Chapter 11: The Historical Evolution of Macroeconomic Models & the Classical Model

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Chapter 11: The Historical Evolution of Macroeconomic Models & the Classical Model
Models are devices economists use to run thought experiments. For example, suppose the U.S. government was considering placing an embargo on the product of another country. It makes sense that those decision-makers in the government who are considering this policy would ask themselves, given what they know about how economies generally work and what results have occurred when countries have used embargoes in the past, what are the likely results of the policy? How would this policy affect the industries that have been exporting this product? Would the country to be the target of our action retaliate by placing an embargo on some of our products? The more often embargoes have been enacted, by both the U.S. and other countries, the better policymakers should be at anticipating the likely results. What this suggests is that policymakers have a model, based on previous experience, that allows them to answer the following if/then question: If the U.S. embargoes the product of another country, then what is likely to happen.
People use models all the time. But some models are better than others at correctly anticipating the results of an event or action. I’ve noticed when I’m driving near the campus, many college students appear to abide by a model that says, if they are driving along and a traffic signal they’re approaching turns yellow, then they should step on the gas. I’m guessing that after a few traffic tickets for running red lights, students must learn that a better model would be, if the traffic signal turns yellow, then they should step on the brake. I’m assuming that change in their operating model based on the fact that when I’m any distance from the college, a much higher percentage of drivers will brake at yellow lights. Consequently, when models do not correctly anticipate what will happen in if/then situations, then we hone our model based on experience to better anticipate the actual outcomes of actions and events that present themselves in real life.
The Classical Model
David Ricardo (remember him as the originator of the Law of Comparative Advantage?) is commonly credited with systematizing economic thought sufficiently in his Principles of Political Economy and Taxation published in 1817 to launch what a later economist we will talk about, John Maynard Kenyes writing more than a hundred years later, will refer to as the Classical Theory1. The Classical theory or model was people’s understanding of how macroeconomies worked throughout the 19th century, right up to the 1930s. That’s a long time for a model to hold sway. Consequently, I’d describe it as a robust model. Apparently, it reasonably accurately described how people saw their economies unfold for a very long time.
The 19th century Classical economists did not have a formal model, and certainly did not graph their model. However, we will use the circular flow model with the three leakages and three injections that we developed in Chapter 6 to explain what we’ll term the Classical model.
Let’s suppose we are looking at the U.S. economy in the year 1900. I think that warrants a couple of simplifying changes to the circular flow model. First, in 1900 international trade represented only 3% of U.S. GDP. As such a small share of economic activity, I think we can safely ignore, and therefore, remove foreign trade from the circular flow model.
Second, spending by all levels of government represented only 6% of GDP in 1900, making the government sector too small to have much effect. This is particularly so since, at the time, for reasons the Classical model will make clear, governments almost always balanced their budgets, except in times of war. Furthermore, after wars the federal government often ran surpluses in order to pay off bonds sold during the war to borrow needed war funds in excess of those raised by taxes. Consequently, governments did not borrow nearly as much of the funds they spent as they do today. That means governments had much less of an effect on credit markets than they do now. For both of those reasons, I think we can remove governments from the circular flow without doing harm to the predictive abilities of the model.
Notice that this leaves us with only one pair of leakage and injection, namely, savings and investment, respectively. (I’m hoping you recall how economists define investment. If you’re still thinking it’s about buying something in the hopes its value will go up, you’d better go look the definition up again). Notice that the savings arrow is coming out of households. This is a very apt description of our early twentieth century economy. Not only did workers save out of their wages and salaries, but self-employed sole proprietors’ profits were also an important part of households’ savings. The typical household in 1900 saved 20% of its disposable (after tax) income.
There were lots of good reasons why American households were heroic savers. Households saved because they were likely to experience periods of unemployment, or if self-employed, business losses in the highly cyclical economy of the 19th and early 20th centuries. During the 1800s the U.S. economy experienced a depression in each of the odd-numbered decades, with the depressions of the 1830s, 1870s and 1890s being particularly severe. Savings could help put food on the table during bouts of unemployment.
