THE CLASSICAL ECONOMY’S SUPPLY SIDE The Firm’s Problem and Labor Demand Our investigation of how money relates to economic ﬂuctuations starts with a ‘classical’ model of the macroeconomy – that is, a model that ﬁrmly grounds itself on the axiom of maximizing-behavior while setting aside potentially important economic frictions. This approach will let us see how far a simple model goes in rationalizing business cycles, and highlight empirical regularities that deserve further attention. Our classical model develops macro-insights from micro-foundations by deﬁning a ﬁrm’s (real) proﬁt as follows: ϭ f(L) Ϫ (wրP) L where f transforms labor (L) into output, w denotes a nominal wage for which individuals can trade leisure in the labor market, and P denotes the price level of ﬁnal goods and services. Before moving forward, we should understand some of this representation’s details. First, the ﬁrm’s technology can reasonably be characterized as transforming labor into output at a positive but decreasing rate. Stated more formally, ѨfրѨL Ͼ 0 and Ѩ2fրѨL2 Ͻ 0. This latter condition appreciates the diminishing rate at which ﬁxed capital stocks can augment the productivity of marginal labor units (as well as those units’ contribution to congestion costs). In addition, we’ll deﬁne the economy’s price level P as an ‘average’ nominal price for each good and service that an economy produces – for example, the ‘consumer price index,’ or CPI, that popular and business media frequently report. Finally, we’ll assume (and ultimately derive the hypothesis) that input and output prices move...
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