The Classical Long-Run Model

2003 South-Western/Thomson Learning

Macroeconomic Models: Classical Versus Keynesian

Classical Model A macroeconomic model that explains the long-run behavior of the economy, assuming that all markets clear

Macroeconomic Models: Classical Versus Keynesian

Keynesian Model
Keynes and his followers argued that, while the classical model might explain the economys operation in the long run, the long run could be a very long time in arriving. In the meantime, production could be stuck below its potential.

Macroeconomic Models: Classical Versus Keynesian

Keyness ideas and their further development help us understand economic fluctuations - movements in output around its long-run trend - the classical model has proven more useful in explaining the long-run trend itself.

Assumptions of the Classical Model

A critical assumption in the classical model is that markets clear: The price in every market will adjust until quantity supplied and quantity demanded are equal.

Important Questions About the Economy in the Long Run

How is total employment determined? How much output will we produce? What role does total spending play in the economy? What happens when things change?

Important Questions About the Economy in the Long Run

The classical model: focus on real variables real GDP real wage real saving, and so on

How Much Output Will We Produce?

The Labor Market Determining the Economys Output

The Labor Market

Real Hourly Wage $20 A Excess Supply of Labor B E H Excess Demand for Labor 100 million = Full Employment J LD Number of Workers LS

15

10

Determining the Economys Output Aggregate Production Function The relationship showing how much total output can be produced with different quantities of labor, with land, capital, and technology held constant

Determining the Economys Output

The production function shows thatwith given amounts of capital and land and the current state of technology those 100 million workers can produce $7 trillion of real GDP.

Real Hourly Wage

LS

Output (Dollars) $7 Trillion = Full Employment Output

Aggregate Production Function

$15

LD 100 million Number of Workers 100 million Number of Workers

In the labor market, the demand and supply curves intersect to determine employment of 100 million workers.

Determining the Economys Output In the classical long-run view, the economy reaches its potential output automatically.

Total Spending in a Very Simple Economy

Circular Flow A diagram that shows how goods, resources, and dollar payments flow between households and firms

Circular Flow
Goods and Services Purchased Households Resources Sold $Consumption Spending $Income

Goods Markets

Factor Markets

Goods and Services Sold

$Firm Revenues

$Factor Payments

Resources Purchased

Firms

Total Spending in a Very Simple Economy

In a simple economy with just households and firms, in which households spend all of their income, total spending must be equal to total output.

Total Spending in a Very Simple Economy

Says Law The idea that total spending will be sufficient to purchase the total output produced.

Total Spending in a More Realistic Economy

In the real world: Households dont spend all their income Households are not the only spenders in the economy There is a market for loanable funds

Total Spending in a More Realistic Economy

Net Taxes Government tax revenues minus transfer payments T = Total taxes Transfer payments

Total Spending in a More Realistic Economy

(Household) Saving The portion of after-tax income that households do not spend on consumption goods

S=YTC

Leakages and Injections

Leakages Income earned, but not spent, by households during a given year Injections Spending from sources other than households Planned Investment Spending Business purchases of plant and equipment

Leakages and Injections

Total spending will equal total output if and only if - total leakages in the economy are equal to total injections. That is, only if the sum of saving and net taxes is equal to the sum of investment spending and government purchases.

Leakages and Injections

es Leakag 25 T ($1. ) r T illion 75 S ($1. ) r T illion

Injectio ns G ($2 T illion) r

I ($1 T illion r )
P

G ($2 Trillion) IP ($1 Trillion)

$7 Trillion

$7 Trillion C ($4 Trillion) C ($4 Trillion)

Total Output

Total Income

Total Spending

The Loanable Funds Market

Loanable Funds Market Arrangements through which households make their saving available to borrowers

Loanable Funds Market

When G > T, the government runs a budget deficit equal to G T When G < T, the government runs a budget surplus equal to T G

The Loanable Funds Market

Loanable funds market: The supply of funds is the sum of household saving and the governments budget surplus, if any. The demand for funds is the sum of the business sectors planned investment spending and the government sectors budget deficit, if any.

The Supply of Funds Curve

Supply of Funds Curve Indicates the level of household saving at various interest rates. The quantity of funds supplied to the financial market depends positively on the interest rate, so the saving, or supply of funds, curve slopes upward.

The Supply of Funds Curve

Interest Rate 5%
As the interest rate rises, saving or the quantity of loanable funds supplied increases.

Saving = Supply of Funds B

3%

1.5 1.75

Trillions of Dollars

The Demand for Funds Curve Investment Demand Curve When the interest rate falls, investment spending and the business borrowing needed to finance it rise, so the investment demand curve slopes downward.

The Demand for Funds Curve

Interest Rate 5% A
As the interest rate falls, business firms demand more loanable funds for investment projects.

3%

B Investment Demand

1.0

1.5

Trillions of Dollars

The Demand for Funds Curve

Government Demand for Funds Curve Indicates the amount of government borrowing at various interest rates Total Demand for Funds Curve Indicates the total amount of borrowing at various interest rates

The Demand for Funds Curve

Summing the governments demand for loanable funds ...
(a) Interest Rate Government Demand for Funds B 5%

and business firms demand for loanable funds at each interest rate ...
(b) Business Demand for Funds B 5% A

gives us the economys total demand for loanable funds at each interest rate.
(c) Total Demand for Funds B

5%

3%

3%

3%

0.75 Trillions of Dollars

1.0

1.5 Trillions of Dollars

1.75

2.25 Trillions of Dollars

Equilibrium in the Loanable Funds Market

In the classical view, the loanable funds market -like all other markets - is assumed to clear: The interest rate will rise or fall until the quantities of funds supplied and demanded are equal.

Equilibrium in the Loanable Funds Market

Interest Rate Total Supply of Funds (Saving) E

5%

Total Demand for Funds (Investment + Deficit) 1.75 Trillions of Dollars

The Loanable Funds Market and Says Law As long as the loanable funds market clears, Says law holds even in a more realistic economy with saving, taxes, investment, and a government deficit.

The Loanable Funds Market and Says Law

The interest rate will adjust until
Quantity of funds supplied

= 1P + G T
Quantity of funds demanded

and when the loanable funds market clears

= 1P + G S+ T
Leakages Injections

The Classical Model: Conclusions

The economy will achieve and sustain potential output on its own. We need never worry about there being too little or too much spending; Says law assures us that total spending is always just right to purchase the economys total output.

Fiscal Policy in the Classical Model

Fiscal Policy A change in government purchases or net taxes designed to change total spending and total output In the classical view, fiscal policy is ineffective and unnecessary.

Fiscal Policy with a Budget Deficit

Crowding Out A decline in one sectors spending caused by an increase in another sectors spending Complete Crowding Out A dollar-for-dollar decline in one sectors spending caused by an increase in another sectors spending

Fiscal Policy with a Budget Deficit

Interest R a te

Total Supply of Funds (Saving)

B A C

7%

I
H

5%

C
D2 = Ip + G2 T D1 = Ip + G1 T
1.75 2.05 2.25
Funds ($Trillions)

Fiscal Policy with a Budget Surplus

Interest Rate S2 = Savings + T G 2 S1 = Savings + T G1 7% H C B

5%

D = Planned Investment Funds ($ Trillions) 1.25 1.75 1.55