After reading this chapter, you will be conversant with:
• The Classical Aggregate Supply Model
• The Keynesian Aggregate Supply Model
• The Classical Analysis of Income Determination
EARLIER WE HAVE SEEN THE ROLE OF AGGREGATE DEMAND IN DETERMINING OUTPUT AND EMPLOYMENT AT A GIVEN PRICE LEVEL. WE HAVE SIMPLY KEPT ASIDE SUPPLY SIDE AND ITS ROLE IN THE DETERMINATION OF OUTPUT AND EMPLOYMENT. AS WE HAVE SEEN, THE AGGREGATE DEMAND FUNCTION REPRESENTS THE TOTAL QUANTITY OF OUTPUT WILLINGLY BOUGHT AT A GIVEN PRICE LEVEL, GIVEN THE VALUES OF EXOGENOUS OR AUTONOMOUS COMPONENTS LIKE GOVERNMENT SPENDING, NOMINAL MONEY STOCK AND THE TAX RATE AND BEHAVIORAL PARAMETERS SUCH AS THE MARGINAL PROPENSITY TO CONSUME (MPC), MARGINAL PROPENSITY TO IMPORT (MPI), ETC. THE VARIATION IN THE PRICE LEVEL WAS OF A PURELY HYPOTHETICAL SITUATION. WHATEVER AMOUNT OF GOODS WAS DEMANDED WOULD BE SUPPLIED AT THE EXISTING PRICE LEVEL.
We now turn to a complete model of determination of aggregate output and the price level. To start with, we analyze the conditions determining aggregate supply in both Classical and Keynesian macroeconomic frameworks. Later on we integrate both aggregate supply and aggregate demand functions to have a complete model of income determination and price level, with the help of both Classical and Keynesian analyses. The aggregate supply curve describes the combinations of output and the price level at which firms are willing, at the given price level, to supply the given quantity of output. The amount of output that business firms are willing to supply depends on the prices they receive for their goods and the amount they have to pay for labor and other factors of production. Accordingly, the aggregate supply curve shows conditions in the factor markets, especially, the labor market, as well as the goods market.
In this section we concentrate on two special cases in discussing aggregate supply function, i.e. Classical and Keynesian. From a historical standpoint it is very important to compare and contrast the views expressed by the classical economists and J.M. Keynes. The main reason is that the analysis have different implications regarding a market economy’s tendency to adjust to full employment and the relative effectiveness of monetary and fiscal measures.
THE CLASSICAL AGGREGATE SUPPLY MODEL
TO DEVELOP AN AGGREGATE SUPPLY MODEL, WE HAVE TO CONSIDER A NUMBER OF RELATIONSHIPS: THE PRODUCTION FUNCTION, THE DEMAND FOR LABOR FUNCTION AND THE SUPPLY OF LABOR FUNCTION. FROM THESE RELATIONSHIPS, WE DERIVE AN AGGREGATE SUPPLY FUNCTION, A RELATIONSHIP BETWEEN OUTPUT AND THE PRICE LEVEL. THE FIRST STEP IN THE DERIVATION OF THE SUPPLY CURVE IS THE PRODUCTION FUNCTION.
The Production Function
This is a technological relation between the rates of input of productive resources and the maximum rate of output that can be had from those inputs, given the technology of production. For example, suppose it takes two units of capital and three units of labor (in fixed proportion) to produce a particular product. This functional relationship between inputs and outputs is an example of a production function. The measure of quantity of aggregate output is national product or GDP(Y).
Generally, economists are concerned with production functions in a microeconomic context, i.e. production function of a single firm or an industry. For our purpose, we must consider an aggregate production function. For the economy as a whole we postulate the following relationship. Given the nation’s land, natural resources, and technology, the economy’s output is a function of the economy’s capital stock and the amount of labor employed. In equation form, the relationship is
Y = f(K, N) .... (8.1)
where Y represents the economy’s output or income, K the...