Transcript Economics Principles and Applications

The Classical Long-Run
Model
Slides by: John & Pamela Hall
ECONOMICS: Principles and Applications 3e
HALL & LIEBERMAN
© 2005 Thomson Business and Professional Publishing
The Classical Long-Run Model
• Economists sometimes disagree with each other
• Actually much more agreement exists among
economists than there appears to be
• Once distinction between long-run and short-run
becomes clear
– Many apparent disagreements among
macroeconomists dissolve
• If no time horizon is specified, however, an
economist is likely to focus on horizon he or she
feels is most important
– Something about which economists sometimes do
disagree
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The Classical Long-Run Model
• Ideally, we would like our economy to do well in
both long-run and short-run
– Unfortunately, there is often a trade-off between these
two goals
• Doing better in short-run can require some sacrifice of long-run
goals, and vice versa
• Polices that can help us smooth out economic
fluctuations may prove harmful to growth in the
long-run
– While policies that promise a high rate of growth might
require us to put up with more severe fluctuations in
short-run
3
Macroeconomic Models: Classical
Verses Keynesian
• Classical model, developed by economists in 19th and early 20th
centuries, was an attempt to explain a key observation about economy
– Over periods of several years or longer, economy performs rather well
• If we think in terms of decades rather than years or quarters, business
cycle fades in significance
• In the classical view, this behavior is no accident
– Powerful forces are at work that drive economy towards full employment
• An important group of macroeconomists continues to believe that
classical model is useful even in shorter run
• In 1936, in midst of Great Depression, British economist John
Maynard Keynes offered an explanation for economy’s poor
performance
– Argued that, while classical model might explain economy’s operation in
long-run, long-run could be a very long time in arriving
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Macroeconomic Models: Classical
Verses Keynesian
• Keynesian ideas became increasingly popular in
universities and government agencies during 1940s and
1950s
– By mid-1960s, entire profession had been won over
• Macroeconomics was Keynesian economics
– Classical model was removed from virtually all introductory economics
textbooks
• Classical model is still important
– In recent decades there has been an active counterrevolution
against Keynes’s approach to understanding the macroeconomy
– Useful in understanding economy over long-run
• While Keynes’s ideas and their further development help
us understand economic fluctuations—movements in
output around its long-run trend
– Classical model has proven more useful in explaining the long-run
trend itself
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Assumptions of the Classical Model
• All models begin with assumptions about the
world
– Classical model is no exception
– Many of its assumptions are simplifying
• Make model more manageable, enabling us to see the broad
outlines of economic behavior without getting lost in details
• One assumption in classical view that goes
beyond mere simplification
– Markets clear
• Price in every market will adjust until quantity supplied and
quantity demanded are equal
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Assumptions of the Classical Model
• Market-clearing assumption provides hint about
why classical model does a better job over longer
time periods (several years or more) than shorter
ones
• We’ll use classical model to answer a variety of
important questions about economy in long-run,
such as
–
–
–
–
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?
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How Much Output Will We Produce?
• How can we disentangle web of economic
interactions we see around us?
– Decide which market or markets best suit the problem
being analyzed, and
– Identify buyers and sellers
– Identify type of environment in which they trade
• But which market should we start with?
– Logical start is market for resources
• Labor, land and natural resources, capital and entrepreneurship
• We’ll concentrate our attention on labor
• Our question is
– How many workers will be employed in the economy?
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Figure 1: The Labor Market
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The Labor Market
• Labor supply curve slopes upward
– Because—as wage rate increases—more and more individuals are
better off working than not working
– Thus, a rise in wage rate increases number of people who want to
work—to supply their labor
• As wage rate increases each firm will find that—to
maximize profit—it should employ fewer workers than
before
– When all firms behave this way together a rise in wage rate will
decrease quantity of labor demanded
– This is why economy’s labor demand curve slopes downward
• In classical view, economy achieves full employment on its
own
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Determining the Economy’s Output
• Most effective way to master a macroeconomic
model is “divide and conquer”
– Start with part of model, understand it well, and then
add in other parts
• Accordingly, our classical analysis of economy is
divided into two separate questions
– What would be the long-run equilibrium of the economy
if there were a constant state of technology
• And if quantities of all resources besides labor were fixed?
