupled with the decline in US exports, will tend to eliminate the original trade surplus.

So now balance has been achieved in the foreign capital market.  There are natural market forces that will tend to create equilibrium (X - M = 0).  If we couple this with our earlier result from the domestic capital market (I - S = 0), we find a market economy will achieve domestic and foreign balance without government intervention.   Returning to the original equation that appears below, a balance in these markets means that the government MUST balance its budget ( G - T = 0).  At the conclusion of this section we will examine more carefully the implication of this result for fiscal policy.  It is a belief in this idea that prompted president Hoover to react to falling tax revenues at the outset of the Depression with calls to raise taxes and cut government spending to eliminate the budget deficit.

(I - S) + (X - M) = (T - G)

To fully understand the logic of this view, however, we need to introduce money into the analysis. More specifically, we need to discuss briefly two aspects of money - the money supply process - how money gets into the system - and the monetary transmission mechanism - what happens to the economy once the money is in the system.

Money Supply Process

As we saw in the previous discussion of the external balance, any discussion of the money supply process at the time of the Great Depression begins with the gold standard.  This provides a direct link between the trade balance and the supply of gold.

The key link between the gold supply and the money supply is the Federal Reserve, the central bank of the US [we will discuss in detail the Federal Reserve in our discussion of monetary policy in the 1970s]. For now all we need to examine is the financial structure of the Fed which establishes the link between gold and the money supply.  The financial structure of the Fed, can be best demonstrated with a simple T-account - a simplified balance sheet. As we will see later in our analysis of banks in the 1970s, the two sides of the account need to balance. In this case we are looking at the balance sheet of the Fed which is required to balance its books - the value of its assets must equal the value of its liabilities.

Fed's Original Balance Sheet

 Assets Liabilities Gold 500 Federal Reserve Notes: Currency 900 Loans to banks 400 Federal Reserve Notes: Bank Reserves 100 Loans to government: Government Securities 100 Total 1000 Total 1000

The assets of the Fed are Gold, Loans to banks and Government securities. The Fed can be thought of as the bankers' bank, the place where banks would go to borrow funds. The Fed's assets will include loans to the nation's banks.  The Fed would also hold government securities which are simply sophisticated versions of the US Savings Bonds many of you may own. These are essentially loans taken out by the government to finance its operation - government IOUs that pay interest to the person or institution holding the bond. In this case where the Fed buys the government IOUs, it uses its currency to pay the government.  Finally, the Fed's holding of gold would be an asset.

The Fed's liabilities are the Federal Reserve Notes it issues, the \$ bills you use very day.  These notes can end up in the nation's banks, where we would call them bank reserves, and in people's pockets and stores' registers, where we would call them currency. These Notes are what the Fed owes to others.   If you look at the dollar bills you use as money, you will note it says: "Federal Reserve Note." These are liabilities of the Fed, and if anyone decides they want to return them to the Fed and exchange them for gold, the Fed would pay the gold which would reduce the Fed's assets.  If someone showed up at the Fed's door with \$20 they would have to pay the holder of the \$20 an ounce of gold.

The relationship between assets and liabilities is demonstrated with the simple example above. The Fed has assets consisting of \$500 M in gold, \$100 M in government securities, and \$400 M in loans to banks.  The Fed's liabilities are \$900 M of notes (currency) held by the public (in your pockets) and \$100 M of notes held by banks as deposits at the Fed (cash in bank vaults). The link between the two sides of the balance sheet is the reserve requirement.  The reserve requirement specifies the amount the Fed must hold as Gold or Loans when it issues Federal Reserve Notes (dollar bills). The basis for the rule is that the Fed should have enough gold so that whenever anyone wants to exchange the dollars for gold, the Fed will have enough gold. For example, to satisfy the "reserve requirement" (100 percent to make the math easier), the Fed maintains gold and bank loan assets equal to 100 percent of the outstanding dollar bills. For every dollar in circulation the Fed must hold approximately one dollar in gold or bank loans so that the public remains confident that paper money is actually backed by gold. The required reserve thus links the supply of currency and the supply of gold.

