The Classical Model

Introduction

This page describes *the* Classical Model.

The Production Function and the Demand for Labor

The Production Function

In the classical production function, output Y is taken to be a function of capital K and labor N. (The notation for labor suggests the number of hours or the number of workers.) In the short run the capital stock is taken to be fixed at K so that

**Y = f(K,N).**

Demand for Labor

The marginal product of labor is **dY/dN = MPN**,
which should be a decreasing function of **Y**. A profit-maximizing
firm should hire additional workers if **P·MPN
> W**. At the margin

**P·MPN = W**or, equivalently,

**MPN = W/P**. The

**MPN**curve thus is the demand for labor.

The Supply of Labor

The supply of labor is an increasing function of the real wage rate.

Equilibrium Output

Equilibrium in the supply and demand for labor as
functions of the real wage rate determine the real wage rate and the quantity of
labor hired **N**. The quantity of labor hired then determines, via the
production function, the level of output **Y**.

The graphic to the right also shows the effects of a negative technology shock. Output goes down for two reasons. First, the labor demand curve shifts to the left, lowering the equilibrium amount of labor hired. Second, output for that amount of labor is lower because the production function has shifted downward.

Aggregate Supply and Demand

Equilibrium in aggregate supply and aggregate demand
determines the price level **P**.

Aggregate Supply

Given that the level of output **Y** is already
determined, the
aggregate supply curve is vertical.

Aggregate Demand

The classical
aggregate demand is based on **M = k P Y**,
where **k** is a constant because the velocity of money (Veocity
of Money, Wikipedia) is fixed.

Supply and Demand for Loanable Funds

Adding a supply and demand for loanable funds produces an equilibrium interest rate. This completes the Classical Model.

Note that the interest rate does not appear in any other part of the model. There is no mechanism by which changes in the interest rate (or investment) lead to changes in output.

EconModel

The EconModel presentation for the Classical Model has the following features.

Building Blocks

The EconModel presentation explains the following curves:

Production Function

Labor Demand

Labor Supply

Aggregate Supply

Aggregate Demand

Loanable Funds Supply and Demand

Analysis

The EconModel presentation analyzes the effects of changes in:

Technology/Productivity Shock

Taxes on Labor Income

Money Supply

Government Spending/Taxes