Households saved against the possibility of the illness, injury or death of the primary breadwinner. The age of the typical American male at death in 1900 was almost 48. Many young families would need savings to see the family through the loss of income due to the all-too-common death of a young head of household. Also, savings would pay for doctors’ visits, medications and treatments for other family members. The U.S. experienced a serious tuberculosis epidemic in the late 19th century and polio epidemic in the early 20th century that placed health-related financial burdens on many households.
Though Americans did not retire in the sense that they do today, mature adults saved against the prospect of physical infirmity that meant an inability to work in their latter years. Ideally, their children would help with their support, but not all seniors had surviving children to care for them in their old age. Hence, savings late in life were necessary.
Americans also saved in order to replace property losses. Fires were common, as one can imagine, in households that were heated and lit by the open flames of fires, candles and kerosene lanterns. Work animals died and weather events could damage crops and other property. Owners needed savings in order to replace lost assets.
Household Saving Today

I’d like to digress for a moment. You’ve probably noticed that early 20th century Americans saved a whole lot more than Americans seem to today. You’ve probably heard that at times in recent years American households have saved virtually nothing. I think that mischaracterizes what is going on, and deserves some clarification.

The data we see that suggests Americans are hardly saving is the percentage of disposable (after tax and receipt of transfer payments) personal income that is not spent, as measured by the National Income and Product Accounts as part of the measurement of GDP. It’s an accurate measure, but doesn’t really allow us to compare current Americans’ behavior with Americans of 1900.
For example, Americans today, often with the help of their employers, usually buy health insurance to cover the costs of health care, rather than paying out of savings, as in the early 20th century. In fact, the Affordable Care & Patient Protection Act passed by Congress in 2010 requires all Americans to buy health insurance. Purchases of health insurance are measured as consumption expenditures in the measurement of GDP. However, that insurance expenditure takes care of the same healthcare purchases that savings would have provided for families a hundred years ago.
The same is true for life insurance and property insurance. Today Americans buy insurance to protect them against the early demise of adult family members or damage or theft of their homes or cars. In times gone by, savings repaired or replaced that property.
Actually, life insurance began to be sold in the early twentieth century. Frankly, it’s a better way to protect a young family, when the loss of the primary breadwinner would be most damaging to a family. It’s hard for a young family to put enough savings aside to protect them from such a loss, but not hard to pay the premium for a term life insurance policy that could do so.
Plus, insurance companies supply borrowable funds to the credit markets, just as savings would. Consider, insurance companies charge premiums for policies, which provide the pool of funds from which insurance companies indemnify or pay benefits to policyholders who experience insured losses. It probably makes sense that, by regulation, insurance companies must charge enough to create a pool of funds sufficient to redeem policyholders even in the case of a rash of claims, as when a hurricane hits. Consequently, insurance companies are required have more funds in reserve than they are likely to pay out at any one time, to provide sufficient reserves in the event of an unusually large number of claims.
The insurance companies, obviously, don’t bury those reserves in the basement of their head offices. Rather the insurance companies are allowed to buy and hold (invest in the colloquial sense) those reserves (savings) in the form of assets that will provide a return. The assets insurance companies buy and hold are required to be in a relatively safe. Typically, insurance companies used these reserves to buy packages of mortgages, as we discussed back in our money and banking unit. The insurance companies’ reserves supplied the funds lent by banks to homebuyers, just as depositors’ savings would have.
Some taxes deducted during the calculation of disposable personal income also provide the same protection to households that savings would have a hundred years ago. Unemployment insurance taxes, Social Security taxes and Medicare taxes are intended to provide households income in the case of a bout of unemployment, at retirement or for healthcare of those over 65. Americans in 1900 would have used savings.
