| 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. |
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| Review questions for this section can be found here. |