Macroeconomic Models: Classical Theory & Policy Interactions
Classical Economic Principles
In the classical system of economics, the major determinants of output and employment are supply-side factors such as:
- Labor
- Capital
- Technology
- Natural Resources
According to classical economists, these factors determine the aggregate supply, which in turn decides the level of output and employment in an economy. They believed in the concept of full employment, meaning all resources, including labor, are fully utilized. The labor market is assumed to always clear due to flexible wages, and firms always produce at their maximum potential.
The role of aggregate demand in this model is minimal. Classical theory is based on Say’s Law, which states: “Supply creates its own demand.” This means that the production of goods automatically leads to income generation, which is then spent to buy those goods, keeping markets balanced. If there is any short-term unemployment, it is considered temporary, and wage adjustments would bring the labor market back to equilibrium. Therefore, classical economists believed that the economy is self-correcting, and aggregate demand does not influence real output or employment—it only affects the price level in the long run.
Mundell-Fleming Model: Policy Effects
In the Mundell-Fleming model with imperfect capital mobility, the effects of monetary and fiscal policy vary depending on whether the exchange rate is fixed or flexible.
Monetary Policy Effects
Under a Fixed Exchange Rate:
A decrease in money supply (e.g., from M0 to M1) shifts the LM curve to the left, increasing the interest rate and attracting foreign capital. This causes a balance of payments surplus, forcing the central bank to intervene and restore the money supply. Consequently, monetary policy is ineffective under a fixed exchange rate regime.
Under a Flexible Exchange Rate:
The rise in the interest rate causes capital inflow, leading to currency appreciation. This reduces net exports, lowering output and making the contractionary monetary policy more effective in reducing income.
Fiscal Policy Effects
Under a Fixed Exchange Rate:
A decrease in government spending (e.g., from G0 to G1) shifts the IS curve to the left, reducing output. The fall in income causes fewer imports, improving the balance of payments and allowing the central bank to expand the money supply to stabilize output.
Under a Flexible Exchange Rate:
Reduced government spending lowers income and the interest rate, causing capital outflow and currency depreciation. This helps improve net exports and partially offsets the fall in output.
Neutralizing Crowding Out in the IS-LM Framework
The crowding-out effect occurs when an increase in government spending (an expansionary fiscal policy) leads to a rise in interest rates, which discourages private investment. To neutralize this effect, policymakers can use a policy mix—that is, combine fiscal policy with monetary policy.
Specifically, the central bank can adopt an expansionary monetary policy by increasing the money supply. This shifts the LM curve to the right, which helps keep interest rates stable or even lower, even as government spending increases. As a result, both government and private investment can increase, leading to a higher national income without the negative impact of high interest rates. This coordinated approach helps maximize the benefits of fiscal stimulus while minimizing its side effects.