Back when I was in my 30s and first began to teach, I added up all the taxes I paid to government insurance funds, what I spent on various private and public insurance policies, including my short, medium and long term disability policies, what I was required to put into the state retirement program and my actual savings. It didn’t surprise me at all to find that the sum total came to 20% of my before tax income. However, my traditional savings (after tax income not spent) came to only about 5 to 10%. My conclusion was and is that most Americans continue to commit the same percentage of their incomes to protecting their families from the vicissitudes of life as in the past. And they often do it in a much more effective way; by means of the purchase of insurance.
One more thought on this topic; when the government measures savings rates as the percentage of households’ after tax income not spent, it is measuring a flow concept, the net saving and borrowing of all households over a quarter of a year. As a result, if I saved money during a quarter of the year, but my daughter and son-in-law borrowed money to buy a home during the same quarter, it is the difference between our saving and borrowing that is measured as how much households saved. It’s not at all surprising, in fact it is the purpose of credit markets to match saving with borrowing (by all the major actors in the economy). The notion that the net borrowing is not big as a percentage of GDP is to be expected. If, instead, one was to look at the stock of American households’ saving, a stock concept measured by the Fed as part of its Flow of Funds Accounts, the most recent year’s data (2010) suggests American households’ (and nonprofit organizations’) net worth was more than 58 trillion dollars. That’s a substantial accumulation of wealth, and is about double the net worth of households twenty years ago.
Our Macroeconomic Experiment
Returning to our adapted circular flow diagram, the only injection is investment. Another way to think of this flow is that this represents expenditures using borrowed funds, no matter which of the four major actors is making the purchase. Today, households, state & local along with the federal governments and foreigners make purchases with dollars borrowed from U.S. savers. In the early 20th century, businesses were the primary borrowers, borrowing to purchase primarily land and physical capital. Households rarely borrowed from banks at this time, unless they were purchasing a business or a farm (which is a business). The first consumer loans were car loans introduced by General Motors; but not until 1919. As recently as WWII, the typical home mortgage loan from a bank was a five-year loan, requiring a very sizeable down payment. And as mentioned earlier, governments usually balanced their budgets, rather than run deficits, as is so common today. Consequently, looking at the early 20th century U.S. economy, it would be fair to say that the investment flow actually was business purchases of land and physical capital with borrowed funds.
Previously, we inserted the credit market in the top half of the circular flow model to show how the credit market re-establishes macroeconomic equilibrium between leakages and injections. Remember that when any of the four major actors in the economy changes saving or spending out of borrowed funds, that change is reflected in a change in either borrower or lender behavior in the credit market, that will cause a new equilibrium in the credit market which, in turn, will move the economy back to macroeconomic equilibrium.
To complete the circular flow diagram of the Classical model, there is one more market I’d like to add, this time to the bottom half of the circular flow diagram. That market is the labor market. Since the bottom half of the circular flow model illustrates factor incomes flowing from businesses to households, labor income (wages & salaries) represents only a part of factor incomes. (The other factor incomes being interest, profits and rents). The labor market is there to stand-in for transactions in the markets of all factors of production.
Now we’re ready to run a mental experiment with the Classical model as illustrated by our adapted circular flow diagram. The purpose is to ask the model an if/then question, and see what it suggests will happen. We will run the same experiment with all three major macroeconomic models that have been used over the past couple of hundred years. We’ll see that the different models give us somewhat different answers as to the effects of the same “suppose this happens” event.
The experiment is: Suppose households decide to save more and spend less, what would be the effect on the economy? This is an excellent experiment to run, because I’m going to give you a couple of examples in U.S. history of occasions when American households did exactly that. Specifically, let’s suppose that instead of saving 20% and spending 80% of their after tax incomes, Americans decide to save 30% and spend 70%.
