The Chinese University of Hong Kong

Department of Economics

ECON3021
Intermediate Macroeconomic Theory
2024-2025 (First Term)

Lecture 2: Introduction to Classical Macroeconomics

Wallace K C Mok
 Classical Macroeconomics
• Building blocks of macroeconomics
• Theory before the “Keynesian Revolution”.

• Classical theory assumes:

Market Clearing (Flexible Prices)
Say’s Law
Fixed Capital Stock at a point in time
Full Employment at a point in time
 Production Side of the Economy
Y = F (K, L)

Output/Income (GDP)

Where:

F(.) is a production function that uses Labour (L) and Capital (K)
 Production Side of the Economy
Y = F (K, L)
Assume that F exhibits: Y

Positive marginal products

Y
 FK  0
K
Y
 FL  0
L K
Marginal products decreases as labour/capital increases

 2Y
 FLL  0
L 2

 2Y
 FKK  0
K 2
 Production Side of the Economy
Assume also that we have a Constant Returns to Scale technology (e.g. Cobb Douglas):

i.e. λY = F (λK, λL)

Since we assume capital and labour are fixed in their supply quantities at a point in
time:

Y  F (K , L )  Y
Key point: In classical macroeconomics, output is determined by the level of
capital and labour stocks in the economy
 Income, GDP, GNP (or GNI)
• In macroeconomic theory, the distinction
between these measures is not clear

• Income
• GDP: How much does the domestic economy
produce in a year
• GNP: How much do the domestic citizens
produce in a year
• GNP = GDP + Net Income from Abroad
 GNP versus GDP in the United States (billions of $)
22,000

20,000
GDP
GNP
18,000

16,000

14,000

12,000

10,000
 The United States GDP

US Real GDP

25,000

20,000
Billions of Chained 2018 Dollars

15,000

10,000

5,000

0
1929 1933 1937 1941 1945 1949 1953 1957 1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013 2017
 HK Real GDP

3,000

2,500

Billions of Chained 2017 Dollars

2,000

1,500

1,000

500

0
1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013 2017r
Expenditure Side of the Economy
E = C + I + G + (X – M)

Expenditure on domestic goods

• E: Expenditure
• C: Consumption
• I: Investment
• G: Government Spending
• X: Exports
• M: Imports
Expenditure Side of the Economy
E = C + I + G + (X – M)

Expenditure on domestic goods

Consumption

Biggest component of expenditure

Includes purchases of durable, nondurable goods, and services. Also including

imports of these items.
Consumption
Highlights

• Consumption takes about 70% of the

US GDP (about 55% when imports are
subtracted)

• “Services” is a larger portion of

consumption than “Goods”
Evolution of Consumption

US Consumption as a percentage of US GDP

0.7

0.68

0.66

0.64
Percentage of GDP

0.62

0.6

0.58

0.56

0.54

Year
 Evolution of Consumption
HK Consumption as a percentage of HK GDP

0.8

0.75

0.7
Percentage of GDP

0.65

0.6

0.55

0.5

0.45

0.4
1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
r
Year
 Consumption
Let Consumption be a function of disposable income:

C = C(Y – T)

Where T is taxes, so Y-T is the disposable income

C
 C ' (Y  T ) is the Marginal Propensity to Consume
(Y  T )
Expenditure Side of the Economy
E = C + I + G + (X – M)
Investment

Spending for new capital goods, inventory investment, replacement of

depreciating capital goods, additions to housing stock

Assumes that Investment is a function of interest rate

I = I (r)
Investment
Highlights

• Investment constitutes about 17% of

the 2020 US GDP.

• “Nonresidential” investment is much

larger than “Residential” investment.
 Evolution of Investment
US Investment as a percentage of US GDP
US Investment as a percentage of GDP

0.25

25

0.2
Percentage of GDP

20
Percentage of GDP

0.15

15

0.1

10

0.05

0
Year

Year
 Evolution of Investment
HK Investment as a percentage of HK GDP
HK Investment as a percentage of GDP
0.4

40
0.35

35
0.3
Percentage of GDP

30
Percentage of GDP

0.25
25

0.2
20

0.15
15

0.1
10

0.05
5

00
1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
1961 1965 1969 1973 1977 1981 1985 1989 1993 1997 2001 2005 2009 2013 r 2017
Year
Year
Expenditure Side of the Economy
E = C + I + G + (X – M)
Government Spending

• Building new schools, offices

• Public libraries buying new books
• Building new roads
• Financed by Taxes (T)

Budget Deficit = G - T
Government Spending
Highlight

• Government spending is about 20% of

the US GDP
 Evolution of Government Spending
US Government Spending as a percentage of US GDP
US Government Spending as a percentage of GDP
0.3

30

0.25

25
Percentage of GDP

0.2

20
Percentage of GDP

0.15

15

0.1

10

0.05

Year
Year
 Evolution of Government Spending
HK Governemnt Spending as a percentage of HK GDP
HK Government Spending as a percentage of GDP
0.12

14

0.1

12
Percentage of GDP

Percentage of GDP

0.08
10

0.068

6
0.04

0.02

0
0 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
1961 1965 1969 1973 1977 1981 1985 Year 1989 1993 1997 2001 2005 2009 2013r 2017
Year
Expenditure Side of the Economy
E = C + I + G + (X – M)

Exports (X) and Imports (M)

Net Exports: NX = X – M = NX (Y , Y f , er )

Net Exports is a function of:

1. Domestic Income Level

2. Foreign Income Level
3. Real exchange rate (relative price of foreign goods)
 Evolution of Net Exports
US Net exports as a percentage of GDP
US Net Exports as a percentage of US GDP

0.02
6

0.01
4
Percentage of GDP

0
2

-0.01
Percentage of GDP

-0.02

-2

-0.03

-4

-0.04

-6

-0.05

-8
Year
-0.06
Year
 Evolution of Net Exports
HK Net Exports as a percentage of GDP
HK Net Exports as a percentage of HK GDP

0.15
15

0.1
Percentage of GDP

10
Percentage of GDP

0.05
5

0
0 1961 1963 1965 1967 1969 1971 1973 1975 1977 1979 1981 1983 1985 1987 1989 1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013 2015 2017
r

-0.05
-5

-0.1
-10 Year
Year
 General Equilibrium in
Classical Macroeconomics
Supply = Demand implies:

Y E
Thus:

Y  C (Y  T )  I (r )  G  NX (Y , Y f , er )
 Application: Twin Deficits
Disposable Income is either consumed or saved:

Y–T=C+S
Substitute in the equilibrium equation (1) implies:

C + S + T = C + I + G + NX

 S – I = (G-T) + NX

 Savings – Investment = Budget Deficit + Net Exports

 Application: Twin Deficits
S – I = (G-T) + NX

Savings – Investment = Budget Deficit + Net Exports

What happens when the government runs a higher budget deficit:

Example: Tax Cuts in the US in the 1980s (problem set)