The Classical Model and Macroeconomic Policy "the greatness of America has grown out of a political and social system and a method of control of economic forces distinctly its own our American system - which has carried this great experiment in human welfare further than ever before in all history. We are nearer today to the ideal of the abolition of poverty and fear from the lives of men and women than ever before in any land."
Overview What do you do as president if you are faced with a stock market crash that produced headlines like "STOCK PRICES SLUMP $14,000,000,000 IN NATION-WIDE STAMPEDE TO UNLOAD," banks closing their doors all across the country, double digit declines in output and prices, an unemployment rate approaching 25%, and protesters taking to the streets? This was America in the 1930s – a very difficult time that required decisive action by President Hoover, but given the prevailing ideological preference for the market's Invisible Hand over the government’s Visible Hand, aggressive government intervention was not in the cards.i In retrospect the solutions seem obvious; the government could help by printing money and / or by increasing its spending – a solution at least hundreds of former students have suggested over the years when confronted with the situation. If these solutions are obvious to even novices, 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. For President Hoover, it was the American system. the greatness of America has grown out of a political and social system and a method of control of economic forces distinctly its own - our American system - which has carried this great experiment in human welfare further than ever before in all history. We are nearer today to the ideal of the abolition of poverty and fear from the lives of men and women than ever before in any land. And his policies were grounded in this view. To both Hoover and Meyer there was a logic in their policies: markets would take care of all problems, and in this unit we'll outline the basics of the Classical model that dominated economic thinking and policy at the time and provided the theoretical justification for those policies. We begin with the national income identity version of equilibrium - AS = AD. If there is to be full employment, then all of the output produced in the economy (AS) needs to be purchased (AD).
Y=C+I+G+X–M With a little bit of algebra, this equation can be transformed into the following form.
(I - S) + (X - M) = (T - G) Although both 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 funds to build factories and buy machines, while Savings (S) represents households' supply of funds to the market as they put money in
savings accounts, stocks, or bonds. This supply and demand for funds provides 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 foreign currency market because all international transactions - exports and imports - require the use of foreign currency. For the US, Exports (X) represent the demand for $s to buy currently produced goods and services produced in the US, while Imports (M) represents the supply of $s needed to be sold to buy currently produced foreign goods and services. The third term (T-G) is simply the government budget surplus - the difference between how much the government collects in Tax revenue (T) and the level of Government spending (G). If the government is spending more than it is bringing in, it is running a budget deficit and (T - 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)