The link between the trade surplus, the gold supply, and the money supply can be seen in the Fed's balance sheet below.  The trade surplus of \$50 million appears as an increase in the gold holdings of the Fed (500 to 550). The holders of the gold will show up at the Fed and ask to convert the gold into \$s that can be used to buy "stuff." The Fed will then "print" \$50 million of new currency to pay for the gold.  When it is done, the reserve requirement of 100% will still be satisfied.  The value of gold and loans (550 + 400 = 950) equals the value of the currency (950). The link between the trade surplus and the money supply has now been completed - a trade surplus creates an inflow of gold that translates into an increase in the money supply.

Fed's new Balance Sheet with trade surplus of 50

 Assets Liabilities Gold 500 +50 Federal Reserve Notes: Currency 900 +50 Loans to banks 400 Federal Reserve Notes:Bank Reserves 100 Loans to government: Government Securities 100 Total 1000 +50 Total 1000 +50

This simple example of the Fed's balance sheet also allows us to see what happened to the money supply during the Great Depression, although a full treatment of the money supply process will not be developed until our discussion of the 1970s.  First there was an external drain on the system due to the fact that gold was leaving the US.  By 1931 BIG world money people, worried about leaving their money in US banks and stock markets, were bringing their money home which drained gold from the US.   If there was a decrease in gold of \$50, then the Fed would need to reduce the level of currency in the country by the \$50.

There was also an internal drain on the system.  One of the asset items on the Fed's balance sheet is the loans to banks.  Commercial banks could borrow from the Fed only if they used commercial loans as collateral.  The idea was known as the Real Bills Doctrine.  If a business had a god idea then they could sell that idea to a commercial bank and receive a loan from the bank.  The bank would then "exchange" that loan with the Fed which would pay for the loan with new currency.  In this situation the Fed was supplying all of the currency that the economy needed.  When the economy expanded, as it did through much of the 1920s, companies came to banks for loans and these banks then went to the Fed to borrow the money to lend to the companies. As a result, during the boom years the money supply increased.

Things looked very different, however, on the other side of the business cycle - when the economy slipped into a recession.  When business went bad in the early 1930s, bank lending to businesses declined, and with it came a decline in bank borrowing from the Fed.  For example, if loans to banks fell by \$50, then this would be offset by a reduction in Federal Reserve notes (currency) of \$50.  In fact, between 1929 and 1930, the loans made to banks declined nearly 60 percent.  Because the dollars in circulation are considered part of the money supply, the result of the decrease in loans to banks would be a reduction in the money supply, which is in fact what we saw.  Thus one of the features of the onset of the Great Depression was an internal and external drain on the financial system that led to a decrease in the money supply.

Fed's Newer Balance Sheet after decline in loans to banks

 Assets Liabilities Gold 500 Federal Reserve Notes: Currency 900 Loans to banks 400 - 50 Federal Reserve Notes:Bank Reserves 100 - 50 Loans to government: Government Securities 100 Total 1000 - 50 Total 1000 - 50

In the 1930s the Fed allowed the decrease in loans to banks to pull down the money supply because it was committed to the gold standard that linked the two sides of the Fed's balance sheet.  When gold or loans to banks decreased, the Fed allowed the change to be reflected in a change in the money supply and this tended to exacerbate the effects of the recession.  [In the discussion of the money supply process in the 1970s we will see how the reduction in the Fed's supply of currency will eventually result in a substantially larger decrease in the money supply].  As we will see later, the Fed had some policy tools that could have broken the link between the money supply and the assets of the Fed, but the Fed took a hand's off approach to domestic economic policy.  In 1987 on the other hand, when the stock market crashed, the Fed flooded the system with money so that the crash in the stock market would not translate into large numbers of bankruptcies and a decline in the money supply.  To better understand the impact of the fall in the money supply on the economy, we will now turn our attention to the transmission mechanism - the impact of changes in the money supply on the macroeconomy.

