The Classical Long-Run Model © 2003 South-Western/Thomson Learning.

The ClassicalThe ClassicalLong-Run ModelLong-Run Model

© 2003 South-Western/Thomson Learning© 2003 South-Western/Thomson Learning

Macroeconomic Macroeconomic Models: Classical Models: Classical Versus KeynesianVersus Keynesian

Classical ModelClassical Model

A macroeconomic model that A macroeconomic model that explains the long-run behavior of explains the long-run behavior of the economy, assuming that all the economy, assuming that all

markets clearmarkets clear


Keynesian ModelKeynesian ModelKeynes and his followers argued Keynes and his followers argued that, while the classical model that, while the classical model might explain the economy’s might explain the economy’s

operation in the long run, the long operation in the long run, the long run could be a very long time in run could be a very long time in

arriving. In the meantime, arriving. In the meantime, production could be stuck below production could be stuck below

its potential.its potential.


Keynes’s ideas and their further Keynes’s ideas and their further development help us understand development help us understand

economic fluctuations - movements in economic fluctuations - movements in output around its long-run trend - the output around its long-run trend - the

classical model has proven more classical model has proven more useful in explaining the long-run trend useful in explaining the long-run trend

itself.itself.

Assumptions of the Assumptions of the Classical ModelClassical Model

A critical assumption in the A critical assumption in the classical model is that classical model is that markets markets

clearclear: The price in every : The price in every market will adjust until market will adjust until

quantity supplied and quantity quantity supplied and quantity demanded are equal.demanded are equal.

Important Questions Important Questions About the Economy in About the Economy in

the Long Runthe Long Run

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

Important Questions Important Questions About the Economy in About the Economy in

the Long Runthe Long Run

The classical model: focus on The classical model: focus on realreal variables - variables -

•real GDPreal GDP•real wagereal wage

•real saving, and so onreal saving, and so on

How Much Output How Much Output Will We Produce?Will We Produce?

•The Labor MarketThe Labor Market•Determining the Determining the Economy’s OutputEconomy’s Output

The Labor Market The Labor Market

100 million = Full Employment

Number of Workers

Real Hourly Wage

$20

15

10H

E

J

BA

LDExcess Demand

for Labor

Excess Supplyof Labor

LS

Determining the Determining the Economy’s OutputEconomy’s Output

Aggregate Production Aggregate Production FunctionFunction

The relationship showing The relationship showing how much total output can how much total output can be produced with different be produced with different

quantities of labor, with quantities of labor, with land, capital, and land, capital, and

technology held constanttechnology held constant


100million

Numberof Workers

RealHourlyWage

$15

LS

LD

In the labor market, thedemand and supply curves intersect

to determine employment of100 million workers.

100million

Numberof Workers

Output(Dollars)

$7 Trillion= Full

EmploymentOutput

AggregateProductionFunction

The production function showsthat–with given amounts of capital and

land and the current state of technology–those 100 million workers can produce

$7 trillion of real GDP.


In the classical long-run In the classical long-run view, the economy view, the economy

reaches its potential reaches its potential output automatically.output automatically.

Total Spending in a Total Spending in a Very Simple EconomyVery Simple Economy

Circular FlowCircular Flow

A diagram that shows how A diagram that shows how goods, resources, and dollar goods, resources, and dollar

payments flow between payments flow between households and firmshouseholds and firms

Circular FlowCircular Flow

Households

Firms

Goods Markets

Factor Markets

Goods and

Services Purchased

$Consumption Spending

$Income

Resources Sold

$Firm Revenues

$Factor Payments

Goods and

Services Sold

Resources Purchased


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

be equal to total output.be equal to total output.


Say’s LawSay’s Law

The idea that total spending The idea that total spending will be sufficient to will be sufficient to

purchase the total output purchase the total output produced.produced.

Total Spending in a Total Spending in a More Realistic More Realistic

EconomyEconomyIn the real world:In the real world:•Households don’t spend all Households don’t spend all their incometheir income•Households are not the only Households are not the only spenders in the economyspenders in the economy•There is a market for There is a market for loanable fundsloanable funds


EconomyEconomyNet TaxesNet Taxes

Government tax revenues Government tax revenues minus transfer paymentsminus transfer payments

TT = Total taxes – Transfer = Total taxes – Transfer paymentspayments


EconomyEconomy(Household) Saving(Household) Saving

The portion of after-tax income The portion of after-tax income that households do not spend that households do not spend

on consumption goodson consumption goods

SS = = Y Y –– T T –– C C

Leakages and Leakages and InjectionsInjections

Leakages Leakages

Income earned, but not spent, by Income earned, but not spent, by households during a given yearhouseholds during a given year

Injections Injections

Spending from sources other than Spending from sources other than householdshouseholds

Planned Investment Spending Planned Investment Spending

Business purchases of plant and Business purchases of plant and equipmentequipment


Total spending will equal total Total spending will equal total output if - output if - and only ifand only if - total - total leakages in the economy are leakages in the economy are

equal to total injections.equal to total injections.

That is, only if the sum of That is, only if the sum of saving and net taxes is equal to saving and net taxes is equal to

the sum of investment the sum of investment spending and government spending and government

purchases.purchases.


