Answer to Question #272364 in Macroeconomics for Saman Khalil

Question

Suppose that due for example to reconstruction after a war, the capital stock of a

nation increases. Use the graphical framework to illustrate the effect that the

increase in the capital stock would have on output, employment, and the real wage

in the classical model.

Answer 1

The classical theory of output and employment is that changes in the quantity of money affect only nominal variables (i.e. money wages, nominal GNP, money balances), and have no influence whatsoever on the real variables of the economy such as real GNP (i.e. output of goods and services produced), level of employment (i.e. number of labour – hours or number of workers employed), real wage rate (i.e. wage rate in terms of its purchasing power).

Classical economists explained that real variables such as GNP, employ­ment, real wage rate are determined by real factors such as stock of capital, the state of technology, marginal physical product of labour, households’ preferences regarding work and leisure.

Let us first assume that the money supply in the economy is M 0 . In this case, as seen from (d), the aggregate demand curve for output is AD 0, which in interaction with the aggregate supply curve AS determines the price level P 0 . At the price level P 0 , the labour market equilibrium determines the monetary wage rate W 0 and the real wage rate equal to W 0 / P 0 , and the employment rate N F at (a) . The employment rate N F given the production function determines aggregate output Y F. at (b).

Now assume that the money supply increases from M 0 to M 1, which causes the aggregate demand curve to shift upwards from AD 0 to AD 1 [see panel (d)]. Panel (d) . the aggregate demand curve from AD 0 to price level AD 1 rises from P 0 to P 1. Now, as shown in (a) , with the monetary wage rate W 0 and the price level equal to P 1 , the real wage rate falls to W 0 / P 1 at which the demand for labour exceeds the supply of labour. This will cause, according to classical theory, the monetary wage rate to rise to W 1 in equal proportion to the price level, so that the real wage will recover to its initial level (W 1 / P 1 = W 0 / P 0 ) and the labour market equilibrium determines the initial employment level N 1.

As the money supply increased, the nominal wage rate and the price level increased, but the real wage rate, employment and output remained unchanged. Hence, this shows that money is neutral in its effect on real variables.