Chapter 8 The Classical Long-Run Model Part 1 CHAPTER 1

Economic Policy 2 Normative and Positive economics.  Government borrowing increases interest rates  The government role should be expanded in the economy

Economic Policy 3 Interesting and important question: - Does government spending financed by borrowing improve the economy’s performance or make things worse? This has been debated for a long time, most recently with the ARRA of Its possible for both sides to be right. It depends on long-run vs. short-run impact.

Economic Policy 4 Do the benefits of sort run impact out weight cost associated with long-run impact? We need to understand how the economy operates in the short-run and the long-run Chapter 8 addresses the long-run, presenting the long-run classical model Chapter 10 begins the presentation of the short-run model

The Classical Long-Run Model Macroeconomic model that explains the long-run behavior of the economy. We are talking about potential GDP. Look back at figures 4 and 5 in chapter 6 and the following slide. Developed by economists in the 19th and early 20th centuries The argued that market forces drive the economy toward full employment, possibly quickly. 5

Actual and Potential Real GDP, 1980– Macroeconomics is concerned about both the trend and fluctuations around the trend. Potential Real GDP Actual Real GDP

Macroeconomic Models Where are we Today Classical model –Has proven more useful in explaining the long-run trend itself Decades Keynes’s ideas and further development help us understand economic fluctuations Movements in output around its long-run trend Quarter to quarter and year to year 7

The Long-Run Classical Model Critical assumption about how the world works: Markets clear! The price in every market will adjust until quantity supplied and quantity demanded are equal A reasonable assumption if trying to explain behavior of the economy over decades 8

The Long-Run Classical Model We use the classical model to answer the following questions about the economy in the long-run: – How is the level of full employment determined? – How much output will we produce at full employment? – What is the role of total spending in the economy? – What happens when things change? 9

How Much Output Will We Produce? Firms use resources (land, labor, capital and ______ )to make the goods and services that people demand We’ll focus on labor and the labor market. We assume: –Firms are already using the available quantities of the other resources –Aggregate all the different types of labor into a single variable, labor 10

Start With The Labor Market Labor Supply and Demand Households ( you and I ) supply labor Firms demand labor Graph Horizontal axis: number of workers Vertical axis: real hourly wage rate Real wage (we measure all variables in real terms) Measured in the dollars of some base year The amount of goods that workers can buy with an hour’s earnings 11

The Labor Market Labor supply curve Shows how many people will want to work at various real wage rates Slopes upward As the real wage increases, more and more individuals decide they are better off working than hanging around the pool and not working. 12

The Labor Market Labor demand curve Shows how many workers firms will want to hire at various real wage rates Downward sloping Firms maximize profits. As the wage rate decreases, each firm in the economy will find to maximize profit, it should employ more workers than before When all firms behave this way together a decrease in the wage rate will increase the quantity of labor demanded in the economy 13

The equilibrium wage rate of $25 per hour is determined at point E, where the upward- sloping labor supply curve crosses the downward-sloping labor demand curve. At any other wage, an excess demand or excess supply of labor will cause an adjustment back to equilibrium. Labor Market Equilibrium 14 Number of Workers Real Hourly Wage LDLD LSLS E $ million = Full Employment Excess Supply of Labor Excess Demand for Labor J H B A

The Labor Market Equilibrium Equilibrium full employment Market clears In the Classical Model the economy achieves full employment on its own [Side Note: Keynes questioned this. How can you have 25% unemployment and assume the labor market “clears”.] 15

From Employment to Output Assumptions Quantities of other resources are fixed Technology is fixed Aggregate production function How much total output the economy can produce with different quantities of labor when quantities of all other resources and technology are held constant 16

Y output Aggregate Production Function L labor

Output Determination in the Classical Model 18 Number of Workers Real Hourly Wage LDLD LSLS $ million In the labor market, the demand and supply curves intersect to determine employment of 150 million workers. Number of Workers Total Output (Real GDP) 150 million The production function shows that those 150 million workers can produce $10 trillion of real GDP. The is full employment potential GDP. Aggregate Production Function $10 Trillion =Full Employment Output

From Employment to Output Equilibrium real GDP –In the classical long-run view the economy tends towards its potential full employment level of output on its own. –Later in the course we refer to this as the “self-correcting” mechanism. 19

The Other Side of the Market The Role of Spending Total spending in a very simple economy, we assume: – Households Spend all income on domestic output (no imports) No saving – Domestic business firms – No Government, no taxes – No exports or imports With these assumptions, total spending must be equal to total output 20

An economy producing total output of $10 trillion will, by definition, creates $10 trillion in total income (factor payments). If households spend all of this income on consumption goods, then total spending will equal $10 trillion as well. Total Spending in a Simple Economy 21

The Role of Spending Say’s law (J.B. Say,1821) By producing goods and services (i.e., supply) firms create a total demand for goods and services equal to what they have produced Supply creates its own demand Full-employment can be maintained 22

Total Spending in a More Realistic Economy Assumptions – Still a closed economy (no imports or exports) – But now have government Collects taxes and purchases goods and services –Households save Households no longer spend their entire income on consumption. Some is saved and they pay taxes –Business firms Purchase capital goods (investment spending) 23

Actual and Potential Output (GDP)$10 trillion From the production function Total Income (Y)$10 trillion Y = output = GDP Consumption Spending (C)$7 trillion Households don’t spend all of their income Planned Investment Spending ( I p ) $1 trillion Business planned investment Government Purchases (G)$2 trillion Net Taxes (T)$1.25 trillion Disposable income (Y – T)$8.75 trillion Total income (Y) less taxes (T) Household Saving (S)$1.75 trillionY - T - C Example: Flows in the Economy of Classica,

Important definition! Planned investment spending ( I P ) I P = Business planned purchases of plant and equipment Total actual investment ( I ) = I P +Δ inventories Δ inventories are treated as unplanned investment and can be positive or negative 25

A few more definitions Net Taxes (T) -Total government tax revenue minus government transfer payments Disposable income – household income minus net taxes (Y – T) – after tax income 26

Household Saving (S) in our More Realistic Economy Household saving ( S ) - portion of after-tax income that households do not spend on consumption S = Disposable Income – C S = ( Y - T - C ) Household saving in Classica S = ( Y - T - C ) = $10 - $ $7 = $

Total Spending in a More Realistic Economy Total spending in Classica – Sum of the purchases made by Household sector (C) Business sector (I P ) Government sector (G) We assumed no exports or imports Total spending = C + I P + G = $7 + $1 + $2 = $10 28