$7 Trillion

C ($4 Trillion)

I P

($1 Trillion)

G ($2 Trillion)I P($1

Trillion)

G ($2 Trillion)

S ($1.75

Trillion)

T ($1.25

Trillion)

Leakages Injections

C ($4 Trillion)

$7 Trillion

Total Output

Total Income

Total Spending

=

The Loanable Funds The Loanable Funds MarketMarket

Loanable Funds MarketLoanable Funds Market

Arrangements through Arrangements through which households make which households make their saving available to their saving available to

borrowersborrowers

Loanable Funds MarketLoanable Funds Market

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

G – TG – T

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

T – GT – G

The Loanable Funds The Loanable Funds MarketMarket

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

The Supply of Funds The Supply of Funds CurveCurve

Supply of Funds CurveSupply of Funds Curve

Indicates the level of Indicates the level of household saving at various household saving at various

interest rates. interest rates.

The quantity of funds supplied The quantity of funds supplied to the financial market to the financial market

depends positively on the depends positively on the interest rate, so the saving, or interest rate, so the saving, or supply of funds, curve slopes supply of funds, curve slopes

upward.upward.

The Supply of Funds The Supply of Funds CurveCurve

1.5 Trillionsof Dollars

InterestRate

5%

3%A

Saving = Supplyof Funds

1.75

B

As the interestrate rises, saving or thequantity of loanablefunds supplied increases.

The Demand for Funds The Demand for Funds CurveCurve

Investment Demand CurveInvestment Demand Curve

When the interest rate falls, When the interest rate falls, investment spending and investment spending and the business borrowing the business borrowing

needed to finance it rise, so needed to finance it rise, so the investment demand the investment demand curve slopes downward.curve slopes downward.


1.5 Trillionsof Dollars

InterestRate

5%

3%

A

Investment Demand

1.0

B

As the interest rate falls,business firms demand moreloanable funds for investmentprojects.


Government Demand for Funds Government Demand for Funds CurveCurve

Indicates the amount of Indicates the amount of government borrowing at government borrowing at

various interest ratesvarious interest rates

Total Demand for Funds CurveTotal Demand for Funds Curve

Indicates the total amount of Indicates the total amount of borrowing at various interest borrowing at various interest

ratesrates


Trillionsof Dollars

InterestRate

5%

3%A

Government Demandfor Funds

0.75

B

Trillionsof Dollars

A

Business Demandfor Funds

1.0

B

1.5

Trillionsof Dollars

A

Total Demandfor Funds

B

1.75 2.25

(a) (b) (c)

5%

3%

5%

3%

Summing the government’sdemand for loanable funds

and business firms’ demandfor loanable funds at each

interest rate

gives us the economy’stotal demand for loanablefunds at each interest rate.

Equilibrium in the Equilibrium in the Loanable Funds MarketLoanable Funds Market

In the classical view, the In the classical view, the loanable funds market -like all loanable funds market -like all other markets - is assumed to other markets - is assumed to

clear: clear:

The interest rate will rise or The interest rate will rise or fall until the quantities of fall until the quantities of

funds supplied and demanded funds supplied and demanded are equal.are equal.

Equilibrium in the Equilibrium in the Loanable Funds MarketLoanable Funds Market

1.75 Trillions of Dollars

Interest Rate

5% E

Total Supply of Funds (Saving)

Total Demand for Funds

(Investment + Deficit)

The Loanable Funds The Loanable Funds Market and Say’s LawMarket and Say’s Law

As long as the loanable As long as the loanable funds market clears, Say’s funds market clears, Say’s law holds even in a more law holds even in a more realistic economy with realistic economy with

saving, taxes, investment, saving, taxes, investment, and a government deficit.and a government deficit.

The Loanable Funds The Loanable Funds Market and Say’s LawMarket and Say’s Law

The interest rate will adjust The interest rate will adjust untiluntil TG1S P

Quantity

demanded funds ofQuantity

supplied fundsof

G1TS P InjectionsLeakages

and when the loanable and when the loanable funds market clearsfunds market clears

The Classical Model: The Classical Model: ConclusionsConclusions

The economy will achieve and The economy will achieve and sustain potential output on its sustain potential output on its

own. own.

We need never worry about there We need never worry about there being too little or too much being too little or too much

spending; spending;

Say’s law assures us that total Say’s law assures us that total spending is always just right to spending is always just right to purchase the economy’s total purchase the economy’s total

output.output.

Fiscal Policy in the Fiscal Policy in the Classical ModelClassical Model

Fiscal PolicyFiscal Policy

A change in government A change in government purchases or net taxes purchases or net taxes

designed to change total designed to change total spending and total outputspending and total output

In the classical view, fiscal In the classical view, fiscal policy is ineffective and policy is ineffective and

unnecessary.unnecessary.

Fiscal Policy with a Fiscal Policy with a Budget DeficitBudget Deficit

Crowding OutCrowding Out

A decline in one sector’s spending A decline in one sector’s spending caused by an increase in another caused by an increase in another

sector’s spendingsector’s spending

Complete Crowding OutComplete Crowding Out

A dollar-for-dollar decline in one A dollar-for-dollar decline in one sector’s spending caused by an sector’s spending caused by an

increase in another sector’s increase in another sector’s spendingspending

Fiscal Policy with a Fiscal Policy with a Budget DeficitBudget Deficit

1.75 Funds($Trillions)

InterestRate

7%

5%

2.05 2.25

Total Supplyof Funds(Saving)

D2 =Ip + G2 – T

1

D1 =Ip + G – T

B

AH

C

C

I

Fiscal Policy with a Fiscal Policy with a Budget SurplusBudget Surplus

S2 = Savings + T – G2

S1 = Savings + T – G1

1.75Funds ($ Trillions)

InterestRate

7%

5%

1.251.55

D = Planned Investment

B

AH C

The Classical Long-Run Model © 2003 South-Western/Thomson Learning.

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