The Monetary Transmission Mechanism

Once the money is in circulation, the next question is: What impact will it have on the economy? If the change in the money supply had no impact on the real economy, on jobs and output, then the reduction during the early stages of the depression should have been a non event.  The prevailing theory suggested precisely this, which may have contributed to the Fed's decision to allow the decrease in the money supply. According to the prevailing Classical view, money was neutral, all that we could expect from changes in the money supply would be changes in the price level.  It would have absolutely no impact on output and employment which was the real problem that needed to be solved as the Depression deepened.

The key to understanding this link between money and prices is the Quantity Theory of Money. In the Classical view, money was simply a medium of exchange.  Money had no intrinsic value - you could not eat it or wear it - so if you had it, you would spend it. This Quantity Theory of Money can be best presented with a simple equation.

MV = PY

The value of nominal GDP (PY) equals the product of the money supply (M) and velocity (V) which is defined as the number of times money turns over in a year. For example, if there were ten \$1 bills in circulation (M), and each dollar is spent an average of twenty times in a year, then velocity (V) would be twenty and this money supply would support spending (PY) valued at \$200.  In this example let's assume that we have 200 units of output (Y) at an average price of \$1 (P).

Given this relationship between the money supply and the value of spending (nominal GDP), the question now is: how will the increase in the money supply resulting from the trade surplus be allocated between higher prices and higher output? Returning to our example, if the money supply were increased to twenty \$1 bills, two possible outcomes would be: output could increase to 400 units with an unchanged price level, or the average price could rise to \$2 with an unchanged level of output.

Possible impact of increase in money supply

\$20*20 = 400*\$1 (higher output)
or
\$20*20 = 200*\$2
(higher prices)

While the math may be the same, the two possibilities are quite different. In the first, the increase in the money supply results in higher prices without any change in the "real" economy. There will be no changes in the amount of output produced and thus there will be no change in employment. This inability of monetary policy to have an impact on the real economy has been referred to as the "neutrality of money." In the second scenario, however, the money supply will result in higher levels of output and therefore higher levels of employment.

So what is it?  Do we get higher output and more employment, or do we get higher prices?  To determine which of these outcomes is most likely we need to introduce one last piece of the model - the Classical view of the labor market.

The Labor Market

The Classical model is represented in Diagram 3 where the interaction of suppliers and demanders of labor determines employment (L) and earnings (w). The Classical tradition of belief in flexible prices and well functioning markets is reflected in the assumption the economy will always operate at full employment. In a well functioning labor market, a wage rate (w*) would be established that would produce a balance between labor supply and demand. If the wage rate happened to be above w*, a likely event given that any number of shocks to the system could have produced it, then there would be unemployment, but it would be temporary.  Classical economists felt confident that the unemployment would be cured as unemployed workers bid down wages until an equilibrium was established at w*.  Similarly, if wages were below w*, then wages would be expected to rise as firms competed for scarce workers. At all times there would be a movement toward the equilibrium which by definition is at full employment - all who wanted to work would be able to find work.  In this simple world, there is no long-term unemployment.

Returning to the initial question of how the increase in money would be allocated between higher prices and output, the answer would be higher prices.  Because the economy was already at full employment, when the money supply increased and people tried to use the 'new' money to buy more stuff, there were no free resources sellers could tap into to raise production.  Producers would offer wage increases to attract more workers, but they would have to raise their prices to cover the higher costs.   Workers, meanwhile, would see the higher prices and demand higher wages just to keep up.  Where once workers worked for \$5 an hour when the price level was 1, we would now find that workers received \$10 an hour when the price level was 2. What we would find is that prices would rise and wages would rise, but that we would get no more employment.

