Transcript Economics: Principles and Applications, 2e by Robert E. Hall & Marc

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
economy’s 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
Keynes’s 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 Economy’s Output
The Labor Market
Real
Hourly
Wage
LS
$20
A
E
15
10
Excess Supply
of Labor
B
H
J
Excess Demand
for Labor
100 million =
Full Employment
LD
Number
of Workers
Determining the Economy’s
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 Economy’s
Output
The production function shows
that–with 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)
Aggregate
Production
Function
$7 Trillion
= Full
Employment
Output
$15
LD
In the labor market, the
demand and supply curves intersect
to determine employment of
100 million workers.
100
million
Number
of Workers
100
million
Number
of Workers
Determining the Economy’s
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
Goods
and
Services
Sold
Factor
Markets
$Firm
Revenues
$Factor
Payments
Firms
Resources
Purchased
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
Say’s 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 don’t 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=Y–T–C
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
G
($2 Trillion)
IP
($1 Trillion)
$7
Trillion
=
$7
Trillion
C
($4 Trillion)
Total
Output
Total
Income
C
($4 Trillion)
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 government’s
budget surplus, if any.
• The demand for funds is the sum of the
business sector’s planned investment
spending and the government sector’s
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
As the interest
rate rises, saving or the
quantity of loanable
funds supplied increases.
B
5%
3%
Saving = Supply
of Funds
A
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
As the interest rate falls,
business firms demand more
loanable funds for investment
projects.
Interest
Rate
5%
A
B
3%
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
Interest
Rate
5%
3%
Summing the government’s
demand for loanable funds...
and business firms’ demand
for loanable funds at each
interest rate...
(a)
(b)
5%
A
B
1.0
Trillions
of Dollars
Total Demand
for Funds
5%
A
3%
0.75
(c)
Business Demand
for Funds
Government Demand
for Funds
B
gives us the economy’s
total demand for loanable
funds at each interest rate.
1.5
Trillions
of Dollars
B
A
3%
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
5%
Total Supply of
Funds (Saving)
E
Total Demand
for Funds
(Investment + Deficit)
1.75
Trillions
of Dollars
The Loanable Funds Market
and Say’s Law
As long as the loanable funds market
clears, Say’s law holds even in a more
realistic economy with saving, taxes,
investment, and a government deficit.
The Loanable Funds Market
and Say’s Law
The interest rate will adjust until
S
Quantityof
funds supplied
 1P G T
Quantity of funds
demanded
and when the loanable funds market
clears
P

S T 1  G
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;
Say’s law assures us that total spending is
always just right to purchase the economy’s
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 sector’s spending caused by
an increase in another sector’s spending
Complete Crowding Out
A dollar-for-dollar decline in one sector’s
spending caused by an increase in another
sector’s spending
Fiscal Policy with a Budget
Deficit
Interest
Rate
Total Supply
of Funds
(Saving)
7%
B
A
5%
C
DI
H
DC
D2 =
Ip + G2 – T
D1 =
Ip + G1 – T
1.75 2.05 2.25
Funds ($Trillions)
Fiscal Policy with a Budget
Surplus
S2 = Savings + T – G 2
Interest
Rate
S1 = Savings + T – G1
B
7%
5%
H
C
A
D = Planned Investment
Funds ($ Trillions)
1.25
1.75
1.55