The Classical Long-Run Model Topic 3 The Classical Long-Run Model

Classical Model A macroeconomic model that explains the long-run behavior of the economy Classical model was developed by economists in 19th and early 20th, to explain a key observation about economy Over periods of several years or longer, economy performs rather well In the classical view, powerful forces drive economy towards full employment

Assumption of the Classical Model Markets clear Price in every market will adjust until quantity supplied and quantity demanded are equal Markets might not be clear in the short-run, but if we wait long enough, eventually, the change in price will equalize demand and supply.

The Classical Model We’ll use classical model to answer important questions about economy in the long-run, such as How does economy achieve full employment? How much output will we produce? What role is played by total spending?

Full Employment Our first question is How many workers will be employed in the economy?

Figure 1: The Labor Market

The Labor Market Labor supply curve slopes upward As wage rate goes up, the opportunity cost of not working increases, so people are more willing to provide more labor Labor demand curve slopes downward As wage rate goes up, the labor cost to firms increases, so firms tend to employ fewer workers than before In classical view, economy achieves full employment on its own

Determining the Economy’s Output The Production Function Relationship between total employment and total production in the economy Given that the amount of other resources and current state of technology are fixed

Figure 2: Output Determination in the Classical Model

Full Employment Output In the classical or long-run view, economy reaches its potential output automatically Output reaches its potential, full-employment level on its own, with no need for government to maneuver the economy toward it.

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 Total spending on output has to be equal to total production during the year Can we be sure of this? In classical view, the answer is YES

Total Spending in a Very Simple Economy Imagine a world with just two types of economic units Households and business 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

Figure 3: The Circular Flow

Total Spending in a Very Simple Economy Say’s Law named after classical economist Jean Baptiste Say (1767-1832), who popularized the idea 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

Total Spending in a More Realistic Economy In the real world Households don’t spend all their income Saving & 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’s saving is made available to borrowers in business or government sectors

Some New Macroeconomic Variables Planned investment spending (IP) IP = I – Δ inventories Net taxes (T) T = total tax revenue – transfers Household saving (S) Household sector’s disposable income Disposable Income = Total Income – Net Taxes S = Disposable Income – C Total Spending Total spending = C + IP + G

Figure 4: Leakages and Injections

Total Spending = Total Income To achieve equilibrium of economy, total spending must be equal to total income: C+S+T = C+IP+G From Figure 4, it must be true that all the leakages have to equate all the injections: S+T = IP+G Moving T from the left to the right of equation, we have S = IP+(G-T) So, if household saving is equal to planned investment Spending plus government budget deficit, then the equilibrium of economy is achieved. See the following slides for proof.

The Loanable Funds Market Where households make their saving available to those who need additional funds Supply of loanable funds – household saving Demand of loanable funds – businesses and government

The Loanable Funds Market Businesses’ demand for loanable funds is equal to their planned investment spending Funds obtained are borrowed, and firms pay interest on their loans Government’s demand for loanable funds Budget deficit (G – T) Excess of government purchases over net taxes Government’s supply for loanable funds Budget surplus (T – G) Excess of net taxes over government purchases

Figure 5: Supply of Household Loanable Funds

Figure 6: Business Demand for Loanable Funds

Figure 7: The Demand for Funds

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?

Figure 8: Loanable Funds Market Equilibrium

Figure 9: An Expanded Circular Flow

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