The Classical Model
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 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.
Given that the level of output Y is already determined, the aggregate supply curve is vertical.
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.
The EconModel presentation for the Classical Model has the following features.
The EconModel presentation explains the following curves:
Loanable Funds Supply and Demand
The EconModel presentation analyzes the effects of changes in:
Taxes on Labor Income