Diagram 3
Labor Market in the Classical Model

We now have all the pieces of the Classical model that provided the basis for the Fed's policy decisions in 1931. Before we look at the policy implications, let's return to the AS-AD model. The implication of the Classical assumptions is a vertical AS curve at full employment.  A change in the price level will not change aggregate supply since it will not change the level of equilibrium employment in the labor market.  If there are no more workers at higher prices, then there will be no more output.  More importantly, the level of income/output in the economy is determined exclusively by the supply-side of the economy, which is why Classical economists focused their attention on the supply-side and tended to ignore the demand-side of the economy.   If they build it, someone will buy it — an economic version of Field of Dreams concept known in the profession as Say’s Law.

Diagram 4
The Classical AS - AD Model

The Policy Implications

The implication of the vertical aggregate supply curve for traditional demand management policy should be obvious.  Policy makers could enact macroeconomic policies that would shift aggregate demand, but they would have no impact on output and employment. For example, over the years students, when confronted with the realities of the Depression, have opted for expansionary monetary and fiscal policies.  It always seemed reasonable to increase the money supply or increase government spending when the economy fell into a depression, but as we have seen, the Classical economists did not believe in these policies.

On the fiscal policy side, the Classical model implies that any efforts to expand public sector spending through borrowing would prove futile [Diagram 5].  If the government decides to increase its spending ( ­ G) by running a deficit and borrowing funds in the capital market, this will result in an increase in demand for funds which will raise interest rates ( ­ r). The rise in interest rates will reduce investment spending (¯ I) and consumption spending (¯ C) so that the net change in aggregate demand is zero. The implication for fiscal policy is simple and direct: balance the budget. Any efforts to expand the economy with expansion of government spending and / or lower taxes will result in a "crowding-out" of the private sector and will have no net effect on the economy's short run performance.   Fiscal policy is ineffective and cannot be considered a stabilization tool.

Diagram 5
Fiscal Policy in the Classical Model

­ G Þ ­ r Þ ¯ I Þ [­ G = ¯ C + ¯ I ]

ß Þ ­ S Þ ¯ C

The logic of crowding-out can be seen by returning to the equation (I - S) + (X - M) = (T - G). Because of the belief in a ‘natural’ tendency for equilibrium (I = S) and (X = M), the government is left with the job of balancing its budget (G = T). Furthermore, if the government runs a deficit (G>T), then the balance will only be restored if there is an imbalance in one of the other two terms — if imports exceed exports (M > X) and / or savings exceeds investment (S > I).

What if the government financed the increased spending by printing more money?   How would the situation be different if the government financed the increased spending by printing more money? Is monetary policy an option for stabilization of the macro economy? The answer to these questions, or at least the answer at that time, was no. The rationale for this position can be traced to the Quantity Theory of Money summarized in the equation MV = PY.

Any increase in the money supply(­ M ) must end up as either higher prices (­ P ), higher growth rate in output (­ Y ), or slower velocity (¯ I). If one accepts the Classical assumptions that velocity is constant and there is full employment in the labor market so that output does not change, then there would be a direct link between the money supply growth and the inflation rate. The growth in the money supply will generate increased aggregate demand as individuals attempt to purchase goods and services with the additional money. But because the economy is already at capacity, output will not increase and the additional demand will manifest itself in higher prices.

Diagram 6
Monetary Policy in the Classical Model

­ M Þ ­ PY Þ ­ P {If ­ Y = 0 then ­ P = ­ M}

ß Þ ­ Y {p = m}

The implications of this analysis are very clear - government should stay out of the business of managing the economy.  Any attempts to stimulate the economy, either with fiscal or monetary policy, will prove to be ineffective at best - the victim of crowding out.  These ideas were not lost on officials at the Fed who, when faced with the UK's abandonment of the gold standard and mounting unemployment lines, refused to aggressively expand the money supply. They were heeded by the President and Congress which refused to aggressively cut taxes or increase spending to counter the decline in private spending.

The logic of the model is impeccable, but it provided no guidance for policy makers dealing with the Great Depression.  This opened the door for John Maynard Keynes and his 'new' theory of how the economy operated - a Keynesian macroeconomic theory that we will now examine.