Turning to our adapted circular flow diagram, we can start by imagining the effect of this change in behavior on the labor market. Clearly, if households buy less, after a short period of inventory accumulation, businesses will produce less. Firms will not need as many employees to produce less output, so firms’ demand for labor will decrease and the demand for labor will shift left. Layoffs will follow. Can you see that on the horizontal axis of the labor market graph, when you compare the original labor market equilibrium with the new equilibrium following the demand decrease? Unemployment and the unemployment rate will rise. The economy will fall into recession.
Now let’s turn to the credit market. If Americans decide to save a larger percentage of their income, the effect will be to increase the supply of borrowable funds. Hence, the supply of credit curve will shift right. Check out the new equilibrium. This says that interest rates will fall and the quantity of dollars businesses will want to borrow will increase. So, really, businesses will go out and borrow more in the middle of a recession? That’s what the model says, but do businesses really do that?
Historically, that is in fact exactly what at least some businesses do. Admittedly, early in a recession, businesses seeking loans are often trying to cover losses. Many such businesses will close, and banks rarely lend to those businesses for fear they will not be repaid. However, as a downturn progresses, and the businesses that will close are shuttered, there are often others who recognize an economic downturn as an excellent opportunity to invest. After all, both interest rates and wages will have fallen. And remember that the labor market on the bottom of the circular flow diagram is standing in for the markets of all factors of production. I would expect that the prices of brick, lumber, iron and steel, land and most other factors of production will also have fallen. If prospective business owners have the savings or can borrow the funds necessary to put new production facilities in place, they can do so during an economic downturn at lower cost than already existing firms in their industries, giving the new firms a competitive advantage.
One notable historical example of an individual who did exactly that was a son of Scotch immigrants named Andrew Carnegie. He began working as a young teen and by the time he was 18 was working for the Pennsylvania Railroad Company as a telegraph operator. (Intercity telegraph wires ran along the railroads’ right-of-ways, so telegraph offices were often in railroad stations). He moved up in the firm to more responsible positions until he was superintendent of the Pittsburg Division of the railroad.
From his position working for a railroad, Carnegie could see that engines and rail cars were becoming heavier, doing damage to the weak and brittle iron rails used at that time. He, along with others in the industry, recognized that steel rails would hold up much better, but steel was still very expensive to make. He became aware, however, of a new steel production process, called the Bessemer process, being used in England that could make much larger batches of steel at substantially lower cost per ton. Carnegie used some of his own savings and borrowed from his boss and a few other senior executives of the railroad to build a plant in the depths of the 1870s depression. To be willing to do this, he had to be confident that the economy would be recovered, including demand for steel rails, by the time his plant was ready to produce. His bet panned out, as the demand for steel rails was there when he was ready to supply. The venture was so profitable that he paid off the plant a year and a half after it opened. His firm went on to become the largest steel company in the country in the late 19th century. He sold the firm to J.P. Morgan in 1901, where it became the nucleus of U.S. Steel Corporation.
Not every investment becomes this type of resounding success, but many of these types of successes on a smaller scale tend to occur during economic downturns. This is the very process that sparks economic recoveries from downturns. As firms begin to invest, because the prices of borrowed funds and factors of production are relatively low, the demand for labor and other factors of production begins to rise, putting people back to work. The majority of the new wages and salaries these newly employed workers receive, they then spend, increasing the demand for consumer goods and services. That in turn, increases the demand for more factors of production to produce the increased demand for products. As a result, an economic recovery unfolds.
There are a few features or characteristics of the Classical model or theory’s take on how the economy works worth listing. First, this is a long run-oriented model. Those individuals following economic developments in the 19th century weren’t particularly interested in what caused the downturn. They may have had a good idea what the economic problem was that caused any particular downturn. But their perspective was more, now that we’re in this recession/depression, how can the economy recover. Their focus was on the long run recovery process.
Second, the Classical model is a supply-oriented model. Classical economists were proponents of Say’s Law, named for 19th century, French economist Jean Baptiste Say’s aphorism, “[s]upply creates its own demand”. (This is John Maynard Keynes’ interpretation of what Say actually wrote. James Mill and others actually came closer to articulating Say’s Law early in the 19th century). The point is, it is businesses’ investment spending on factors of production that creates additional supply, producing new factor incomes that, in turn, increase product demand. It is the additions to the productive capacity of the economy that spark recovery.
