ECONOMICS: Principles and Applications 3e HALL & LIEBERMAN © 2005 Thomson Business and Professional Publishing Slides by: John & Pamela Hall The Classical Long-Run Model

2 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

3 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

4 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

5 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

6 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

7 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?

8 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?

9 Figure 1: The Labor Market

10 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

11 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?

12 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

13 Figure 2: Output Determination in the Classical Model

14 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

15 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

16 Figure 3: The Circular Flow

17 Total Spending in a Very Simple Economy Say’s Law named after classical economist Jean Baptiste Say ( ), 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

18 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

19 Some New Macroeconomic Variables Planned investment spending (I P ) over a period of time is total investment spending (I) minus change in inventories over the period –I P = 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 (I P ), and government sector (G) Total spending = C + I P + G

20 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 (I P ) 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

21 Figure 4: Leakages and Injections

22 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

23 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

24 Figure 5: Supply of Household Loanable Funds

25 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

26 Figure 6: Business Demand for Loanable Funds

27 Figure 7: The Demand for Funds

28 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?

29 Figure 8: Loanable Funds Market Equilibrium

30 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 = I P + (G – T) Rearranging this equation by moving T to left side –Loanable funds market clears  S + T = I P + 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

31 Figure 9: An Expanded Circular Flow

32 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

33 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

34 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

35 Figure 10: Crowding Out With An Initial Budget Deficit

36 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

37 Figure 11: Crowding Out With An Initial Budget Surplus