– What happens to this long-run equilibrium when
technology and quantities of other resources change?
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The Production Function
• Relationship between total employment and total
production in the economy
– Given by economy’s aggregate production function
• Shows total output economy can produce with different
quantities of labor
– Given constant amounts of other resources and current state of
technology
• In classical, long-run view economy reaches its
potential output automatically
– An important conclusion of classical model and an
important characteristic of the economy in long-run
• Output tends toward its potential, full-employment level on its
own, with no need for government to steer the economy toward
it
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Figure 2: Output Determination in
the Classical Model
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The Role of Spending
• What if business firms are unable to sell all output
produced by a fully employed labor force?
– Economy would not be able to sustain full employment
for very long
• If we are asserting that potential output is an
equilibrium for the economy
– Had better be sure that total spending on output is
equal to total production during the year
– But can we be sure of this?
• In classical view answer is yes
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Total Spending in a Very Simple
Economy
• Imagine a world with just two types of economic
units
– Households and business firms
• Circular Flow
– A diagram that shows how goods, resources, and dollar
payments flow between households and firms
• 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
• Known as Say’s Law
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Figure 3: The Circular Flow
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Total Spending in a Very Simple
Economy
• Say’s Law named after classical economist Jean
Baptiste Say (1767-1832), who popularized the
idea
• In Say’s own words
– “A product is no sooner created than it, from that
instant, affords a market for other products to the full
extent of its own value…Thus, the mere circumstance
of the creation of one product immediately opens a vent
for other products”
• Say’s law states that by producing goods and
services
– Firms create a total demand for goods and services
equal to what they have produced or
• Supply creates its own demand
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Total Spending in a More Realistic
Economy
• Does Say’s law also apply in a more realistic
economy?
• In the real world
– Households don’t spend all their income
• Rather, some of their income is saved or goes to pay taxes
– Households are not the only spenders in the economy
• Businesses and government buy some of the final goods and
services we produce
– In addition to markets for goods and resources, there is
also a loanable funds market
• Where household saving is made available to borrowers in
business or government sectors
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Some New Macroeconomic
Variables
• Planned investment spending (IP) over a period of time is total
investment spending (I) minus change in inventories over the period
– IP = I – Δ inventories
• Net taxes (T) are total government tax revenue minus government
transfer payments
– T = total tax revenue – transfers
• Household saving (S)
– It’s often useful to arrive at household saving in two steps
• Determine how much income household sector has left after payment of net
taxes
– Household sector’s disposable income
» Disposable Income = Total Income – Net Taxes
• Part that is not spent is defined as saving (S)
– S = Disposable Income – C
• Total Spending in Classica
– In Classica, total spending is sum of purchases made by household sector
(C), business sector (IP), and government sector (G)
• Total spending = C + IP + G
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Some New Macroeconomic
Variables
• Saving and net taxes are called leakages out of spending
– Amount of income that households receive, but do not spend
• There are also injections—spending from sources other
than households
– A government’s purchases of goods and services
– Planned investment spending (IP)
• Total spending will equal total output if and only if total
leakages in the economy are equal to total injections
– Only if sum of saving and net taxes is equal to sum of planned
investment spending and government purchases
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Figure 4: Leakages and Injections
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The Loanable Funds Market
•
•
Where households make their saving available to those who need additional
funds
Total supply of loanable funds is equal to household saving
– Funds supplied are loaned out, and households receive interest payments on these
funds
•
Businesses’ demand for loanable funds is equal to their planned investment
spending
– Funds obtained are borrowed, and firms pay interest on their loans
•
Budget deficit
– Excess of government purchases over net taxes
•
Budget of surplus
– Excess of net taxes over government purchases
•
When government purchases of goods and services (G) are greater than net
taxes (T)
– Government runs a budget deficit equal to G – T
•
When government purchases of goods and services (G) are less than net
taxes (T)
– Government runs a budget surplus equal to T - G
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The Supply of Funds Curve
• Since interest is reward for saving and supplying funds to
financial market
– Rise in interest rate increases quantity of funds supplied
(household saving), while a drop in interest rate decreases it
• Supply of funds curve
– Indicates level of household saving at various interest rates
• Quantity of funds supplied to the financial market depends
positively on interest rate
– This is why the saving, or supply of funds, curve slopes upward
• Other things can affect savings besides the interest rate,
including
– Tax rates
– Expectations about the future
– General willingness of households to postpone consumption
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Figure 5: Supply of Household
Loanable Funds
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The Demand for Funds Curve
•
When interest rate falls investment spending and the business borrowing
needed to finance it rise
– Business demand for funds curve slopes downward
•
What about government’s demand for funds?