Finally, the Classical model is often referred to as a flexible price model. Its whole recovery process depends on factor prices adjusting down, so that the downturn becomes a low cost opportunity to acquire factors of production, subsequently increasing the employment and output capacity of the economy. If there are no factor price reductions, there is no incentive to invest, and no impetus for recovery. The downward factor price adjustments are essential to the recovery process. Consequently, no impediments to price adjustment would be desired.
However, federal government regulation of industry began about this time. The first permanent regulatory body of the federal government was the Interstate Commerce Commission, established in 1887, which regulated the railroad industry. Among the ICC’s first acts was to begin regulating the prices of rail service. Many historical observers of the railroad industry have noted that railroads began their long decline about this time. Government did not have a good track record with respect to price interventions in markets.
This understanding of how the real world worked had policy implications. When, inevitably, economic downturns occurred, people did not look to government for policies to help the economy out. There were two reasons. First, there was a general perception that quite a bit of the bad stuff that happened to cause downturns was the result of actions governments took. A convincing case could be made that the depressions of the 1830s, 1870s and 1890s were largely the result of specific governmental policies. (See the appendix for more on this). It is no surprise that people would not look to the source of downturns for their remedies.
The second reason people did not look for governmental policy to correct economic downturns was that the economy always corrected itself back to full employment output. Consequently, the economy appeared to be a self-correcting mechanism. Policy was not thought to be necessary.
Finally, we noticed in the money and banking unit that stimulatory monetary policy has often been called on since the Great Depression to help the U.S. economy when it is experiencing difficulties. This call would have been very unlikely when the Classical model held sway. We can see why by returning to the very first circular flow model we looked at in Chapter 2.
Insert original circular flow diagram.
Recall that stimulatory monetary policy is implemented by the central bank (the Fed) injecting dollars into the economy, these days, by means of open market operations (the purchase of treasury securities in the bond market). Nineteenth century observers of the economy had seen occasions when significant amounts of money were injected into the economy. During the Revolutionary War, when state governments failed to provide sufficient dollars for the war effort, the Continental Congress, having no taxing authority, simply began to print and mint Continental dollars to use as script for the purchase of war matériels. The result was a hyperinflation, an inflation of more than 50% per month. For decades after the Revolutionary War something that was worthless was described as “not worth a continental”.
Insert Revolutionary War inflation graph.

Notice in our simplest circular flow diagram that there are two circles of flow. Factors of production flow from households to businesses and products from businesses to households in a counterclockwise flow. Economists refer to this as the “real flow” of actual products and factors of production. The clockwise “money flow” is households’ payments in dollars for products to businesses and the payment by firms in dollars for the use of factors of production to the households that provided them.

The Classical economists saw these as very separate flows. If more and more dollars were injected in the economy, inflating the clockwise flow, they didn’t see why this would change the quantity of factors of production or products in the economy in the real flow. Consequently, there would simply be “more dollars chasing the same number of goods”. There was, in their minds, no possible result except inflation. In fact, they expected that doubling the money supply would double prices, tripling the money supply would triple prices, etc. This is exactly what they had seen happen during the Revolutionary War, during the 1830s and during the Civil War, particularly in the South. Classical economists would never have seriously entertained the type of monetary policy we use today.

Chapter 12: Speculative Bubbles, the Great Depression & the Keynesian Model.

The events that fundamentally changed Americans’ perceptions of how the economy works were a pair of speculative bubbles that occurred in the 1920s, followed by the Great Depression of the early 1930s. To understand these events and the subsequent policy changes of the 1930s, we’ll need to know more about speculative bubbles.
There is no set definition of a speculative bubble, but we’ll need at least a working definition to proceed. For our purposes, the following definition will be serviceable:
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