Consider a classical economy with the following characterist

Consider a classical economy with the following characteristics:

Investment Function: I= i0 -i1r +i2IC where IC represents investor confidence

Consumption Function: C= a+b(Y-T) - cr

Standard saving functions

All model parameters are positive

Suppose that a plague suddenly occurs, and wipes out half of the working population. How does this change in the labor supply affect the Classical model and what happens to {Y, N, P, r, S, C, PrS, PuS,W,W/P} Assume the change in the labor force does not impact the capital stock.

Solution

The classical model assumes than an economic shock will adjust from price level and wages adjusting themselves.

Sudden decrease in labor supply will reduce output, and real GDP (Y) will fall. Labor supply curve will shift left, and level of employment (N) will fall.

Lower output will raise price level P (caused by shortage). Consumption demand will fall due to higher price level.

Lower supply of labor will raise nominal wage rate (W), but as price level also increases, the real wage rate (W/P) will remain unchanged.

This labor shortage and consequent inflation will lower the investor confidence and, as IC decreases, Investment demand also decreases. Lower investment demand reduces the interest rate (r).

As both Y and C falls, savings (S) also decrease.

Note: It\'s not understood what PrS and PuS are!