"Classical" is a term used to describe economic doctrine before Keynes. Classical economists were mainly interested in understanding long-term changes in national economies, rather than the short-term fluctuations that the Keynesian income-expenditure describes. No classical economist actually wrote down this model -- rather, it's an effort by recent textbook writers to encapsulate Classical views in a simple mathematical form that can be compared to the income-expenditure model. The following treatment is adapted from Mankiw's Macroeconomics.
Here is our model:
Y = C + I + G (equilibrium condition,
in which total output equals the demand for it)
C = C(Y - T) (consumption function -- C is function of disposable income)
I = I(r) (investment function -- r is the interest rate, and investment rises as r falls, falls as r rises. This is bcause firms that want to undertake cpital investment have to finance it by borrowing from the bank.)
G = some fixed amount (government expenditure is exogenous)
T = some fixed amount (taxes are exogenous)
Y = some fixed amount (output is fixed at full employment)
Here is a specific numerical example of this model, of the kind we will work with in class:
Y = C + I + G
Y = 1,000
G = 250
T = 200
C = 100 + .5(Y - T)
I = 500 - 25r
1. Figure out C, I, and personal S, and make up a flow picture. Figure out equilibrium r.
2. Now balance the budget by raising T. Figure out C, I, and personal S, and make up a flow picture. Figure out equilibrium r.
3. Instead of balancing the budget, spend like crazy and double G. Figure out C, I, and personal S, and make up a flow picture. Figure out equilibrium r.
4. Try something else. Starting again with the assumptions in (1), lower both G and T to 100. Figure out C, I, and personal S, and make up a flow picture. Figure out equilibrium r.
5. How about this. Starting with the assumptions in (1), change the investment function to I = 750 - 25r (imagine that businesses suddenly want to buy more machines). Figure out C, I, and personal S, and make up a flow picture. Figure out equilibrium r.
6. And finally try this. Suppose that the marginal
propensity to consume rose from .5 to .75 so that the new consumption function
is C = 100 + .75(Y - T). Work out the results.
How/why things change in thsi model: the interest rate adjusts to equilibrate the flow of national savings with the flow of investment.
Key features: There is always full employment in this
model, by assumption. The interest rate is the great equilibrator
-- if people
decide to spend less and save more (lowering C) r will fall to raise I, so that AD will never be insufficient. In other words output is not
demand-constrained. This is a model in which you will get complete crowding-out of investment by any increase in government spending. There also is no point in doing macro policy to raise employment in this model.