– Will it, too, be influenced by the interest rate?
• Probably not very much
– Government seems to be cushioned from cost-benefit considerations that haunt
business decisions
– Any company president who ignored interest rates in deciding how much to borrow
would be quickly out of a job
• U.S. presidents and legislators have often done so with little political cost
•
•
Government sector’s deficit and its demand for funds are independent of
interest rate
As interest rate decreases quantity of funds demanded by business firms
increases
– While quantity demanded by government remains unchanged
– Therefore, total quantity of funds demanded rises
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Figure 6: Business Demand for
Loanable Funds
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Figure 7: The Demand for Funds
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Equilibrium in the Loanable Funds
Market
• In classical view loanable funds market is
assumed to clear
– Interest rate will rise or fall until quantities of
funds supplied and demanded are equal
• Can we be sure that all output produced at
full employment will be purchased?
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Figure 8: Loanable Funds Market
Equilibrium
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The Loanable Funds Market and
Say’s Law
• As long as loanable funds market clears, Say’s law holds
– Total spending equals total output
• This is true even in a more realistic economy with saving, taxes,
investment and government deficit
• Here’s another way to see the same result, in terms of a
simple equation
– Loanable funds market clears  S = IP + (G – T)
• Rearranging this equation by moving T to left side
– Loanable funds market clears  S + T = IP + G
• Say’s law shows that total value of spending in economy
will equal total value of output
– Rules out a general overproduction or underproduction of goods in
the economy
• It does not promise us that each firm will be able to sell all of the
particular good it produces
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Figure 9: An Expanded Circular
Flow
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The Classical Model: A Summary
• Began with a critical assumption
– All markets clear
• In classical model, government needn’t worry
about employment
– Economy will achieve full employment on its own
• In classical model, government needn’t worry
about total spending
– Economy will generate just enough spending on its own
to buy output that a fully employed labor force produces
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Using the Theory: Fiscal Policy in
the Classical Model
• Could government increase economy’s total employment
and total output by raising total spending?
• Two ideas for increasing spending come to mind
– Government could simply purchase more output itself
• More goods, like tanks and police cars, or more services, like those
provided by high school teachers and judges
– Government could cut net taxes, letting households keep more of
their income
• So they would spend more on food, clothing, furniture, new cars, and
so on
• Fiscal policy is a change in government purchases or in
net taxes
– Designed to change total spending in the economy and thereby
influence levels of employment and output
• Idea behind fiscal policy sounds sensible enough
– But does it work?
• Not if economy behaves according to classical model
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Using the Theory: Fiscal Policy With
A Budget Deficit
• What would happen if the government of Classica—which
is running a deficit—attempted to increase employment
and output by increasing government purchases
• Crowding out is a decline in one sector’s spending caused
by an increase in some other sector’s spending
• In classical model a rise in government purchases
completely crowds out private sector spending so total
spending remains unchanged
• In classical model, an increase in government purchases
has no impact on total spending and no impact on total
output or total employment
• Opposite sequence of events would happen if government
purchases decreased
– Total spending and total output would remain unchanged
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Figure 10: Crowding Out With An
Initial Budget Deficit
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Fiscal Policy With A Budget Surplus
• Total spending remains unchanged, and fiscal
policy is completely ineffective
• Same conclusion we reached about fiscal policy
with a government budget deficit
• Our exploration of fiscal policy shows us that, in
long-run
– Government efforts to change total output by changing
government spending or taxes are unnecessary and
ineffective
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Figure 11: Crowding Out With An
Initial Budget Surplus
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